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For an estate that will likely incur taxes upon the death of the grantor, lifetime gifts may provide certain tax advantages over death-time transfers of wealth. Although the following advantages may be enhanced by the use of valuation minimizing devices (such as grantor retained income trusts “GRITS,” family limited partnerships, fractional interest discounts, etc.), this article seeks only to illuminate some of the advantages associated with outright gifts of property. How the Gift Tax and the Estate Tax Interact Some of the most overlooked tax advantages associated with lifetime transfers of wealth derive from how the gift tax and the estate tax interact. For instance, when computing the estate tax at death, the amount of taxable gifts made by the decedent during life is added to the tax base in computing his taxable estate. Gift taxes that had been paid are then offset against the estate tax payable on death. The practical effect of adding the value of gifts back into the estate and then crediting the estate for gift taxes previously paid, is to limit the grantor’s ability to affect his marginal estate tax rate by making intervivos transfers of wealth. As a result, one cannot gift property from a fifteen million dollar estate and then expect to be taxed at a seven million dollar estate tax rate. Tax Inclusive Transfers v. Tax Exclusive Transfers However, despite the inclusion of gifts in determining a decedent’s estate tax liability, it is often preferable from a tax perspective to make gifts during lifetime rather than upon death. One key difference between the gift tax and the estate tax is that the former is imposed on a tax-exclusive basis whereas the latter is imposed on a tax-inclusive basis. Generally speaking, an inclusive tax is imposed on the total amount of the transfer (part of which goes to the gift’s recipient and part of which goes to the government). In contrast, an exclusive tax is levied only on that amount actually transferred to the gift’s beneficiary. To clarify the difference between inclusive taxes and exclusive taxes, consider the following hypotheticals: Lester, a businessman with a gross estate of ten million dollars dies in 2008. Applying Lester’s unified credit (simplistically speaking, equivalent to a two million dollar exemption) and an estate tax rate of forty-five percent (45%), Lester’s estate tax liability is four million, four hundred forty thousand, eight hundred dollars ($4,440,800). For readers who are mathematically inclined, see the chart below[1]:
In contrast, consider Bob, another businessman. Bob’s gross estate also totals ten million dollars ($10,000,000). However, unlike Lester, Bob made gifts totaling two million, five hundred thousand dollars ($2,500,000) back in 2004. Also in 2004, Bob paid a gift tax of one million, twenty thousand, eight hundred dollars ($1,020,800), taking into account the maximum tax rate of 48% in that year coupled with the annual exclusion of twelve thousand dollars ($12,000) for gifts made to a single donee in a single year.
At death in 2008, Bob’s taxable estate is only six million, four hundred seventy-nine thousand, two hundred dollars ($6,479,200) (less gifts given and gift taxes paid). Applying Bob’s unified credit (simplistically speaking, equivalent to a two million dollar exemption) and an estate tax rate of forty-five percent, Bob’s estate tax liability is two million, one hundred seventy-nine thousand, eight hundred forty dollars ($2,179,840). Whereas Lester paid three million, six hundred sixty thousand dollars ($3,660,000) in estate and gift taxes, Bob paid only three million, two hundred thousand, six hundred forty thousand (3,200,640) in estate and gift taxes. Thus, Bob had a tax savings of four hundred fifty-nine thousand, three hundred sixty dollars ($459,360)! The Value of Assets As seen above in the Lester/Bob dichotomy, the tax savings inherent in making gifts can be sizable. However, lifetime transfers of wealth have additional advantages over death-time transfers. One such advantage is evident where an asset appreciates over time. At death, the taxable estate is determined based upon the value of the assets held by the decedent. However, when previously made gifts are added back into the gross estate, those gifts are valued as of the date the transfer was made. For instance, where Bob gifts a single family home located in Pacific Beach (valued at four hundred thousand dollars) in 1998, only the 1998 value of the home is taken into account at Bob’s death in 2008. The tax savings associated with rapidly appreciating assets can thus be huge. The Pacific Beach home referenced above could be worth millions in 2008. With tax rates of at least 45%, these options simply must be considered. In addition, it should be noted that the Internal Revenue Service may only attempt to challenge a gift's valuation for a certain statutory period.[2] Shifting Income to the Beneficiaries One often overlooked benefit to gifting property is the ability to shift income generated by income producing property (such as a rental unit) to a beneficiary with a lower marginal income tax rate. For example, suppose Bob owns an apartment building that generates forty thousand dollars ($40,000) in income per year. Bob, a wealthy individual must pay income tax on that forty thousand dollars at a rate of 35%. However, if Bob were to gift the apartment complex to his son Benny, whose marginal income tax rate is only 18%, a substantial yearly tax savings might be realized in addition to the estate and gift tax savings outlined above. Caveats Although the aforementioned tax saving opportunities are available to most donors, some important caveats must be mentioned. The following caveats outline some of the situations where some or all of the savings associated with gift giving are lost. When the Donor dies within three years of making the gift Where the donor of property dies within three years of making a gift, the gift tax paid will also be included in the donor’s gross estate. As a result, the tax-inclusive/tax-exclusive savings described above will be lost in addition to the other advantages outlined above. Certain Transfers Included In The Gross Estate In addition to gifts made within three years of death, certain intervivos transfers will lose some of the tax benefits listed above. Such transfers include: transfers taking effect at death; gifts with possession or enjoyment retained; and, transfers with a retained power to alter, amend, revoke, or terminate. Unlike transfers within three years of death, the gift tax previously paid is not included in the taxable estate. Therefore, the tax-inclusive/tax-exclusive savings described above are not lost. However, the gifts will be valued at the time of transfer and the entire transfer, not merely the taxable portion, is included in the taxable estate (for instance, the twelve thousand dollar ($12,000) annual exclusion is inapplicable). The 2010 Exception and the 2011 Penalty Since the tax reform act of 2001, the estate tax rate and the unified credit for gifts have been in a state of flux. In the year 2010, the estate tax maximum rate will be zero percent (0%) and the gift tax rate will be thirty-five percent (35%). In 2011, however, the maximum estate tax rate will be fifty-five percent (55%) and the gift tax rate will also be fifty-five percent (55%). Given the wide fluctuation in rates in the coming years, it would be extremely advantageous to peer into that crystal ball which is the future. Unfortunately however, such insight is unavailable. Moreover, the likelihood that Congress may intervene prior to 2010 is high. Although we cannot predict the future, we can provide you with the most up-to-date information to help you make informed decisions regarding your estate plan. Conclusion The foregoing is a rough sketch of the considerations that should be evaluated when deciding whether or not to make intervivos transfers of wealth. This memorandum is in no way intended to be comprehensive. In addition, our office can suggest many other estate planning tools and techniques designed to help you limit your estate tax liability. These products include, but are in no way limited to, net gifts, installment contracts, gifts of remainders, gifts of income interests, family limited partnerships, and irrevocable live insurance trusts. In short, there is no one-size fits all fix to estate and gift tax liability. The best solution is a personal solution. Only by consulting a qualified, top-notch estate planner who is willing to review your personal assets and holdings while attentive to your goals, concerns, and needs can you obtain the best possible estate plan. We here at Doheny Law look forward to working with you to create the best possible estate plan – yours! [1] The tentative estate tax is arrived at using information provided by the internal revenue code. [2] See, Internal Revenue Code 2001(f), 6501. For More Information Contact: |
