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Thursday, May 26, 2011

Deathbed Transfers in New Jersey

Often times, a person who is on his or her deathbed will make gifts to family members in an effort to reduce the potential taxes owed.

For transfers to anyone other than a charity, making gifts in a way that minimizes taxes is actually a very complex process. In deciding whether to make a gift, you must consider the amount of the gift, the type of asset you wish to transfer, to whom it is going to and the basis in the gifted item.

Taxes That Must be Considered When Making Gifts

There are generally six taxes that might be triggered as result of the gift. These include the New Jersey estate tax, the New Jersey inheritance tax, the federal estate tax, the federal gift tax, the capital gains tax and the generation skipping transfer (GST) tax.

I discuss all of these taxes in more detail elsewhere, but to quickly review the general purpose of each tax:
  1. The New Jersey estate tax is imposed by the state on transfers at death to the extent the decedent's net estate exceeds $675,000 and the money passes to someone other than a charity, surviving spouse, domestic partner or civil union partner.

  2. The New Jersey inheritance tax is also a tax imposed on transfers at death. However, the inheritance tax is based more upon who the money is going to rather than the amount involved. New Jersey does offer a dollar for dollar credit against its estate tax for any inheritance tax paid.

  3. The federal estate tax is imposed by the federal government on transfers at death to the extent the decedent's estate exceeds $5,000,000 and the money passes to someone other than a charity or a surviving spouse.

  4. The federal gift tax is imposed by the federal government on transfers during a person's lifetime to the extent the person's lifetime gifts exceed $5,000,000 and the money is transferred to someone other than a charity or a spouse.

  5. The generation skipping transfer tax (also known as the GST Tax) is generally assessed by the federal government on transfers during life or at death to a person's grandchildren, or more remote descendants to the extent such transfers exceed $5,000,000.

  6. The capital gains tax imposed on the sale of appreciated property, stock or similar assets.
As you may have noticed, only four of the six taxes named above are directly attributable to a transfer being made as the result of someone dying. The reason that a lifetime gift can be taxed at the donor's death is because New Jersey and the federal government have lookback provisions. Lookback provisions basically say that if you make a certain kind of transfer, the government can tax it at your death even if you gave the money away during your life. As you can imagine, this creates a host of problems including finding a way to pay for the tax.

What is a Deathbed Gift?

New Jersey defines deathbed gifts as gifts made in contemplation of death (N.J.S.A. 54:34-1(c)). People usually know the deathbed gift rule as the three year lookback rule because gifts made within three years of death are presumed to be in contemplation of death. If a gift is made in contemplation of death, and the gift was over $500, then New Jersey asserts it was really a transfer at death subject to the inheritance tax.

For New Jersey tax purposes, this particular three year rule ONLY appears under the NJ inheritance tax statutes. There is a very different rule for the New Jersey estate tax because the New Jersey estate tax generally follows the federal estate tax for determining what is taxable and what is not taxable. I will discuss this in more detail below.

Since gifts made in contemplation of death are subject to an inheritance tax, and the inheritance tax only applies for transfers to certain beneficiaries, it is important to know how New Jersey classifies the beneficiaries of the gift.

Determining the Class of the Beneficiary

To determine if a lifetime gift will result in a New Jersey inheritance tax, the first thing that you must do is differentiate between gifts made to Class A beneficiaries, Class C beneficiaries and Class D beneficiaries.

Class A beneficiaries include the decedent's spouse, civil union partner, domestic partner, all lineal descendants (such as children, grandchildren and great-grandchildren), all lineal ascendants (such as parents, grandparents and great-grandparents) and step-children. An adopted child, grandchild or great-grandchild is also considered a lineal descendant. Transfers to Class A beneficiaries are exempt from the NJ inheritance tax, meaning there is no inheritance tax on deathbed gifts or transfers at death to such individuals.
Class C beneficiaries include the decedent's brother or sister and son-in-law or daughter-in-law of the decedent even if the decedent's child is also deceased. Class D beneficiaries includes everyone else (most notably nieces and nephews).

If the gift is made to a Class C Beneficiary, and the gift was over $25,000, there definitely will be a NJ inheritance tax if the gift was made "in contemplation of death". If the gift was made more than 3 years prior to the decedent passing, it will not be subject to a NJ inheritance tax.

