Lifetime Gifts Save Gift and Estate Tax

Lisa S. Hunter

Federal estate tax is imposed on estates valued at more than $1 million in 2003. The estate tax rate starts at thirty-nine (39%) percent and increases to forty-nine (49%) percent. Thus, the estate tax can substantially reduce the amount of wealth that can be passed to younger generation family members. The $1 million exemption is scheduled to increase slowly to $3.5 million in 2009 under current law, with repeal in 2010 followed by reinstatement of the tax with a $1 million exemption in 2011.

Often when people add up their assets, they are surprised to discover the total value of their estate. When you include the value of a home, IRAs and 401(k)s (and life insurance, if not removed from the taxable estate by proper planning), even a family that considers themselves “middle-class” could become subject to the estate tax. One tried and true method of reducing the value of your estate is making annual gifts of up to $11,000 per beneficiary. This amount can be given to an unlimited number of individual beneficiaries. But annual exclusions are not cumulative. If gifts are not made in a year, the opportunity to make gifts protected by the annual exclusion for that year is permanently lost.

Married individuals can elect to “split” gifts. A married couple can thereby use both spouses’ $11,000 annual exclusion even if one spouse makes a $22,000 gift to one beneficiary. If a couple wishes to split gifts, it will be necessary for them to file a federal gift tax return.

The gift tax and estate tax are a part of a single transfer tax system. The $1 million exemption described above can be used during lifetime as well as at death in 2003. The advantage of making $11,000 annual exclusion gifts is that these gifts do not reduce the $1 million lifetime exemption. For example, assume Diane, a widow, has three children and seven grandchildren. By making a $11,000 gift to each of her ten descendants, she can remove $110,000 from her taxable estate. What’s more, by using her annual exclusions of $11,000 per beneficiary, she will not reduce her $1 million lifetime exemption from gift and estate tax.

In addition to removing the gifted amount from the donor’s potential estate, the gift also removes all appreciation and earnings on the gifted property from the donor’s estate. That is why individuals often use all or part of their $1 million gift and estate tax exemption during their lifetimes.

For example, suppose Diane made a gift of stock worth $51,000 (not $11,000) to each of her three children in 2003. The first $11,000 of each gift would be protected by the annual exclusion, while the remaining $40,000 would use part of her lifetime exemption from transfer taxes. Thus, Diane would use up $120,000 (3 x $40,000) of her lifetime transfer tax exemption. Assume Diane thereafter makes only annual exclusion gifts until her death in 2006 (when the estate tax exemption amount is $2 million). Her estate tax exemption would then be $1,880,000 ($2,000,000 – $120,000). All appreciation on the transferred assets from the time of the gifts until her death would also be removed from her estate. If the stock given to each of her children appreciated from $51,000 to $81,000 during her lifetime, the $30,000 of appreciation (multiplied by 3, or $90,000) would also be excluded from Diane’s estate.

There is one disadvantage to lifetime gifts. For income tax purposes, assets included in a decedent’s estate receive a “step-up” in basis to the fair market value of the asset at the decedent’s death, thus eliminating any built-in capital gains if the estate beneficiaries turn around and sell the assets at their date of death value. Gifted assets do not receive the step-up in basis since they are not included in the donor’s taxable estate. For this reason, it is often recommended that donors select assets with a high income tax basis for gifting purposes. However, there are many other considerations involved in selecting assets with which to make gifts (such as the appreciation potential of the assets, and whether a “discount” would be available in valuing the gift), so it is advisable to consult an estate tax planning advisor before significant gifts are made.

Gifts made in trust can qualify for the $11,000 gift tax annual exclusion. The annual exclusion applied only to gifts of “present interests” in property, not to gifts of future interests. A gift in trust becomes a present interest to the extent a beneficiary has a so-called “Crummey” power (named after the leading case on the topic) to withdraw gifts made to the trust. Note that the Crummey power can be given to anyone who is a trust beneficiary. Diane, in our example, could have made the transfers for her children and grandchildren in trust. By providing in the trust that her descendants have Crummey withdrawal powers (even if they won’t be exercised), Diane could utilize the $11,000 per beneficiary annual exclusion. Moreover, she could give Crummey powers to her minor grandchildren, no matter how young, by directing her trustees to give the notice of the Crummey power to their parents or guardians.

There are other often-overlooked types of gifts that can be made without using up any of an individual’s $11,000 annual exclusion or $1 million lifetime exemption from gift tax. Payment of another individual’s tuition expense directly to an educational institution is not treated as a gift. Similarly, payment of an individual’s medical expenses directly to a medical care provider is not treated as a gift.