The Amazing and Likely Disappearing $5 Million Gift Exemption?

Posted on Mar 27, 2012

Current law allows tax free gifts up to $5,120,000 per taxpayer. However, this tax free amount is scheduled to fall to $1 million on January 1, 2013. What, if anything, should you do now? If you have the resources to make large gifts should they be completed before the end of the year?

A married couple can give up to $10,240,000 to their descendants, or trusts for their benefit, totally free of gift tax if the gifts are completed before the end of the year. The tax free amount has never been higher. Next year the couple would only be able to give $2 million before paying gift tax under the current tax laws.

President Obama’s proposed 2013 budget indicates his preference for an estate tax free amount of $3.5 million. However, it provides for a smaller gift tax exemption of $1 million. No one really knows what the tax laws will look like next year. Just recall the debacle that took place with the tax laws at the end of 2009. Because the two sides could not agree, the estate tax went away in 2010 and was scheduled to awaken in 2011 with a $1 million exemption. In late 2010 a dysfunctional Congress finally passed a temporary fix to the tax law which provided for the $5 million exemptions we currently enjoy, but provided that they would expire at the end of 2012.

The bottom line is this: If you are inclined to make large gifts they are probably better made this year than next. It is not likely we will see a gift tax exemption this large for a long, long time.

There are numerous advantages to lifetime gifts versus gifts at death. All post gift appreciation escapes tax. The property is readily available for the support and maintenance of your descendants. The income belongs to your donees and is out of your estate. The property escapes probate. If your estate is large enough to be taxable, the tax on gifts is actually smaller than the tax on estates. If transferred to a long term trust, the property can avoid estate tax for multiple generations rather than being subjected to inheritance tax several times.

Gifts can be made outright or in trust. We like trusts for several reasons. Property held in trust is insulated from claims of creditors and protected in case of divorce. Donors can use long term trusts and avoid estate tax on the trust property for several generations. Your children can be appointed trustee of their own trust and thus administer and control the trust property similarly to outright ownership. You might want to consider making the trust a “grantor trust” for income tax purposes. This means that you would be paying the trust’s income taxes and effectively transfer more to your descendants free of gift taxes.

Lets look at an example. Assume that you transfer $10 million to a long term trust which is a grantor trust. Assume that the $10 million earns $500,000 per year in taxable income and distributes $350,000 to your children each year. So your children would have taxable income of $350,000 each year and the trust would have $150,000 in taxable income. The trust would owe about $50,000 in income tax each year which you would pay allowing the trust to grow by $50,000 each year. In effect, by paying the trust’s income tax bill you are transferring $50,000 to your children each year but it is not a gift.

Other estate planning techniques might be considered which would enhance the value of your gift. For example, you might consider giving the trust a fractional interest in property or an interest in a family partnership or LLC which would qualify for a discount in value for gift tax purposes. Thus allowing you to transfer a larger amount tax free. You might consider using the property given to the trust as seed money for a larger purchase of some of your property. These techniques can effectively transfer property to your children and descendants with a value of several times the amount of the original gift.

Finally, for those who are not feeling financially comfortable in permanently parting with substantial sums at this time, you could consider large gifts to trusts for your spouse that will lock in the exemption and keep the gift property out of both of your estates.

All the lawyers in the tax department at Branscomb Law would be happy to talk with you in more detail if you are inclined to take advantage of the amazing and likely disappearing $5 million gift tax exemption in 2013.