A Primer on the Complexities of Gift Tax and Estate Tax

You likely already know that the tax code places limits on the amounts that individuals can gift to others (as money or property) without paying taxes. This limit is meant to keep individuals from using gifts to avoid the estate tax that is imposed upon inherited assets. It can be a significant issue for family-owned businesses when the business owner dies, and the business has to be sold to pay the resulting inheritance (estate) taxes. This is, in large part, why high-net-worth individuals invest in estate planning.

Current tax law provides both an annual gift-tax exemption and a lifetime unified exemption for the gift and estate taxes. Because the lifetime exemption is unified, gifts that exceed the annual gift-tax exemption reduce the amount that the giver can later exclude for estate-tax purposes.

Annual Gift-Tax Exemption

This inflation-adjusted exemption is $15,000 for 2020. Thus, an individual can give $15,000 each to an unlimited number of other individuals (not necessarily relatives) without any tax ramifications. However, unlimited amounts may be transferred between spouses without the need to file such a return – unless the spouse is not a U.S. citizen. Gifts to noncitizen spouses are eligible for an annual gift-tax exclusion of up to $155,000 in 2020.

For example, Jack has four adult children. In 2020, he can give each child $15,000 ($60,000 total) without reducing his lifetime unified exemption or having to file a gift tax return. Jack’s spouse can also give $15,000 to each child without reducing either spouse’s lifetime unified exemption. If each child is married, then Jack and his wife can each also give $15,000 to each of the children’s spouses (raising the total to $60,000 given to each couple) without reducing their lifetime unified tax exemptions. The gift recipients are not required to report the gifts as taxable income and do not even have to declare that they received the gifts on their income tax returns.

If any individual gift exceeds the annual gift-tax exemption, the giver must file a Form 709 Gift Tax Return. However, the giver pays no tax until the total amount of gifts in excess of the annual exemption exceeds the amount of the lifetime unified exemption. The government uses Form 709 to keep track of how much of the lifetime unified exemption that an individual has used prior to that person’s death. If the individual exceeds the lifetime unified exemption, then the excess is taxed at the current rate of 40%.

Lifetime Exemption from Gift and Estate Taxes

The gift and estate taxes have been the subject of considerable political bickering over the past few years, particularly the asset value at which estate tax should apply. In 2020, the lifetime unified exemption is $11.58 million per person. By comparison, in 2017 (prior to the recent tax reform), the lifetime unified exemption was $5.49 million.

This history is important because the exemptions can change significantly at Congress’s whim. For this reason, individuals have been hesitant to make large gifts as there was concern that the gifts could be “clawed back” into their estate if the estate tax limits were reduced in the future. However, the IRS recently came out with guidance to alleviate these concerns and provide a significant planning opportunity for donors. According to the IRS, “Individuals planning to make large gifts between 2018 and 2025 can do so without concern that they will lose the tax benefit of the higher exclusion level once it decreases after 2025.”

For example, a wealthy donor may be hesitant to gift $10 million, although that amount gifted would be under their lifetime exemption and thus not taxable. The concern is that a new administration would only allow for a $5 million estate tax; meaning half of the gift would remain in his estate. Under new IRS guidance, no matter when the person dies the full amount would remain exempt, even if the exclusion is reduced in the future.

With the additional clarification of the lifetime gift exclusion availability for future estates, wealthy donors should strongly consider ensuring that their gifting strategy maximizes future tax benefits.

Other Gift Exemptions

All donors, wealthy or not, should be cognizant of other gift tax exclusions such as certain gifts of medical expenses and tuition. When planned for correctly, these gifts are nonreportable and do not count against an annual or lifetime exclusion.

Cray Kaiser is here to help you understand the complexities of gift and estate tax. Please contact us at 630-953-4900 if you’d like to discuss your personal gifting strategy.