On December 22, 2017, President Trump signed into law what is commonly known as the Tax Cuts and Jobs Act of 2017 (2017 Act). The 2017 Act increased the estate, gift, and generation-skipping (GST) transfer tax exemptions to $10 million, indexed for inflation ($11.18 million for 2018), and retained the estate/gift/GST tax rates of 40 percent. The gift tax exemption is now significantly larger than it has ever been, and larger than it was ever expected to be. Below are 10 things to consider in determining whether to make a gift to take advantage of the existing $11.18 million gift tax exemption. In addition to the tax benefits, making a gift during your lifetime allows your children or other beneficiaries to benefit from the gift, and you will also benefit by seeing them enjoy it.
- The $11.18 Million Gift Tax Exemption May Disappear. This is the perfect time to make a gift. If you have a large enough estate that you expect to be paying estate tax when you die, then it is more tax efficient to use gift tax exemption while you are alive as opposed to estate tax exemption when you die. Unfortunately, unless Congress acts sooner, the 2017 Act expires at the end of 2025 and will revert to $5.49 million estate, gift, and GST tax exemptions, adjusted for inflation. If you do not use all of your $11.18 million gift tax exemption before 2026, it may disappear forever.
- Tax Benefits of a Lifetime Gift. The primary estate tax benefit of a lifetime gift is that all of the future income and appreciation on the gifted assets passes estate tax free to the donee. For example, if you gave $11.18 million to a trust for your children in 2018 and lived another 20 years, then the trust would be worth almost $36 million and you would exclude almost $25 million more from estate taxes than if you had waited until your death to use the $11.18 million exemption (assuming 6 percent annual growth and assuming the trust is a grantor trust, as explained below). With a 40 percent estate tax rate, this $25 million excluded from your estate results in tax savings of $10 million. Another tax benefit is that you can currently create trusts with up to $11.18 million of assets that will be exempt from future gift, estate, and GST taxes forever.
- Cushion Effect. Another reason to make a gift now, while the gift tax exemption is $11.18 million, is to reduce the IRS’s motivation to audit the gift by contesting the discount. If you give significantly less than $11.18 million, then you will have a large cushion available to shield any potential revaluation of the assets from gift taxes. The IRS will have little motivation to argue about the value of discounted assets, such as limited partnership units or shares in a closely held business, if reducing the discount will not cause a gift tax.
- Supercharging the Gift with Discounted Assets. The best use of gift tax exemption is to gift assets that are subject to a discount. IRS regulations meant to eliminate discount planning were never implemented, so this continues to be an effective planning tool. For example, if you give away a limited partnership interest, the gift will qualify for discounts for lack of control and lack of marketability. In other words, the value of the gift takes into account that a hypothetical third party would not pay full value for a partnership interest that only entitles them to distributions in the discretion of the general partner. Typical discounts are in the 35 percent range, so a gift of an $11.18 million partnership interest could have a gift tax value of only $7,267,000.
- Best/Worst Assets to Give. The best assets to give are those most likely to appreciate. The primary benefit to the gift is excluding the future income and appreciation from estate tax, so the more the asset appreciates the larger the tax benefit. Unfortunately, no one can predict the future, so choosing the right assets is more of an educated guess than a science. The worst assets to give may be personal use assets. It is usually not a good idea to give real estate or other assets that you may use in the future. If you make a gift of personal use assets, then you will have to pay fair market value rent for your use of the asset to avoid estate taxes at your death.
- Disadvantages and Risks of a Lifetime Gift. The primary disadvantage of a gift is that you can no longer use the assets gifted. Another downside is that if the assets depreciate in value between the date of gift and your death, then you would have been better off – for gift/estate/GST tax purposes – if you had not made the gift. Another downside of a gift is that your family loses the benefit of the adjustment in basis at your death (that would have been available if you had not made the gift). Under the adjustment in basis rules the beneficiaries of your estate receive an income tax basis on the property they inherit equal to the fair market value of the property at the time of your death. This eliminates any built-in gain on the property that would otherwise be subject to income tax upon the sale of the property. The adjustment in basis only applies to assets that are included in your estate at death. With a gift, the donee receives a basis in the gifted assets equal to your basis in those assets before the gift. This is called “carry-over” basis. In many cases, the reduction in estate taxes outweighs the increased gain when the asset is eventually sold – but this will not always be the case. The potential estate tax benefits of gifting low basis assets should always be measured against the potential increase in income taxes.
- Treasury Regulations. The 2017 Act directs Treasury to create regulations to address any difference in the exemption amount at the time of a gift and at the time of death. Some refer to this as a “clawback.” For example, if you make an $11.18 million gift in 2018 and die in 2026 when the gift tax exemption is $5.49 million and estate tax rate is 40 percent, could your estate owe more than $2 million in estate taxes at your death due solely to the prior gift? It appears this is not what Congress intended and hopefully the regulations will clarify this soon.
- A Gift with a Safety Net (SLATs). The safest way to take advantage of the existing $11.18 million gift tax exemption is to only give assets you are positive to never need during the rest of your life. A more aggressive approach is for spouses to each create an irrevocable trust for the other (sometimes called a spousal lifetime access trust, or SLAT). This allows each spouse to retain access to the assets while both are alive. However, a spouse will lose access to the other trust when his or her spouse dies or if there is a divorce.
- Reasons to Give to a Trust. There are at least five important reasons to make gifts to an irrevocable trust, as opposed to a gift to an individual or a revocable trust. First, you can maintain control over the investment and distribution of the assets until your death by serving as the Trustee. Second, the beneficiaries of a trust enjoy a level of creditor protection not available if they own the assets outright. Third, with careful drafting the trust can be structured to protect the assets from a marital property division if a beneficiary divorces. Fourth, making the gift to a trust allows the assets to escape estate taxes at multiple generations. For example, if you give $11.18 million to a trust for your children, then – if the trust is drafted properly – the $11.18 million (and all income and appreciation on the $11.18 million) will not be subject to estate tax at your death, or the deaths of any of your children, or the deaths of any of your grandchildren, or any of your great grandchildren . . . and on and on forever or until the assets are eventually depleted or distributed out of the trust. Lastly, if you make the gift to a trust, then you get to choose the remainder beneficiaries – and can ensure the remaining assets will stay in your family if your children or grandchildren die without exhausting the trust assets.
- Using a “Grantor Trust”. If you retain certain specific powers over an irrevocable trust, then the trust will be ignored for income tax purposes and you will continue to report the trust income on your personal income tax return. This type of trust is known as a “grantor trust.” A grantor trust allows you to make gift-tax free transfers for the trust beneficiaries by paying the income taxes for them (essentially, a grantor trust grows income tax-free while you are alive, similar to a 401(k) or IRA). If at some point in the future, you no longer wish to pay the income taxes (you cannot be a beneficiary of the trust, so you are paying the taxes and receiving nothing in return), you can “turn off” the grantor trust feature by renouncing certain powers over the trust.
When planning for 2018, you may also want to consider these other gifting strategies: grantor retained annuity trusts (GRATs), installment sales to a grantor trust, forgiving loans, and qualified personal residence trusts (QPRTs).