GIFTING YOUR TAXES AWAY

One of the best estate planning techniques to save taxes at your death is to give away your property while you are still living. Of course, you need to keep back enough assets to provide for your needs and those of your spouse for your respective lifetimes. This concept, while easy to understand, is often misapplied.

Recently, a client contacted me for assist with an elderly relative’s trust. Let’s call the elderly relative Jane. Years earlier, when Jane’s Trust was much larger, her attorney set up a gifting program to reduce the total size of her estate and thereby minimize or avoid taxes at her death. This plan was fine as far as it went.

Two things happened over the intervening years. First, the tax laws changed and increased the size of estates that could escape estate taxation. Second, Jane had gifted away enough assets that her estate was now smaller than the minimum taxable estate, so no estate tax would be due at her death.

Unfortunately, everyone lost track of the original reason for the gifting and Jane continued to make gifts every year long after the need was gone. The attorney continued to document the gifts without pointing out that Jane need not continue giving her property away.

This wouldn’t be so bad, but Jane was gifting interests in real property. Over the years, her real estate had grown in value so it was now worth more than nine times what she paid for it. Jane’s basis in the property was only $10,000, but it was worth over $90,000. If she had sold it, she would have paid capital gains tax on this difference of $80,000. If, however, she let the property pass to her heirs under her Trust, they would receive the property at its stepped up basis of $90,000 and no capital gains taxes would be owed if they then sold the property for this amount.

By gifting a partial interest in the property each year, Jane had created a capital gains tax problem where none had existed. Instead of saving taxes, Jane’s beneficiaries faced a significant capital gains tax if they sold the property.

A well planned gifting program can be a great tax savings device. Where not properly planned, however, it may create more problems than it solves.

The point of the above is to remind you to think about why you are making gifts. If it to help out family members, then continue by all means. If, however, it is to avoid estate tax at your death and your estate is worth $1.5 million or less, you may want to consider discontinuing your gifting program (unless your intent is to minimize or eliminate Oklahoma Estate Tax, which is computed differently).

If you plan to give away a large portion of your estate, whether for Medicaid or estate tax planning reasons, you might want to consider purchasing medical, disability, liability and/or long-term care insurance. You never know when an emergency or need for care will arise. If you have limited resources available, insurance may be the only answer. As a parent, you don’t want to be put in the position of having to ask your children for financial help.

If you still have a taxable estate of over $1.5 million, giving assets to your family and relatives can be a good way to reduce or eliminate the estate tax due at your death. You can do this with non-taxable gifts of $11,000 per person per year or through a combination of non-taxable and taxable gifts (those in excess of $11,000 per year per person).

Each of you have an exemption for gift and estate taxes equal to $1.5 million, which will increase to $3.5 million in 2009. The estate tax is scheduled for elimination in 2010, but under current law will return for estates over $1million in 2011. The gift tax exemption will remain at $1 million throughout this period.

If you have already given away $1.5 million, you might ask why you should continue to give away property if you now will have to pay gift tax. The answer is threefold.

First, the initial $11,000 of any gift you make ($22,000 if your spouse joins in the gift) still passes free of tax.

Second, the growth in the value of any assets you give away and any income earned on these assets belongs to your beneficiaries rather than increasing the value of your estate.

Finally, there is the issue of how gift and estate taxes are calculated. Any gifts to a person in excess of the $11,000 annual exclusion ($22,000 for joint gifts) are reported on a Form 709 Gift Tax Return. Until you use up your $1.5 million lifetime exemption, this is all you do–report the gift. Once you pass the $1.5 million threshold, you will pay taxes on any gifts in excess of $11,000 per person. This is where the rules come into play. Although the tax rate schedules for gift tax and estate tax seem the same, the taxes are calculated differently. Gift taxes are computed on the amount the recipient actually receives. Estate taxes are computed on the assets the recipient receives and those used to pay taxes to the government.

Let’s assume you made a gift and then lived three more years. The maximum gift tax rate is about 33% while the estate tax rate is between 41%-50%. The highest gift tax rate is still lower than the lowest estate tax rate. If you made taxable gifts of $2 million in 2003, you would have owed gift taxes of some $435,000. If, however, you wanted to leave your family $2 million in spendable assets in 2003, you would have needed an estate of $2, 860,000 since the estate tax is about $860,000. The estate tax to leave your family a net estate of $2 million is almost double the gift tax of giving your family this same amount ($860,000 vs. $435,000).

If you have a taxable estate, it may make sense to give it away even if you have to pay some taxes now. This may not be true if the property’s basis is significantly less than it’s current fair market value, but even then, your estate planning attorney will want to "run the numbers." With capital gains tax rates as low as they are, it may still be better to gift even highly appreciated property.

© Jerry E. Shiles 2004

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