I’m often asked how the gift tax rules and the estate tax rules relate to one another. Gift and estate taxes are known as “transfer” taxes, based upon the value of assets being transferred from one person to another.
The federal tax system entitles each of us to a $5.43 million lifetime exemption from gift and estate taxes. This exemption can be consumed during your lifetime, and any unused exemption may be applied at your death. So assume that I own a commercial office building worth $5 million and transfer that office building to a family partnership owned by my three daughters. I have consumed $5 million of my lifetime exemption against gift and estate taxes, leaving me with only $430,000 of exemption to be applied at the time of my death. If, at the time of my death, my will bequeathed another $2 million of assets to my three daughters, then an estate tax would be due from my estate since I have made total transfers of $7 million against my lifetime exemption of $5.43 million.
The estate tax is paid before the additional transfers are made, so my daughters would receive a net inheritance after the tax is calculated and paid. The federal estate tax return actually “adds back” prior taxable gifts to compute the amount of gross estate tax owed. The net estate tax equals the tax on the taxable estate (lifetime taxable gifts plus gross estate value at death) less the total amount of exemption available at the time of the death.
You may have noticed that I referred to “taxable gifts.” Certain gift transfers that are made during your lifetime do not reduce the gift/estate tax exemption available to you. The first is an “annual exclusion” gift. You may gift up to $14,000 annually to anyone that you want, and not have that gift counted towards your lifetime exemption. You may also gift unlimited amounts for someone’s health or education, provided that you make the gift directly to the medical care provider, or the educational institution respectively.
My daughter Gabrielle attends Brandeis University. I can gift Gabi $14,000 annually (as can my wife) so she can receive gift tax free transfers from both of us in the amount of $28,000 without anyone having to report the gift on a Federal Gift Tax Return Form 709. Even if the entire $28,000 was paid from my personal checking account, so long as Patti and I timely file a Federal Gift Tax Return where we elect to “split the gift,” no part of the gift will be deemed taxable, meaning that we will not reduce our federal estate and gift tax exemptions. These annual exclusion gifts must be “present interest” gifts, meaning that they have to be currently available to the recipient rather than being restricted in any way, such as contributed to a trust that the recipient has no access to.
In addition to the annual exclusion gifts to Gabi, my wife and I can also pay Gabi’s tuition at Brandeis, so long as we write the check directly to the University. I can also pay Gabi’s health insurance premiums, doctor bills and prescriptions, so long as I don’t give her the money to pay those expenses and I pay them directly myself. None of those gifts should reduce our lifetime exemption.
Spouses can transfer unlimited amounts between themselves, both during their lifetimes and at their deaths and not incur any transfer taxes, so long as both are United States citizens. Bill Gates can transfer his entire fortune to Melinda without incurring any transfer taxes.
You can probably determine that it’s important for your estate tax attorney to both know, and have copies of, any taxable lifetime transfers. This can be readily accomplished by providing your estate attorney copies of all prior Federal Gift Tax Return Form 709s filed with the IRS. Without this information, your attorney may assume that you have not made any lifetime transfers, and the estate plan recommended for you might not be proper.
Further, if you have made lifetime transfers that haven’t been reported, you should meet with your attorney and/or CPA to discuss filing a late return. When one files a Federal Gift Tax Return, the IRS generally has three years in which to challenge the return. When transfers are made of hard to value assets like real estate or business interests, the IRS isn’t shy about challenging the value and assessing back taxes, interest and penalties. Failure to file a return opens the door at the donor’s death for the IRS to go back in time and make assessments.
It’s always a good idea to discuss these issues with your tax professionals.
©2015 Craig R. Hersch