Charles A. Redd discusses the pros and cons of making gifts at this time of a greatly enhanced, historically high basic exclusion amount.
At this time, and for the indefinite future, individuals have a greatly enhanced, historically high basic exclusion amount. This higher basic exclusion amount is scheduled to evaporate Jan. 1, 2026,1 and a future Congress and President could take it away at any time before that date. Thus, clients having significant wealth who wish to maximize their use of what could be a fleeting opportunity to use the basic exclusion amount now in place should consider expeditiously making one or more lifetime taxable gifts that fully absorb the basic exclusion amount. Individuals making gifts sooner rather than later will remove more appreciation from their gross estate, which would be highly beneficial if the basic exclusion amount declines on Jan. 1, 2026 or sooner. Making a gift, however, is always subject to the risk that a basis step-up on the owner’s death with respect to the gifted asset will be forfeited. Moreover, if the basic exclusion amount doesn’t decline, an individual whose net worth is safely under the basic exclusion amount may regret having made a gift to remove post-gift appreciation and income with respect to the gifted asset(s) from his gross estate.
If an individual makes annual exclusion gifts2 or gifts for educational expenses or medical expenses,3 the value of the gifts themselves, along with all post-gift appreciation and income with respect to the gifted property, is permanently excluded from the donor’s transfer tax (estate and gift tax) base.4 Otherwise, an individual’s gifts are reflected, at gift tax values, on his federal estate tax return, as “adjusted taxable gifts” (or lifetime taxable gifts).5 In this circumstance, what’s excluded from the donor’s transfer tax base is post-gift appreciation and income with respect to the gifted property. The making of lifetime taxable gifts erodes the donor’s basic exclusion amount.6 The making of annual exclusion gifts or gifts for educational expenses or medical expenses doesn’t.7
Pros and Cons of Gifting
If an individual makes aggregate lifetime taxable gifts (after 1976) exceeding his available basic exclusion amount, he owes federal gift tax. If gift tax is paid with respect to a gift, and the donor doesn’t survive for at least three years after having made the gift, the amount of such gift tax is included in the value of the donor’s gross estate.8 The net result is that, if Internal Revenue Code
Section 2035(b) doesn’t apply (because the donor survived the requisite 3-year period), a 40% estate tax rate is effectively reduced to 28.6%. Whether paying gift tax and surviving for the requisite 3-year period may be economically advantageous depends on whether the present value of the estate tax savings (which, in turn, depends on how much longer the donor lives) and the increase in the basis in the gifted property by the amount of gift tax paid9 is greater or less than the value of the dollars used to pay the gift tax. Even if paying gift tax and surviving for the requisite 3-year period could be economically advantageous, some individuals lack sufficient liquidity to pay gift tax on a significant gift, and many donors simply don’t want to pay tax any sooner than necessary.
Additionally, what amounts to pre-paying estate tax potentially to take advantage of an effective 28.6% rate could backfire. The donor’s consumption, or decline in the value of the donor’s estate, during his remaining life could bring the donor’s gross estate plus lifetime taxable gifts within the basic exclusion amount at the donor’s death. The basic exclusion amount could be sufficient in any event to cause no estate tax to be due. (Who foresaw an $11 million basic exclusion amount?) The federal estate tax could be repealed.
Sale as Possible Gifting Alternative
By contrast, with a sale of assets (a transfer in exchange for full and adequate consideration), the consideration, except to the extent consumed, will compose a part of the seller’s gross estate.10 The consideration, depending on its character, could grow in value, shrink in value or remain the same in value between the time it’s received and the date of death of the seller. The consideration, except to the extent consumed, and depending on its value at the seller’s death, may receive a basis step-up under IRC Section 1014. The value of the sold property is excluded from the donor’s transfer tax base. To the extent (if at all) that value exceeds the value of the consideration in the hands of the seller at the seller’s death, the sale may be considered a successful estate-planning maneuver. Because a sale isn’t a gift, the seller’s basic exclusion amount remains unchanged, and no gift tax is payable, regardless of the size of the transaction. A sale may be preferable to a gift in a case in which an individual has used up his entire basic exclusion amount by making large gifts and doesn’t want to pay gift tax and/or may have an economic need (or believe he has an economic need) to receive consideration in exchange for the contemplated transfer. Of course, selling a low basis/highly appreciated asset has significant potential disadvantages. Not only would the seller lose the ability to obtain a basis step-up with respect to the asset, but also the seller may incur significant income tax on the sale (unless the sale is to a grantor trust).
