Academic journal article Boston College Law Review

Toward a Reality-Based Estate Tax

Academic journal article Boston College Law Review

Toward a Reality-Based Estate Tax

Article excerpt

INTRODUCTION

This Article proposes reforming the estate tax by eliminating devices and distortions that have crept into the estate tax and frustrated its goal. The present focus in reforming the estate tax is to make the current estate tax a reality-based tax. This means that the estate tax should encompass testamentary property transfers at their real values, and the marital and charitable deductions should reflect actual marital and charitable transfers.

The biggest sources of unreality and distortion include omitting certain common testamentary transfers, allowing valuation games to defeat the impact of transfer taxes, and skewing the major benefits of certain deductions away from their purported beneficiaries. Therefore, Part I of this Article focuses on the problems associated with testamentary transfers, specifically involving life insurance, will substitutes, and retained powers.1 Part II proposes alternative methods of valuation to prevent gaming of transfer taxes.2 Part III proposes that certain deduction provisions be either repealed or changed.3

I. TESTAMENTARY TRANSFERS

Because of the many benefits associated with gift-giving, such as the annual exclusion, as well as the tax-exclusive nature of the gift tax, and the benefit of value freezing,4 Congress has historically tried to prevent inherently testamentary transfers from receiving those tax advantages.5 Those measures have failed to ensure that some of those inherently testamentary transfers are included in the decedent's estate at their date of death values, either because of case law or inadequate safeguards in the statutes. Thus, section A of this Part proposes changes to the taxation of life insurance proceeds.6 Section B proposes an amendment to § 2036.7 Section C addresses the consequences of eliminating certain powers from inclusion in a decedent's estate.8

A. Life Insurance on Decedent's Life Indirectly Funded by Decedent

In trying to grapple with the issue of inherently testamentary property, Congress and the courts have developed estate tax laws that have become counterproductive. A prime example of this consequence is that the proceeds of life insurance on decedent's life, paid for with decedent's funds, are rarely taxed in decedent's estate. With a common estate-planning device most of those life insurance proceeds are in fact exempt. This is because of the interplay of a couple of estate tax statutes9 and because of changes made to the insurance inclusion statute.10

Currently, inclusion in decedent's estate is the subject of gaming through the creation of an irrevocable life insurance trust ("ILIT").11 Literally, under the estate tax statute, because the decedent never owned any of the incidents of ownership in the policy, because the trust-although empowered to-does not have to purchase life insurance on the decedent's life, and because the insurance proceeds do not pass to the estate, the life insurance proceeds in an ILIT are not taxed in the decedent's estate.12 Further, through the use of another fiction referred to as Crummey powers,13 the decedent's lifetime transfers to the ILIT, which are made in order to pay the life insurance premiums, are further minimized for gift tax purposes.14 Thus today, informed taxpayers create an ILIT, designate the beneficiaries of the trust-basically, the beneficiaries of the insurance proceeds-and are the source of premium payments. By means of an ILIT, the taxpayer effectively and legally evades estate taxes.

The current approach to life insurance is the result of years of legislative change. The 1939 Internal Revenue Code ("I.R.C.") contained a premium payment test that required that any portion of the proceeds from life insurance policies on the decedent's life purchased directly or indirectly in premiums paid by the decedent were includible in decedent's estate.15 Ex plaining the reaction to this provision, the Joint Committee on Internal Revenue Taxation stated that many taxpayers considered this provision to be unfair where owners transfer all of the incidents of ownership in the policy during their lifetimes. …

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