Choosing the right property to gift. (High Net Worth: The Accoutrements of Success) (Cover Story)by Streer, Paul J.
Gifts may be an important component in the overall financial plan of many high-net-worth individuals. There are numerous personal reasons an individual may have for making gifts. For example, there may be a desire to help family members get started in life. This could include cash gifts to children to purchase a home or to start a business. Wanting to assist grandchildren by paying college education costs may provide another impetus for gifts. Others simply do it becuse of the enjoyment that comes from making others happy.
A principal incentive for gift giving in addition to the desire to share the benefits of wealth accumulation may be the substantial transfer tax savings that can result. The unified transfer tax base is permanently reduced to the extent a gift is one of a present interest that qualifies for the $10,000 per donee, per year exclusion available to all donors. Gift splitting with a spouse, if available, can double the benefit to $20,000 per donee per year. Therefore, if a donor embarks on a gift giving program involving multiple donees, sizable tax savings will result over time.
Any gift tax paid is also removed from the donor's gross estate if he or she lives for at least three years after the gift is made. The fact that any after-tax income earned on the gifted property will be excluded from the donor's gross estate provides the donor with another advantage from gift giving. In addition, gifts of income producing property to a lower income tax bracket donee may produce immediate income tax savings for a family unit. However, if the donee is under the age of 14, the opportunity for immediate tax savings is minimal since un-earned income in excess of $1,200 is taxed at the tax rate of the donee's parents.
A greater potential benefit in many situations is the possibility of excluding post-gift appreciation from the estate tax base. For computational purposes, only adjusted taxable gifts are included. These are post-1976 taxable gifts that are not otherwise directly included in the decedent's gross estate. Gifts are valued at their date-of-gift fair market values, net of any available annual exclusions and deductions. Thus, to the extent property increases in value after the date it is given to the donee, the donor's transfer tax base is lower than it would have been if the gift had not been made. Conversely, subsequent declines in the value of gifted property will artificially inflate the tax base and cause the transfer tax to be higher. Consequently, gifting property whose value could fluctuate and significantly decline presents the donor with substantial risk of loss of tax benefit.
Basis considerations can also have an important impact on the gift giving decision. The basEs of gifted property in rthe hands of the donee is generally equal to the donor's basis increased by any gift tax paid by the donor on the transfer attributable to appreciation in the property's value. However, in the case of depreciated property, the donee's basis for loss cannot exceed the fair market value of the property at the date of the gift. Thus, built-in losses are not transferable by the donor to the donee. Confronted with this situation, a knowledgeable donor should first sell the depreciated business use or investment property, recognize the dedubtible loss, and then gift the sales proceeds to the donee. If gifted depreciated property is sold for a price between its bases for gain (donor's basis plus gift tax) and loss (fair market value at date of gift), no taxable gain or loss is reportable.
Alternatively, property that passes through a decedent's estate normally has a basis in the beneficiary's hands equal to its date-of- death fair market value. However, if the alternative valuation date is available and properly elected, the fair market value of the property at the earlier of 1) the time of its disposition or 2) six months after the date of the decedent's death, controls the determination of basis. Therefore, if property has significantly appreciated in value, a tax- payer who has a limited life expectancy has a powerful incentive to retain ownership of the property until death rather than dispose of it by gift or sale. This basis step-up provision allows all the appreciation to permanently escape Federal income taxation. On the other hand, the same taxpayer has an equally strong motivation to sell anh depreciated property before death so that he or she can generate a tax deductible loss. Otherwise, the basis of the property will be stepped-down to date-of-death fair market value and a portion of the basis will vanish.
