Susan Rothwell, Partner
January 11, 2019
In the extended season of giving which continues through 2025, here’s a primer on what’s new under the Tax Cuts and Jobs Act, the tax law that went into effect in the beginning of 2018. And a primer on what’s old, but still relevant.
First, the new tax law nearly doubled the amount of wealth you can give away during your life or at your death without having to pay federal gift, estate or generation skipping transfer taxes. The new amount (which I’ll refer to as the exclusion amount) for 2019 is $11,400,000 for individuals and $22,800,000 for married couples. For convenience, I’ll refer to $11 million and $23 million. Nevertheless, the requirement to file a gift tax return for each year in which you make a taxable gift remains unless the gift falls under an exception (discussed below).
What’s significant about this doubling is that if you are an individual or married couple you may have used gifting techniques under the old law to move wealth out of your estate that used up your exclusion amount ($5.49 million for an individual, $11 million for a married couple in 2017).
Under the new law, you can now use the same or different gifting techniques to transfer a total of about $11 million (individual) or $23 million (married couple) out of your estate. So you should revisit your old estate plans. Don’t wait, either. In 2026, the new law sunsets and the old lower exclusion returns (unless Congress changes it again). Implementing a gifting strategy now will enable you to take advantage of the larger exclusion amount.
And what if Congress lets the old lower exclusion amount return in 2026 after your gifting based on the new law? Here is some comfort: the Treasury Department and the IRS recently issued proposed regulations that remove uncertainty about being penalized for gifts made today totaling $11 million if you were to die after 2025 when the amount you can exclude from federal estate tax has reverted to $5 million (adjusted for inflation).
To restate the new law’s main benefit in terms of gift and estate tax: $11 million ($23 million for married couples) is now the threshold below which there’s no federal estate or gift tax.
Below, I will discuss how owners of interests in commercial property, shares in closely held companies and other hard-to-value assets (art, classic cars, other collectibles) can leverage gifting opportunities under the new law.
What is a “gift” for gift tax purposes? A gift is any transfer of property to another in which the transferor doesn’t get compensated for the fair market value of the property being exchanged.
This includes everything you would normally think of as a gift as well as some things that you might not think of: for example, an interest free loan to a family member. The amount of the interest not paid is considered a taxable gift from the person making the loan.
You can also have a transfer of property that is part gift and part sale, e.g., a house sold to your child at a fraction of its fair market value (the difference between the price paid and the fair market value is the value of the gift). The definition of a gift in the Internal Revenue Code and the Regulations is very broad.
When is a gift not a gift for gift tax purposes?
In the following situations you can give away property without incurring a gift tax or the requirement to file a gift tax return. These are ways to give that aren’t taxable:
- The Annual Exclusion: The “annual exclusion amount” is the amount that any person can give away in a year to any number of people without having to worry about gift tax consequences. In 2019, that amount is $15,000; it’s indexed for inflation, so it may change from year to year. A person can give $15,000 ($30,000 for a married couple) to an unlimited number of people over the course of a year without having to file a gift tax return or pay a gift tax.Here is an example illustrating the power of this technique to move wealth out of your estate without incurring gift tax. John Smith, divorced, the father of 4 and grandfather of 16, can give each family member up to $15,000 this year for a total of $300,000 (20 people * $15,000) without having to worry about gift tax. And if he manages to do this every year for 10 years, he will have transferred $3,000,000 to his family free of tax.If Mr. Smith makes gifts valued at more than $15,000 to any of his family members, or to any one else within a year, then he will need to file a gift tax return (and pay gift tax if he’s used up his $11 million exclusion amount).
- Paying someone’s medical expenses or paying tuition for someone’s education: Unlimited amounts can be spent without any gift tax consequences or gift tax filing requirement.
- Married Couples: Married couples can transfer unlimited amounts of property between each other (as long as they are both U.S. citizens) without gift tax consequences.
- Charities: Finally, there are no gift taxes or gift tax filing requirements on amounts transferred to charities and certain government agencies.
