The Value of Annual Gifting to an Estate Plan

As we assist a client preparing their estate plan, we must be aware of a number of factors, one of which is a desire to minimize the amount of assets subject to the Federal Estate Tax. The Federal Estate Tax is the tax levied when the estate of a decedent transfers assets to beneficiaries. Currently the first $5,120,000 transferred is exempt from taxation (this is the “Estate” portion of the Estate and Gift Tax Lifetime Exclusion). The value of gifts (other than "Annual Exclusion" gifts which will be discussed later) that the decedent made during their lifetime reduces the $5,120,000.00 exclusion dollar for dollar (this is the “Gift” portion of the Lifetime Exclusion). After a person has exceeds the $5,120,000.00 mark, further gifting (either during life or at death) results in a tax liability. Keep in mind, each person has their own Lifetime Exclusion, so married couples can transfer  more than  $10,000,000.00 before incurring any tax liability, and the present law even allows a widow to use their deceased spouse’s unused Exclusion.

For most clients, knowing that they need to give away $10,000,000 before the IRS comes knocking is reassuring. It means that even if they succeed in accumulating a substantial estate, they can make gifts with little worry about paying anything extra in taxes. You likely remember however that the current $5,120,000 Lifetime Exclusion is scheduled to decrease to $1 million beginning in 2013. In addition, the top tax rate for gifts is scheduled to increase from 35% to 55%. If Congress does nothing and the default outcomes occur, this change will pace increased emphasis on clients addressing their lifetime gift planning now. Last week we addressed the possibility of making large lifetime gifts before the end of the year in order to take advantage of the current Estate and Gift Tax Lifetime Exclusion. It is important that clients look at those options before the end of the year. However, even if a client is not interested in making large gifts, the client can benefit loved ones by making gifts using another exclusion, the Annual Gift Exclusion.

The Annual Gift Tax Exclusion allows a person to make gifts of $13,000 or less to as many people as they desire each year, whether or not they are related, without incurring any tax liability and without using any portion of the Lifetime Exclusion. This means that a person with two children and four grandchildren could make Annual gifts of $13,000 to each of those people (totaling $78,000) without using any of their Lifetime Exclusion. As with the Lifetime Exclusion, the Annual Gift Exclusion is unique to each person, so a married couple can each make gifts to children and grandchild (using the example above a married couple can give away $156,000 each year without incurring any tax liability). While clients only should make such gifts if they are comfortable they have sufficient assets for their own  needs, a schedule of regular gifting can reduce the assets of person to the point where their estate has minimal tax liability.

For clients that worry that making substantially lifetime gifts will negatively effect their beneficiaries, due to concerns over addiction, problem marriages, or even a concern that the beneficiary will work less due to the Annual gift, additional planning can allay these concerns.

A primary tool to delay a beneficiary’s access to gifted funds is an Irrevocable Trust for the beneficiary’s benefit. The client makes the annual gifts to the Trust, thus limiting the beneficiary’s use of the gift subject to the terms of the Trust. Frequently, the terms of the Irrevocable Trust are similar to the terms of a client’s Living Trust, such that a beneficiary is able to request funds from the trustee for a limited number of reasons and then receives distributions of principal following the client’s death.

A gift to an Irrevocable Trust for a beneficiary must be a "present interest" in order to qualify for the Annual Gift Exclusion. This means that a beneficiary must have the right to immediately take possession of the gift and use the gift as the beneficiary pleases. However, by using a “Crummey Notice” a client is able to side step this limitation. As we have previously discussed while discussing Irrevocable Life Insurance Trusts, a “Crummey Notice” informs a beneficiary of their right to withdraw the Annual gift for a limited period of time, otherwise that gift becomes part of the trust for the beneficiary’s benefit. Most beneficiaries are aware that future gifts may be conditional upon the beneficiary's willingness to let the "Crummey Notice" period lapse and allowing the gift to be held in trust. For minor beneficiaries “Crummey Notices” are signed by Guardians, thus for clients making gifts only to their own minor children, husbands may sign the “Crummey Notice” for the wife’s gift and vice versa.

