To Give, or Not to Give

The tax changes back in 2001 included one that shocked some observers: The federal estate tax would be eliminated in 2010. Congressional negotiators who favored keeping the tax evidently thought that they had nine years to engineer a repeal of the provision. Experts “knew” that some change would be made; the estate tax couldn’t be allowed to expire.

As it turned out, those experts were wrong, and 2010 began without a federal estate tax because the law on the books automatically went into effect. In a lame-duck session of Congress that year, the estate tax was retroactively restored, but large estates (notably that of billionaire George Steinbrenner) were given the choice of opting out of the tax.

Why is this history relevant today? Because the 2010 compromise came with an expiration date. If the law now on the books goes into effect, today’s $5.12 million federal estate and gift tax exemptions drop to $1 million, and tax rates rocket upwards. Accordingly, wealthy families are mulling whether to make substantial taxable gifts this year to “lock in” the higher exempt amounts. The tax savings could come to millions of dollars.

Scenarios

Or, the savings might be ephemeral.

There is substantial political support for ending all federal taxation of family wealth transfers. On the record, estate and gift taxes don’t raise much revenue; they are expensive to administer; and the very wealthy are able to avoid them. One observer went so far as to call the estate tax a voluntary tax. Taxes at death have been shown to be a major reason that family businesses fail. Should these taxes be ended, making large gifts this year would be pointless from a tax standpoint.

President Obama advocates a return to the 2009 rules on wealth transfer taxation. The estate tax exemption would drop to $3.5 million, and the gift tax exemption would plummet to $1 million. Top tax rates would rise from the current 35% to 45%, but would still be well short of the 55% currently scheduled.

Those who expect this approach to become reality would be well advised to make major gifts this year. We are approaching a fiscal cliff, in which the scheduled income tax increases dwarf the estate tax in importance. It’s possible that as Congress wrestles with those issues, the estate tax goes to the back burner, and the $1 million exemption goes into effect. Once again, in that scenario gifts this year would be advisable.

State taxes

Another variable to toss into the equation is the state death tax. Twenty-two states and the District of Columbia impose an estate tax, an inheritance tax or both when their citizens die. In many states these taxes kick in at much lower wealth levels than the federal estate tax.

Moving wealth within the family through gifts this year positions that money beyond the reach of state revenue administrators. No state except Connecticut still levies a gift tax, so the transfers would be tax free up to $5.12 million.

What to give?

From a tax perspective, the best gift is money or property that has not yet appreciated. Assets that have appreciated in value are better candidates to be left to beneficiaries at death, because then they will receive a “basis step-up,” a forgiveness of the tax on the built-in capital gains.

Trusts

For those taking the long view, this could be a good year to fund a “dynasty trust,” one that avoids successive impositions of death taxes on family wealth. Such trusts are subject to the generation-skipping transfer tax, but the exemption from that tax is also $5.12 million this year. Once the transfer is complete, future appreciation accrues to the family without additional estate or gift tax.

See your estate planning and tax advisors to learn more.

(October 2012)