These well known basis adjustment rules for inherited property have several notable exceptions. The principal exception relates to items of gross income to which a decedent was entitled but which were not properly included in his taxable income in the year of death or prior years under his method of accounting. Known as items of income in respect of a decedent, they include upaid salaries and interest, the income element embedded in installment receivabbles and the value of pension benefits in excess of the decedent's contributions. No basis step-up or step-down occurs even though the property is fully included in the decedenths gross estate. Instead, the income tax basis of these items in the hands of the decedent carries over to the estate or its heirs. In addition, each item of income in respect of adecedent has the same character in the transferee's hands that it had in the hands of the decedent. The failure to provide a basis adjustment stimgatizes items of income in respect of a decedent by potentially subjecting them to both the Federal income tax and Federal estate tax. Limited relief is provided by allowing the recipient of an item of income in respect of a decedent an itemized deduction for the incremental estate tax paid in the year it is included in gross income.
A second exception denies a basis step-up to appreciated property that passes back to a donor (or his spouse) from adonee if the donee dies within one year receiving the original gift. Property is appreciated for this purpose if its fair market value at the date of the gift exceeds the donor's adjusted basis on that date. This provision was incorporated into the law to curtail the planning technique of having a donor gift low basis, appreciated property to a terminally ill family member at little or no gift tax cost with the near term expectation that the donor would receive the gifted property back tax-free by way of inheritance with a stepped-up basis.
Selecting the Right Property to Gift
An important issue involved in maximizing the tax benefits available from making gifts is the proper selection of gift property. Perhaps the ideal type of property to gift would be property that--
* has very high appreciation potential but a low gift tax value;
* produces a substantial current income flow that will be shifted to a lower income donee; and
* will be held indefinitely by the donee so that a possible basis step-up is of little concern.
However, its probably safe to assume few if any, high-net-worth individuals consistently have this type of asset on hand and possess a willingness to transfer it. Consequently, the selection process becomes one of working within the constraints introduced by the individual's actual asset mix and personal preferences. It emphasizes the making of trade-offs between the considerations discussed earlier--appreciation potential and basis step-up opportunities. it also involves assessing the individual's aversion to the risk that post-gift depreciation will occur.
The following material will address the issue of gift selection by focusing on several different types of property tht are often the objects of a gift and discussing the inherent advantages and disadvantages each category may offer to donors.
Cash. Cash or cash equivalents are a safe choice of gift for conservative donors at a time other property values can be volatile. Transaction costs are minimal, and valuation issues and basis considerations are nonexistent. The risk of post-gift depreciation is nil and a permanent transfer tax base reduction in an amount equal to the annual exclusions availed of is assured. However, this certainty of results comes at the cost of the loss of any possible future growth in the size of the transfer tax base reduction. Essentially, a cash-based gift giving plan is an efficient, riskless and productive means of achieving limited transfer tax savings.
Securities. Securities of both public and privately-held companies have significant appeal as potential gift property. In many cases, shares of stock in publicly traded companies with good long-term growth prospects make ideal candidates for gifts. The potentRal for the elimination of significant post-gift appreciation from the donor's transfer tax base is often very appealing. However, increases in stock prices are never assured and the risk of large fair market value declines should be carefully assessed considering@the individual's risk tolerance. If donees are minors or they lack the desire or discipline to hold the stock for long-term appreciation, it may be necessary to employ a trust vehicle.
On the other hand, if the donor owns stock in which substantial appreciation has already occurred and the likelihood of future appreciation is not significant, income tax savings may be realized by gifting the securities to a lower tax-bracket donee who can then sell the stock. Income tax savings may also be realized by gifting dividend paying stocks or bonds with more limited appreciation potential to these donees. Listed stocks and bonds also offer the advantages of certainty of valuation and low transaction costs. Consequently, they make ideal candidates for a multi-year gift plan designed to take maximum advantage of any annual exclusions available.
