Use It or Lose It - The $5.12 Million Gift Tax Exemption

The 2010 Tax Act created significant, but temporary, reductions in estate and gift taxes.  The estate and gift tax exemption amount of $5.12 million plus lower tax rates have created opportunities for individuals to transfer wealth and save thousands or even millions of dollars in taxes - but only through December 31, 2012. 

Many focus on the fact that the estate tax exclusion amount was raised to $5 million for 2011 and 2012 was big news.  But the really big news was that the gift tax lifetime exemption, which had previously remained at $1 million even as the estate tax exemption increased to $2 million and $3.5 million, was also increased to $5 million. This creates an unprecedented planning opportunity to transfer assets by gift before the end of 2012 to take advantage of this exemption.

If the estate tax exemption is reduced in future years, a current lifetime gift can substantially reduce the estate tax burden to a family on the death of the donor.  In many cases, a current gift of $5 million can reduce the estate tax burden by about $2 million.  That means an additional $2 million goes to family members or other beneficiaries instead of to the federal government in taxes.  Lifetime gifts also reduce the Pennsylvania inheritance tax if made more than one year before death.

In addition, when assets are transferred by gift today, any future income and appreciation on the transferred assets are also removed from the donor's taxable estate.  Transferring assets that are likely to appreciate is one way to leverage the gift; and if non-marketable property is transferred, valuation discounts may be available to further leverage the gift tax exemption.

Gifts carry-over the donor's income tax basis to the donee.  That is a disadvantage compared to passing property through an estate where it gets a basis step-up.  However, often the donees are in a lower bracket than the donors.  Keep in mind that the 15% capital gains tax rate we have now may be the lowest we ever see again.

Married donors have the opportunity to create a "spousal access trust."  One spouse makes a $5 million gift to an irrevocable trust.  The terms of the trust permit distributions of income and principal in the trustee's discretion to the donor's spouse.  The spouse could be the trustee.  This allows the donor to retain, through his or her spouse, some access to the assets that were given to the trust.  Some planners recommend each spouse making one of these trusts but I caution you to beware of the reciprocal trust doctrine.  If each spouse makes one and the IRS takes the position that each was made in consideration of the other (in other words, "I'll make a gift to a trust for you if you make a gift to a trust for me"); then your plan fails.

Another catch is that a gift that will use the $5.12 exemption must be irrevocable.  The person making the gift can no longer have control over the assets.

Some people are worried about the effect such large gifts will have on their children or other beneficiaries.  They don't want to take away the children's incentive to be productive.  This can be addressed by making the gifts to trusts where access is limited.  Keep in mind that the same problem will exist at death if lifetime gifts are not made.