To understand the loophole, it's important to understand the purpose of the gift tax itself. Contrary to what many realize, the primary purpose of the gift tax is not really just to tax gratuitous transfers of property from one person to another. Its real purpose is to provide a backstop to the estate tax, by providing a mechanism that prevents taxpayers from simply trying to dodge the estate tax by giving all their money away before they die.
For example, if someone with $3,000,000 is subject to an estate tax on all amounts above $1,000,000, the solution to avoid the estate tax is simple: give the $3,000,000 away before death. Or in point of fact, it's not even necessary to give away the entire $3 million; just give away $2,000,000, because the remaining assets will be protected by the $1 million estate tax exemption. On the other hand, if there's not only an estate tax on amounts above $1,000,000 bequeathed at death, but also a gift tax on amounts gratuitously transferred during life that also exceeds $1,000,000, it's a moot point; either it's taxed at death, or it's taxed when transferred during life, but either way it's taxed.
For Federal tax purposes, the gift tax exemption amount has remained at - or below - the estate tax exemption for the past decade. From 2002 to 2009, the estate tax exemption rose from $1 million to $3.5 million, while the Federal gift tax exemption remained at $1 million, thereby ensuring that individuals couldn't gift the excess assets above their estate exemption amount before they died. As numerous states decoupled from the Federal estate tax exemption during that time period and kept their own exemption amount (most commonly at $1 million), the Federal gift tax on gifts above $1 million continued to backstop the state estate tax on estates above $1 million. When the Federal estate tax was repealed in 2010, the gift tax exemption amount still remained at $1 million, both preventing taxpayers from jettisoning significant excess assets in contemplation of an estate tax that could return (as it did), and continuing to backstop the states that maintained a state estate tax.
However, this all changed with the Tax Relief Act of 2010, which increased both the Federal estate tax exemption and the gift tax exemption to $5 million for 2011 and 2012. Suddenly, a problem has emerged - the $5 million Federal gift tax no longer backstops a $1 million state estate tax exemption amount! Which means a client with $3,000,000 can once again dodge the state estate tax - just give away at least $2 million before death! The entire estate will be below the $5 million Federal estate tax exemption, the gift will be below the $5 million Federal gift tax exemption, and after the gift the estate will be below the $1 million state estate tax exemption. Poof, state estate taxes gone!
Some states seek to prevent this with so-called "gift-in-contemplation-of-death" rules, which stipulate that even in the absence of an overt gift tax, any gifts made in contemplation of death (i.e., on the client's deathbed, or within just a few years of death) may be drawn back into the estate for state estate tax purposes. But notably, not all states have such a rule; and even for states that do have an in-contemplation-of-death gifting rule, the provision itself varies from gifts within 3 years of death, to within 2 years of death, to within 1 year of death, and while some states draw any gifts made within the time window back into the estate for tax purposes, others only draw back gifts that were clearly made in contemplation of death (which means the gift can still avoid taxation if it can be shown that death wasn't anticipated at the time of gift).
There are 23 states that have some form of state estate or inheritance tax. But only 2 of them have a state gift tax, and only 7 others have some form of gifts-in-contemplation-of-death rules in the absence of a gift tax. For the remaining states, the door appears to be wide open... and for some of those 7 states, the door may still open if death is not necessarily imminent.