From the December 2008 issue of Investment Advisor • Subscribe!

Now or Then?

Should your wealthy clients gift to heirs now, or from their estates? A guide to help you decide

When the wealthy make plans to transition assets to their heirs, they must consider whether it is better to gift during their lifetime or transfer the assets at death. The estate and gift tax schedules were merged in 1976 and the estate tax calculation requires that all post 1976 gifts in excess of the annual exclusion (adjusted taxable gifts) be added back into the estate tax calculation. Then a credit is allowed for gift taxes paid on these gifts. While we won't address this specific issue we will cover some important information concerning the gross estate, the probate estate, the role of the executor, and how assets pass to heirs at death. Then we'll conclude with a discussion on lifetime gifting, specifically, the Grantor Retained Annuity Trust (GRAT).

Gross Estate

An individual's gross estate consists of everything they own and is defined in IRS Code Sec 2031(a) as follows:

The value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.

For determining the value of the gross estate, all assets are valued as of the date of death or the alternate valuation date (six months later). The alternate valuation date option is only available if using it will reduce the value of the gross estate and the net estate tax and generation skipping transfer (GST) taxes due. For instance, let's assume John dies on January 1 with a gross estate of $3 million, which includes his business valued at $1 million. Six months later his estate is worth $2.3 million due to a decline in the value of the business. Since this would also cause the net federal estate tax to decline, the alternate valuation date may be used instead of the value on the date of his death.

Probate and the Executor

The probate estate is the portion of the gross estate subject to the probate process. Probate is a public process, and in some states is very costly.

When an individual dies, their executor has a fiduciary responsibility to inventory and value all assets, pay all taxes and expenses, and distribute the remaining assets of the estate. As a fiduciary they can be held personally responsible if something goes awry. An executor's fees will vary but if they are also a beneficiary of the estate, such as a family member, they will often serve without a fee. If an estate tax is due, even if the executor is a family member, it may be advantageous to charge a fee since it is a deduction on the decedent's federal estate tax return. Fees received by an executor are also subject to income tax but, according to IRS Publication 559, the fee may not be subject to self-employment tax. Here's what it says:

All personal representatives must include in their gross income fees paid to them from an estate. If paid to a professional executor or administrator, self-employment tax also applies to such fees. For a nonprofessional executor or administrator (a person serving in such capacity in an isolated instance, such as a friend or relative of the decedent), self-employment tax only applies if a trade or business is included in the estate's assets, the executor actively participates in the business, and the fees are related to operation of the business.

So even though an executor must pay personal income tax on his fee, if he does not meet the "professional" test, there would be no self-employment tax due, resulting in a savings of 15.3%.

How Assets Pass to the Heirs of an Estate

Generally, assets will pass to a decedent's heirs by one of three methods. The first is by operation of law; next, is by contract; and the last is through the will. It's important to note that the first two methods take precedence over the will. For instance, if the IRA document listed the decedent's brother as beneficiary and the will listed the wife, the brother will get the asset. However, if this were a qualified retirement plan instead of an IRA, then the spouse would inherit unless she waived her right. If the IRA had no valid beneficiary listed then it would pass according to the provisions in the decedents will and would be subject to probate. Let's take a closer look at the three primary methods.

The operation of law method includes such things as titling of assets and is typically found in common law states. For instance, the house may be titled in both spouses names as Joint Tenants with Rights of Survivorship (JTWROS) or Tenants by the Entirety. An investment account may also be titled in the same manner. One spouse may decide to go out and purchase a summer home and title it in their name alone, in which case, 100% of it would be included in their estate. In the case of joint ownership the decedent's half will automatically pass to the survivor outside of probate.

Operation of law is not very common in community property states plus, if the asset is indeed community property, titling is irrelevant. So if a husband and wife live in a community property state and have a joint investment account which is titled as JTWROS it be will treated as community property even though it is titled otherwise. Currently, community property states include Arizona, California, Idaho, Louisiana, Nevada, Texas, Washington, and Wisconsin. Puerto Rico is also a community property regime and Alaska has an optional system.

The contract method includes beneficiary designations such as found in trusts documents, retirement plans, annuities, and life insurance. At the death of the owner, these assets will pass according to the beneficiary designation listed in the relevant document. This method is common to all 50 states.

Any assets which do not pass by one of the first two methods will generally be governed by the will or appropriate state law in the absence of a will. Basically, whatever passes through the will is subject to the probate process.