Every other transfer of a property interest for less than full consideration is a “taxable gift” that must be reported on a timely filed gift tax return.
Paying the gift tax vs filing the return
When do you have to pay a gift tax? The simple answer is after you give away more than $11 million in taxable gifts.
When do you have to file a gift tax return? You’re required to file a gift tax return for each year in which you make a gift unless it falls into one of the above exceptions.
In this way, the government keeps track of whether you’ve used up your $11 million exclusion amount during your lifetime. At death the gifts you’ve made get added back to your estate for the purpose of calculating the amount of the exclusion used. In this way, the government makes sure that it can tax you if you give away more than $11 million either during your life or at your death or some combination of the two.
How the gift and estate tax work together
You’re excited to learn that the new tax law doubles the amount you can give away tax free while you’re alive. You call your estate planning attorney to ask how it works. You tell your attorney that you have $20 million. You’re a single, retired woman with excellent retirement benefits. You’d like to know the tax consequences of giving the $20 million right now to your only daughter who is starting an investment business.
Answer 1: The first $11 million given to your daughter escapes gift tax but not the next $9 million which incurs a gift tax of about $3.5 million. (See Chart on following page.) There is no gift tax in New York state, so the federal gift tax is the only tax.
You think that this sounds like a lot, so you ask your attorney whether it would save taxes if you split the $20 million into a gift now of $11 million and $9 million upon death bequeathed under your will.
Answer 2: No, this scenario which transfers some of the property at the client’s death incurs more tax. There’s no gift tax on the $11 million gifted now, but there will be estate taxes on the $9 million transferred at the client’s death. It’s not only federal estate tax but New York estate tax as well. The federal estate tax (roughly $3,233,440) plus the New York State estate tax ($916,400) total $4,149,840.
You have one more question. Your daughter is actually doing well financially. But you also have a granddaughter who’s graduating from college. What about skipping your daughter and leaving everything to your granddaughter ($11 million now and then $9 million on your death)?
Your attorney responds, “Stop!” Transferring assets to your granddaughter incurs an additional tax, the Generation Skipping Transfer tax or GST tax. This additional tax comes into play when you transfer funds to a grandchild or someone who is deemed to be two generations below you (a person who is more than 37 ½ years younger, called a “skip person”). The government allows you to give away the first $11 million to a skip person, such as a grandchild, tax free, during life or at death, as with the gift and estate tax, but any additional amount (whether gifted or transferred at death) gets taxed at the highest gift and estate tax rate, 40%.
Why is this? The government’s intention is to tax every estate that exceeds $11 million, in every generation. By giving your money to a grandchild, you could potentially skip a generation (your daughter’s generation) of paying estate or gift tax on your wealth. To discourage this, the government says in effect, “Ok, you can give your money to your granddaughter, but we’re going to tax it twice to make up for the tax your daughter would have paid.” That’s why the GST tax kicks in at the highest rate, 40%.
What would be the total tax (gift, estate and GST tax) consequence of transferring the property to the granddaughter?
Answer 3: Again, the first $11 million gifted avoids tax, but the client’s estate will have to pay New York state ($916,400) and federal estate tax ($3,233,440) as well as a GST tax of $3,600,000. The total is $7,749,840, more than twice as much as when the client gifts the same funds to her daughter during the client’s life.
These examples illustrate some of the tax benefits of gifting during life rather than transferring wealth at death. (See the Chart below illustrating the three examples: 1 Gift to daughter; 2 Gift and bequest to daughter; 3 Gift and bequest to granddaughter.)
|Gift||Gift Tax||Bequeathed at death||NY and Federal Estate Tax||GST Tax||Total Tax|
|1||To Daughter during life||$20 million||$3.5 million||-0-||-0-||-0-||$3.5 million|
|2||To Daughter during life and at death||$11 million||-0-||$9 million||$4.1 million||-0-||$4.1 million|
|3||To Granddaughter during life and at death||$11 million||-0-||$9 million||$4.1 million||$3.6 million||$7.7 million|
These examples also illustrate the enormous impact of the GST tax and why planning to minimize this tax plays an important role in estate planning.
