ESTATES AND TRUSTS

April 2002

Gift Taxes: BEYOND The $325,000 Exemption Increase

By Marc A. Aaronson, JD, LLM (Tax), CPA, Richard A. Eisner and Company, LLP

The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the gift and estate tax applicable exclusion amount to $1 million, effective January 1, 2002. The gift and estate tax continue to have the same graduated rate structure, but the maximum rate, currently 50%, will decrease to 45% by 2007. The gift tax exemption will remain at $1 million, however, while the estate and generation-skipping transfer (GST) tax exemptions will increase to $1.5 million in 2004 and reach $3.5 million in 2009.

Under prior law, the gift and estate tax exemptions were the same and the GST exemption (originally $1 million) was indexed for inflation. For 2001, the gift and estate tax exemption was $675,000 and the indexed GST exemption was $1,060,000. Under current law, the 2002 gift and estate tax exemption is $1 million and the indexed GST exemption is $1,100,000.

Maximizing lifetime gifts is one hallmark of a good estate plan. A common strategy is to make annual exclusion gifts (currently $11,000 per donee; $22,000 if gift-splitting); another is to use up the gift tax exemption during the taxpayer’s lifetime.

Taxpayers that have already made $675,000 of taxable gifts should consider taking advantage of the increase in the exemption by making additional gifts of as much as $325,000. No additional gift tax will be incurred on this amount by taxpayers whose cumulative lifetime taxable gifts do not exceed $1 million in 2002 or 2003. Some such taxpayers, however, may owe some gift tax on an this additional gift because of the cumulative nature of the gift tax as well as its graduated rate structure. Taxable gifts from $675,000 to $750,000 are subject to the 37% rate. Gifts from $750,000 to $1 million are taxed at the 39% rate. This graduated rate structure means that the $325,000 exemption increase is equivalent to a $125,250 applicable credit increase, computed on the first $1 million of cumulative lifetime taxable gifts. But if a taxpayer’s taxable gifts are taxed at a higher effective rate, such that the tax before the credit is more than $125,250, there will be a gift tax liability.

Example 1

John has made $750,000 of cumulative lifetime taxable gifts, using his $675,000 exemption equivalent and paying gift tax of $27,750 (37% of $75,000). He is thinking of making an additional nontaxable gift of $325,000 in 2002. Because he has already exhausted the 37% bracket, the precredit tax on this gift is would be $128,250. Since the additional credit is only $125,250, John would owe $3,000 of gift tax. To avoid paying any gift tax, John should limit his taxable gift to $317,683 (on which his precredit tax would be $125,250).

The maximum amount of tax-free gift that can be made in 2002 also depends on when prior taxable gifts were made. Unused prior year exemption increases can protect a larger amount from gift tax this year.

Example 2

Mary made all $750,000 of her cumulative lifetime taxable gifts in 1999, when the exemption was $650,000. She thought that the maximum tax-free gift she could make this year would be $325,000, but actually she can give as much as $340,244 in 2002 without paying any gift tax.

Taxpayers need to understand how the exemption increase affects substantial gifts; otherwise they may owe gift tax when they thought no tax was due. Conversely, they may be able to give more than $325,000 without paying any gift tax. Computing the maximum tax-free gift is necessary, and although determining the maximum tax-free gift for 2002 may require complicated calculations, estate planning software programs can make that job easier.

Another strategy in maximizing lifetime gifts is the making of taxable gifts. Lifetime taxable gifts are more advantageous than transfers at death, when an estate tax will be imposed on the donor’s estate. Post-gift appreciation on taxable gifts is out of the estate. Perhaps more important, however, the gift tax is “tax exclusive” whereas the estate tax is “tax inclusive.” Gift tax is computed only on the value of the transferred property. In contrast, estate tax is figured on the total market value of the estate—including the assets from which the estate tax will be paid. Because gift taxes are not considered part of a gift, a larger amount can be transferred by making lifetime gifts rather than transfers at death. Gift taxes paid by a decedent on gifts made within three years of death, however, are included in the taxable estate.

Due to the current law’s repeal of the estate tax in 2010, taxpayers may be tempted to avoid any transfer tax by simply passing assets out at death. But this strategy is risky because there is no guarantee the estate tax repeal will be made permanent or even occur in 2010, or that the donor will survive until 2010. Even if the estate tax is actually repealed, the stepped-up basis at death (a major reason for not making lifetime gifts of highly appreciated property) will disappear. That is because the new law makes the carryover basis rules (similar to the rules applying to gifts) generally applicable to property transferred at death. Despite the new tax laws, maximizing lifetime gifts should remain a significant estate planning technique.

©2002 CPA Journal. Legal Notices

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