Under current law, the unified credit against estate and gift tax sits at $10,000,000, subject to indexing for inflation (the “Exemption”).[1] As a result of the Tax Cut and Jobs Act, this number increased from $5,000,000 effective January 1, 2018 and through December 31, 2025, with the number set to drop back down to $5,000,000on January 1, 2026.[2] After taking into account adjustments for inflation, the Exemption currently sits at $11,700,000 for 2021[3] and is set to increase by $360,000 to $12,060,000 for 2022.[4]
The Exemption has been the topic of much discussion lately. On September 15, 2021, the House Ways and Means Committee approved certain tax provisions to be included in the draft of the Build Back Better Act (“BBBA”), one of which was accelerating the sunset reduction in the Exemption from 2026 to 2022. This change, along with quite a few other changes including the grantor trust rules, caused quite a stir with planners. However, the most recent version of the BBBA dropped these changes and the Exemption appears to be safe for now.[5] But the Exemption could change at any time with a simple amendment or addition to any bill should Congress choose to do so. From a technical standpoint, reducing the Exemption can be achieved by simply amending §2010(c), no technical drafting would be required. And with this amendment having already been drafted previously, simply dropping it into the BBBA or another bill would not take much effort. We are at the mercy of Congress for whether this happens later this year, perhaps early next year, or not at all.
With initial proposed reduction of the Exemption in the first draft of the BBBA, and the ease of which it could be added back later this year or even early next year with a retroactive date of January 1, 2022, does it make sense for taxpayers contemplating lifetime gifts to make them now? As with most questions, the answer is it depends on a lot of varying factors and what happens in the future. Given that question has come up a lot recently, one should consider the pros and cons of lifetime gifting. While we can’t predict what the future holds as far as law changes, appreciation or depreciation, death, etc., we can analyze the pros and cons and make the best decision we can with the information we have available.
Pros of Lifetime Gifting
Potential Use or Lose It with Regard to the Exemption
The Exemption sits at $11,700,000, but that could change at anytime should Congress choose to do so. If nothing happens prior to the end of the year in 2025, then this number will automatically be cut in half as a result of current law. What happens if you don’t use it before it goes away? Unfortunately, at that point, it is too late. Since the use of the Exemption, whether for estate or gift tax purposes, uses the bottom dollars first, any reduction in the Exemption which brings the Exemption down to an amount less than what the taxpayer has currently used, results in a permanent loss of such unused Exemption, unless of course Congress decides to increase the Exemption at a later date. A quick example might clarify this: Taxpayer gifts $5M and uses $5M of Exemption at a time when the Exemption amount is $10M. Subsequently, Congress reduces the Exemption amount to $5M. Taxpayer now has no Exemption left. Had Taxpayer made a $10M gift and used $10M of Exemption prior the reduction, taxpayer would still be left with no Exemption but would have availed himself or herself of the benefit of removing $10M from his or her estate rather than only $5M.
Remove Future Appreciation from Estate
By transferring assets at their current value, taxpayers can remove future appreciation on such assets from their estate. The value of the gift, and thus the amount of Exemption used (and tax paid if applicable), is determined as of the date of the gift. So, if taxpayer transfers property with $10M in 2021, and it balloons to $15M in 2022, the Exemption amount used is only $10M, the value of the property at the date of the gift. That additional appreciation of the $5M is not included in the taxpayer’s estate nor does it use taxpayer’s Exemption. To this end, selecting assets to gift that have the highest likelihood of significant appreciation during one’s lifetime maximizes this benefit.
Leverage Potential Discounts Available
The discussion of discounting for gift and estate tax purposes is yet another hot topic that may or may not be on the chopping block in the future. Under the Obama administration, the hotly debated and somewhat controversial (depending on who you ask) proposed Section 2704 Regulations attempted to curb this practice for closely held entities, but such Regulations were subsequently withdrawn. A full discussion of this is and the reasons and analysis of discounting is far beyond the scope of this article. However, at least under current law, courts have consistently recognized a variety of discounts for assets that were gifted, such as lack of control, lack of marketability, and tax affecting discounts for gifts of entity interests, and partial interest discounts for gifts of real estate. By combining the use of the Exemption with appropriate discounting, taxpayers can leverage the use of their Exemption to transfer more value than the amount of the Exemption that is used. By way of a quick example, taxpayer transfers an interest in a closely held business that has a net asset value of $10M, but due to lack of control and lack of marketability, it is determined that the fair market value of the interest is only $7M. Thus, taxpayer has transferred $10M in net asset value but only used up $7M of Exemption for the gift.