An additional tool for gifting to minor children is the §529 Education Savings Plan. The primary advantage of a §529 plan is the earnings of the plan are not subject to Federal Income tax and generally not subject to State Income tax when used to pay for “qualified education expenses” including tuition, books, computers, and room and board. While contributions to such plans are not deductible from Income tax purposes, §529 plans do allow individuals to pre-pay up to five years of contributions in one year, which will count as gifts made in the current year and the following four years. Using the example above, the couple with four grandchildren can contribute $130,000 in the first year to a §529 plan for each grandchild, totaling $520,000). §529 plans are flexible and there is no penalty for changing the beneficiary from one family member to another or for combining §529 plans with the same beneficiary. When clients desire to provide for education of family members and have the  ability to pre-pay contributions, §529 plans are an excellent part of a schedule of regular gifting.

A final method of gifting involves the direct payment of medical care and tuition expenses. Using this method, a person may make unlimited payments, directly to a school or medical provider, for the benefit of another person. Gifts made in this fashion do not count toward either the Annual Exclusion or the Lifetime Exclusion. The Internal Revenue Service broadly defines the meaning of medical care to include not only diagnosis, treatment, and prevention of diseases but also payments for transportation to such care and payments for qualified long-term care services. Tuition gifts can pay for both private and public institutions and are not limited to college tuition, private primary and secondary school tuition is also payable. The key for a client making use of this method of gifting is making payment directly to the school or medical provider.

As we have said both earlier in this post and in discussing large lifetime gifts, before making any gift it is important to consider the consequences of that gift. Clients should consider the impact on their own lives, the chance that they will need the gifted funds later in life, and the impact on the beneficiary receiving the gift to determine if the benefits of gifting outweigh the potential consequences. Using the Annual Gift Tax Exclusions and the Lifetime Estate and Gift Tax Exclusion may require the filing of Gift Tax Return, and  making gifts to and Irrevocable Trust requires the existence of a valid trust, so clients should make sure to include their attorney and tax professional are a part of the planning process. Annual gifts are an effective way to pass assets on to future generations without the expense of additional tax liability. The sooner a client begins a regular gifting program, the more effectively they can make use of the process.

Taking Advantage of the Present Gift and Estate Tax Lifetime Exemption

           Many years ago, I stopped trying to use a "crystal ball" to determine what Congress would do with estate tax law. I can only counsel my clients about what the current law is and what opportunities are available today.

           

           As many commentators have discussed, one planning opportunity available through the end of 2012 is the ability to make large lifetime gifts to remove significant assets from an estate before death. The Gift and Estate Tax Lifetime Exemptions are currently $5,120,000.00. This means that in 2012, an estate having a net value of $5,120,000 or less is completely exempt from Estate Tax. In addition, this exemption allows individuals to make large gifts during 2012 that are not subject to the Gift Tax. In 2013, the exemption drops to $1,000,000.00 unless Congress decides to extend or modify the current law in some way.

           By taking advantage of the higher Lifetime Exemption in 2012, clients can make gifts to children and other beneficiaries without any out-of-pocket cost for Gift Tax. In addition, gifts in 2012 can save future estate taxes by removing future appreciation on the gifted assets. Gifts made to multiple generations (e.g. children, grandchildren, etc.) this year, also can avoid any Generation-Skipping Transfer Tax. 

           While taking advantage of this strategy has the potential to reduce the taxes imposed upon large estates, the "tax tail should not wag the dog". This means that achieving a client's goals for their estate plan should take priority over the desire to avoid paying taxes. Before the client takes the steps necessary to utilize this strategy, it is important to ask the following questions:

1. Can I afford to make a large gift?
2. Will I need these funds in the future?
3. Am I concerned that my heirs will not be able to manage the assets I give or may have creditor or divorce problems?
4. If I make gifts, do I want them to be outright gifts or do I prefer gifts into irrevocable trusts for control purposes?

