A Time for Giving

For the last decade the lifetime gift exclusion has been $1 million. Even when the estate tax exemption increased from $600,000 to $3.5 million from 1999 to 2009, the lifetime gift exclusion remained static at $1 million. So why the big fuss over another increase?

BRIEF HISTORY – ESTATE AND GIFT TAX

For tax years 1981 through 1999 the applicable exclusion amount was $600,000. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increased the applicable exclusion amount for estate taxes as shown below.

* There was no repeal of the gift tax. In 2010 the top gift tax rate was equal to the top income tax rate – 35%.

** Reinstatement occurred under the 2010 law.

But EGTRRA had a sunset provision. The entire law was repealed as if it had never been enacted effective for years after December 31, 2010. That meant that the estate taxes were scheduled to revert to the law as it existed in 2001. We were headed back to an estate tax exemption and lifetime gift exclusion of $1 million.

The conventional wisdom for the years 2001 through 2009 was anticipating a reform of the estate tax prior to 2010. For tax practitioners, attorneys and financial planners it was incomprehensible that Congress would allow the estate tax to be repealed for 2010. The clear reality is that Congress gave nine years advance warning to the American public of how the estate tax would be repealed and then revived.

THE COMPROMISE

As 2010 waned to an end the White House intervened in a political stalemate and got bipartisan support for a compromise bill that extended the Bush-era tax cuts and reinstated the estate tax.

The reinstated estate tax included an increase in the exemption amount to $5 million and a reunification of the estate and gift tax exclusions. In 2009 the estate tax exemption was $3.5 million, so an increase to $5 million was significant but not extraordinary. However, the lifetime gift tax exclusion in 2009 was only $1 million. The increase of the lifetime gift tax exclusion to $5 million is extraordinary.

On December 17, 2010 the president signed the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010 (the Act). The Act not only reunified the gift and estate tax exemptions, it included the generation skipping transfer tax (GSTT) in the same schedule. GSTT imposes a separate tax for transfers to individual more than one generation below the transferor. One of the trade-offs for these unprecedented increases in exclusions from transfer taxes is that they are temporary. The newly reinstated estate and gift tax regime is short-lived, with all provisions expiring on December 31, 2012.

ON TO THE PLANNING

Most people are familiar with the annual gift tax exclusion. This is the amount that can be gifted to any individual without the requirement of filing a gift tax return. In 2010 and 2011 the amount is $13,000. Traditional gifting strategies have included the plan to gift up to the annual exclusion amount to an individual’s heirs. These annual gifts remove the assets from the giver’s estate and are not included in the income of the recipient. Gifts are never taxable to the recipient. When the individual’s estate is at or slightly above the exemption amount the annual gifts can be used to reduce the estate to where it may not be taxable. But what about when the individual’s estate is substantially greater than the exemption amount?

Consider an estate of an unmarried individual that has a fair market value of $4 million in 2011. If the individual dies in 2011 the entire estate will escape transfer taxes because the exemption for 2011 is $5 million. It does not appear that there is any need to make annual gifts because there is no estate tax savings. While that may be true for 2011 and 2012, what about 2013? In 2013 the estate tax exemption and lifetime gift exclusions are scheduled to revert back to $1 million. Assuming no additional legislation, in 2013 the same individual would have a taxable estate. If the individual had not made gifts in 2011 and 2012 they would have lost the opportunity to remove some of the assets from their estate and reduce their estate tax bill.

The lack of certainty regarding the future of the estate tax is why continued annual gifting is still advisable.

HOW TO DOUBLE (OR QUADRUPLE) THE ANNUAL EXCLUSION AMOUNT

The annual exclusion amount is for each recipient. That means that in 2011 I can give $13,000 each to as many individuals as I care to without having to file a gift tax return. For married individuals gifts can be split. Me and my spouse can give $26,000 each to as many individuals as we care to without incurring the obligation to file a gift tax return – we just split the gifts so that each of us is considered to have given one-half of the total amount. If we give gifts to another married couple (say our married child and their spouse) we could gift up to four times the annual exclusion.

SHOULD I GIFT MORE THAN THE ANNUAL EXCLUSION AMOUNT?

One theory of gifting is that the value of property transferred today will be less than the value of the same property when an individual dies – property will appreciate in value. If you will have a taxable estate, it is advisable to remove appreciating property as early as possible. When the property appreciates in value, the appreciation will occur for the benefit of the heirs, rather than for the benefit of the government. This concept has lead planners to recommend using the lifetime gift exclusion to transfer the full $1 million in value during the individual’s life rather than letting the assets appreciate and having to tax the appreciated assets at death.

The same concept applies now with an increased lifetime exclusion of $5 million. The additional benefit for 2011 & 2012 is that the future of the gift tax exclusion is unknown and could possibly be less than $5 million in years after 2012. This is a unique opportunity to transfer wealth in amounts that have never been available in the past.