Shifting of Income
By transferring income producing assets downstream or into trusts, taxpayers can shift that income to other taxpayers. This can, in the right situation, serve to lower tax in the aggregate, and can also provide the beneficiary with income to use. Of course, whether the tax is lowered depends on a variety of factors including what income tax brackets the grantor and beneficiary are in, and if in trust, the type of trust for income tax purposes. If the trust is a nongrantor trust, then the answer depends on whether distributions are made that carry out income causing the beneficiary to be taxed on the income or if the income is taxed at the trust level.[6] If the trust is grantor trust, the grantor will still be taxed on the income even though the beneficiary receives it. This of course can be a powerful way for the taxpayer to make additional gifts tax free in the form of paying the income tax.[7] Regardless of the tax situation, shifting income downstream can prevent additional growth in the grantor’s estate and serve to provide the beneficiary with the benefit and enjoyment of the income.
Watching Beneficiaries Enjoy the Fruits of the Gift
This one is a hot topic and many folks debate the pros and cons of lifetime gifting from the standpoint of whether it is beneficial to the beneficiary. See my discussion of the flipside of this argument below, but one benefit of lifetime gifting is the grantor’s ability to watch the recipient enjoy the benefits of the gift. Perhaps the grantor spent his or her whole life building up a business and now wants to enjoy the fruits of his or her labor and watch his or her family do the same. By making lifetime gifts, the grantor’s children and descendants do not have to wait until the grantor is gone to enjoy these benefits, and the grantor might take great joy himself or herself in being alive to see others enjoy these benefits.
This might also serve in another manner by allowing the beneficiary to take a job or choose a career path that he or she might not otherwise choose due to financial reasons. If they know they are financially secure, they may be much more likely to choose a career or job that they enjoy rather than choosing something for financial reasons.
Creditor Protection
Assets that are gifted during life are generally no longer subject to the grantor’s creditors, absent any fraudulent conveyance or bankruptcy avoidance issues. Once the asset is owned by a third party, it generally would not be available to satisfy creditors of the grantor. Further, by making such a transfer to a properly drafted trust, gifted assets can also be protected from the recipient’s creditors, including the possibility of divorcing spouses.
Gift Tax is Cheaper than Estate Tax
The gift tax rate and the estate tax rate are the same, so how can the gift tax be cheaper? Well, the answer is due to the tax exclusive nature of the gift tax versus the tax inclusive nature of the estate tax. In short, gift tax is not paid on the money that is actually used to pay the gift tax, thus it is tax exclusive. On the flip side, estate tax is paid on the money that is actually used to pay the estate tax, thus it is tax inclusive. As illustrated by the example below, this distinction results in the gift tax actually only costing 28.57% rather than the 40% cost of estate tax, all else being equal and assuming that if no gift tax is paid, then estate tax would be paid.
Taxpayer has no Exemption left, and $1.4M. If he or she were to gift $1M to the beneficiary, he or she would owe $400K in gift tax. As a result, the recipient receives $1M and the IRS gets $400K. What if taxpayer just held that $1.4M and left everything to the recipient at death, all of it being subject to estate tax? The estate tax owed on that $1.4M is $560K, leaving the recipient with $840K. The reason for the difference is that under the gift example, the $400K used to pay the gift tax was not subject to tax, but the money used to pay the estate tax in the other example was subject to estate tax. Doing the math, in the gift example, the effective tax rate of 28.57% is calculated as follows: 400,000 (tax paid)/1,400,000 (total). Doing the same math for the estate tax example, you get 40%, 560,000 (tax paid)/1,400,000. Accordingly, while it may not make sense before diving into the math, all else being equal, the gift tax is cheaper than the estate tax and there are many situations where it makes sense to go ahead and pay the gift tax during life rather than waiting to be subjected to the estate tax at death.
Cons of Gifting
Loss of Basis Step Up
Perhaps the biggest downside to making a lifetime gift is the loss of the step up in basis at death under §1014, assuming the gifted assets increase in value. Under §1014, assets that are included in the estate of decedent generally receive a step up in basis to the fair market value of the asset at the date of the decedent’s death. By gifting assets during life in a manner that causes such assets to not be included in the taxpayer’s estate at death, the taxpayer loses the benefit of this step up in basis. Of course, §1014 also applies to cause a step down in basis, so this could be seen as a pro in the case of assets that have a built-in loss.