If the gift is made to a Class D Beneficiary, and the gift was over $500, there definitely will be a NJ inheritance tax if the gift was made in contemplation of death. If the gift was made more than 3 years prior to the decedent passing, it will not be subject to a NJ inheritance tax.

If the deathbed gift is subject to the New Jersey inheritance tax, there will be a tax due of 11-16% of the transferred amount. There is an 11-16% tax on transfers to Class C beneficiaries on the gifted amount in excess of $25,000 and a 15-16% tax on the entire transfer to Class D beneficiaries if the gift is in excess of $500. The more that is transferred, the higher the rate will be.

As an example, assume I owned $5,000,000, and I gifted away $1,000,000 to my nieces and nephews four years ago, $3,500,000 to my nieces and nephews this year and then died within three years, leaving the remaining $500,000 to my two siblings. The $1,000,000 gift to my nieces and nephews would not be subject to a New Jersey inheritance tax because it was longer than three years ago. The first $700,000 of the $3,500,000 deathbed gift to my nieces and nephews would be taxed at a 15% inheritance tax rate ($105,000). The remaining $2,800,000 would be taxed at a 16% inheritance tax rate ($448,000). For the transfers to my siblings, $50,000 will pass free of taxes, and the remaining $450,000 will be taxed at an 11% inheritance tax rate ($49,500). In total, there will be a $602,500 NJ inheritance tax.

For gifts to charity in any amount and gifts of less than $500 to any person, there is an easy answer - it is not subject to an inheritance tax in New Jersey.
Regardless of what classification a beneficiary is in, there MAY BE a New Jersey estate tax and/or federal estate tax if the gift is subject to a three year lookback under the federal estate tax rules or a lifetime lookback if the gifted items are in excess of the annual exclusion amount.

Certain Transfers are Automatically Subject to a Three Year Lookback for Estate Tax Purposes

Under Section 2035 of the Internal Revenue Code there is a limited three year lookback that most significantly applies to life insurance policies transferred within three years of death.
A. Life Insurance: If you learn nothing else from this post, make sure you learn this:
  1. If a decedent OWNS a life insurance policy insuring his or her own life, the entire death benefit is subject to both the New Jersey estate tax AND the federal estate tax. Many people assume life insurance proceeds are tax free. While this is true for income tax, it is not true for estate tax. The only relief is if the beneficiary is a charity, a surviving spouse, a civil union partner or domestic partner because then the estate may be entitled to a deduction;

  2. If the decedent transferred OWNERSHIP of the policy on his life to another party within three years of death, the 2035 rule kicks in and it is considered a taxable deathbed gift.
B. You should also be aware that the Section 2035 lookback rule also applies to certain interests in trusts and real estate. This does not affect most people, so I will not discuss them here.

Gifts in Excess of the Annual Exclusion Amount

Currently, each United States citizen and permanent resident alien can give away $13,000 to as many donees as he or she wishes. This is known as the federal annual exclusion amount or 2503(b) exclusion. Gifts in excess of the federal annual exclusion amount result in a "taxable gift". Usually there is no immediate out of pocket expense though because New Jersey does not have a gift tax and the federal government will only institute a gift tax if the sum of these gifts exceeds the lifetime exclusion amount (currently $5,000,000).

When calculating the New Jersey estate tax, we are required to look not just at what a person owned when he or she died, but also the taxable gifts that the decedent made over his or her lifetime.

In most situations, if the decedent's taxable estate, including prior taxable gifts, is in excess of the New Jersey estate tax exemption amount (currently $675,000), there will be a New Jersey estate tax. However, there is a big difference in the tax depending upon whether the decedent died with estate over the $675,000 threshhold or died with an estate under the $675,000 threshhold, but is deemed to have an estate in excess of $675,000 due to the lookback provisions.

