Preservation | Family Wealth Protection & Planning

Gifting assets can have beneficial estate and income tax consequences for both the individuals making the gifts (the donors) and the gift recipients (the donees). Under the current law, in 2020, each individual may give $15,000 per calendar year to any number of individuals without incurring a gift tax. Married couples can give up to $30,000, per donee, gift tax-free. This amount is often referred to as the annual exclusion amount, and it is indexed for inflation, resulting in occasional increases. In addition to the annual exclusion amount, tuition and medical expenses that are paid for someone else may also be made gift tax-free.

Gifts to an individual in excess of the annual exclusion amount, and that are not tuition or medical expenses paid on his or her behalf, will reduce the donor’s remaining lifetime gift and estate tax exemption amount. The gift and estate tax exemption is “unified,” meaning that if one goes down, so does the other. That is, gifts during your life in excess of the annual exclusion amount will reduce not only your lifetime gift tax exemption, but also your estate tax exemption at death.

In 2020, each individual has a total lifetime gift/estate tax exemption amount of $11,580,000. This exemption amount is indexed for inflation each year; however, this amount is scheduled to revert to the prior levels of $5 million, adjusted for inflation, effective Jan. 1, 2026, and could possibly go down sooner. Fortunately, the IRS has indicated in recent guidance that even if the lifetime gift/estate tax exemption decreases, any previously used exemption will still be utilized at death. In other words, there will be no “clawback” of previously used gift tax exemption at the donor’s death, even if the donor made gifts during life in excess of the available estate tax exemption amount at death.

An individual may choose to gift assets to family members outright or to a trust created for their benefit, taking advantage of the annual exclusion and the lifetime gift/estate tax exemption. Gifting assets removes not only the value of the assets from the donor’s taxable estate for federal estate tax purposes, but also removes any subsequent income and appreciation related to those assets.

While both an outright gift and a gift in trust removes the value of the assets from the donor’s estate, gifts to an irrevocable trust can have significant advantages. The trust can be structured so that the assets in most cases will be shielded from the claims of the beneficiaries’ creditors and may not be subject to division in the event of divorce.

In addition to the creditor protection benefits of a gift to an irrevocable trust, there are important transfer tax benefits to the donor and the donee. An irrevocable gift trust can be structured so as to remove the trust assets from the taxable estate of the family members who are the trust beneficiaries. Such a trust is sometimes known as a “dynasty trust.” This type of irrevocable trust is often structured to also avoid a separate transfer tax, known as the GST tax, which applies to transfers to grandchildren and further descendants. The application of the GST tax can be avoided by allocating GST exemption to the initial and later transfers to the irrevocable trust. Similar to the lifetime gift/estate tax exemption, in 2020, each person has a separate $11,580,000 in GST tax exemption. This amount is also indexed for inflation each year. By allocating this GST exemption to all transfers to the irrevocable trust, the donor can avoid transfer taxation for the trust and the trust beneficiaries for as long as the trust lasts. That is, the trust can be designed to last in perpetuity.

To further maximize the tax savings available with making gifts to an irrevocable trust, the trust could be structured as a grantor trust, meaning that the individual who creates the trust (the grantor) would continue to pay the income taxes on the earnings of the trust as though he or she still owns them. These payments can be made without gift tax consequences or reduction in the annual exclusion amount otherwise available. So, for example, if the irrevocable trust is structured as a grantor trust and owns only gifted business interests, the grantor would continue to pay the income tax on the income and dividends related to the business interests. In addition, because of the grantor trust structure, at a later date income tax planning can be implemented, such as swapping high basis assets with trust assets having a low basis. By including the low basis assets rather than the high basis assets in the grantor’s taxable estate, such low basis assets may receive a step-up in basis at the grantor’s death to fair market value.

Alternatively, the trust could be structured as a separate taxpayer that would pay its own income taxes or pass the income tax burden to its beneficiaries by making distributions to the beneficiaries. This could be advantageous if the trust beneficiaries are taxed at a lower tax rate or possibly reside in a low- or no-income-tax state. If the grantor is unsure whether he or she will always be willing to pay the income taxes on behalf of the trust, the grantor can structure the trust as a grantor trust initially, and later renounce the powers that cause it to be taxed that way, resulting in the trust then becoming a separate taxpayer.

To maximize the type of planning described above, at minimum an individual could begin an annual gifting program to transfer their assets over time, utilizing the annual exclusion amount, thereby retaining their lifetime gift/estate tax exemption. However, in light of the potential reduction in lifetime gift/estate tax exemption amounts, utilizing the exemption now should be considered due to the increased exemption potentially going away. This is further compounded by the opportunity to gift assets with currently depressed values that we hope will eventually increase in value, allowing such future appreciation to accrue to the benefit of the donees.

Stay tuned for Part 3 of this series, in which we will discuss planning opportunities with making and refinancing loans in a low interest rate environment.