Do Gifts Count Toward Estate Taxes?
With all of the talk about changes to estate taxes, estate planning attorneys who specialize in the tax law have been watching and waiting as changes were added, then removed, then changed again, in pending legislation. The passage of the infrastructure bill in early November may mark the start of a calmer period, but there are still estate planning moves to consider, says a recent article “Gift money now, before estate tax laws sunset in 2025” from The Press-Enterprise.
Gifts are used to decrease the taxes due on an estate but require thoughtful planning with an eye to avoiding any unintended consequences.
The first gift tax exemption is the annual exemption. Basically, anyone can give anyone else a gift of up to $16,000 every year (starting in 2022). If giving together, spouses may gift $32,000 a year. After these amounts, the gifts count toward estate taxes and are subject to gift tax. However, there’s another exemption: the lifetime exemption.
For 2022, the estate and gift tax exemption is $12.06 million per person. Anyone can gift up to that amount during life or at death, or some combination, tax-free. The exemption amount is adjusted every year. If no changes to the law are made, expect a slight increase in 2023.
However, the current estate and gift tax exemption law sunsets in 2025. This will bring the exemption down from historically high levels to the prior level of $5 million, as adjusted for inflation. Even with an adjustment for inflation, this would make the exemption about $6.2 million. This will dramatically increase the number of estates required to pay federal estate taxes.
For households with net worth below $6 million for an individual and $12 million for a married couple, federal estate taxes may be less of a worry. However, there are state estate taxes, and some are tied to federal estate tax rates. Planning is necessary, especially as some in Congress would like to see those levels set even lower. Luckily, Louisiana residents with all of their property in Louisiana need not worry about a state-specific estate tax. But if you are a Louisiana resident with real estate in other states, you have to know about a potential tax liability there.
Let’s look at a fictional couple with a combined net worth of $30 million. Without any estate planning or gifting, if they live past 2025, they may have a taxable estate of $18 million: $30 million minus $12 million. At a taxable rate of 40%, their tax bill will be $7.2 million.
If the couple had gifted the maximum $23.4 million now under the current exemption, their taxable estate would be reduced to $6.6 million, with a tax bill of $2,520,000. Even if they were to die in a year when the exemption is lower than it was at the time of their gift, they’d save nearly $5 million in taxes.
There are a number of estate planning gifting techniques used to leverage giving, including some which provide income streams to the donor, while allowing the donor to maintain control of assets. These include:
Discounted Giving. When assets are transferred into an entity (commonly a limited partnership or limited liability company), a gift of a minority interest in the entity is generally given a discounted value, due to the lack of control and marketability.
Here is an example. Suppose an LLC is a business or it owns real estate. The LLC is worth $5 million. If the LLC is structured correctly with proper documents, the LLC can often achieve a discount of 40% (sometimes more) on the value assessed for estate taxes. Accordingly, a gift or an inheritance of that $5 million LLC to the children will not go against the lifetime exemption in the amount of $5 million. Rather, it would reduce it by only $3 million ($5 million X (100% – 40%)). Therefore, the estate tax reduction is $800,000, calculated by taking the $2 million reduction achieved in value times the 40% federal estate tax rate.
Grantor Retained Annuity Trusts. The donor transfers assets to the trust and retains right to a payment over a period of time. At the end of that period, beneficiaries receive the assets and all of the appreciation. The donor pays income tax on the earnings of the assets in the trust, permitting another tax-free transfer of assets.
Intentionally Defective Grantor Trusts. With an Intentionally Defective Grantor Trust (IDGT) a donor sets up a trust, makes a gift of assets to the trust, and then sells other assets to the trust in exchange for a promissory note. If this is done correctly, there is a minimal gift, no gain on the sale for tax purposes, the donor pays the income tax and appreciation is moved to the next generation. This is often called an “estate freeze” technique, which freezes the value of the property transferred by effectively converting it into a stable-value promissory note. Property transferred to the IDGT can continue to appreciate over time, whereas the promissory note received in exchange stays relatively the same (particularly in a low interest rate environment). The wise client has just “frozen” all or a large portion of his estate by removing the future appreciation from it. Note that this is the same technique used by Tom Benson when he transferred part of his ownership in the New Orleans Saints and the New Orleans Pelicans to his IDGT. (The family litigation that many Louisiana residents may know something about did not involve tax issues, rather the litigation focused on the retained powers over the IDGT, which is a topic for another blog post).
These strategies may continue to be scrutinized as Congress searches for funding sources, but in the meantime, they are still available and may be appropriate for your estate. Speak with an experienced estate planning attorney, preferably one that is Board Certified in Tax Law to see if these or other strategies should be put into place.
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Reference: The Press-Enterprise (Nov. 7, 2021) “Gift money now, before estate tax laws sunset in 2025”