Many of the same considerations that apply to publicly traded securities also apply ho gifts of stock in closely held corporations. However, gifts of closely held stock have some unique aspects. These gifts are often motivated by a desire to encourage family members to become actively involved in the business with the idea they will eventually assume full management responsibility. The normal intent is for the shares to be held indefinitely by the donee, and the inherent lack of marketability for the minority interests involved typically insures this result. Consequently, the forfeiture of a basis step-up opportunity at the donor's death is usually of more limited importance. In addition, if an S corporation election is in effect or could be elected, income shifting opportunities can be beneficially availed of within a family unit. One overriding disadvantage of closely held company stock gifts is the difficult valuation problems they normally entail. Since actual arm's length sales prices and bona-fide bid and asked prices are often unavailable, the valuation of the stocks or bonds of closely held corporations is a very subjective undertaking. Although broad, general guidelines have been provided by the IRS, significant amounts of the donor's time and money must often be expended to arrive at a justifiable and defensible valuation position. Even if the gift tax return filed is not audited within the statutory period provided, the appropriate value to be assigned to the gifted stock could become an issue years later upon the audit of the Federal estate tax return. The IRS has successfully argued that since "adjusted taxable gifts" are part of the unified transfer tax computation, their proper determination is subject to its scrutiny within the normal period allowed for auditing the estate tax return filed.
Other Personal Property
Almost any other type of personal property is a candidate to be gifted. However, it should be property the donor no longer intends to use. Otherwise, if he or she uses, possesses, or enjoys the gifted property (or reserves the right to do so) after the date of gift, the entire date-of-death fair market value of the property may be included directly in the gross estate. It is particularly appropriate to gift appreciated property that is unlikely to be sold by the donee in the foreseeable future. This could be property to which the donee is sentimentally attached or an item that is a family heirloom. The possibility of obtaining a basis step-up at the death of the owner will not be important. Alternatively, the fact that property has a basis greater than its value at the date of gift should not be an impediment to gifting the item because losses resulting from the sale of personal use capital assets are normally nondeductible for income tax purposes.
Documentary evidence should be created to substantiate that a completed gift of personal property has occurred on the date of the transfer to the donee. A signed, notarized statement precisely describing the property given and witnessing the intent of the donor to make the gift and its acceptance by the donee should be executed. If this procedure is not followed, the IRS may successfully argue that inclusion of the property in the donee's gross estate is appropriate. Since many types of personal property are easily divisible, (e.g., a collection of antique jewelry can be gifted on a piece-meal basis), the donor can easily make partial gifts over a period of several years to maximize the benefits available from multi-year annual exclusion.
The gift tax values used should be substantiated by means of appraisal (e.g., art objects) or legitimate market quotes if available (e.g., rare coins). This is particularly true in the case of valuable pieces of personal property that are not easily divisible and hence their values may exceed the annual exclusion amounts for the year of the gift. Property such as jewelry, antiques or works of art may also make good gifts simply because they may be unsuitable for testamentary disposition. They are illiquid and difficult to divide or value. Without a specific bequest in the donor's will, questions of retention or sale may arise. Also, the selection of the appropriate heir to receive the property may be a very divisive issue that could prove difficult for the fiduciary and beneficiaries to resolve satisfactorily.
Mortgages, Notes and Other Receivables
Various types of receivables owned by a donor may be prudent choices as gifts for several reasons. The value of a gifted note or mortgage is normally the amount of unpaid principal plus accrued interest to the date of gift. It may be possible to minimize the value of the property for gift tax purposes if the security provided is inadequate, the financial condition of the debtor has deteriorated or the maturity date specified is inordinately long. Recent reductions in real property values may mean in many cases mortgage fair market value has declined because the value of the underlying collateral has been significantly diminished. If there is a substantial risk the receivable will prove to be uncollectible, it normally should not be gifted. The resulting loss may be more beneficially used by the donor. A discount may also be justified if a below market rate of interest is specified. Because of recent rate declines, however, some older receivables carry above market interest rates that may indicate the existence of a premium.
All post-gift payments of principal and interest will be excluded from the donor's gross estate. In addition, the interest earned will provide the donee with a regular, controlled stream of income that may be taxed at a lower marginal tax rate. This income flow could be an ideal gift if there is a concern the donee could not or would not properly manage a less restricted and more liquid type of gift. In an environment of declining interest rates, however, unless specifically prohibited by the terms of the instrument, repayment before maturity is a very real possibility that should be considered.