As an example, assume I owned $5,000,000, and I gifted away $4,500,000 to my daughters and then died in 2012 as a widower, leaving the remaining $500,000 in my estate to my children. Normally, there would be no estate tax on a New Jersey estate of only $500,000, but we must add back the prior gifts. Even adding back the prior taxable gifts, it would only produce a $10,000 NJ estate tax. (To learn how this is calculated, you will need to prepare a 2001 Form 706 federal estate tax return and a New Jersey estate tax return. I will discuss this in future post, entitled "Deathbed Transfers in New Jersey - Advanced")

To realize the benefit of making this gift, you should know that if I had died with the entire $5,000,000, my estate would have to pay a $391,600 New Jersey estate tax. In years past, nobody would give away more than a $1,000,000 because that was the old lifetime gift limit for federal gift tax purposes. Any gifts above $1,000,000 were taxed at a very high gift tax rate. However, with a $5,000,000 lifetime federal gifting limit and no New Jersey gift tax, there is ample opportunity for planning to avoid or drastically reduce the New Jersey estate tax.

You should also be aware that if you do make a gift in excess of the annual exclusion amount, you should file a federal gift tax return (Form 706). If a lifetime transfer is in excess of the federal annual exclusion amount, it could lead to a federal estate tax or a federal gift tax at some future time. To minimize this possibility, you should try to structure gifts over longer periods of time and for an amount equal to or less than the annual exclusion amount. To read more about this, see my article entitled: Federal Estate and Gift Taxation of Deathbed Gifts.

The Importance of Knowing the Basis of the Gifted Item

It is important to know the basis of the property that is being gifted. If the donor is gifting cash, the basis is exactly the amount of the gift. If the donor is gifting property or stock, it may be unwise to make the deathbed gift because there could be substantial built-in capital gains.

When property is gifted away, the donee usually takes the property with a basis equal to that of the donor's basis. (For more on basis, see my post on Understanding Basis.) If the donor keeps property until his or her death, the recepient will receive the property with a new basis equal to the fair market value of that property on the date of the death. This is often referred to as a step-up in basis rule, although in this economy it may be a step-down in basis.

Let's assume I give away a real estate property worth $4,500,000 to my daughters shortly before I die to save on the New Jersey estate tax. If my basis in the property was only $1,000,000, the kids will take the property with that same basis. If my kids sell it immediately after I die for $4,500,000, there will be a 15% capital gains tax on the $3,500,000 of built in gain. This will produce a federal capital gains tax of $525,000 and probably a New Jersey income tax of $315,000. As discussed above, the New Jersey estate tax would have only been $391,600 if I had held onto the property.

Due to the carryover basis rule, it is usually best not to give away appreciated property during life. It is usually better to pay a smaller estate or inheritance tax than to risk losing the step-up in basis on the decedent's death.

Summary

In summary, large deathbed gifts are not necessarily going to be taxed after the donor passes. Whether there will be a New Jersey tax on a deathbed gift is based upon whether the transaction has occurred in the last three years, to whom the item is being gifted, the type of asset being gifted and on the size of the donor's net estate after factoring in prior gifts.

When all is said and done, even if there is a New Jersey tax (estate or inheritance), large gifts made to Class A beneficiaries prior to death and large gifts made to Class C and D beneficiaries more than three years prior to death will greatly reduce the overall estate and inheritance tax liability unless the donor is making a gift of a highly appreciated asset.

Simple, right?

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I want to give a special thank you to Martin Bearg, Esq., Rekha Rao, Esq., Rebecca Esmi, Esq., and to individuals at the New Jersey Transfer Inheritance Tax Branch (who wish to remain anonymous) for taking the time to speak with me about this and helping me to gather my thoughts.

20 comments:

Anonymous said...

"Class C beneficiaries include the decedent's brother or sister and son-in-law or daughter-in-law of the decedent if the decedent's child is also deceased".

In your article it sounds like a son-in-law or daughter-in-law are Class C beneficiears ONLY if the decendent's children are deceased. But son-in-law and daughter-in-law are Class C dependents...period.

Thanks

Great article

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous of 11/13/14,

Thanks for the constructive feedback. I corrected the article.

Paul said...

Thanks for all the posts in your bLAWg. One question coming to mind in the implementation of this strategy is as follows: A NJ parent has a joint account with an adult child of theirs. The funds in the account are the parent's. Can the child make gifts from the joint account for the parent (for convenience)? This could take place by using a check signed by the child or an online transfer from the child's online access to the account. IRS form 709 will be submitted showing the gift coming from the parent.

