“Are You Ready to Make a Gift? Top Ten Things to Consider”
On December 17, 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“2010 Act”). The 2010 Act increased the estate, gift, and generation-skipping (GST) transfer tax exemptions to $5,000,000 and reduced the estate/gift/GST tax rates to 35%. The gift tax exemption is now significantly larger than it has ever been and larger than it was ever expected to be. Below are ten things to consider in determining whether to make a gift to take advantage of the existing $5 million gift tax exemption. Keep in mind, in addition to the tax benefits, making a gift during your lifetime allows your children or other beneficiaries to benefit from the gift, and you will also benefit by seeing them enjoy it.
The $5 Million Gift Tax Exemption May Disappear Soon
This is the perfect time to consider making a gift. If you have a large enough estate that you expect to be paying estate tax when you die, then it is more tax efficient to use gift tax exemption while you are alive as opposed to estate tax exemption when you die. Unfortunately, unless Congress acts sooner, the 2010 Act expires at the end of 2012 and we revert to 2001 tax laws – $1 million estate, gift, and GST tax exemptions and 55% estate, gift, and GST tax rates. In addition, the President’s current budget proposal calls for a reduction in the gift tax exemption from $5 million to $1 million and reduction in the estate tax exemption to $3.5 million.
Tax Benefits of a Lifetime Gift
The primary estate tax benefit of a lifetime gift is that all of the future income and appreciation on the gifted assets passes estate tax free to the donee. For example, if you gave $5,000,000 to a trust for your children in 2011 and lived another 20 years, then the trust would be worth $16 million and you would exclude $11 million more from estate taxes than if you had waited until your death to use the $5 million exemption (assuming 6% annual growth). With a 35% estate tax rate, this $11 million excluded from your estate results in a tax savings of $3,850,000. Another tax benefit is that you can currently create trusts with up to $5 million that will be exempt from future gift, estate, and GST taxes forever. The President’s budget proposal would limit the duration of these trusts to 90 years, but this would not apply to preexisting trusts.
Another reason to make a gift now, while the gift tax exemption is $5 million, is to reduce the IRS’s motivation to audit the gift by contesting the discount. If you give significantly less than $5 million, then you will have a large cushion available to shield any potential revaluation of the assets from gift taxes. The IRS will have little motivation to argue about the value of discounted assets, such as limited partnership units or shares in a closely held business, if reducing the discount will not cause a gift tax.
Supercharging the Gift with Discounted Assets
The best use of gift tax exemption is to gift assets that are subject to a discount. For example, if you give away a limited partnership interest with $5 million of assets, the gift will qualify for discounts for lack of control and lack of marketability. In other words, the value of the gift takes into account that a hypothetical third party would not pay full value for a partnership interest that only entitles them to distributions in the discretion of the general partner. Typical discounts are in the 35% range – the gift of the $5 million partnership interest could have a gift tax value of only $3,250,000. Creating a partnership to implement the gift adds additional complexity and costs but may result in substantial estate tax savings.
Best/Worst Assets to Give
The best assets to give are those most likely to appreciate. The primary benefit to the gift is excluding the future income and appreciation from estate tax, so the more the asset appreciates the larger the tax benefit. Unfortunately, no one can predict the future, so choosing the right assets is more of an educated guess than a science. The worst assets to give may be personal use assets. It might not be a good idea to give real estate or other assets that you may use in the future. If you make a gift of personal use assets, then you will have to pay fair market value rent for your use of the asset to avoid estate taxes at your death. A qualified personal residence trust (QPRT) may be a better way to give away your personal residence or vacation home.
Disadvantages and Risks of a Lifetime Gift
The primary disadvantage of a gift is that you can no longer use the assets gifted. Another downside is that if the assets depreciate in value between the date of gift and your death, then you would have been better off – for gift/estate/GST tax purposes – if you had not made the gift. Another downside of a gift is that your family loses the benefit of the step-up in basis at your death (that would have been available if you had not made the gift). In most cases, the reduction in estate taxes outweighs the increased gain when the asset is eventually sold – but this will not be the case if the estate tax exemption is increased to such a level that you never pay any estate taxes.
One more potential risk is that if you make a gift that is more than the estate tax exemption available at your death, then your estate may pay estate taxes on the difference. In other words, your estate will not be able to keep the benefit of the increased gift tax exemption. Some refer to this as a “clawback.” For example, if you make a $5 million gift in 2011 and die in 2013 while the gift tax exemption is $3,500,000 and estate tax rate is 45%, then your estate may owe approximately $1.2 million in estate taxes at your death due solely to the prior gift. No more estate taxes will be due compared to if you had not made the gift, by the estate tax may come sooner – at the first spouse’s death. Most estate plans are designed to defer estate taxes until the death of the survivor of both spouses, so paying tax at the first spouse’s death may be an unexpected surprise. It appears this is not what Congress intended with the 2010 Act and many commentators expect a technical correction of the law.
A Gift with a Safety Net
The safest way to take advantage of the existing $5 million gift tax exemption is to only give assets that you are positive you will never need to use during the rest of your life. A more aggressive approach is for you and your spouse to each create an irrevocable trust for the other. This allows each of you to retain access to the assets while you are both alive. However, to the extent you or your spouse actually uses trust assets, then your gift and GST exemption will be wasted. If either of you dies, then the survivor will only have access to the assets in the trust for the survivor. Careful planning should take into account the potential for a divorce. The trusts also cannot be identical or there will be adverse estate tax consequences.
Reasons to Give to a Trust
There are at least five important reasons to make gifts to an irrevocable trust, as opposed to a gift to an individual or a revocable trust. First, you can maintain control over the investment and distribution of the assets until your death by serving as the Trustee. Second, the beneficiaries of a trust enjoy a level of creditor protection not available if they own the assets outright. Third, with careful drafting the trust can be structured to protect the assets from a marital property division if a beneficiary divorces. Fourth, making the gift to a trust allows the assets to escape estate taxes at multiple generations. Lastly, if you make the gift to a trust, then you get to choose the remainder beneficiaries – and can ensure the remaining assets will stay in your family if your children or grandchildren die without exhausting the trust assets.
Using a “Grantor Trust"
If you retain certain specific powers over an irrevocable trust, then the trust will be ignored for income tax purposes and you will continue to report the trust income on your personal income tax return. This type of trust is known as a “grantor trust.” A grantor trust allows you to make gift-tax free transfers for the trust beneficiaries by paying the income taxes for them (essentially, a grantor trust grows income tax-free while you are alive, similar to a 401(k) or IRA). If at some point in the future, you no longer wish to pay the income taxes (you cannot be a beneficiary of the trust, so you are paying the taxes and receiving nothing in return), you can “turn off” the grantor trust feature by renouncing certain powers over the trust.
Other Gifting Strategies
You may also want to consider these other gifting strategies: grantor retained annuity trusts (GRATs), installment sales to a grantor trust, forgiving loans, funding insurance trusts by paying large premiums, and qualified personal residence trusts (QPRTs).
To reach a member of our Trusts & Estates Practice Group, click here.