It is critically important to distinguish installment receivables from other types of receivables a donor may choose to gift. At first glance they would seem to be suitable gifts because as items of income in respect of a decedent they possess no basis step-up potential that could be jeopardized. However, the gift of an installment receivable will be treated as a taxable disposition by the donor. A gain will be recognized by the donor to the extent of the difference between the fair market value of the installment obligation and its basis at the date of the gift. This would cause immediate recognition of the full amount of deferred gain by the donor upon disposition without the receipt of a sufficient amount of cash to pay the additional income tax liability created.
The decades of the 1970's and 1980's were witness to soaring real estate values. Consequently, gifts to real property with their presumed limitless appreciation potential were thought to be ideal vehicles for realizing transfer tax savings. The arrival of the 1990's has shown many of these assumptions to be incorrect. Consequently, many donors have failed to realize the benefits of earlier gifts of real estate because of declines in value. The moral of the story is there is a definite risk of post-gift depreciation that must be considered if real estate is gifted. The prudent selection of the appropriate parcels of real property to gift is now a much more challenging endeavor.
Nevertheless, gifts of real property can be advantageous. If the property is income producing, income tax savings can be realized if income is shifted to lower bracket donees. Of course, in spite of general price declines, a particular parcel of real estate can have excellent post-gift appreciation potential.
A donor can benefit by keeping the yearly value of each gift within the annual exclusion amount. In the case of real property gifts, the donor is often confronted with the need to make a series of gifts of a portion of a single larger parcel. This is accomplished, for example, by deeding a specific number of acres of land or by giving an undivided percentage interest as a tenant in common to a donee.
In all cases, valuation of the gifted property should be substantiated by appraisal. In this regard, the courts have found that because of the restrictive nature of the common ownership of property, the fair market value of an undivided fractional interest is often less than a full pro- rata share of the value of the entire property. In addition, it is critical the transfers be properly recorded by deed and the donor not continue to exercise control over the property or receive income from it.
There are however, several possible disadvantages to this approach. The donor and donee become co-owners of a single parcel of property that may require joint management. Conflict between the parties can develop. In addition, implementation costs can be high since a separate appraisal should be obtained and a deed recorded in each year a gift is made. Furthermore, all controversy is not eliminated since valuation established by appraisal does not assure its acceptance by the IRS.
An alternative technique used to accomplish the same result is for the donor to consummate an installment sale with an intended donee and then systematically cancel the installment receivables due each year in an amount equal to the available annual exclusions. This approach requires only one appraisal and avoids the possible problems of property co- ownership. However, the IRS has contended that if, at the time of the sale, the donor did not intend to collect the installment receivables, the entire gift took place in the year of sale. In addition, the donor (seller) must recognize taxable income each year as the obligations are canceled. Another point to consider is the possibility of depreciation recapture in the year of sale.
Life insurance on the donor's life can also make a very appropriate gift. In some cases (e.g., term insurance), it has a low gift tax value and a high estate tax value. In addition, the fair market value of a life insurance policy is not difficult to establish. Paid-up policies are valued for gift tax purposes at their replacement cost at the time of transfer. Other policies are valued at their interpolated terminal reserve value on the date of transfer plus the unearned portion of the last premium paid on the policy. However, the transfer of a life insurance policy on the donor's life will not be recognized as a completed gift unless or until the policy owner transfers all of his incidents of ownership in the policy. Basis considerations are often of little importance because insurance proceeds paid by reason of the death of the insured are normally received tax-free by beneficiaries. In addition, there is little risk of post-gift depreciation and transfer costs are minimal.
