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.