While virtually every American is familiar with the federal income tax, the U.S. Internal Revenue Code contains another system of taxation related to individual wealth: the taxation of the passage of wealth through gratuitous transfers of property by individuals. This overall area of federal taxation is embodied in three separate, but interrelated “taxes”: the estate tax, the gift tax, and the generation skipping transfer tax. For wealthy families who are affected, these taxes can be significant, and their ultimate impact can often be reduced by careful planning.
The federal estate tax applies to the transfer of property at death. The federal gift tax applies to transfers made while a person is living. The generation-skipping transfer tax is an additional tax on a transfer of property when a generation is skipped with respect to the collection of the estate tax.
The federal estate tax applies only to the portion of the estate’s value that exceeds an exemption level. The Tax Cuts and Jobs Act (TCJA) of 2017 temporarily doubled the estate tax exemption to $11.2 million for single individuals and $22.4 million for married couples, but only for the years 2018 through 2025. The exemption level is indexed for inflation.
Basic Federal Estate Tax Mechanics
The executor must file a federal estate tax return within nine months of a person’s death if that person’s gross estate exceeds the then prevailing exempt amount ($11.58 million in 2020, as indexed).
The estate tax applies to a decedent’s gross estate, which generally includes all the decedent’s assets, both financial (e.g., stocks, bonds, and mutual funds) and real (e.g., homes, land, and other tangible property). It also includes the decedent’s share of jointly owned assets and life insurance proceeds from policies (1) owned by the decedent or (2) payable to the descendant’s estate or (3) used to discharge a legal obligation of the estate.
The estate and gift taxes allow an unlimited deduction for transfers to a surviving spouse. Estates may also deduct debts, funeral expenses, legal and administrative fees, charitable bequests, and estate taxes paid to states. The taxable estate equals the gross estate less these deductions.
Although tax rates are graduated, all transfers in excess of the exemption ($11.58 million in 2020) are taxed at the top rate because the exemption exceeds the threshold at which the top rate applies.
Basic Federal Gift Tax Mechanics
Congress enacted the gift tax to prevent donors from avoiding the estate tax by transferring their wealth by gift before they died.
The federal gift tax provides a lifetime exemption of $11.58 million per donor in 2020. This exemption is the same as that which applies to the estate tax and is integrated with it such that lifetime gifts (except those that qualify for the gift tax annual exclusion) reduce the exemption amount available for estate tax purposes. Beyond that exemption, donors pay gift tax at a the rate of 40 percent (same as the estate tax rate). It is noteworthy that the gift tax is tax exclusive while the estate tax is tax inclusive (i.e., we do not have to pay gift tax on the money we use to pay gift tax but we do pay estate tax on the money we use to pay the estate tax).
An additional amount each year is excluded from gift taxation. This so-called annual exclusion ($15,000 in 2020) is indexed for inflation in $1,000 increments and is granted separately for each donee. Thus, a married couple with two children could give their children a total of $60,000 each year ($15,000 from each parent to each child) without owing tax or using any portion of their lifetime exemption.
Gifts received are not taxable income to the recipient. The basic rule is that property transferred by gift (other than at death) carries over to the recipient the same basis it had in the hands of the donor at the time of the gift. The rule is altered, however, in the event that the carryover basis is greater than the fair market value of the property at the time of the gift. In such circumstances, the basis for purposes of determining loss on a future disposition is deemed to be the market value at the time of the gift.
Basic Federal Generation-Skipping Transfer Tax Mechanics
The generation-skipping transfer tax (GSTT), a separate tax from the unified estate and gift taxes, is best thought of as a supplement to the basic unified estate and gift tax wealth transfer tax system. Given that the purported purpose of the estate tax is to impede the build-up of massive family fortunes by imposing a significant tax on the accumulated wealth each time it passes to the next succeeding generation, the fruits of the transfer tax system are reduced to the extent that a generation is skipped when property is passed. Thus, the GSTT was instituted as a measure to avoid the loss of tax revenues resulting from such generation-skipping transfers. However, through leveraged use of the estate owner’s lifetime GSTT exemption (which is separate from but keyed to the same dollar amount as the estate tax exemption) allocated to gifted assets likely to grow substantially in value over time, the GSTT can be permanently avoided with respect to all benefits derived by succeeding generations, regardless of the extent to which trust assets may grow in value over several decades. Obtaining the benefits of generation-skipping transfer tax planning (i.e., utilization of the donor’s generation skipping transfer tax exemption) does not require “skipping” children as beneficial owners of family assets during their lifetimes. A child can be the beneficiary of a so-called generation skipping transfer tax-exempt trust with grandchildren only acceding to a beneficial interest in family assets after the child’s death.
Sunset of Temporary Increased Exemption Amount – Use It or Lose It
As discussed above, the federal estate and gift tax exemption is the amount that an individual can transfer to another individual tax-free either during lifetime or at death before a 40% wealth transfer tax is imposed.
In 2017, the Tax Cuts and Jobs Act (TCJA) raised the exemption amount from $5 million to $10 million per person. The $10 million exemption amount is adjusted annually for inflation. The inflation-adjusted exemption amount for 2020 is $11.58 million per person.
The increased exemption amount is temporary and is scheduled to sunset such that it will return to $5 million per person (adjusted for inflation) effective January 1, 2026.
The Treasury Department has issued regulations indicating that individuals who take advantage of the increased gift tax exemption (in effect from 2018 to 2025 - at least under current law)) will not be adversely impacted when TCJA sunsets on January 1, 2026. But, the regulations also set forth a “use it or lose it” rule: If an individual dies after 2025 and did not make gifts between 2018 and 2025 in excess of the sunsetted exemption amount in effect at his or her death, the excess exemption is lost.
Current Planning Environment
Valuation of gifts: Reduced asset values due to COVID-19 may make gifting of certain assets desirable.
Interest Rates: Interest rates are low (the Section 7520 rate for September 2020 is 0.4%). Intra-family loans, installment sales to grantor trusts, and GRATs (Grantor Retained Annuity Trusts) are techniques that work better when interest rates are low.
Possibility of future tax law changes: While future tax law changes are anyone's best guess, it's plausible that estate taxes may increase. If that turns out to be the case, gifting assets under current favorable laws may prove opportune.
Wealth transfer tax laws have become captive to political interests: Might the estate tax be repealed and replaced with a capital gains tax on death? Will basis step-up on death remain? Tax laws may change substantially under a future administration (and then again with the next administration, and so on).