Whether or not to give substantial lifetime gifts in 2011 and 2012 is going to be a hot topic between now and the end of 2012. But deciding whether to take advantage of the record high ($5 million) gift, estate and GST tax exclusion amount and low (35%) transfer tax rate isn’t a trivial matter.
Even your most tax savvy clients are going to need help deciding whether to take advantage of the new law.
The problem is that the new law—which was put into place by the Tax Reform Act of 2010—is scheduled to lapse on January 1, 2013. So is it worth taking the risk that Congress will radically change transfer tax laws for years post-2012? And what will happen to your clients’ transfer tax liability if Congress does change the law?
Keep in the mind that the following discussion is heavily premised on a number of assumptions. No one can predict how Congress will act tomorrow, let alone in two years. We are no exception. Any discussion with your clients about 2011/2012 gifts must be conducted with the understanding that it’s a process of weighing the risks and rewards of making gifts now rather than waiting for Congress to act.
Gifts in 2011 & 2012
Gifts made in 2011 and 2012 can be offset by a $5 million exclusion from gift taxation. In other words, a taxpayer can make a $5 million gift in 2011 or 2012 without being subject to the gift tax. This is the highest the exclusion amount has ever climbed, and there’s a good chance it’ll be reduced when Congress reconsiders the estate and gift taxes in 2012.
What kind of assets are ideal candidates for a 2011/2012 gift?
The best assets to gift in 2011 or 2012 are those that: (1) are unneeded by the grantor, (2) have a good chance of appreciating between the time of the gift and death, and (3) that “heirs won’t just go out and liquidate.”
Your clients shouldn’t gift income producing assets that they need or may need at some point. Better candidates for gifting would be a business interest or “depressed real estate holdings.” Life insurance is also a great candidate for gifting during the duration of the current estate, gift, and GST taxes.
Life insurance owned by a person at death will be included in the decedent’s gross estate; and if the policy is a high-value policy, it could explode the value of the estate and its tax liability, dramatically decreasing the value of property that’s passed to beneficiaries. But if the policy is gifted during the insured’s lifetime, the policy will be removed from the gross estate and its death benefit can pass to beneficiaries without any tax.
What if Congress changes the exclusion amount and transfer tax rate?
Although lifetime gifts may make sense if you’re working under the assumption that the estate tax remains the same between now and your client’s date of death, there’s a very good chance that Congress will change the law.
Where would that leave your clients who made lifetime gifts? Answering that question requires us to
delve into a brief discussion of the way lifetime gifts are treated on a decedent’s estate tax return. Note that the following discussion makes a number of simplifying assumptions. The actual estate tax liability calculation is far more complicated.
Lifetime gifts are added back into a decedent’s estate for purposes of calculating the size of the estate. Then, a “tentative estate tax” is computed on the estate—including lifetime gifts. That tentative estate tax is then reduced by gift tax on lifetime gifts. This step ensures that the gifted property isn’t subject to double taxation—once when gift tax is paid on the gift and again when the gift is added back into the estate.
The way that the tentative estate tax is reduced by lifetime gifts changed with the Tax Reform Act. Prior to the Act, the tentative estate tax was reduced by the amount of estate tax that would have been paid had the gift been made (as a lifetime gift) in the year of death but using the exclusion amount that was actually in effect at the date of the gift. That kept the estate from being taxed to the extent the gift tax rate increased between the date of the gift and the date of death.
Example of the tentative estate tax computation
For example, if a person made a $5 million taxable gift at a time when the gift tax was 45% and the exclusion amount was $3.5 million (paying $675,000 in gift tax after utilizing the full exclusion amount), and dies when the gift tax exclusion amount is $5 million and the gift tax rate is 35%, the tentative estate tax would be reduced by gift tax that would have been paid had the exclusion amount in effect at the time of the gift were in place ($3.5 million) and the rate at the time of death (35%) were in effect. This results in the tentative estate tax being reduced by $525,000. But that amount is less than the amount of gift tax actually paid, $675,000. As a result, if the old law were kept in place, the decedent’s estate would have been taxed an additional $150,000 on the decedent’s lifetime gifts.
But under the new law, the tentative estate tax will be reduced by the exclusion amount ($3.5 million) and tax rate (45%) applicable at the time the gift was made. Under this calculation, the tentative estate tax will be reduced by the full $675,000 [($5 million - $3.5 million) x 45%]. This results in the estate avoiding any additional estate tax on the lifetime gifts.
