Advantages of making gifts during life, Pt. 2
By Connie Fontaine
The American College
Editor's note: This is the second article in a series on the advantages of making gifts during life. The first in the series is a discussion on motivations for lifetime giving other than for the purpose of obtaining tax savings and benefits.
Although some practitioners think there is a possibility Congress may enact new legislation to undo the 2010 estate and generation skipping tax repeal, this likelihood becomes increasingly remote as 2010 progresses. The federal gift tax provisions, however, are not repealed for 2010 and remain the same as in recent previous years.
A basic premise of the gift tax system allows a $1 million lifetime exemption for all donors. In other words, an individual can gift up to and including an aggregate of $1 million of taxable gifts during their lifetime and not have to write Uncle Sam a check for gift tax. With this in mind, some estate owners may surmise that if you hold onto property until your death — and if you die in 2010 — and if Congress does not promulgate new laws that retrospectively reinstates the estate tax in 2010, you could avoid transfer tax on the transferred property. Following this line of thinking may naturally lead many to question why, then, should you make gratuitous transfers during lifetime? The following discussion concerns some of the tax benefits achieved through inter vivos gifting.
At the top of the list is the gift tax annual exclusion. This exclusion permits an individual to give up to $13,000 (the amount for 2009, 2010 and 2011 as indexed for inflation) gift tax free every year to each of an unlimited number of donees. This means that in 2010, a father desiring to make a $13,000 gift to each of his four children and four grandchildren could give a total of $104,000 without gift tax liability.
Because an individual’s spouse can also make such gifts, up to $26,000 in 2010 of money or other property — multiplied by an unlimited number of donees — can be transferred gift tax free. In the example above, the donor and spouse together could give as much as $208,000 (2010) on a gift-tax-free basis. In fact, one spouse can make the entire gift if the other spouse consents. If the 709 gift tax return is filed noting the one spouse’s consent, the transaction will be treated for tax purposes as if both spouses made gifts. This is known as gift splitting. As previously mentioned, annual exclusion gifts can be made each and every year.
A second tax incentive for making an inter vivos gift, as opposed to a transfer at death by will or intestacy, is that if a gift is made more than three years prior to a decedent’s death, the amount of any gift tax paid on the transfer is not brought back into the computation of the gifting party’s gross estate.
Bringing the amount of gift tax paid back into a decedent’s gross estate for calculation of estate tax payable purposes can increase the amount of estate tax due. In the case of a sizable gift, avoidance of this so-called “gross-up rule” can result in meaningful tax savings.
In other words, the gross-up rule means that all gift tax paid on taxable gifts made within three years of the donor’s death is included in calculating the value of the gross estate, even though the value of the actual gift itself may not be added back into the decedent’s gross estate. For example, if a donor makes a $2 million taxable gift more than three years before the donor dies and the donor has not previously used his or her $1 million gift tax exemption, the gift tax paid on the value of the gift in excess of the exemption amount will not be brought back into the deceased person’s gross estate to compute the estate tax.
Third, when a gift is made during a lifetime, any appreciation accruing between the time of the gift and the date of the donor’s death escapes estate taxation. This may result in a considerable estate tax savings, as well as probate and state death tax savings.
For instance, if a mother gives her daughter stock worth $100,000 and the stock appreciates to a value of $600,000 by the date of the mother’s death five years later, only the $100,000 value of the stock, its value at the time it was gifted, enters into the mother’s estate tax computation as an adjusted taxable gift. The $500,000 of appreciation is not part of the computation and, consequently, does not increase the decedent-mother’s marginal estate tax bracket.
An excellent example illustrating this advantage is a gift of life insurance made more than three years before the insured’s death. By making this transfer, a substantial death benefit could be removed from a donor’s estate at the cost of only the gift tax, if any, on the value of the policy at the time of the transfer. In the case of a whole life policy, this is usually roughly equivalent to the policy cash value plus unearned premiums at the date of the gift. If the insured lives for more than three years after the transfer and the premiums are annual gift tax exclusion gift amounts or less per year, there is no estate tax inclusion. In addition, none of the appreciation (the difference between the death benefit payable and the adjusted taxable gift, if any, at the time the policy was transferred) becomes part of the insured’s estate tax computation.
Fourth, there may be strong income tax incentives for making an inter vivos gift. This advantage is derived from moving taxable income from a high income tax bracket donor to a lower-bracket recipient (donee). Of course, this advantage is limited by tax rules often referred to as the “kiddie tax rules” relating to the unearned income of certain children under age 19, or 24 for full-time students.
Fifth, gifts of the proper type of assets may enable a decedent’s estate to meet the mathematical tests required to qualify for specific Internal Revenue Code sections that provide tax advantages for estates that include small businesses.
Sixth, gift taxes do not have to actually be paid until the transferring individual makes cumulative taxable gifts in excess of the $1 million exemption amount. Once gifts are more than the $1 million exemption amount, taxes must be paid no later than April 15 of the year following the year in which the gift was made. The top gift tax rate for gifts exceeding $1 million is 35 percent in 2010.
Although there are numerous general reasons and advantages of making gifts during lifetime, the merits of making gratuitous transfers of property should be carefully evaluated for clients on a case by case basis.