Under the tax act which passed in December of 2010, the federal estate tax exemption was set at $5 million* per client ($10 million for a husband and wife). Unlike the prior law, the exemption is structured to allow utilization of the entire exemption during life or at death. For instance, if no taxable gifts are made during life; there is a $5 million exemption at death. Likewise, a $3 million gift can be made during life without gift tax, leaving a $2 million exemption to be used at death.
Some practitioners are concerned that Congress, under pressure to address deficits, may roll back the $5 million exemption. It is impossible to know what Congress will do. Regardless, for high net worth clients, using the $5 million exemption today rather than saving it to use it at death may represent an excellent estate planning alternative.
Assume Jill has an estate substantially in excess of $5 million. Jill is 65 years of age and has a life expectancy of 20 years. Making a large gift today and using the exemption removes all of the appreciation of the gifted property out of Jill’s estate. If the $5 million is not gifted, but grows at an annual return of only 3 ½%, then 20 years from now the $5 million will have nearly doubled to $10 million. Death taxes in excess of $2 million will be imposed on the appreciation. With no gift, all appreciation will be included in Jill’s estate. If Jill makes the gift today, the gifted assets will be taken into consideration at her death as a prior gift. However, the value will be frozen at $5 million. The entire $5 million in appreciation will be excluded from Jill’s estate. Federal estate tax savings exceeding $1,750,000 are possible.
Even if the property only grows at a 2% rate, nearly $2.5 million is removed from the estate over a 20 year period. If the property should grow at an 8% rate, over $18 million is removed from the estate. Death taxes at approximately 40% are avoided.
A major consideration before gifting is who to gift to and how. The assets can be gifted outright to children and/or grandchildren, or in trusts for children and/or grandchildren. Consider also the possibility of a gift in trust for a spouse for life and then for children for life and grandchildren. This is often called generation skipping planning. Consider the following example.
Husband, whose estate is substantial, establishes a trust for the benefit of his wife for life. Wife is to receive income from the trust. Principal may be distributed to wife for her reasonable health, support, care and to maintain her accustomed manner of living. Wife can be the Trustee.
At wife’s death, the assets are distributed to the children and/or grandchildren as wife may direct. Absent wife’s decision to the contrary, following the death of the wife the assets are held for the children for life and ultimately pass to the grandchildren.
From a federal gift tax standpoint, if the gift is less than $5 million in 2012 (assuming no prior taxable gifts), there are no federal gift taxes to pay when the gift is made. The assets are held in trust for wife for life. The assets pass death tax free at wife’s death to the children. In the alternative, the assets can be held in trust for the children for life and ultimately pass estate tax free again upon each child’s death to each child’s children.
State Gift Tax Issues
As of 2014, neither Arkansas, Kentucky, Indiana, Mississippi or Tennessee have a tax on gifts.
Some estate planners are concerned that Congress will act in the future to reduce the exemption to an amount less than $5 million. Accordingly, many practitioners are suggesting that we use the exemption now in order to avoid loss of the exemption later. There is some risk in this action in that if Congress modifies the law, we do not know how they will modify it. However, it is highly unlikely that Congress would come back and retroactively impose gift tax where none had been previously applicable. There are a number of court cases that prohibit retroactive application of tax law.
The type of gift outlined in this article does not appeal to every client. However, for high net worth clients, it is a technique that should at least be considered as a part of the estate planning process.
Cynthia J. Tobin
*Note – Inflation adjustments for 2014 bring the 2014 gift/estate exemption to $5,340,000. A $5 million exemption is used here for convenience purposes.