Tax-favored gift exemptions that give back — in any administration
With a president-elect Joe Biden heading to the White House, estate and gift tax exemptions could be on the chopping block next year. Even if nothing happens, these exemptions are slated to be halved after 2025.
The upshot: Wealthy clients wishing to make big gifts can save taxes by using the generous exemptions now.
The gift tax is only assessed on the amount of the gift received, but the estate tax is based on the full inheritance so even the funds used to pay the estate tax are themselves taxed.
For 2020, the estate and gift exemption is $11,580,000 per person ($23,160,000 per couple). The exemption can and should be used for lifetime gifts for wealthier clients who are more likely to be subject to a future estate tax.
Gifting saves taxes as opposed to leaving the same funds to beneficiaries at death.
Annual exclusion gifts do not even have to be reported and can be made to an unlimited number of people.
Plus, once the funds are gifted, the funds are not only removed from the estate, but so is any future income those funds might have earned or appreciation that could be subject to a larger estate tax later on. In addition, the gifts are not taxable to the recipients.
Tax-exempt gifting to reduce estate values
The first level of gifting should focus on tax-exempt gifting. There are three tiers of tax-free gifting:
1. Annual exclusion gifts
These are always tax exempt.
These gifts are limited to $15,000 per person, per year and can be made to anyone for any reason. They do not reduce the gift/estate exemption, either. They do not even have to be reported and can be made to an unlimited number of people.
A married couple can join forces in gift-splitting, which does have to be reported on a gift tax return (see Form 709) and thereby doubles the annual amount to $30,000.
Any unused exclusion amount is lost. There is no carryover to a future year.
2. Tuition and medical: Direct gifts to providers
This provision is one of the biggest wealth transfer loopholes in the tax code and most people don’t take advantage of it.
These gifts are always tax exempt and can be made in unlimited amounts for an unlimited number of people if the gifts are paid directly to the institutions providing the education and medical services and not to the person for whom these gifts are intended.
Like annual exclusion gifts, these direct-to-provider gifts do not reduce the gift/estate exemption amount. These direct gifts, too, do not have to be reported anywhere.
One caveat here, though, is that tuition gifts can reduce financial aid eligibility, but this is generally not an issue for wealthy clients looking to trim their estate.
3. Lifetime gift/estate exemption
This one-time exemption — $11,580,000 in 2020 — can and should be used for still-living wealthy clients looking to transfer assets and reduce their estate now, before the exemption may be reduced. If the exemption is used now, in conjunction with lifetime gifts, and this exemption is reduced in future years, the IRS has ruled that any part of the higher exemption amount already used (gifted) will not be clawed back. Simply put, the IRS is saying “use it or lose it.”
These transfers are tax-exempt up to the lifetime limit, plus this exemption is portable to a surviving spouse.
For example, if one spouse leaves everything to the surviving spouse (and has not used any of the exemption during their life), then the surviving spouse now can use both spouses’ exemptions, doubling the amount available for 2020 to $23,160,000. That portability add-on is called the deceased spouse’s unused exemption or DSUE.
The exemption is portable for both estate and gift taxes, but not for generation-skipping transfer taxes, which is another reason for spouses to each use their GST exemption with lifetime gifts, to avoid the deceased spouse’s GST exemption being lost after death.
The same is true for the few states that have their own estate tax. Most of these states do not have state portability, so using the state exemption at the first death can lock-in that spouse’s state estate tax exemption to make sure it is not lost.
Although it sounds counterintuitive, clients with larger estates should look ino saving taxes by making taxable gifts. Yes, paying federal gift tax now may save a bundle in future estate taxes.
The federal gift and estate tax rate is 40% once the estate exceeds the exemption amount.
Can it pay to pay this tax? Yes. Once the gift/estate exemption is used up, it’s still worthwhile to make taxable gifts since they save taxes as opposed to leaving the same funds or property at death to beneficiaries. This obviously applies to clients with larger estates where an estate tax would be due.
The gift tax advantage
Assuming the gift exemption has been used up, taxable gifts will be less expensive because the gift tax is tax exclusive as opposed to the estate tax, which is tax inclusive.
The gift tax is only assessed on the amount of the gift received, but the estate tax is based on the full inheritance so even the funds used to pay the estate tax are themselves taxed. It’s a tax-on-tax scenario that can be avoided with lifetime gifts. The tax benefit for lifetime gifting is the tax on the gift tax or 40% of the gift tax.
You’ll need to show clients the math on this so here is a simple example:
1. If the federal exemption has been used up
Gift tax on a $1 million gift is $400,000 ($1 million x 40% = $400,000)
The beneficiary receives $1 million and IRS receives $400,000 so the total cash outlay is $1.4 million to make a $1 million gift.
