Lifetime gifts to family members can be a very effective technique to remove property from an estate before death. Although federal estate tax rates are the same as the federal gift tax rates, the federal gift tax is imposed only on the value of what the donor gives; it is not imposed on the amount of federal gift tax itself. By contrast, the federal estate tax is imposed on the full value of the decedent's assets at death including the property used to pay estate taxes. Therefore, if the taxpayer makes a gift and pays a federal gift tax, and if the taxpayer lives at least three years after the date of the gift, the federal gift tax itself will not be subject to federal gift or estate tax. With the federal estate tax rate being 40%, each $1.00 of federal gift tax which the taxpayer pays (if the taxpayer lives at least three years after the date of the gift) saves $0.40 of federal estate tax which would otherwise be payable because of the taxpayer's death.
Giving away property during lifetime has other advantages. By giving away property with appreciation potential, the appreciation between the time of the gift and the time of the giver's death would escape both gift and estate tax. Also, if property is given to someone in a lower income tax bracket, the income can be taxed at a lower rate.
If gifting is to be used as part of the estate plan, it would be advisable to make gifts using property with a high basis, because the recipient will receive a basis in the gifted property equal to the giver's basis. Basis, which is generally equivalent to the owner's cost of purchasing the asset, determines the amount of taxable gain on the subsequent sale or disposition of the asset. Property kept until death will, under current law, receive a "stepped-up" basis equal to its date-of-death value.
In 2019, each person can give, without paying gift tax, up to $15,000 annually to as many different persons as he or she desires. A husband and wife can combine their gifts to give up to $30,000 annually to as many persons as they wish. In addition to the $15,000 amounts, you can pay another's medical expenses directly to the provider or pay another's tuition expense directly to educational institutions without paying any gift tax. The $15,000 amount is adjusted annually for inflation.
Due to the 2017 Tax Cuts and Jobs Act, estates of decedents who die on or after January 1, 2018 have a basic exclusion amount of $11,180,000, up from a total of $5,490,000 for estates of decedents who died in 2017. This amount is adjusted annually for inflation, but is scheduled to return to the 2017 exclusion amount with inflation adjustments at the end of 2025. Married couples with very large estates may combine their exclusion amounts using a concept called portability to shield up to $22,360,000 from estate tax. There will be very few estates subject to taxation under this new tax act. However, below are techniques for reducing value of an estate for those who may still be facing an estate tax.
Personal Residence Trusts are a good technique to remove the family residence or vacation home from both parents' estates at a low gift value. The parents give their residence or vacation home to an irrevocable Qualified Personal Residence Trust. They retain the right to live in the house for a term of years and give the remainder interest in the residence to their children at the end of the term of years. The value of the gift of the remainder interest is reduced by a hypothetical income interest for the retained term of years and the gift cost is reduced significantly. The gift to the children may be only 30 to 40% of the actual value of the residence. If the parents survive the term of years, the residence passes to their children without any further taxable gift. If they die before the term is up, the residence returns to their estate. Using this technique also removes the value of all the appreciation in the residence during the retained term. A potential disadvantage of the Qualified Personal Residence Trust is that the children receive the residence without a step-up in basis. Also, at the end of the term, the children own the residence and you may still want to live in it. This problem can be resolved by arranging to lease the residence after the end of the term.
Grantor Retained Income Trusts work like Qualified Personal Residence Trusts. A parent contributes property to an irrevocable trust. The parent retains an income interest in the property for a term of years and the remainder goes to children at the end of the term. The income interest must be a fixed income rate applied to the value of the trust assets at the time of contribution or the value of the trust assets re-determined annually. If the parent survives the term, property is removed from his or her estate at reduced gift tax cost. If the fixed income rate paid to the parent is high or the term is ten years or longer, the gift cost can be very low. This technique can work well for a closely-held business, family limited partnership, or securities that generate a predictable income stream. By using the right combination of an income payment and term of years, the value of the taxable gift for a Grantor Retained Income Trust can be reduced to zero or very close to zero.
A family limited partnership (FLP) or family limited liability company (FLLC) can be a very valuable part of estate planning for the owners of farms, ranches, family businesses, or income producing real estate properties.
One of the main benefits of an FLP or FLLC is that the value of an FLP or FLLC interest is generally much lower than value of assets owned by the entity. This occurs because the IRS permits valuation discounts for interests in business entities that are not freely marketable and when the interest is a minority interest. Wyoming limited partnership and limited liability company statutes are very favorable for creating family limited partnerships and limited liability companies with enhanced levels of discounts.
The goal is to reduce the older generation's interest in the FLP or FLLC to a minority interest. For Example, when Sam Walton, the founder of WalMart, began his business, he created an FLP to own the business. At the time of his death, Sam Walton only owned a very small interest in the FLP and he gave that to charity. The result was no estate taxes payable upon his death. He had given his children and other relatives ownership interests in the FLP during his lifetime and no taxable interests passed to them on his death.
Upon the creation of an FLP or FLLC, the ownership interests are divided between the parents. After the FLP or FLLC is formed, small interests may be given to the children. Each year the parents may give more interests to children as annual exclusion gifts. The value of gifts will be entitled to discounts for lack of marketability and as minority interests. The FLP or FLLC also provides flexibility and control advantages. They permit consolidation of family assets into one entity. The older generation can retain control as the general partners of the FLP or managers of the FLLC and gradually relinquish control to the children as they learn management and investment skills. The FLP and FLLC will also protect the assets of the business from the children's creditors and ex-spouses.
However, for those owners of farms, ranches, family businesses, or income producing real estate properties who are no longer in estate taxable situations due to the doubling of the estate tax exclusion amount in 2018, discounting may not be a favorable technique. The resulting discounts reduce basis step-up on the shareholder, member, or partner's death and increase income tax exposure for the children and other recipients of the interests.
Business that previously had discounting provisions built into their agreements for estate tax savings may want to consider liquidating and dissolving the entity if factors such as creditor protection, restrictions on transfer of family business, and exposing younger family members to business management are not presently important considerations. Alternatively, businesses can change the terms of their agreements to eliminate or reduce discounts applied at death. The agreements can be revised to lessen restrictions on transfer of interests, but provide transferees are assignee without voting rights; to give owners the ability to force a buy-out (put right), but extend term of buyout with low initial payment; to provide buy-out is to be for full value; and to provide limited withdrawal right when children or grandchildren are gifted interests.