In my prior blog several months ago, I explained in general terms the rules concerning lifetime gifting and potential gift taxes associated with such gifts. I now move on to the estate tax.
The estate tax and gift tax are linked at the hip, so to understand the estate tax, it’s necessary to lay some groundwork by explaining the relationship between the estate and gift taxes. Under current law, each US citizen, (as well as resident aliens, and we are talking legal resident aliens here), has an exemption from the gift tax of $5.49 million. This means that, in addition to the annual gift tax exclusion of $14,000 per person per donee (and if you read our prior blog on , you will know exactly what I am talking about) each person may make tax free gifts during their lifetime of $5.49 million without incurring any gift tax whatsoever. So for most of us, that eliminates any concerns about paying the gift tax. Even if I have $5.49 million, I’m certainly not going to give it to anyone! And if you are married, then you and your spouse have a combined gift tax exemption of $10.98 million, (and I’m going to be certain my wife doesn’t give away her nonexistent $5.49 million either).
But, believe it or not, there are people out there who do make gifts of these very large amounts. (And just to be clear, gifts to charities are entirely exempt from the gift tax, regardless of the amount.) So, as the old song goes by the one who writes the songs (that’s right, Barry Manilow), “this one’s for you”, being those of you who have the wherewithal to make multi-million dollar gifts. If you are still reading, you are either 1) a tax professional, 2) a person with a lot of money, or 3) a person who hopes someday to have a lot of money with which to make gifts.
Here is how the gift and estate taxes are linked. Leaving aside the annual exclusion gifts (remember, those are annual gifts that you can make of up to $14,000 per year to any number of persons, including me if you are so inclined, which do not incur any gift tax AND which do not count against your $5.49 million gift exemption), to the extent you utilize any of your $5.49 million gift tax exemption, such utilization counts against your estate tax exemption, which by some miracle, also happens to be exactly $5.49 million. So you see how the gift and estate exemptions are linked: they both start out at $5.49 million (although this amount is increasing every year, based upon some inflation index) and if you use some of the $5.49 million during your lifetime, that is considered a gift, which reduces both your gift tax exemption and the amount of estate tax exemption remaining at your death. And it is the remaining estate tax exemption which your heirs may apply to your estate at your death (or mine, if I’m the one doing the dying).
So to understand this, let’s just create an example. Let’s say Jim is single and has an estate valued at $7.0 million and he has two children. For various reasons, he has decided to set up a trust for the benefit of his children and transfers $3.0 million of his estate into the trust. As a result, he now has an estate worth $4 million and his children are beneficiaries of a trust that holds $3 million. The transfer of the $3 million to the trust for the benefit of his children is a taxable gift. So he files a gift tax return, reporting the $3 million gift. Before he made the gift, he had a gift tax exemption of $5.49 million. So following a gift of $3 million, his gift exemption is reduced by $3 million from $5.49 million to $2.49 million.
Now let’s say Jim lives another five years and his estate has increased from $4 million back up to $7 million, so Jim decides to transfer another $3 million to the trust he previously established for his children. (By the way, for those who know my dad’s name was Jim, please understand this example is by no means autobiographical.) So if Jim makes a gift of $3 million, since his remaining gift exemption was only $2.49 million, his gift exceeds the remaining exemption by $0.51 million, so Jim must pay a gift tax of 40% on the amount by which the total of his lifetime gifts exceeds his lifetime exemption.
One more example. Let’s say that Jim died before making the second gift of $3 million, so at his death, his estate was worth $7 million and he had made lifetime gifts of $3.0 million. This would mean that at his death, he had $2.49 million of unused gift tax exemption. The good thing is that this unused gift tax exemption of $2.49 million can be applied at death to his $7 million estate, so his taxable estate will be the $7 million value, reduced by the remaining exemption of $2.49 million, leaving $4.51 million of the estate subject to the 40% estate tax. So you can see that the estate tax exemption is generally equal to $5.49 million, less the amount of taxable gifts made by the deceased person prior to death.
One of the reasons we write these blogs is to make sure our readers are so confused afterwards, that they realize they need professional assistance and will call us. So with that goal in mind, let me introduce one additional wrinkle to the gift and estate tax. Let’s now say that we have a couple, Dave and Kathy, and they have an estate valued at $8 million. And let’s say that they don’t make any gifts to their children during their lifetimes, and that Dave, after a long and successful life, moves on to his reward, leaving Kathy with her reward of $8 million for staying with Dave all those years. And let’s also say that Dave and Kathy did no estate planning, so on Dave’s death, Kathy inherits the entire estate directly. Since Dave had a $5.49 million exemption to apply to his estate, there would be no estate tax on his death as to his one-half of the estate, $4 million. However, since Dave left it all to his wife, his estate did not need to use his $5.49 million to cover his estate tax, so his $5.49 million exemption is not needed. But the problem is, when Kathy dies, her estate, assuming it remains at $8 million, will exceed her $5.49 million exemption. Therefore, if her estate is valued at $8 million on her death, $2.51 million would be subject to tax unless there is something their capable, not to mention charming, estate planning attorney can do to save the day. And there is. By filing an estate tax return on Dave’s half of the estate, we can preserve Dave’s $5.49 million exemption, so Kathy will have available at her death not only her $5.49 million exemption, but she can also use Dave’s unused and previously unneeded exemption, thus allowing her to leave $10.98 million tax free to their deserving children. This procedure is called “portability” and merely means that the estate tax exemption available to the estate of the first spouse to die may be preserved for the surviving spouse’s estate tax return merely by filing an estate tax return upon the first death of the spouses.
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