If the client decides not to make the gift and instead leaves the same $1.4 million to the beneficiary at death, there will be an estate tax on the full $1.4 million of $560,000 ($1.4 million x 40% = $560,000). The beneficiary will only net $840,000 (the $1.4 million less the $560,000 of estate tax = $840,000). The beneficiary receives $160,000 less by inheriting than if the funds were gifted.
That $160,000 additional tax is the 40% tax on the $400,000 gift tax.
2. The tax savings formula
Use this formula to show the client the math on the gift tax advantage:
Let’s say the parent has $1 million to give (including the tax). How much will the actual gift be and how much will the 40% gift tax be?
The cash available divided by 1 + the tax rate = the amount of the taxable gift.
Cash available / 1+ 40% = the taxable gift amount
$1 million / 1.40 = $714,286
The taxable gift amount is $714, 286 and the gift tax on that amount is $285,714 ($714,286 x 40% = $285,714). The total cash outlay was $1 million (the gift of $714,286 plus the gift tax of $285,714 = $1 million).
If the same $1 million was instead left to the beneficiary at death, an additional $114,286 in tax would be paid (the gift tax of $285,714 x 40% = $114,286).
Here is the math on this:
Total estate is $1 million x 40% rate = an estate tax of $400,000, as compared to the gift tax (if the gifting was done instead) of $285,714 = a difference of $114,286. Once again, the extra tax is based on the gift tax itself being taxed (285,714 x 40% = $114,286).
These are the results on a $1 million gift. The tax savings on a $10 million gift (as opposed to the estate tax route) would be 10x higher or $1,142,857 (the $2,857,143 x 40% = $1,142,857).
The president-elect's pledge to repeal President Trump‘s tax cuts as soon as he is inaugurated may be stymied for the foreseeable future.
Regardless of who wins the White House, the scope for tax legislation in the near term will be limited.
If the donor dies within three years of making the gift, the gift advantage is lost and the amount of the gift tax paid is added back to the estate. That would eliminate the gifting tax benefit.
When not to make lifetime gifts
These examples deal with cash gifts. If gifting property other than cash, for example stocks and real estate, it’s generally not advisable to gift highly appreciated assets that would otherwise receive a step-up in basis. That type of property is better left to beneficiaries at death so that the step-up will eliminate the income tax on any appreciation during the client’s lifetime. If the property has decreased in value, then it’s best to sell the property, claim a loss (or use the loss to offset capital gains) and then gift the proceeds.
Step-up disallowance — one-year rule
A donor cannot make a gift to a dying person (a spouse, for example) and then have that person leave the funds to back to the donor to receive a step-up in basis.
Per IRS Code Section 1014(e), if the dying recipient (the spouse) dies within one year of receiving the gift, the step-up would be lost. The donor who inherits the property will pick up the deceased person’s basis. However, one way around this would be to have the dying spouse leave the property to someone else, like a child or grandchild who would receive the step-up.
Client concerns with gifting
While gifting certainly has all the above tax advantages, advisors need to address client concerns.
Even very wealthy clients who can afford to make large gifts can have reservations, for personal non-tax reasons.
Control issues: Gifting means the funds can no longer be controlled. That might not sit well with some clients. They lose the use of the funds during their lifetime. Once the funds are gifted, they are gone. Some clients may worry about giving up funds they feel they might need later.
If there are strings attached, the transfer might not qualify as a gift and be brought back into the estate.
Beneficiary concerns: Once the gift is made, the grandchild, child or other gift recipient owns the funds and they could be squandered. The funds might also be exposed to potential loss through poor money management, divorce, bankruptcy or to creditors or financial predators. Trusts can be set up for this, but the gift must still qualify as a completed gift — irrevocable.
Targeted gifting can reduce client fears about how the funds will be spent.
Direct gifts for tuition or medical expenses, as described above, might help quell clients’ concerns and reassure them that their gifts are used as intended. In addition to e education or medical bills, gifts can also be used to pay the taxes on Roth conversions, pay off student loan debt or help buy a home or business.
No tax deduction
There is no tax deduction for gifts made to family members or other non-charitable beneficiaries. However, gifting does remove the property from the estate, and a gift is not taxable to the recipient.
Paying tax upfront
Some people just cannot get past paying a gift tax now, even though the math shows the tax savings, and even though a larger tax might be paid later as an estate tax (and that estate tax might be much higher if the estate exemption is decreased by future tax laws – very likely at this point!).
Advisors have plenty to talk about coming into the season of giving.