As we have previously reported, changes to the federal gift tax exemption passed by Congress at the end of 20 10 have provided taxpayers with a new opportunity to make significant gifts free of gift tax. Unless Congress otherwise acts, the increased gift tax exemption is set to expire on December 31, 2012.
Currently, the gift tax laws allow taxpayers to make non-taxable gifts two different ways. The first, known as the annual exclusion, allows an individual to give away up to $13,000 per person, per year. Gifts in excess of the annual exclusion are gifts that use up gift tax exemption. The gift tax exemption now shelters the first $5,000,000 of gifts made during a taxpayer's lifetime from the gift tax.
Last December, Congress increased both the federal estate and gift tax exemptions to $5,000,000. Under current law, both exemption amounts are scheduled to expire on December 31, 2012, and return to their previous $1,000,000 levels. The two exemption amounts are integrated. To the extent that a taxpayer uses some gift tax exemption during his or her life, then his or her estate tax exemption effectively is decreased by a corresponding amount.
Massachusetts, however, does not have a gift tax. As a result, an individual who makes significant gifts reduces the assets that will be subject to Massachusetts estate tax on a dollar-for-dollar basis. For example, if an individual with $4,000,000 of assets makes gifts equal to $1,500,000 in 2011, no Massachusetts gift tax is due on the gift, and the individual will pay Massachusetts estate tax only on the remaining $2,500,000 owned at the time of death.
The benefits of a gift at the federal level are less straight-forward. The individual in the previous example would not pay federal gift tax on the $1,500,000 gift because the amount is less than the available $5,000,000 federal gift tax exemption. However, the extent to which the taxpayer will achieve federal estate tax savings as a result of making the gift depends upon whether or not the gifted assets appreciate between the time of the gift and death. To the extent that the gifted assets appreciate, that appreciation will escape federal estate tax. But, to the extent that the gifted assets do not appreciate, no federal estate tax savings from the gift will be obtained.
This result, though counterintuitive, is the by-product of the method by which federal estate taxes are calculated. Federal estate taxes are based on the assets owned by an individual as of the date of death, plus the amount of all taxable gifts made by the individual during life (valued as of the date of the gift). Federal estate taxes are imposed on the sum of these two amounts after applying the full amount of the taxpayer's federal estate tax exemption in effect at the time of death. As a result, any appreciation in the gifted assets subsequent to the date of the gift is not taken into account.
By way of example, assume a taxpayer made taxable gifts during his lifetime of $3,000,000 and that those assets appreciated to $9,000,000 at the time of death. Also assume that the taxpayer owned $2,000,000 of taxable assets at death. The federal estate tax would be calculated based on the sum of taxable lifetime gifts and the assets owned at death, or $3,000,000 + $2,000,000 = $5,000,000. The $5,000,000 federal estate tax exemption would then be applied against the total. The $6,000,000 of appreciation on the gifted assets would escape federal estate tax. However, if the gifted assets did not appreciate subsequent to the gift, the taxpayer's estate tax calculation would not change, and the taxpayer would not have realized any federal estate tax savings from the gift. Massachusetts estate tax savings would have been realized since the Massachusetts estate tax would be calculated based solely on the $2,000,000 of assets owned by the taxpayer at death.
This method of calculating the federal estate tax also creates a possible "clawback" situation, whereby if the federal estate tax exemption were to be lower at the time of death than at the time of the gift (which previously has never happened, but which may happen if the current estate tax exemption is reduced from its current amount of $5,000,000), then the amount of the gifted assets could exceed the exemption amount applied at the date of death. This would subject the gifted assets to more tax at the date of death than was anticipated at the time of the gift due to the application of the lower exemption amount. However, the individual will be in no worse of a position than had he or she not made the gift.
In our previous example, if as of the date of death the federal estate tax exemption has decreased from $5,000,000 to $1,000,000, then a $1,000,000 exemption amount would be applied (instead of the $3,000,000 worth of exemption amount that was used at the time of the gift). This "clawback" would result in $4,000,000 of assets being subject to federal estate tax, due to $5,000,000 of assets subject to estate taxes reduced by the $1,000,000 exemption in existence at the time of death. Assuming the current federal estate tax rate of 35%, a $1,400,000 federal estate tax at the date of death would result, even though only $2,000,000 of assets were actually owned by the decedent at the date of death.
It is also important to keep in mind that the benefits of making large gifts are not limited to the ultra-wealthy. Lifetime gifting can benefit individuals of more modest means. Consider the case of an individual with a primary residence worth $300,000, investment assets of $500,000, a pension to help fund retirement, and a vacation home on the Cape worth $600,000, all of which taken together will comfortably take care of the individual's projected lifetime needs. If this individual continues to own all of the assets until death, a Massachusetts estate tax of approximately $58,000 will be owed. No federal estate taxes will be owed if the federal estate tax exemption amount does not decrease to $1,000,000. If the vacation home were to be gifted away prior to death, it would be possible to substantially reduce, or possibly eliminate, Massachusetts estate tax.
Finally, individuals should be aware that there is a possible income tax disadvantage associated with gifting assets. Gifted assets have carryover basis, meaning the recipient of the gift takes the donor's basis. As a result, if the recipient subsequently sells the assets, the recipient would be responsible for the capital gains tax on the appreciation of the assets over the donor's basis. If the donor instead retained the assets until death, the basis in the assets would have been increased (or stepped up) to date of death value, resulting in no capital gains tax upon the subsequent sale of the assets after the donor's death. However, the assets would still be subject to any applicable estate taxes. Individuals must keep in mind that all types of taxes must be taken into account in order to achieve the best overall tax result when contemplating gifting.
In conclusion, individuals should carefully consider the possible benefits offered by lifetime gifting. Given the current financial climate, waiting too long could definitely result in a lost opportunity.