Loss of Use
This one really does speak for itself. By gifting assets away, the taxpayer loses access to and use of such assets. Of course, the beneficiary might be generous and allow the taxpayer to still use the beach house that he or she gave away on occasion (this may have its own tax consequences), but the taxpayer would have no right to use such assets once given away absent the generosity of the recipient.
Loss of Control
When a taxpayer makes a gift, he or she must part with “dominion and control”[8] in order for the gift to be considered a completed a gift for federal gift tax purposes. Additionally, there are numerous provisions in the estate tax code that serve to pull assets back into the estate of the grantor where he or she maintains certain aspects of control.[9] Thus, a taxpayer loses (or should lose) control over assets that are gifted away. Of course, there are ways to mitigate this, one being transferring such assets to a trust over which the grantor retains indirect control by controlling who the Trustee is, as long as this power over the Trustee has appropriate limitations.[10]
Loss of Income
As discussed above regarding shifting of income, the grantor loses the income that is generated by assets that are gifted during life. This may well be a pro as we’ve discussed, but it might also be a con if taxpayer relies on income from gifted assets. Accordingly, the grantor must be willing to part with that income, and if not, perhaps the gift is ill-advised or another asset should be chosen.
Potential Negative Effect on Productivity of Beneficiaries
Many people fear that gifting assets to their children too early or without the appropriate limitations will have a negative effect causing such children to be unproductive or to subject the gifted assets to misuse, loss, or other unintended consequences. Unproductive is a relative term, but the general thought is a so-called “trust fund baby” who has no drive, no job or career, and generally just lives a life of leisure thanks to gifts received from relatives. This is always a risk, but the use of a properly prepared trust can certainly serve to mitigate this risk, as can instilling a work ethic and values in children at a young age such that this hopefully will not be an issue.
Potential Claw Back[11]
One topic that has been discussed ad nauseum over the years is the potential claw back of previously used Exemption which may result in additional estate tax for the taxpayer. Say you gift $10M and use all of your Exemption, and then the Exemption is reduced to $5M, the claw back would serve to pull that additional $5M of Exemption back into your estate at death. Thankfully, at least for now, this does not seem to be a concern or a target of even the most aggressive tax proposals, and we now have the anti-claw back rules in place to provide us some certainly in this area.[12] Of course, as with any other tax laws, Congress could change this, but at least for now, taxpayers can feel good that the claw back will not apply.
What to Do?
As with any complicated analysis, it’s difficult to determine what the right answer is, particularly given our ever changing tax laws and the economy. Unfortunately, we do not have a crystal ball to predict the future, so all we can do is weigh the pros and cons and make the best decision we can using the information available to us at the time of the decision. I will however, throw in one piece of advice that I often tell clients when they are debating whether to make a gift, don’t let the tax tail wag the dog. There are more important things in life than tax, primarily the taxpayer’s own comfort and security. If making a large gift will put the taxpayer in a situation where he or she feels vulnerable financially, then it is probably not the best idea.
[1] §2010 and §2505.
[2] §2010(c)(3)(C).
[3] Rev. Proc. 2020-45.
[4] Rev. Proc. 2021-45.
[5] For a discussion of the BBB and the most updated version as of the date of this writing, please see Devin Mills’ article titled “Proposed Tax Changes in the Updated Build Back Better Act”, November 10, 2021, https://esapllc.com/bbba-2021/.
[6] A discussion of income taxation of trusts is far beyond the scope of this article, but suffice to say there are some income tax strategies that may be used to lower overall tax by making or not making distributions from a trust as long as the trust is nongrantor trust that pays its own taxes.
[7] Rev. Rul. 2004-64, which states that a taxpayer has not made an additional gift by paying tax on a grantor trust.
[8] Treas. Reg. §25.2511-2.
[9] See §2036-2038, among others, that may serve to pull assets back into the estate of a grantor.
[10] Rev. Rul. 95-58.
[11] “IRS Issues Final Regulations Protecting Gifts Utilizing Enhanced Exemption Amounts”, Joshua W. Sage, November 26, 2019: https://esapllc.com/clawback-finalregs/
[12] Treas. Reg. §20-2010-1(c).
