Some estate planners have urged their clients to make large lifetime (inter vivos) gifts to their heirs in 2012, when the current federal gift tax exemption is $5.12M, and the federal gift tax rate is 35%. We don’t know what will happen after 2012 when the current tax law is due to “sunset” out of existence. They argue that, in case the exemption is lowered or the tax rate increased, you should take advantage of the high exemption to avoid gift tax, or else pay the low gift tax now to get assets out of your estate, and so reduce the amount in your estate that will be subject to estate tax. Let’s take a closer look to see if this really makes strategic sense.
Gifting in 2012
For the remainder of 2012, the gift tax exemption is $5,120,000 per person (there was a 2012 inflation adjustment), which would be doubled for a married couple. The tax rate is 35%. You can make annual tax-free gifts of $13,000 ($26,000 if married) to as many individuals as you want. If you give more the exemption amount, the excess is a taxable gift. You can pay the gift tax now, or not, in which case, it will be taxed upon your death as estate tax. The exemption is a unified gift/estate tax exemption credit, which is a limit on the total transfer, no matter whether given as a lifetime gift or through your estate. If you use your unified credit while you are living, it’s applied to gift tax; if you use it after you die, it’s applied to estate tax. Both exemptions are portable (currently): can be transferred between spouses.
The way this works is that you must report any gift in excess of the annual tax-free limit to the IRS by filing an informational gift tax return (Form 709) for the year in which the gift is made. You can then either pay the tax or not. If you do not pay, your unified exemption credit will be decreased by the amount. When you die, the IRS will know how much of the exemption you have used in lifetime gifts, and how much is left over for use against estate tax. The amount of exemption which has not been used will be deducted from the total of all gifts, both lifetime and testamentary. The remainder is subject to taxation.
You should note that you can give gifts of revocable living trust assets the same as from any other source. Under prior law, gifts made from trust assets within three years of death were considered by the IRS to be in your taxable estate at death; under current law these gifts are now considered the same as if they were made directly from you.
Would Making A Gift in 2012 Lock in the $5M Exemption or 35% Tax Rate?
At first glance, it may appear that you can give millions of dollars away in 2012 as gifts, subject to the large current gift tax exemption and low tax rate, to lock in that those rates, in case the exemption amounts and tax rates change negatively. However, you must recall that the gift and estate taxes are unified, so that the effective exemption and tax rates will be those in existence when you die. For example, you might give $3.5M in 2012 and choose not to pay gift tax, but instead rely on the $5M exemption, thinking you will have $1.5M in credit left. But, what would happen if the unified exemption is only $3.5M in the year you die? You will have no exemption credit left to shield the rest of your estate from taxation.
The same reasoning applies to the tax rate. You might think that would be a savings by paying gift tax on the transfer at the current to tax rate of 35%, instead of paying estate tax on the same asset when you die, at a rate which might be 55%. However, it does not work like that. The rate that matters will be the rate in effect at the time of death. If that rate is 55%, then the 35% paid at the time a gift was made would be an underpayment, so that the difference would have to be made up at the time of death.
There’s no escaping the grim reaper or the grim taxman.
So, Is There Any Benefit to Making Inter Vivos Gifts Above the $13K Exclusion?
Yes, there is. One clear benefit is that by making a lifetime gift and paying the gift tax, you will remove the amount of gift tax actually paid from your estate. If, instead, you keep an asset in your estate until you die or give it without paying the tax, the amount you would have paid in gift tax on that asset (if you had paid it) would still be in your estate. This makes your taxable estate larger and increases the amount of estate tax your estate would have to pay. In effect, you would be paying a tax on the tax!
You might think that merely removing the amount of tax seems a small benefit; however, it can be substantial. For example, assume you have completely used up your gift tax exemption through prior gifts and, as a result, now must pay the full marginal 35% gift and estate tax on any further gift or bequest. You want to give your kids an additional $1 million. If you give your children a gift of $1M and pay the tax, the current gift tax, at 35%, would be $350,000. This means that it would cost you a net $1,350,000 to give your kids $1M. Put differently, by paying the tax now, $1,350,000 would be removed from what would be in your taxable estate. If you don’t pay the tax, that extra $350,000 will still be in your estate when you pass away. To pay tax on $1,350,000 would cost you $472,500 (35% of $1,350,000 = $472,500). That’s $112,500 more than if you gave the $1 million as a lifetime gift and paid the tax.
On the other hand, this example assumes that you have already used up your entire unified credit, so that the additional full $1M gift (and the tax on it) would be charged at the marginal tax rate of $35%. Not everybody is in the situation of having used up their entire credit on lifetime gifts and wanting to give more. In fact, very few would be in that situation. I point this out to emphasize that any tax strategy should only be employed after a complete analysis of your specific situation in conjunction with legal and financial advisors.
Gifts of Appreciated Assets
Another advantage of making lifetime gifts would be the case of giving assets that are appreciating in value, since any income and appreciation which accrue after the gift would also be removed from your taxable estate. If you have stocks worth $500K today, which would be worth $750K on your death, it might make sense to give them as a lifetime gift. The estate/gift tax on $500K would be $175K, while on $750K it would be $262,5000, a saving of $87,500.
However, you must carefully weigh estate tax savings against the capital gains the recipient may have to pay upon later sale. When the recipient sells the asset, capital gains tax must be paid on the difference between the selling price and the cost basis. With death transfers, capital asset bases are generally “stepped-up” to current levels; on the other hand, inter vivos gifts of appreciated assets maintain our original cost basis (plus any gift tax paid). When the recipient sells the asset, capital gains tax would be paid on the difference between the selling price and original cost basis, which is what you paid for it.
Currently, the maximum federal long term capital gains rate is 15%, considerably lower than the estate tax. So, there could be a real benefit to both you and the beneficiary to make it a lifetime gift. Nonetheless, you must calculate what you paid for the asset, what it’s worth now, what you think it will be worth when you die, your current health, and if the recipient plans to sell or keep it. And keep in mind that you cannot be sure of the tax rates and exemptions which will be in effect at your death.
While there may be instances in which it would be beneficial to make gifts in 2012, this determination must depend upon an analysis of the actual circumstances of your estate and of the costs and benefits to both the estate and the beneficiaries, and not the mere idea that gift transfers are “free” or “cheap” in 2012, as opposed to any other time. The law at the time of death will be what matters.
One further consideration: remember that if you give away assets as a gift, you no longer have them for your lifetime. Think of old King Lear.
 If congress does nothing about the “sunset” of the current tax law, on January 1, 2013 the exemption will be only $1 million and the top tax rate will be 55%. For more detail, see Estate Tax Law: Where We’ve Been, Where We May Go, and What to Do In The Meantime, (© Terry J. Traktman, 2012), and Estate Tax Law Changes: 2011, 2012 and Beyond, (© Terry J. Traktman, 2012), elsewhere on this website
© Terry J. Traktman, July, 2012, all rights reserved