Changes in the federal transfer tax laws over the last few decades, as well as the economic volatility brought on by a global pandemic, have called into question the wisdom of making large lifetime gifts for estate planning and tax purposes. In today’s economic and tax environments, many professionals remain uncertain about whether advising clients to make lifetime gifts still makes sense. Given the large estate and gift tax exemption amounts, and the decreases in value of many types of accounts and properties caused by COVID-19, it may be a perfect time for clients to make significant gifts to family members or loved ones. Helping clients understand the tax consequences and other issues surrounding gifting is critical, however, so they are informed before making large gifts.
Annual Gifting and Gift Taxes
In 2020, an individual can make tax-free gifts of up to $15,000 per person per year using the annual federal gift tax exclusion. A married couple can give up to $30,000 per year to each child without needing to file a federal gift tax return. Such gifts can be made by each spouse individually, or one spouse can make the entire $30,000 gift from separate assets and attribute half of that gift to the other spouse through the practice of “gift-splitting.” When gift-splitting, the couple must file an Internal Revenue Service (IRS) Form 709, Gift (and Generation-Skipping Transfer) Tax Return, which notifies the IRS that half of the gift should be allocated to the spouse.
Gift-splitting can be very useful when a couple wants to gift property that is titled in the name of only one spouse such as stock, business interests, or real property. It is important to note, however, that once a married couple elects gift-splitting on a gift tax return, the IRS will consider all gifts made during the year by either of them to be split evenly between the spouses regardless of whether the couple wants this outcome.
The Lifetime Gift Tax Exemption
If an individual makes an annual gift to someone in excess of $15,000 per person per year, an IRS Form 709 must be filed to report the excess gift. Every gifted dollar over $15,000 made to an individual is subject to federal transfer taxes (at an approximately 40 percent tax rate).
Even though a gift may be subject to the gift tax, this does not necessarily mean that the client will have to pay the tax. In addition to the annual gift tax exemption, each U.S. citizen currently enjoys a historically high $11.58 million lifetime estate and gift tax exemption to apply against any gift or estate tax that may be due. Under current law, this exemption amount will continue to increase, indexed with inflation, through the end of 2025.
This exemption is like a coupon that can be used against gift taxes that would otherwise be due. Once all $11.58 million of the exemption has been used, the client will then be required to pay gift taxes on gifts that exceed the annual exemption amount.
If your client is looking to do a lot of gifting, it may be advisable for these gifts to be made prior to 2026, as the IRS released final regulations in November 2019 providing that taxpayers who take advantage of the higher gift and tax exemption applicable between 2018 and 2025 will not lose the tax benefit of the higher exclusion amount upon their subsequent death on or after January 1, 2026, when the exclusion is set to decrease to the pre–tax reform level.
Not all gifts are created equal, and a client should understand this before making a gift. Each type of gift has its own tax and other consequences that should be considered before the client ultimately turns over ownership of any money or property. Outright gifts of cash, stock, real estate, or any other form of property are easy to make. However, although outright gifting may be the simplest way of making gifts, once the gift is made, the property can no longer be controlled or protected by the donor. With full control and ownership, the donee is free to use the gift in any way the donee chooses. This could include spending, selling, encumbering, or otherwise using the gift. The gift could also be seized by any creditors of the donee or considered in a divorce proceeding.
Gifts to Irrevocable Trusts
Risks posed by creditors, lawsuits, divorce, and irresponsible management of assets associated with outright gifting cause many individuals to consider making gifts to irrevocable gifting trusts. Such trusts enable clients to make gifts that qualify as gifts for transfer tax purposes, and also to better control and protect the gift for the person receiving it based on the terms of the trust and the directions given to the trustee for using the gift.
Gifts of Family Business Interests
Another important and useful method for making gifts is for the donor to contribute assets such as real estate or stocks to a family limited partnership (FLP) or family limited liability company (FLLC). The donor can then make gifts of membership interests in that business entity to family members. Gifting in this manner can provide important methods of control over the assets in the business entity by the majority owner (often the donor). This method of gifting also allows the donor to reduce the value of the assets, for gift tax purposes, in the business entity through the use of valuation discounting. Such reductions allow for the transfer of more property at a lower tax cost than would be possible through outright gifts.
Income Tax Considerations
Clients are often surprised by the potential negative tax consequences that accompany gifting. Other than cash, most accounts and property carry a tax basis that results in some level of capital gain when the account or property is sold or converted to cash. When accounts and property appreciate and are then gifted, the tax basis of the gifted account or property carries over to the gift recipient. As a result, if the recipient later sells the account or property, some portion of the increase in value could be subject to capital gains tax. On the other hand, if an individual waits to transfer an account or property to someone through a testamentary instrument like a will or revocable living trust, the account or property would get a stepped-up basis, meaning that any gains on that property based on the date of death value of the property would be effectively erased. The new tax basis for the recipient of the testamentary gift would be the date of death value of the property, decreasing the amount of capital gains tax due.
Deciding Whether to Gift Now
Because of the historically high gift and estate tax exemption, many advisors feel that in certain cases, it makes sense for some clients to aggressively use their gift tax exemption now because of the risk that Congress will reduce the exemption amount in 2026, leaving clients with a missed opportunity. Additionally, gifting during life can provide the donor with the certainty that the donee has in fact received title to the gift, and the donor can ensure that any future growth of the gifted account or property takes place outside of the donor’s estate, further reducing estate taxes at the donor’s death.
In addition to tax benefits, clients can gain significant nonmonetary benefits from seeing their donees enjoy and use their gifts while the client is still alive. Observing how a donee uses (or in some cases, squanders) a lifetime gift could provide the client with valuable information for structuring the remainder of the client’s estate plan with regard to that donee.
Why Gifting Makes Sense For You
You can play an important role in your clients’ decisions to make gifting a part of their estate planning strategy. Whether it is an outright gift or one made in trust, a gift tax return has to be filed. This is an extra return preparers can add to their existing services. Additionally, if an irrevocable trust, FLP, or FLLC is created, an additional yearly income tax return may need to be filed for those entities. If an account is being gifted, you have the ability to gain a new client by discussing the benefits of keeping the money in the account as opposed to liquidating it. Lastly, if the client is choosing to make a substantial gift to one person, the client may need a way to equalize gifts among multiple donees. Life insurance can be a great way to provide liquidity to the client so that in the end, all beneficiaries receive the same value.
Tap into Your Client’s Team
As you can see, there are many considerations when advising a client on whether to make large gifts. Legal, tax, and financial considerations should all be weighed carefully in decisions like these. A team approach that includes a client’s tax advisor, financial advisor, and legal counsel can provide crucial information to help clients make informed decisions. We encourage you to let us know if you or your clients are considering making significant gifts. We are here to help. Please call us today to set up a virtual or in-person meeting so that we can assist you.