From the June 2006 issue of Wealth Manager Web • Subscribe!

'While the Givings Good

They say it's better to give than to receive. And if a client's goal is to minimize overall taxes while transferring assets to future generations, it may be better to do the giving while living. Experts say that transferring assets to the next generation during the client's lifetime is generally the most effective strategy for minimizing overall taxes paid. Taking full advantage of both the $1 million gift tax exclusion and $12,000 annual exclusion is, of course, part of the reason for the advantages of lifetime giving. However, making taxable gifts rather than bequeathing often still makes more sense from a tax perspective, says Ralph Anderson, head of the wealth management group at Weiser LLP, a CPA firm headquartered in NYC.

Gifting can be more efficient than making a bequest because of the inherent structures of the taxes. The estate tax is an inclusive tax. If an estate has $10 million above the estate tax exemption, the entire $10 million is subject to federal estate taxes, even the amounts that are eventually used to pay the estate taxes. That is, the estate will pay taxes on the entire $10 million, including the monies used to pay the taxes. On the other hand, gift taxes are tax-exclusive, meaning that taxes are not paid on the monies used to pay the taxes.

For example, suppose a client has $100,000 which he can part with in 2006, and that client would pay 46 percent in either gift or estate taxes. The client has already given the maximum amount he could to his son tax-free for the year, and has already used up the gift tax exemption. If the client makes a taxable gift, the client could give his son approximately $68,500 and pay $31,500 in taxes. Taxes are only paid on the $68,500 transferred to the son. Thus, on a net transfer of $100,000 the effective tax rate is 31.5 percent.

If, however, the client retained the $100,000 until death, taxes would be owed on the full $100,000 or $46,000. The effective tax rate is 46 percent. Thus, the gift tax, with its tax-exclusive calculation generates a 14.5 percent tax discount. Furthermore, as a gift, the $100,000 would be removed from the client's estate, so no taxes are paid on any of the appreciation of the stock from the time of transfer until the time the client dies. If the $100,000 gift was a gift of stock which appreciated to $150,000 prior to the client's death, that $50,000 appreciation was removed from the client's estate and not subject to estate or gift taxation says Dan Yu, senior manager in the personal wealth advisory practice at Eisner LLP, a 350-person accounting and tax services firm in New York.

James R. Robinson, an associate in the private wealth group of Atlanta law firm Arnall Golden Gregory LLP, , presents a further illustration: Suppose a client makes a $1 million taxable gift to a child that is taxed at $46 percent. The gift tax on the transfer is $460,000. This would mean that a total of $1,460,000 is out of the client's taxable estate, and the transferee gets the appreciation on the $1 million without having to pay additional transfer taxes. If the transferor waited until death, however, taxes would be owed on $1,460,000 not $1 million, says Robinson. Assuming the decedent died in 2006, the tax owed would be $671,600, or $211,600 more than if the money were transferred prior to death.

For family businesses, gifting away parts of the business during the owner's lifetime can generate additional tax savings. If a client owns 100 percent of a business, that 100 percent is valued significantly higher--and exacts more taxes on that business at the client's death-- than if the business were broken up and gifted to children during his lifetime. Minority interests in a closely held business are discounted for gift tax purposes. For example, assume the client owns a business valued at $9 million and has three children. By giving each child a 33.3 percent ownership stake during his lifetime, the value of the gift each child receives is not $3 million, but is discounted at least 10 to 15 percent because it is considered a minority interest. Whereas, if the client dies owning the 100 percent interest, the full value of the $9 million is included in his estate.

In addition to federal estate and gift taxes, other taxes also need to be taken into account when analyzing whether it is better to gift assets away during a client's lifetime. For example, while most states have transfer taxes upon death, very few have transfer taxes on gifts made during someone's lifetime. These state transfer taxes can add another potential 16 percent to the cost of waiting until death to give assets to the next generation. So, if clients live in a state with a death transfer tax, but no taxes on lifetime transfers, those additional tax savings should be explained to them.

Capital gains taxes also must be taken into account. If an appreciated asset is transferred, says Robinson, the impact of capital gains needs to be analyzed. If there are potentially large capital gains, he says it may be better to wait until death to transfer.. When an asset with an appreciated value is gifted tax-free, the transferor's basis in that asset is assumed by the transferee. If gift taxes are paid on the transfer of an appreciated asset, then there is a step up in basis to the extent of the gift taxes paid, not to exceed the fair market value of the asset.

For example, assume a client bought stock for $60,000 which has appreciated to $100,000 when it is transferred to the transferee. If no gift taxes are paid, the basis for that stock remains at $60,000. If the transferee sells the stock, he would owe capital gains taxes on $40,000. If, however, the stock was transferred after the client's death, the beneficiary is entitled to a stepped-up basis of $100,000. Should the beneficiary sell the stock [for $100,000], he would owe no capital gains taxes. Thus, if an asset has appreciated substantially, it might be wise to hold that asset until death to take advantage of the estate tax exemption and receive the stepped-up basis.