Kevin A. Pollock, J.D., LL.M. said...

Dear Paul,

A who book could probably written about this topic. There is a major difference between the legality of what someone does, the tax implications of what someone does, and the mechanics of whether something can be done.

Just because a parent puts another person's name on an account does not mean that it gives the other person the right to take the money. Technically it is about the intent of the person who funded the account.

As a practical matter, once you put someone else on the account, from a mechanical perspective, the new person can then drain the account (via check, wire or otherwise). Depending upon the intent of the person who funded this account, this could be seen as a gift or fraud.

So I recommend establishing a clear understanding of the purpose of the joint account, especially if there are other relatives and especially if "gifts" will not be made equally.

Paul said...

Thanks for your response. I can see where things could get very complicated. In this particular case the gifts would be made equally to those people mentioned in the Will. The intent is to reduce NJ Estate taxes and at the same time to abide by the wishes of the parent as stated in the Will.

Anonymous said...

Thank you for this informative and helpful article. I would like to know are financial assets co-owned by a father and daughter treated for New Jersey Estate Tax purposes, assuming no Federal Estate Tax Return or New Jersey Inheritance Tax Return has to be filed? The father has contributed all the funds to the account over a period of years and no funds have yet to be withdrawn. If these deposits occurred with the past three years, does the father just report 50% of the assets on his return or 100%? If contributions to the account were made more than three years ago, could these be considered a gift to the daughter and not be included in the father's estate return?

In reference to the filing of a New Jersey Estate Tax return when a federal estate tax return is not required, using the Form 706 method to take advantage of a gifting program, are annual exclusion gifts treated the same as lifetime exemption gifts? Are annual exclusion gifts included in Line 6 - Adjusted Taxable Gifts if they were given within the past three years? More than three years ago? Are lifetime taxable gifts always included in Line 6?

Finally, are annual exclusion gifts to a grandchild's 529 plan owned by the daughter considered a gift to the beneficiary or the owner?

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous of 3/14,

If assets are owned by a father and daughter, the federal government and NJ treat it the same way - whoever dies first must include the entirety of the joint asset in his/her estate UNLESS they can prove that the other person paid for it. So, in your situation, father is still alive and no money has been withdrawn, therefore there is no complete gift. If daughter withdraws the money, that is what completes the gift and starts the look-back period.

Annual exclusion gifts are NOT treated the same as lifetime exemption gifts because they do NOT reduce your lifetime exemption. That is often the biggest reason to use the Column B method instead of the column A method.

As far as I am aware, gifts to a 529 are considered gifts to the beneficiary.

Anonymous said...

Thank you for clarifying these issues. Do I understand correctly that annual exclusion are not included in Line 6 - Adjusted taxable gift on Form 706, even if they were within the previous three year period? Or only if it has been more than three years?
Sincere thanks for your help.

Abby Moller said...

If the father and daughter are joint owners on an account, can't the daughter (with the father's permission since it was his money) move the money into a separate account in her name only to get the money out of his estate for NJ estate tax purposes? Since the daughter is a Class A beneficiary, the transfer wouldn't be subjected to the three year look back for NJ inheritance tax purposes, and for NJ estate tax purposes, there is no 3 year look back. Correct?

Kevin A. Pollock, J.D., LL.M. said...

Abby,

A gift is not complete in this scenario until the daughter withdraws money from the account for NJ and federal estate tax purposes. Accordingly, the lookback (3 year or forever depending upon whether you use Column A method or Column B method), does not apply.

You are technically correct that the 3 year lookback is primarily for the inheritance tax, but the NJ division of tax also uses a 3 year lookback on the NJ estate tax return for all gifts made within three years of death if you choose the Column A method for filing the NJ Estate Tax Return. While the column B method is a forever lookback, it does not count smaller gifts (the annual exclusion amount or smaller). So the answer can be quite tricky!

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous of 3/22,

You are correct that on line 6b you do not included annual exclusion gifts because they are not taxable gifts. It does not matter when the annual exclusion gifts where made. This is why if a person made an annual exclusion gift within 3 years of dying it is better to use Column B than Column A.

