By: Randall A. Denha, Esq.
Clients often ask what they can do to reduce the estate tax bite. I begin with the obvious: you have to reduce the value of your taxable estate. There are many ways to accomplish this objective, including the use of irrevocable trusts and other sophisticated estate planning techniques. But one of the most effective methods is also the simplest: leveraging your annual gift tax exclusion. Using this technique can cut down your estate to a manageable size without paying any federal gift tax. Not only will gift and estate planning increase the amount of wealth that you can transfer to your beneficiaries by reducing the eventual estate taxes, it can also improve the future management of your assets. Trusts and other planning vehicles can assist in the transition of your assets to your beneficiaries who may not be fully prepared to manage them after your death. Here are some effective strategies to consider:
Use Annual Exclusion
Using the annual gift tax exclusion, you can give to an unlimited number of family or friends cash or property valued up to a specified amount each year without owing any gift tax — so long as the gifts are considered to be “present interest” gifts. In general, a present interest gift is one in which the beneficiary has an unrestricted right to immediately use and enjoy the property. If you repeat the gifting strategy over several years, you’ll see your taxable estate dwindle, while still keeping the assets within the family. The annual gift tax exclusion is currently $14,000 per recipient, subject to inflation adjustment. In other words, you can give each recipient gifts of cash or property valued up to $14,000 each year ($28,000 if you are married) with no gift tax consequences. You can apply this exclusion for gifts to any number of people. If done on an annual basis to all your beneficiaries, you can end up transferring substantial amounts out of your estate without using any of your other estate or gift tax exemptions.
Let’s suppose you have three adult children and seven grandchildren. If you give each one of them $14,000 in 2016, for a total outlay of $140,000 (10 × $14,000), you’ll have reduced your estate by that amount without paying federal gift tax. If you continue this strategy for five consecutive years, you will have handed out $700,000 (5 × $140,000) completely free of gift tax. You don’t even have to file any gift tax returns! What’s more, if you’re married, you and your spouse can give away a combined gift of up to $28,000 a year — via split gifts — without any gift tax. Assuming you follow the same pattern of gifting all 10 family members for five years, you will have reduced the value of your estate by $1.4 million.
Of course, by giving away cash or property, you’re relinquishing full control over those assets. Once they’re out of your hands, they’re technically gone forever. However, if this was your ultimate goal anyway, the annual gift tax exclusion can certainly provide the means with little fuss.
Giving assets that appreciate in value
The rules are a little trickier if you’re gifting assets such as securities. Generally, the value of property for gift tax purposes is its fair market value. If you gift property that’s appreciated in value, the recipient must use your basis (usually, the original cost) to compute the taxable gain if he or she subsequently sells the property. Nevertheless, the gain will be taxed to the recipient, who’ll likely be in a lower tax bracket than you. Thus, gifting can result in income tax savings for the family as well.
You can directly pay unlimited tuition and medical expenses for any person free of gift taxes. This exclusion is in addition to the annual $14,000 per individual gift tax exclusion and includes health insurance premiums and tuition payments for elementary school through graduate school. You must make these payments directly to the qualifying educational organization or medical provider and, in the absence of other gifts that may be reportable, you won’t have to file a gift tax return.
Finally, you have one other gift tax break in your pocket: the lifetime gift tax exemption. This exemption applies to gifts of up to $5 million, indexed to $5.45 million in 2016, after you’ve exceeded the annual gift tax exclusion. But using any part of this exemption erodes the available tax shelter from estate tax, so you might decide to limit your lifetime gift giving to amounts covered by the annual gift tax exclusion. Absent a gift in this fashion, the transferred assets remain in your estate with all future income and appreciation thereon subject to estate tax, either at your death, or, if married, typically at your surviving spouse’s death.
Gifts to minors
One of the common methods of making gifts to children and grandchildren under the age of 21 is to arrange for ownership of the assets to be held by an individual as custodian for the minor under the Michigan (or other state) Uniform Transfers to Minors Act (UTMA). [This type of ownership was previously under the Michigan Uniform Gifts to Minors Act (UGMA)]. Under the UTMA, the custodian is required to transfer the property to the minor upon the minor’s attaining age 21, or to the minor’s estate upon the minor’s death before age 21. However, it is possible for the custodianship to terminate at age 18 if the designation of ownership contains, in substance, the phrase “until age eighteen.” It is important to make sure that the person who gifts the property does not serve as a custodian under the UTMA for the minor with respect to that property. If the donor is serving as a custodian and dies before the UTMA status terminates (e.g., before the minor reaches the age of 21), the property held under the UTMA will be included in the donor’s taxable estate for estate tax purposes. Fortunately, this result can be avoided with proper planning.
Other methods for transferring assets to minors include:
- Section 529 college savings accounts,
- Section 2503(c) trusts for the benefit of persons under 21 years of age,
- Life insurance trusts,
- Discretionary trusts (preferred!),
- Direct payment of educational and medical expenses, and
- Totten trust (pay-on-death) bank/securities accounts.
Use loans rather than gifts
Lending money to your beneficiaries is a viable option to avoid current gift taxes or the use of your lifetime gift exemption. You can then use your annual gift tax exemptions to enable your beneficiary to pay the interest due and/or part of the debt principal each year. For the month of October 2016, the minimum interest rates required by the Internal Revenue Service to be charged on loans requiring interest rates to be paid annually, referred to as applicable federal rates (AFR) are:
- .66% if the term of the loan is three years or less.
- 29% if the term is more than three years and less than nine years.
- 95% if the term is nine years or longer
Meet and discuss with your team
Even though using the $14,000 per recipient annual exclusion is a simple way of reducing your taxable estate, this is not to say you should abandon other more sophisticated estate planning techniques designed to maximize the benefits of the $5.45 million gift and estate tax exemption. Techniques such as GRATs, Sales to defective trusts, Generation skipping trusts, Charitable Trusts, Family partnerships, QPRTs are just a few additional ways to reduce the value of an estate. Of course no tax planning should be undertaken if it fails the non-tax reasons for doing so. For example, if the money will be wasted if gifted or spent or to support a lifestyle you disagree with then any gifting may need to be further thought through.