Life insurance is not the type of property a donor typically expects to benefit from during his lifetime. Therefore, the donor may be more willing to give up ownership rights in life insurance than in other types of property he or she owns. This is especially true if the gift can be structured in such a way the insurance proceeds will be excluded from his or her gross estate but nevertheless still be available to meet the liquidity needs that arise at death. These goals can be accomplished by gifting the policy to an irrevocable life insurance trust in which the donor retains no interest. The trust can make discretionary loans of the policy proceeds to the grantor's estate if required to meet it's immediate cash needs. Post-gift premium payment requirements can be met by making additional cash gifts or by transferring income producing property to the trust. Trust income used to pay the premiums on any life insurance policies on the life of the grantor or his spouse will be taxed to the grantor. Both the initial transfer of the policy and any subsequent premium payments are gifts of present interests that will qualify for the annual exclusion.
Such transfers will not be an effective means of keeping all the insurance proceeds out of the donor's estate unless he or she lives for more than three years after the completed gift is made. Additionally, the estate cannot be the direct or indirect recipient of any of the policy proceeds, and the donor must not possess any rights (incidents of ownership) in the policy.
Jointly Held Property
Gifts of interests in various types of jointly held property can be advantageous. Generally, a decedent's gross estate includes the full value of any purchased property held jointly with the right of survivorship by the decedent and another person. However, if it can be shown the surviving joint tenant contributed to the purchase price of the property, an exclusion is available. The exclusion is a function of the surviving joint tenant's relative contribution to the purchase price of the property. However, the fiduciary of the decedent's estate must be able to substantiate the surviving joint tenant's independent contribution or else no exclusion will be available. If such evidence is lacking, a client's gift of his or her interest in the property may be advisable as an inexpensive way to reduce the size of the gross estate and avoid later controversy with the IRS.
In the case of joint tenancies between spouses with the right of survivorship (tenancies by the entirety), an inflexible rule applies. Only one-half of the value of this property will be included in the gross estate of the first spouse to die and thereby have its basis adjusted. This result applies without regard to each spouse's actual contribution to the purchase price of the property. This outcome is disadvantageous if the property is appreciated at the date of the decedent's death since an opportunity for a tax-free basis step-up on the entire value of the property is lost. This unfortunate result can be avoided if the spousal joint tenancy is severed by means of a gift to the spouse with the shorter life expectancy. The availability of the unlimited gift tax marital deducation can make this transfer tax-free. It should also be noted that in a recent case, Gallenstein v. U.S., decided by the Court of Appeals for the Sixth Circuit, the court upheld a ruling that a taxpayer was entitled to a stepped-up basis for the entire property where the joint interest was created prior to 1977 and the decedent spouse had provided the sole consideration for the property.
Transferring Investment Opportunities
Another very effective way for a client to reduce the unified transfer tax base is to transfer the next good investment opportunity directly to family members. For example, if a client is planning to acquire stock that has high long-term appreciation potential, he or she can instead arrange for the children to purchase it. If they lack the independent means to make the purchase, gifts of cash can be made to them, taking advantage of the available annual exclusions. If investment values climb as anticipated, the individual has successfully passed significant wealth to his/her heirs and has avoided a substantial estate tax cost. Income tax savings can also result if the property is eventually sold by the children at a time they are in a low marginal income tax rate bracket. In the case of an investment opportunity involving an operating business, if an individual brings family members into the picture as shareholders or partners from inception of the activity, comparable long-run transfer tax savings can be produced.
Another approach available to a high-net-worth individual is to backroll family members in their own separate business ventures. The fruit of any success they enjoy is not diminished by the imposition of a transfer tax at the time of the individual's death. This result will hold true in spite of the fact the funding of the activity and the wise business counsel by the individual may have been instrumental in producing the prosperity the business experienced. The funds can be provided in several different ways. In addition to outright cash gifts, other possibilities include direct loans and guarantees of third party loans. Interest-free and below market interest rate loans have income and gift tax implications that must be considered. If a loan guarantee is used, it should be entered into cautiously because of possible negative estate tax consequences involving the marital deduction.
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