Anonymous said...

Got it. Thank you for being so generous with your knowledge and time

Anonymous said...

One last point. If lifetime exemption gifts have been given, it is better to use the Column B method for the three years following to reduce that amount NJ Estate due, compared to the Column A method? Three years after a lifetime exemption gift has been given, it is better to use Column A, assuming all other factors are equal. If, after this three year period, assuming no other gifting, if an estate is below 675K, then no NJ Estate tax would be due.

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous of 3/31/16,

Generally your analysis is correct. Keep in mind though that technically the Column A method is simplified method that the NJ Division of Taxation and Column B is the true method for calculating the taxes. So it is possible that NJ can come back later and say that you can't use the Column A method. (From experience, I have had them tell me there is a tax on estate, for which there was none, but the amount was so small it would have cost more in legal fees to challenge than to pay the darn fee.)

Anonymous said...

Did you ever write your "Deathbed Transfers in New Jersey - Advanced" article? I am having trouble figuring out how the estate tax is different in situations where its the look back amount that puts you over the $675,000 cap.

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous of 4/5,

I know, I know. I'll try to get around to the Advanced Article. What I can promise you though is that if you run the numbers on the 2001 706 and plug them in on column B, you'll see how it works. It's just very difficult to explain verbally which is why I haven't gotten around to writing the article.

Stephen said...

For the purposes of a New Jersey Estate Tax Return, if a father and daughter are co-owners of real estate, but the daughter neither contributed funds for the purchase nor for any monthly condo payments or maintenance, does the father own 100% of the asset, or just 50%. Is this similar to the previous example of the joint ownership of a bank account where only the father contributed funds? Thank you for considering this question to help clarify the situation.

Kevin A. Pollock, J.D., LL.M. said...

Dear Stephen,

I don't think I have every truly pointed out that there is a massive difference between joint tenants and joint tenants with rights of survivorship. I probably need to write a post on that.

If a real estate is owned with rights of survivorship, under section 2040 of the Internal revenue code, the whole thing is presumed to be owned by the parent unless the child can prove otherwise. On the other hand, let's say that dad gifted 50% of the real estate to child (or even 95%) and they did not own it as rights of survivorship, then only what dad kept would be included in his taxable estate at death.

As discussed in my post on NJ Deathbed gifting, http://willstrustsestates.blogspot.com/2011/04/deathbed-transfers-in-new-jersey.html , the gift of whatever dad made can be looked at when calculated the NJ estate tax return depending upon when dad dies and how much he has left.

To make things more complicated, let's say that dad and child own property with rights of survivorship. If dad gives up survivorship rights, then under Section 2035 of the Code, dad has to survive for 3 years otherwise it is deemed included in his estate.

The reason I point to the federal IRS rules is because NJ follows the federal rules on what is includible.

Like I said. This topic requires a complete post.

Sandy Pan said...

Hi, thanks for your article. It's extremely useful. I have one question, hope you can help me out here. Not sure if my previous comment went through. Mother made a gift of a house worth $200k to Daughter one year prior to death with cost of $100k. Daughter's basis will be $100k plus any gift tax paid by Mother. Since mother died within 3 years of the gift, assuming FMV of house on date of death is $200k, the $200k plus the gift tax paid will be included in the gross estate. What is the basis of Daughter on the house? Will it be the "carry over" basis of $100k plus gift taxes or the "step up" basis of $200k on date of death?

Kevin A. Pollock, J.D., LL.M. said...

Dear Sandy,

Sorry for the slow reply - somehow this got filtered into a Spam box. Most likely mom did not actually pay any gift tax. She may have allocated some of her exemption to the transfer - if that is the case, the basis in the hands of daughter is simply the $100K. If Mom actually paid any gift tax, it will be the $100K plus actual gift tax paid. She does not receive a step up in basis unless Mom owned it at the time of her death.

As a side note, it does not matter that mom died within 3 years of death for this type of transaction. You would get the same result if she had died 50 years later or 1 year later. The federal tax rules apply here to determine a change in basis. The fact that there may be a NJ tax does not change the basis.