In response to IRC Section 2001(g)(2), enacted as part of the 2017 Tax Act,11 in which the Secretary of the Treasury was directed to prescribe regulations to carry out Section 2001(g) with respect to the difference between the basic exclusion amount applicable at the time of a decedent’s death and the basic exclusion amount applicable with respect to any gifts made by the decedent, the Secretary issued Proposed Regulations Section 20.2010-1(c).12
Prop. Regs. Section 20.2010-1(c) is intended to ensure that, if a decedent has used the increased basic exclusion amount for gifts made while the 2017 Tax Act was in effect and dies after the sunset of the 2017 Tax Act (currently scheduled for Jan. 1, 2026), such decedent won’t be treated, on such decedent’s estate tax return, as having made adjusted taxable gifts solely because the increase in the basic exclusion amount effectuated by the 2017 Tax Act was eliminated.
The mechanism by which Prop. Regs. Section 20.2010-1(c) would achieve this result is to provide that, if the total of unified credits that were used in computing a decedent’s gift tax on post-1976 gifts is greater than the unified credit that would be used, pursuant to IRC Section 2010(c), to compute the estate tax on the decedent’s estate, the credit that can in that circumstance be used to compute the estate tax is deemed to be the total of unified credits that were used in computing the decedent’s gift tax.
This was a not unexpected, but nevertheless welcome, development. Why Prop. Regs. Section 20.2010-1(c) hasn’t been published as a final regulation is a mystery.
Defined Value Clauses
In conjunction with the making of large lifetime taxable gifts to take full advantage of today’s basic exclusion amount under the 2017 Tax Act but seeking to avoid the risk of actually incurring gift tax (especially when difficult-to-value assets are involved), the use of defined value clauses (DFCs) in documents effectuating gifts or sales would seem imperative. The Internal Revenue Service appears to despise DFCs, having litigated many cases in an effort to have them declared as void due to public policy considerations, but it’s been decades since the IRS has prevailed in a DFC case, and there are several relatively recent cases that provide a virtual roadmap for how to design an effective DFC that will almost eliminate the risk of incurring gift tax.13
1. Internal Revenue Code Section 2010(c)(3)(C).
2. IRC Section 2503(b).
3. Section 2503(e).
4. IRC Sections 2031 and 2033.
5. IRC Section 2001(b).
6. IRC Section 2505(a).
7. Section 2503(b) and (e).
8. IRC Section 2035(b). If the gift is a direct skip within the meaning of IRC Section 2612(c)(1), neither the amount of the generation-skipping transfer (GST) tax nor the amount of the gift tax on the GST tax (see IRC Section 2515) is included in the value of the donor’s gross estate regardless of whether the donor lives three years or longer after having made the gift. Nevertheless, Section 2035(b) impacts a lifetime direct skip in exactly the same way as it impacts a gift that isn’t a direct skip; it effectively eliminates any direct transfer tax advantage of a lifetime direct skip over a direct skip occurring at the property owner’s death.
9. IRC Section 1015(d).
10. Section 2033.
11. An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, Pub. L. No. 115-97, enacted Dec. 22, 2017.
12. REG-106706-18, 83 Fed. Reg. 59343 (Nov. 23, 2018).
13. See Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009); Estate of Petter v. Comm’r, 653 F.3d 1012 (9th Cir. 2011); Hendrix v. Comm’r, 101 T.C.M. (CCH) 1642 (2011); Wandry v. Comm’r, 103 T.C.M. (CCH) 1472 (2012).