Gift and Estate Planning

July 25, 2016

Whenever you transfer assets to another person, whether during your lifetime or at death, there are potential federal and state tax consequences. Good financial planning can help minimize taxes and also help you better accomplish your gifting objectives. Although most households will not face Gift and Estate Tax due to the current high Applicable Exclusion Amount (explained below), high net worth families are well served to understand the available strategies and plan accordingly.

There are three types of transfer taxes:

• Gift Tax
• Estate Tax
• Generation-Skipping Tax

Taxes on estates and gifts have been unified, meaning that the same tax rates (as well as tax credits) apply to both (the Gift and Estate Unified Rate Schedule can be found on the IRS web site). In other words, you will be subject to the same taxes whether you give away your property during your lifetime or wait to transfer it at your death. The highest marginal tax rate (for transfers above $1 million) is 40%. However, the current Applicable Credit Amount is $2,125,800, which means that the first $5,450,000 of taxable transfers is protected from taxation (this is called the Applicable Exclusion Amount).

It’s helpful to demonstrate by way of example. John B. Nevolent, a long-timer widower, made a $1 million taxable gift to his children in 2012. He filed a gift tax return that showed he owed no taxes because the Applicable Credit Amount was well above the calculated tax of $345,000. In 2014, he again made a $1 million gift to his children. This brought his cumulative lifetime taxable transfers to $2,000,000, with a calculated tax of $745,000. Note that in both instances, though he was required to file a Gift Tax return, no tax was due because the Applicable Credit Amount covered the calculated taxes. John died in 2016 with an estate valued at $10 million. The executor was required to add the prior two gifts to his taxable estate, bringing his tax base up to $12 million. The 2016 Applicable Credit Amount of $2,125,800 is sufficient to cover the first $5,450,000 of transfers ($2 million in lifetime gifts and $3,450,000 of assets transferred at death). Tax would be due on the remaining $6,550,000 of his tax base, resulting in federal estate taxes of $2,620,000 (at the 40% marginal tax rate).

Generation skipping tax (GST) is particularly onerous because all gifts or bequests to a relative two or more generations from the donor (most commonly a grandchild or great-grandchild), which are above the allowable lifetime Generation Skipping Tax exclusion ($5.45 million in 2016), are taxed at 40% in addition to the Gift Tax. This means that gifts/bequests to grandchildren above the exclusion amount are effectively taxed at 80% (40% Estate and Gift tax plus 40% Generation Skipping Tax)! Having a good grasp of the deductions that are available on certain types of transfers can reduce or defer the payment of taxes. Two common deductions which apply to both lifetime and death transfers are:

Charitable Deductions:

Transfers to qualified charities during life or at death receive a corresponding deduction and thus are removed from the computation of transfer tax. Charitable gifts do not count toward the lifetime Applicable Exclusion Amount of $5,450,000. It is important to note that while contributions to tax-exempt organizations are fully deductible from Estate and Gift tax, they are also partially deductible on income tax. For those who plan to donate to charities at some point, this provides a strong tax incentive for gifting to charities while alive.

Unlimited Marital Deduction:

Transfers of assets to a U.S. citizen spouse are non-taxable gifts: any amount can be transferred to a U.S. citizen spouse during lifetime or at death without triggering taxes (different rules apply to non-citizen spouses). The assets which remain in the spouse’s estate are taxed at the death of the surviving spouse, thus deferring taxation to the last spouse’s death.

A corollary of the Unlimited Marital Deduction is the portability of any unused lifetime Applicable Exclusion Amount. Going back to our example of John B. Nevolent, if John had left a surviving spouse to whom he bequeathed his entire estate, the $10 million estate would have passed to her tax-free and no estate taxes would have been paid at that time. In addition, because John had only gifted $2 million to his children during his lifetime, $3,450,000 of John’s unused lifetime Applicable Exclusion Amount would have been ported to his surviving spouse. Assuming she makes no further lifetime gifts, at her death she will receive a tax credit that offsets the tax on $8,900,000 of her estate ($5,450,000 for herself plus $3,450,000 of John’s unused amount). Assuming she died with $10 million in her estate, with the combined lifetime credits, her taxable estate is effectively reduced from $10 million to $1,100,000, resulting in only $385,800 of taxes (compared to the $2,620,000 that John’s estate would had been taxed if he was a long-time widower; unused Applicable Exclusion Amount did not become portable between spouses until 2011). If John’s surviving spouse was charitably-inclined and made a charitable bequest of $1,100,000, her estate would owe no taxes.

In addition to the unlimited marital deduction and the charitable gift deduction, there are three types of lifetime gifts that are excluded from taxation. Because they are not considered taxable gifts, they are not counted in the Applicable Exclusion Amount and do not result in either Estate and Gift Tax or Generation Skipping Tax. These three tools are very effective for transferring money out of an estate for the benefit of others, without taxation:

Annual Gift Tax Exclusion:

This allows for annual gifts up to a specified amount ($14,000 in 2016) for an unlimited number of recipients. For example, someone with four children and 12 grandchildren could give away $224,000 per year ($14,000 to 16 recipients) with no Gift or Generation Skipping Tax, removing those assets from the taxable estate. No gift tax return is filed for gifts up to the Annual Gift Tax Exclusion limit. Moreover, because married persons can split the gift, each using his/her Annual Gift Tax Exclusion, a married couple with four children and 12 grandchildren could transfer out $448,000 from their estate annually with no transfer tax consequences ($28,000 to 16 recipients)! (A gift tax return is required when splitting gifts, though no gift tax is owed). These gifts would never be counted in the estate.

Direct Payment of Tuition:

In addition to the Annual Gift Tax Exclusion above, direct payments of tuition are excluded from both Gift Tax and Generation Skipping Tax. Payment is limited to tuition, and payment must be made directly to the school. There is no limit as to the amount, and payment can be for anyone (not just relatives). No gift tax return is filed, and as a non-taxable gift, it is not added back to the donor’s estate at death. As an example, a grandparent who wishes to pay the tuition of each of six grandchildren, at an average tuition cost of $50,000, would be able to remove $300,000 (6 x $50,000) from his/her estate.

Direct Payment of Medical Care:

As with direct payments of tuition, direct payments of someone’s medical care (with payment made directly to the doctor or health care facility) are non-taxable gifts excluded from Gift Tax and Generation Skipping Tax. There is no limit to the amount and payment can be for anyone.

As demonstrated above, transferring assets out of an estate by way of non-taxable lifetime gifts is an excellent tool for reducing Estate and Gift Tax as well as Generation Skipping Tax.

Bottom line, for single persons with a net worth below $5,450,000, or for married couples with net worth below the combined Applicable Exclusion Amount of $10,900,000, planning to reduce or avoid transfer taxes is not a huge concern at this time. However, keep in mind that the Annual Exclusion Amount and Estate and Gift Tax Schedule can be changed by Congress at any time. For those with a net worth above these excludable limits, careful use of transfer techniques designed to reduce the taxable estate while avoiding transfer taxes is a compelling planning exercise. In a subsequent article, I’ll address the use of trusts and other transfer techniques to freeze the valuation of assets for transfer tax purposes.

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AUTHOR:

JULIA BUTLER, CFP®, JD, MBA, CFEI