As the likelihood of Congress retroactively reinstating the federal estate tax this year begins to fade, 2010 may prove to have been a good year for someone with a very large estate to die. (Just ask the heirs of billionaire George Steinbrenner.) However, the quirky tax rules for 2010 may also provide a unique wealth transfer opportunity for the living.
The Strategy
For higher-net-worth clients who are likely to owe federal estate taxes at death, making taxable gifts in 2010 may be a viable planning opportunity. That’s even if future legislation increases the estate tax exemption to proposed levels of $3,500,000 to $5,000,000.
The downside of this strategy is that it requires paying federal gift taxes during a client’s lifetime; something clients and advisors alike are typically loathe to consider. But, the upside to this strategy is that the net tax rate for taxable gifts made in 2010 could significantly reduce overall transfer taxes.
The Benefits
First, for the remainder of 2010, the federal gift tax rate is 35 percent. Next year—as you and your HNW clients are painfully aware—the top gift and estate tax rate is scheduled to increase to 55 percent, a whopping 57 percent rate increase.
Second, the gift tax is computed on a tax-exclusive basis (as a percentage of the value of property transferred), while the estate tax is computed on a tax-inclusive basis (as a percentage of all property in a decedent’s estate, including the amount used to pay estate taxes). For example, to give away one dollar by taxable gift in 2010, the donor would be out-of-pocket a total of $1.35 (the gift of $1.00, plus gift tax of $0.35). This factor further reduces the effective gift tax rate to approximately 26 percent (35/135 = 25.93 percent), as compared to the top estate tax rate of 55 percent in 2011.
Third, all post-transfer appreciation will be permanently excluded from the donor’s estate. A gift of real estate or other property that has declined in value during the recent economic downturn could spring back in value in the hands of a beneficiary for additional transfer tax savings.
Other Considerations
One caveat is that the donor must survive at least three years after making a taxable gift to avoid a rule that pulls the gift tax paid back into the donor’s taxable estate where it would be subject to the tax-inclusive estate tax. This restriction may limit the opportunity for someone very old or in declining health.
Another factor to consider is that with no federal estate tax returns filed this year, the IRS is likely to redirect audit resources to federal gift tax returns filed for gifts made in 2010. Aggressive gifting strategies such as discounted family limited partnerships will be closely scrutinized by the IRS, whereas gifts of cash or marketable securities are not likely to generate much controversy.
Making taxable gifts in 2010 is not a suitable strategy for clients with total assets at or below the range of $3,500,000 to $5,000,000, who hold out a reasonable hope that future legislation will completely shield their estate from all transfer taxes. Clients with total assets significantly above the $3,500,000- to $5,000,000 -range might consider making taxable gifts in 2010 as part of an overall strategy to reduce transfer taxes.
About the Author
Richard A. Behrendt, First Vice President, Senior Estate Planner, Robert W. Baird & Co. Prior to joining the firm in 2006, Behrendt was an estate tax attorney at the IRS for 12 years.