On the other hand, Yu points out that in some tax years there may actually be further advantages of transferring appreciated stock. If stock is transferred to a low income individual, such as a grandchild in college who is unemployed, further tax savings can be reaped. In 2008, says Yu, there will be a 0 percent capital gains rate on taxpayers who are in the 10 percent or 15 percent tax brackets. If stock with a low basis is transferred to a child or grandchild with no or low income, and the stock is sold in 2008, capital gains taxes may be avoided altogether, he explains.

For example, says Yu, this year Johnny's grandparents can give him stock with a fair market value of $24,000 which they bought for $10,000. Johnny holds the stock for two years, selling it stock in 2008. If at that time Johnny has no other income and is over the age of 14, not only are transfer taxes avoided, but so are capital gains on the appreciated value of the stock.

The moral of the story is to do a complete analysis of all potential tax implications. However, such an analysis is complicated. Estate and capital gains taxes are now "moving targets," says Yu, and if a client were to die in 2010 there will be no estate taxes, but assets transferred on death will have a carryover, not a step-up, in basis.

The caveat is, of course, is that the client should have enough money to give away, says Robinson. Advisors must insure that clients have excess funds--more than enough to meet their lifetime needs, agrees Yu. And, of course, you want to leave enough assets in the estate to take full advantage of the estate tax exemptions, adds Anderson. Clients should also have sufficient assets to utilize the tax-free transfer of up to $12,000 annually per transferee, says Yu, and keep enough funds in reserve to do so.

Despite the advantages, convincing clients to make large lifetime gifts is usually problematic. "Nobody likes pre-paying taxes to the IRS, even when there are advantages to it," says Robinson. Clients believe it's always better to defer payment of taxes, so convincing them that it may be better to pay earlier could be a hard sell. "There's an emotional resistance to pre-paying taxes, particularly in light of the discussions to repeal the estate taxes. Many clients also argue that the money that will go to pay taxes represents lost opportunities," Robinson adds.

But client resistance can be overcome. Once the numbers demonstrating actual savings are run, Robinson says many clients find the argument to gift is compelling. Explaining sophisticated planning strategies such as Grantor Retained Annuity Trusts (GRATS) or family limited partnerships, also works to break down client resistance.

Robinson also likes to point out that with average life expectancies now in the high 70s to early 80s, if clients wait until death, their children will be in their 50s or 60s before they inherit. The greatest need for extra income, however, usually occurs during the late 20s or early 30s when children are buying homes and starting families, so transferring assets to children at this point in time makes sense, he says.

However, no matter the advantages, there will always be some clients who will not gift assets during their lifetime for any reason. Some, says Robinson, prefer to do nothing and let their children receive less overall. "I'm not in the business of selling anything," says Robinson. "It's my job to help clients achieve their goals, and part of that job is also to explain the consequences of not doing anything."

For many clients it's the loss of control that stops them from making gifts, says Anderson. There will always be clients who want to keep everything in their name, and whatever is left after they die is what the children get, he says. At times, says Anderson, he has been able to overcome this attitude with clients, but he always does it carefully and tries to respect the client's opinion. "I just try to convince them why it's better for them," he says.

Anderson recently convinced one client--after 15 years--to finally make gifts to his children. The client, now 68, has more than $30 million in liquid assets and two children. But this client, explains Anderson, did not want to lose control over his assets and always claimed he would die owning everything. Occasionally, he would make gifts up to the annual gift tax exclusion and had given up part of the unified credit, but had never given away anything significant. "I just kept talking to him about it," says Anderson, and discussing the advantages. Finally, last year the client gifted away approximately $6.5 million in real estate and low value stock that had been hard hit."

Elayne Robertson Demby, JD, is a frequent contributor to Wealth Manager and the author of The RIA's Compliance Solution Book.

Summary of Capital Gains Rates Fluctuations:

Prior to the 2003 Tax Act, assets held for longer than one year were taxed at a maximum net capital gains rate of 20percent, with taxpayers in the 10 percent or 15 percent tax brackets being taxed at a 10 percent rate. Assets held for more than five years were taxed at the rate of 18 percent or 8 percent for taxpayers in the 10 percent or 15 percent tax brackets.

After 2003, the maximum net capital gains tax for assets held for longer than one year was lowered to 15 percent. The rate was 5 percent for taxpayers in the 10 percent or 15 percent brackets. Then, for the year 2008 only, the top capital gains rate for taxpayers in the 10 percent or 15 percent tax bracket is lowered from 5 percent to 0.

After 2008, the pre-2003 capital gains rates go back into effect.

Summary of the Gift Tax Rules:

Under the gift tax rules, donors can gift up to $12,000 annually per donee in addition to $1,000,000 tax free. For example, in year one, a parent can give each child $12,000 plus $1,000,000 tax free. In year two and thereafter the client can give each child an additional $12,000 tax free. Gift taxes are only paid on gifts that exceed the $12,000 annual exclusion. So, if in year three, the parent gave each child $12,000 plus an additional $1,000,000, the gift tax is levied only on the $1,000,000 gift.

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