           The client should be careful about gifting any assets they may need to maintain their lifestyle later in life. What is given away cannot be returned without incurring gift tax, income tax and estate tax consequences. The client must be comfortable with giving up control and the use of the asset, subject to restrictions that can be placed on a beneficiary's use. 

           If the client can afford to make a large gift and is comfortable doing so, it is probably advantageous, especially if the tax rates increase from the current 35% maximum bracket to the 55% maximum bracket, as is scheduled in 2013, and the lifetime credit drops to $1,000,000.00. Presuming appreciating assets, heirs can receive significantly more in assets and appreciation from a large gift in 2012 rather than after-tax distributions at death. 

           Two words of warning, first under current law, the donee of a gift receives the donor's income tax basis in the gifted property, while the beneficiary of most inherited property will receive a "step up in basis" to the date of death fair market value of the inherited property. While making a gift may avoid Estate Tax, it may also create additional capital gains income tax when the asset is later sold. Consideration of the income tax consequences should be part of the pre-gifting analysis. Second, there is the possibility that there will be a "tax clawback" in future legislation. That is, an added Estate Tax that takes back some of the tax-free benefits of the 2012 gifts. In the current law, it is not clear that gifts made in 2012 using the larger Lifetime Exemption cannot be added back to the estate of a client who made large gifts, resulting in the imposition of a larger Estate Tax burden at death if the exemption is only $1,000,000 at the time of death. 

           If the client is inclined to take advantage of the current legislation, there are a number of strategies for using the current lifetime exemption to make large gifts, including:

1. Outright gifts to beneficiaries of real estate, business interests (corporations, partnerships and LLCs), investment assets and even cash with no restrictions. If the client gives minority interests in entities, the client can maintain control of the entity, and may even be able to take advantage of minority valuation discounts when determining the value of the gifts made.
2. Gifts to irrevocable trusts for the benefit of minors or children with creditor issues, suspect marriages, or spending problems with provisions that protect these beneficiaries and distribute assets over time. The only limit on restrictions is the imagination of the grantor. The trust can be designed to provide maximum flexibility for distributions to beneficiaries yet protection of the principal.
3. Gifts in trust for a spouse, with the remainder going to children and grandchildren after the death of the spouse. The trust, a "spousal limited access trust", can be designed as a "grantor trust" where the person setting up the trust is considered the owner for income tax purposes, yet is not considered the owner for estate tax purposes. The spouse can receive income and/or principal, which allows the grantor to enjoy the benefits of the trust assets. It may be possible for the beneficiary spouse can even have the right to appoint his or her trust rights back to the grantor at their death without it being considered in the estate of the grantor at the grantor's death. This allows the grantor to continue to have use of the assets
4. Gifts to an irrevocable trust can be used purchase life insurance on the grantor. The gift can provide a significant multiple of insurance coverage, thus providing greater benefit to beneficiaries should
5. For those trying to ensure the maintenance of a family vacation home for the future, that client may want to consider gifting a 49% interest in the home to children, either outright or in the form of an LLC interest. Using this method the client can maintain control of the home and there will be no change in the status for property tax purposes.
6. Gifts of property to "grantor trusts" and then the purchase of assets by the grantor for cash or a promissory note. This type of strategy allows the trust beneficiaries to receive interest income during the repayment of the note, as well as the eventual principal repayment. In addition, because the grantor still owns the assets, they will get a step up in basis for income tax purposes at the death of the grantor.

           Before making any large gifts, clients should have a serious discussion with professional advisors to determine if the gifts are appropriate for the client's financial and family situation. Planning for large gifts does take time, which is obviously limited between now and December 31, 2012. If the client is interested, now is the time to start in order to avoid last-minute decisions that are not productive for the client.