Valuation issues – Advanced gifting techniques
Filing a gift tax return for each year in which you make a taxable gift may seem burdensome, but it also achieves something positive for you. The filed return starts the clock running on the 3 year statute of limitations period within which the IRS can challenge the valuation of the gift.
The difficulty of valuation is obvious for assets such as art, classic cars and other collectibles. Who is the willing buyer? What would such a person pay? A qualified appraiser must be engaged to produce credible answers to those questions.
By filing a proper appraisal disclosing all of the relevant information, you prevent the IRS from coming back after three years have elapsed to challenge the appraised value of the gift. You will have achieved important certainty about amounts removed from your taxable estate via gifts of hard to value property.
Partial interests in property including family owned businesses pose additional questions for the appraiser to address.
Here’s a simple illustration: Mr. Smith is the sole owner of an LLC that holds a rental apartment building. His attorney suggests that with the new larger exclusion amount in place, this might be a good time for him to gift interests in the LLC to his four children. The building would be worth about $10.1 million if he sold it today. His attorney suggests Mr. Smith consider keeping a $100,000 interest as managing member and gifting a quarter of the $10 million remaining interest to each of his four kids.
In order to determine the fair market value of the interests he wants to give away, Mr. Smith engages a qualified appraiser. The value of each gift is not simply $2.5 million ($10 million/4). Instead it’s recognized that no arms length buyer – a stranger – would pay $2.5 million to buy a ¼ share of a building with three of Mr. Smith’s children and Mr. Smith as the co-owners. The appraiser therefore calculates discounts reflecting the disadvantages such a stranger would encounter. Issues such as lack of control over management and sale of the business and restrictions on marketing and selling a minority interest are the basis for determining these discounts.
Suppose, in Mr. Smith’s case, the appraiser concludes that a 30% discount is appropriate. The appraised value of the property that Mr. Smith is gifting is then $7 million ($10 million – (30% of $10 million) = $7 million) for gift tax purposes. The appraised value for each child’s gift is $1.75 million ($7 million /4 = $1.75 million).
These gifts enable Mr. Smith to transfer LLC interests (whose underlying value is $10 million) at an appraised value of $7 million for gift tax purposes. He uses up $7 million of his $11 million exclusion amount. He has $4 million of exclusion left.
For the Art Collector
A collector who spends a lifetime building a collection should also be concerned about preserving its value and minimizing taxes after he or she is gone. Gifting during life is one way to do that. Many different factors affect a collection’s value. Obvious ones are the importance of individual works and the importance or popularity of the artists in the collection.
But most collections are more valuable as a whole than they would be as individual pieces. Even the importance or fame of the collector may add to the collection’s value.
These factors create valuation issues similar to those in closely held businesses. As with closely held businesses, this creates opportunities to minimize taxes through gifts made during life. A qualified appraiser must be engaged who can apply discounts where appropriate in determining the appraised value for a gift of part of the collection (or for a partial interest in a specific work of art).
As is the case with shares in a closely held business corporation, the appraised value of a single work would be lower than its relative value if the whole collection were being transferred or sold at once.
We’ve already learned that giving a gift during life is more efficient from a tax perspective than transferring property at death. If you’re interested in efficiently transferring your collection to someone, gifting individual works of art or partial interests in works of art can lower the transfer tax costs.
Takeaway from all this: with the availability of such gifting tools, people with wealth should plan strategies to make additional gifts now before the law changes in 2026 and the amount you can exclude from gift, estate and GST tax falls back to $5 million.
 Hereafter, I refer to $5 million as shorthand for $5 million plus the adjustment for inflation.
 In 2019, there is no gift tax or recapture of gifts made within three years of death in New York.
 The tax estimates are based on the 2018 basic exclusion amounts.