The Year of the Gift Tax
California CPA: August 2012
Now is the Time to Lock in Estate Tax Savings
By Mary Kay Foss, CPA
What’s so special about 2012 gifts? A number of things. To start, the exemption from the actual payment of tax is the highest in history: $5,120,000. Next, the tax rate is the lowest in history: 35 percent. The gift tax exemption is the same as the estate tax exemption—both of which are at the historic highs. In 2013, the gift and estate tax exemption and highest tax rate revert to 2001 levels: $1 million and 55 percent. With higher rates on the horizon, this is the time to lock in estate tax savings.
Another possible advantage to 2012 gifts results from the “portability” provisions of the 2010 tax law—the same law responsible for today’s low rate and higher exemption. With portability, the death of a spouse who did not need the entire estate tax exemption gives rise to an additional amount that can be used by the surviving spouse. A survivor can use the Deceased Spousal Unused Exclusion Amount (DSUEA) before Dec. 31, 2012, if it was created by a death in 2011 or 2012.
For example, if Fred died in June 2011 with a taxable estate of $3 million, a $2 million DSUEA would be created that could be used by the estate of his surviving spouse, Rita. Rita could also use the DSUEA for gifts. Unfortunately, the DSUEA and portability are set to expire Dec. 31, 2012, so the time is now to using this benefit before it expires. The IRS recently issued temporary regulations on how to elect to use the DSUEA and identical proposed regulations. The regulations require the executor (or a non-appointed executor such as a trustee) to calculate the DSUEA under rules provided. Specific practical situations are explained; how the rules apply when the surviving spouse has multiple deceased spouses is one situation that wasn’t clear before the release of this guidance.
Is There a Downside?
There has been published concern about clawback, which is the term used for the possibility that gifts made during a time of low rates and exemption will be clawed back to the estate of the donor who passes away in a year of high rates and low exemptions. Estate planning experts have put forth a number of reasons why clawback is unlikely or not possible, one example being that Form 706—as designed—would not assess the additional tax. The AICPA has written to Congress requesting that clawback be officially made impossible by law.
How Are the Gifts Reported?
The U.S. Gift Tax Return (Form 709) is filed on a calendar year basis, reporting all gifts made in the year. There are some items that are specifically exempt from the definition of a gift and are not reported, (direct payments of medical and higher education expenses, for example) but elaborate estate planning may require the reporting of items that are not gifts. For example, a donor may sell an asset to a “grantor trust” and report the details of the transaction on the gift tax return to start the statute of limitations running in case the IRS disagrees about the value or nature of the transaction.
Form 709 is due on the same day as the donor’s federal income tax return. If the federal income tax return is extended, then Form 709 is also automatically extended. It’s possible to file Form 709 timely while extending Form 1040. A separate extension form is needed when Form 1040 is filed timely and Form 709 requires additional time. Form 709 is filed separately by each spouse and allows them to treat half of their spouse’s gifts of separate property as their own to maximize the use of annual exclusions ($13,000 per donee for a gift of a present interest). Form 709 requires that gifts be separated into six types:
- Gifts the donor has made to someone in their generation or one generation below. Gifts to children are the typical example.
- Gifts to the same category of donees from the spouse.
- Direct gifts to grandchildren or to others in the same generation as grandchildren. This section also has a separate category for gifts from the donor’s spouse.
- The final two sections of gifts are for “indirect skips,” which are gifts to individuals in the same generation as grandchildren through a trust. Such gifts from a spouse are also reported.
Annual exclusions for gifts of a present interest are totaled and subtracted to determine taxable gifts. A tax is calculated on the taxable gifts. The $5,120,000 is not subtracted from taxable gifts; instead, the tax imposed on gifts of that magnitude is entered as a credit against the calculated tax.
