Gift and Estate Tax Basics

Federal estate and gift taxes are imposed when property is transferred for less than its fair market value. While you are alive such transfers may be subject to the Federal gift tax. After your death, transfers of the property you leave behind may be subject to the Federal estate tax. The Federal estate and gift tax operate together so you cannot avoid the estate tax by giving away your property before you die! But not all transfers are subject to these taxes. The purpose of this article is to describe how the taxes work and why, unless Congress acts before 2011, even middle income taxpayers should have a basic working knowledge of the rules.

Disclaimer – This is a general discussion of estate and gift taxes and is not meant to provide specific legal or tax advice. For information on how these rules apply to your particular situation, consult your own attorney or tax professional for guidance.

Federal Estate and Gift Taxes

During your life, a transfer of property may result in a gift tax being imposed. The obligation to file a gift tax return and pay any gift tax due is on you – the transferor. The recipient of the gift does not file a return or pay the tax. After your death, an estate tax may be due on the value of your estate; the obligation to file and estate tax return and pay any estate tax due is imposed on the estate, not on the beneficiaries.

Together, the estate and gift taxes are often referred to as “transfer taxes” since they are imposed on certain transfers of property. Not every transfer, however, is subject to a transfer tax. A parent’s legal obligations to support a minor child are not considered gifts for tax purposes. But once the child is an adult and the legal obligation ends, a gift tax may be due on transfers between family members (with the exception of the “unlimited marital deduction” discussed below). Transfers of property for fair market value are not subject to transfer taxes – for example, you sell a used car to your adult son for $14,000. If that is the fair market value of the car it would not be subject to the gift tax. If you sold the same car to your son for $100 the amount of the gift potentially subject to tax would be $13,900 (or $14,000 minus $100).

Not every transfer will be subject to a transfer tax. Both the gift and estate tax have exclusions – amounts that may be transferred without imposition of the tax. The exclusions work as follows:

• First, the annual gift tax exclusion allows you to transfer up to $12,000 in 2008 to an individual without imposition of the gift tax. The annual exclusion increases periodically with inflation.
• Secondly, a gift and estate lifetime exclusion work together to allow an individual to transfer up to $2,000,000 of lifetime gifts and bequests without the imposition of gift or estate tax. The lifetime exclusion is scheduled to increase to $3,500,000 in 2009. In 2010 the estate tax is scheduled to disappear altogether leaving only the gift tax in place. The estate tax will return with a vengeance however, in 2011 when the exclusion is decreased to $1,000,000 – making transfer taxes a concern for many individuals and couples who never previously viewed themselves as “rich”. A home and a sizable IRA can result in your being over the $1,000,000 exclusion unless Congress changes the law and increases the exclusion after 2010. This strange result with the one year “holiday” from estate taxes was the result of political compromise.
What’s going on here? Political controversy surrounds the estate and gift tax system. Supporters point to the revenue needs of the Federal government in coming years as the baby boomers age and more is demanded of the Medicare system. Detractors believe it is unfair to tax an individual during life with an income tax and again at death with an estate tax. Tax law changes reflect this controversy. In 2001 a bill was signed into law that increased the lifetime exclusion up to $3,500,000 in 2009 (with some intermediate increases along the way). Due to the political arguments and compromises the new law sunsets at the end of 2009 resulting in no estate tax for one year - 2010. As discussed above, the gift tax remains in 2010. In 2011 the estate tax returns although the exclusion is scheduled to be $1,000,000. In addition to gallows humor recommending wealthy individuals die in 2010 to take advantage of the one year disappearance of the death tax, the uncertainty surrounding the tax law changes make it very difficult to plan.
• In addition to the exclusions, there is an unlimited marital deduction – spouses may transfer assets to each other without imposition of gift or estate tax (referred to as the “unlimited marital deduction”).

Attorneys, CPAs and other tax professionals offer estate and gift tax planning. Such planning involves a number of techniques. These include maximum use of the annual gift tax exclusion through annual gifting programs (a husband and wife can “gift split” giving $24,000 to each child – or two times the $12,000 annual exclusion), ensuring full use of each exclusion (in 2009 the exclusion of $2,000,000 is per person – a husband and wife together can exclude up to $4,000,000). Lifetime contributions to a charity are not subject to the gift tax. At death transfers to a charity are deductible from the gross estate before the estate tax is calculated. Charitable gifting is a popular to reduce transfer taxes while fulfilling altruistic goals.

Opportunities for increasing gifts (especially helpful for grandparents!) – include certain lifetime transfer that receive special consideration – for example, the payment of medical care or educational costs directly to the institution providing the services or education are not subject to gift taxes. There are also favorable rules regarding contributions to Section 529 plans (Qualified Tuition Plans) that allow the “bunching” of the annual gift tax exclusion of up to $60,000 ($120,000 if gift splitting is used) in one year.

The tax rate imposed on transfers is progressive meaning as the amount of lifetime gifts and the value of the estate increases, the tax rate increases. Currently, the gift and estate tax rate ranges from 18% to 45%. At such high rates, a good estate planning attorney or other planning professional can legally save you and your family from significant taxes.

Gift and estate tax planning is a very complex area. As we approach 2011 and the exclusion decreases to $1,000,000 many more of us may be subject to transfer taxes if Congress does not act. Especially vulnerable are small business owners and farmers who may die with substantial estates. But the bulk of the wealth may be tied up in the business or the farm – sufficient cash may not be available to pay the estate tax due. An attorney or CPA can assist with liquidity planning so that estate taxes can be paid without having to sell the farm or business. Often life insurance can provide the liquidity needed.

Other important planning techniques involve annual gifting programs to take advantage of the annual exclusion, the use of trusts, maximizing use of each individual’s lifetime exclusion, understanding the role of the “step up” in the tax basis of assets transferred, and understanding “income in respect of a decedent” (or IRD) and the taxation of IRAs and other qualified retirement plans. A good estate and gift planning professional will work through all of these issues with you.