By Beau Ruff
The concept of gifting is simply that you give something to someone or something for no value in return. That is, the donor gives something worth value to the donee (or the recipient). The concept is simple but it is one of the most powerful tools utilized as an estate and business planning strategy.
Many people believe gifts are limited in value to $14,000. That figure instead represents the “annual exclusion” gift – the maximum amount that may be given by an individual without the need to report the gift to the IRS.
In fact, a person can give any amount he or she chooses. If it is under $14,000 per year, there is no reporting requirement. If it is more than $14,000 but less than the federal unified credit (currently $5.49 million for 2017), then the giver would need to file a gift tax return but would pay zero gift or estate tax. If a person gifts more than the unified credit amount, then he or she would owe tax equal to 40 percent of the value of the gift over the unified credit. This provides a substantial opportunity for gifting for the average person where the gifts will not exceed the unified credit of $5.49 million.
Gifting offers several advantages.
First, Washington state imposes an estate tax but does not track or tax gifts like the federal government. Thus, gifting in any amount is an effective strategy to avoid the Washington state estate tax.
Second, with regard to the federal gift and estate tax regime (where gifts are tracked and potentially taxed), a person can use the annual exclusion amount to move substantial assets out of his estate. Though seemingly limited to $14,000, a person can gift that figure to as many recipients as he wants (think $14K to each child, grandchild, niece, nephew, etc., every year). For a couple, each can gift the $14,000 and therefore pass $28,000 from the combined estate.
Third, gifting also removes the appreciation of the asset out of the donor’s estate. So, if a person has an appreciating asset (maybe land for example) it would likely reduce estate tax exposure to gift the asset while the value is lower rather than waiting until the value increases.
Gifting can be used as an effective tax mitigation strategy for individuals and couples who have a taxable estate. Alternatively, gifting also can be an effective strategy to preserve and protect assets when a person doesn’t have much money and has extensive medical or assisted living needs (e.g. Medicaid assistance).
So, if you have a lot of money, we can use gifting to reduce tax. If you don’t have a lot of money, we can use gifting to preserve the estate for your heirs. Both goals have different strategies and different applicable gifting rules.
Gifts can further be leveraged with the use of valuation discounts. When we prepare large gifts (gifts in excess of the annual exclusion), it is often worthwhile to hire a company to prepare a valuation for the gift. Typically, the gift is structured as a gift of a minority interest in the asset. For example, mom and dad might gift a 49 percent interest in the family farm LLC to their children. That minority interest likely will discount the reported value of gift. The gift will be further discounted by the lack of marketability discount and potentially others. The end result is the parents may be able to report a gift valued at less than anticipated which is a method to pass assets to the next generation outside of the estate tax.
Let’s use an example for a federally taxable estate. In very rough numbers, if you make a $1 million gift and those assets appreciate just 10 percent, your potential tax savings would be about $40,000 for the federal government and up to $200,000 for the state government for a total of $240,000. However, we can leverage the gift further through the use of valuation discounts discussed above. Assuming a 30 percent discount for lack of marketability and minority interest discounts, the tax savings could be even higher. Please keep in mind that the discounts are different for every case and every business and the Treasury Department has proposed regulations which may affect the ability to obtain some of the inter-family transfer discounts.
For gifts, the donee pays no tax on the receipt of the gift. And, for most gifts (except those gifts that exceed the $5.49 million unified credit), the donor pays no tax either. But, it is important to note that when you make a gift, the recipient inherits the donor’s tax basis in the asset. Conversely, when a person dies and an heir inherits an asset, the heir has a so-called “step-up” in tax basis which makes the tax basis of an asset equal to the fair market value of the asset as of the date of death (which equals a win for income tax planning). So, care must be taken to choose the appropriate asset for gifting that considers likely appreciation, tax basis of the asset, goal of gifting, and other factors.
Talk to your local advisor to see if gifting is a good strategy for you.
Attorney Beau Ruff works for Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick, where he focuses on assisting clients with comprehensive planning.