Appraisals, trust agreements, elections and explanations of items that are not gifts are typical attachments to the gift tax return. The IRS is more active in auditing gift tax returns, because so many estates are not required to file an estate tax return. In addition, the IRS has been checking property tax records and found that there are many title transfers reported as gifts to the county officials that do not show up on Form 709. Gifts of a present interest less than the annual exclusion need not be reported on Form 709, but the donor should keep a record of the valuation of such gifts in case of IRS inquires. It’s recommended to file Form 709 to report annual exclusion gifts with discounts or valuation issues.
Inherited property receives a value to the heir equal to the fair market value on the date of death. We call this a “step up” in basis, but the value could be less than the decedent’s cost. Property received by a gift uses the donor’s basis, even though the gifts are reported at fair market value. This is an important consideration in determining what property to give.
For example, let’s say that the parents own highly appreciated rental real estate and a municipal bond portfolio and wish to take advantage of the 2012 gifting opportunity. The real estate is more likely to appreciate than the bond portfolio, but is it the best choice for a gift? If the parents are elderly, it may make sense to keep the real estate and make a gift of bonds. If the real estate is transferred to the children, they will acquire a highly appreciated asset with little or no depreciation potential, but a potential depreciation recapture liability when the property is sold.
If the real estate is community property, only one parent needs to pass away to get the revaluation that provides a better income tax situation for the children. A gift after the first death also makes planning for the second death with fractional interests or a family partnership or LLC more attractive. If the parents are relatively young and healthy, it might be that the cash flow from the real estate is such that the children will be better off by receiving a steady income stream from rents for a number of years instead of low yield municipal bonds.
You may want to remind clients that direct gifts are a way to watch the donee enjoy the assets given rather than knowing that they’ll be better off once those clients pass away. Direct gifts can also be made to a family trust or to establish a Sec. 529 plan to pay for education for children or grandchildren.
A gift to consider is forgiving family loans. If the clients have made loans to family members, forgiving the loan is a good way to reduce the donor’s estate without a cash outlay. The client could have sold assets to a family trust for notes that can be forgiven. The family trust might need amendment to take into account the forgiven debt when the donor passes away.
A family vacation home can be given to a Qualified Personal Residence Trust to preserve the home but remove it from the donor’s estate. The same technique can also be used with the primary residence of the donor. These gifts may be a bargain now because real estate prices are still depressed in areas.
Gifts to family partnerships or LLCs can make use of valuation discounts to make the gift tax exemption go a long way. Assets with a value of $6.8 million and a 25 percent discount would yield a gift valued at $5,120,000. The IRS is auditing gift tax returns with these large estate reductions but armed with a good appraisal, good documentation of the entity and good accounting, the gifts will serve the desired purpose. (See the Wandy case [TC Memo 2012-88]).
As mentioned above, there are some income tax trade-offs when assets are acquired by gift rather than inheritance. In 2012, the highest federal income tax rate is the same as the estate or gift tax rate. In 2013, income tax rates and estate and gift tax rates are all likely to change. You can help your clients determine which assets to give using various scenarios of tax rates.
When Should the Client Take Action?
Congress is unlikely to deal with the estate and gift tax or income tax rates before the election. This will leave any changes to a lame duck Congress, as happened in 2010. Clients do not have the luxury of waiting until late December if they intend to use any complicated techniques such as gifts to new trusts or entities. The time is now to discuss the issue and select the type of gift so that the plan can be fully implemented before Dec. 31, 2012.
Exemption or Not?
Under the unified estate and gift tax system, there are no exemptions. Instead, the law prescribes a “Unified Credit” for gift and estate tax purposes, which translates to an “Exemption Equivalent.” These amounts have been changing over the years. There was an exemption of $60,000 up until 1981. From that point forward we had an exemption equivalent beginning at $225,000 in 1982 and gradually increasing to $3.5 million in 2009. Initially the estate tax was repealed for 2010, but it was reinstated in December 2010 with an exemption equivalent of $5 million. Current law is scheduled to sunset in 2013 and return to the 2001 exemption equivalent of $1 million.
Mary Kay Foss, CPA is a director at Sweeney Kovar LLP.