How the new estate tax calculation affects 2011/2012 gifts
As illustrated by the example provided in the previous section, changes in the estate tax could reduce the utility of a gift by causing the decedent’s estate tax to be increased by some percentage of lifetime taxable gifts. For instance, if the calculations under the Tax Relief Act are kept in place (the tentative estate tax is reduced by the amount of gift tax that would have been paid at the time of death and not the amount of gift tax actually paid), but the gift tax rate and exclusion amount are reduced, the decedent could end up paying estate tax on lifetime gifts that were already taxed under the gift tax regime.
This fact could cause the savviest of your clients to ask: Should I wait to make lifetime gifts until Congress gets the transfer tax situation worked out?
Why 2011/2012 Gifts Make Sense Regardless of What Congress Does with the Estate, Gift & GST Taxes
Answering the question of whether to make gifts in 2011/2012 or to wait until Congress sorts out the transfer tax comes to down to pure speculation. For your more conservative clients, it’s a question of what the worst case scenario would be for the estate, gift and GST taxes.
What’s the worst case scenario if a lifetime gift is made instead of leaving property in the estate?
Within reason, perhaps the worst case scenario would be for the Congress to keep the new tentative
estate tax calculation provisions in place while increasing the exclusion amount—to, for instance, $6,000,000—and lowering the estate tax rate—to 25%, for example. In that case, a $10 million gift made when the exclusion amount was $5 million and the gift tax rate was 35% would have resulted in gift tax liability of $1.75 million at the time of the gift. If the grantor dies when the estate tax rate is 25% and the exclusion amount is $6,000,000, the tentative estate tax would be reduced by only $1 million [($10 million - $6 million) x 25%] to account for the lifetime gift, even though the gift tax paid at the time of the gift was $1.75 million. As a result, $750,000 of the $10 million lifetime gift will be subject to estate tax at the time of death—a kind of double tax.
But even if this unlikely worst case scenario comes to pass, what’s the alternative? If the decedent kept the $10 million in her or his estate until death, the estate tax on the amount would come to $1 million [($10 million - $6 million) x 25%]. In the case of the prior gift, the decedent would have paid $1.75 million in gift tax at the time of the gift and then would have been taxed an additional $187,500 ($750,000 x 25%) on the gift in the estate. The total transfer tax in that case would be $1,937,500—almost double the tax the decedent would have paid had she or he kept the “gift” until death and paid the estate tax on the amount.
Does this worst case scenario mean that gifts in 2011/2012 are too risky?
The tentative answer—again, fueled entirely by speculation—is that the worst case scenario (an increase in the exclusion amount and a decrease in the tax rate) is unlikely. The Republicans were able to push the Tax Relief Act compromise through Congress only because they agreed to limit its duration to two years. It’s hard to imagine Congress agreeing to a further increase in the exclusion amount and a decrease in the tax rate when they reconsider the issue in 2012.
And even if the exclusion amount is increased and the tax rate is decreased in the future, there’s still the fact that a lifetime gift removes the gift from the estate and allows it to appreciate without the appreciation being taxed in the older generation’s estate. So even if the transfer tax paid on the gift is doubled by making the lifetime gift in the worst case scenario, if the value of the gifted property doubles between the time of the gift and the decedent’s death—which isn’t an unlikely scenario if 20 years elapse between the gift and the grantor’s death—the net transfer tax paid on the gift will be about the same in both scenarios.
What’s the likely consequence if a lifetime gift is made instead of leaving the property in the estate?
Although the worst case scenario described above could result in more transfer tax liability for the grantor, the worst case scenarios is fairly unlikely. So what’s the net result if a lifetime gift is made and the more likely scenario plays out in Congress? What if the estate tax remains the same or the exclusion amount decreases and the rate increases?
If Congress extends the current transfer tax regime ($5 million exclusion, 35% rate), and the grantor dies while the estate tax is still in operation at current amounts and rates, the lifetime gift will not increase transfer tax liability. And if the tax rate is increased or the exclusion amount is decreased, the grantor’s estate tax liability will not be increased by the lifetime gift.
The next two years offer your clients an unprecedented opportunity to gift their assets to the next generations while incurring minimal transfer tax liability. Most of your clients will be unaware of this opportunity, and this article can be used as a framework for running through the calculus of 2011/2012 gifts with them. But even if they decide that lifetime gifts are not for them, they’ll be impressed with your knowledge and ability to help them manage their financial futures.
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See also The Law Professor's blog at AdvisorFYI.