To Gift or Not To Gift

Should an individual make lifetime gifts or pass assets at death? If so, what assets should be given and what gifting technique should be utilized? The decision to gift can be very personal and is based on several factors. One key is the donors desire to help others. Another factor relates to tax implications. Other issues include the donor's expected estate tax liability and their need to retain assets. For instance, a client may have an estate tax liability but may choose not to make lifetime gifts because they need the assets to provide for their standard of living. To explain, let's assume the combined estate of both spouses is $8 million and all is community property so each spouse has an estate of $4 million. Further assume that they require $300,000 annually to maintain their lifestyle. Using a 4.0% safe withdrawal assumption, and excluding any other income sources such as Social Security, the amount of financial assets needed to provide for this is approximately $7.5 million ($300,000 / 4.0% = $7.5 million). If their estate was comprised of $7.5 million in financial assets and $500,000 in personal property (including their home), making substantial lifetime gifts could jeopardize their future. So the first step, assuming gifting is something a client desires, is to determine how much they will need to provide for their lifestyle. Then the individual must determine which assets are appropriate for gifting and to whom they want to give them.

Generally, an individual should not gift assets which are valued less than their income tax basis. In other words, if they bought a stock for $50.00 a share and it's now worth $40.00, they would have an unrealized tax loss. If they gift this, they would lose their ability to claim the loss. It would be better to sell the stock, claim the loss, and give away the cash. It's also better to gift assets which are expected to appreciate rapidly in the future. By doing so, the donor will remove the future appreciation from their estate and reduce their estate tax.

The recipient of a gift will either be a qualified charity or a non-charitable person or entity. If a donor gifts to a qualified charity, assuming it's done properly, she would receive some beneficial tax breaks. This tax relief would be realized in the areas of income and estate tax. However, if the gift is to a non-charitable recipient, such as a family member or friend, they'll need to be careful to avoid paying any unnecessary gift tax. We'll discuss this in greater detail in the section "Annual Gift Tax Exclusion" below.

A donor may give directly to an educational institution to pay tuition or to a medical care provider to pay medical expenses on behalf of someone without incurring a gift tax, estate tax, or GSTT liability. It's very important that the gift be made directly to the institution and not to the donee. If the gift is given to the donee, even if the donee uses the money to pay their tuition or medical bills, it may be subject to the federal gift tax. There is also an unlimited gift tax exemption between spouses as long as both are U.S. citizens.

Annual Gift Tax Exclusion

A donor can gift up to $12,000 each year to an unlimited number of recipients without incurring federal gift or federal GSTT. So if a father gave $12,000 to each of his three children and $12,000 to 10 nieces and nephews in the same year, he would not owe any gift tax. If his wife agreed to the same thing, then the amount given tax free would be doubled. When the gift is from both spouses it is referred to as gift splitting. To qualify for gift splitting, both spouses must be U.S. citizens and they must make the gift jointly. In community property states the rules vary slightly. In many community property states, one spouse cannot make a gift of community property without the prior written consent of the other spouse. Failure to do so may result in a voidable gift. In other words, the non-donor spouse may void the gift and it would be brought back into the community.

The Gift Tax Return

A gift tax return must be filed if the gift to any one donee exceeds the annual exclusion of $12,000 per year or if gift splitting is elected, no matter what the size of the gift. Even if the gift exceeds the annual exclusion, there may not be a gift tax due. This is because after the annual exclusion is exceeded, the lifetime gift tax exemption of $1 million is automatically apportioned. For example, a donor could give away $1,012,000 to one donee in a single year without incurring a federal gift tax. Again, this $1 million exemption is a lifetime exemption per donor. Once they fully utilize this, all future gifts exceeding the annual exclusion will be subject to the federal gift tax. There is also a three year statute of limitations for a gift tax return. The IRS cannot challenge a return older than this except in certain cases, such as if fraud is involved. The gift tax return is due by April 15 of the year following the year the gift was made. So for all taxable gifts made in calendar year 2008, a return is due by April 15, 2009. A six-month extension may be filed if necessary.

Gifting Strategies

There are a number of different gifting strategies depending on who is receiving the gift and what is gifted. If an individual gifts to a qualified charity, they could use an outright gift, a charitable trust, a private foundation, a bargain sale, a donor advised fund, a charitable gift annuity, or a pooled income fund. If the donee is a non charity such as a family member or friend, the donor might decide to make an outright gift or establish a trust. One such trust is called a GRAT or Grantor Retained Annuity Trust (see sidebar, page 56).

There is obviously much more to this discussion. Estate planning is, in all of it facets, a very dynamic area of practice. For those advisors interested in delving deeper, I would suggest spending some time at the IRS's Web site and reading some of their publications. I would also suggest printing out the estate tax form (Form 706), along with the instructions to learn how the tax is calculated. Because the estate tax laws are in a constant state of flux, continuing education is vital.

Reprints Discuss this story
This is where the comments go.