MLR

Reduce estate tax through lifetime gifting

Federal estate tax, generally speaking, is imposed on what you own when you die. Thus, a way to reduce exposure to estate tax is to reduce your taxable estate through life-time giving.

gift of money

There are a couple of variables to keep in mind for life-time giving. First, every donor can give $14,000 per donee per year without any tax consequences. This is called the annual exclusion. Thus, if you have five children, you can give each of them $14,000, or a total of $70,000. Spouses may combine their annual exclusions, so husband and wife could give $140,000 to five children each year. Over 10 years, these gifts could represent a transfer of $1.4 million.

Gifts that use the annual exclusion must be gifts of present interests. Sometimes this is undesirable because the donee may be a minor child or a spendthrift. However, there are ways to structure the transfers using irrevocable trusts with what are called “Crummy” powers (named after an IRS case involving a taxpayer named Crummy) that can qualify the gifts for the annual exclusion.

A way to increase the bang of your annual exclusion gift is to make gifts of fractional interests in property. Suppose you have a family farm and wish to give away a fraction of it each year to take advantage of the annual exclusion. Let’s say the farm is worth $1 million. You might think that a gift of 1 percent of the farm would be valued at $10,000 since 1 percent of a million dollars is $10,000.

However, fractional or partial interests may be discounted because the limitations of partial ownership can depress the value of the interest being transferred. Multiple owners share control and the rights to use and occupancy.

Using the property as collateral for a loan is more difficult – banks may not accept a partial interest as collateral. A fractional interest is harder to sell, making it less liquid.

These sorts of factors, in the hands of a qualified appraiser who understands how to calculate discounts and what the IRS is likely to accept as reasonable, can result in substantial discounts, enabling you to cram more of the farm into each $14,000 transfer.

The same principle applies to gifts of shares in a limited liability company or other entities. Appraisers should apply discounts for lack of control and lack of marketability. However, the IRS may challenge some transfers if it appears that creation of the entity is merely for the purpose of accomplishing gift giving to minimize taxes.

More sophisticated gift-giving estate planning requires the advice of professionals familiar with court cases and IRS regulations concerning attempts that, in the view of the IRS, unfairly exploit the concept of discounting gifts.

In addition to the $14,000 annual exclusion, gifts for medical care and education – tuition only, not room and board, books, etc. – are tax free. However, the payments must be made directly to the educational institution or medical care provider, not to the donee, because making direct gifts is the only way to guarantee that the money has been applied for the exempt purpose. Gifts to spouses and gifts to charity are also exempt from gift tax.

If you make gifts that are not exempt from gift tax or covered by the annual exclusion, you can use what’s referred to as the federal estate tax exemption to offset the gift. We all have a credit – currently $5.43 million – that can be applied to our estates to exempt property from federal estate tax, but it also can be used to exempt lifetime gifts from federal gift tax.

To the extent that you use the credit to exempt lifetime gifts from tax, the amount available to exempt estate property from tax is reduced. However, in some situations, it makes sense to make lifetime gifts, even if they eat into the unified credit. For example, for gifts made now, future appreciation and income from the property after the date of the gift would be excluded from the donor’s taxable estate.

Federal estate tax can be as high as 40 percent. If your estate is large enough to be subject to federal estate tax, but you are comfortable parting with some of your wealth, life-time giving is a way to reduce exposure to this tax. Qualified professionals can help you create a life-time giving plan as part of your overall estate planning. – Mike Wilson, J.D.