Estate tax planning tends to get complicated quickly. There’s an alphabet soup of strategies available—grantor retained annuity trusts, spousal lifetime access trusts, intentionally defective grantor trusts (IDGTs), qualified personal residence trusts—the list goes on.
Used appropriately, these strategies can be very effective. However, clients and advisors should never forget the surprising power of the humble annual exclusion gift.
Some states impose their own estate taxes. For example, Illinois imposes an estate tax on estates over $4 million. The effective tax rate varies but can be surprisingly high—potentially up to 28.5% for estates only slightly over $4 million. The federal government imposes an estate tax on estates over $11.58 million, at a rate of 40%, although this $11.58 million exemption is scheduled to be reduced by 50% in 2026 and could be reduced earlier by a future Congress. Gifts made during lifetime are generally counted against this $11.58 million lifetime exemption.
Internal Revenue Code Section 2503 provides that a certain amount of gifts each year are excluded from being counted toward the lifetime exemption. That amount is currently $15,000 per donor/per recipient and will be adjusted for inflation in future years. Yearly gifts of this amount are commonly referred to as "annual exclusion gifts."
Basic Use of Annual Exclusion Gifts
Annual exclusion gifts are a perfect first step for individuals who would like to reduce their estate tax exposure but aren’t yet prepared to undertake more involved strategies. The amount of estate tax savings obtained through annual exclusion gifting can be surprisingly large. This is because married couples can combine their annual exclusion amounts when making gifts, meaning that a married couple can give $30,000 per year to a child without using any transfer tax exemption (although filing a gift tax return may be required in some circumstances). When the spouses of children are included, the amount that can be gifted is doubled again, meaning that a married couple can give a total of $60,000 per year to a child and the child's spouse without using any transfer tax exemption.
Consider, for example, a married couple living in Illinois who have with three married adult children. Suppose that the couple expects the taxable estate of the survivor of them to be valued at $5 million. Absent any planning, $285,714 of Illinois estate tax due would be due on the death of the surviving spouse. However, if both members of the couple were to make annual exclusion gifts to each of their children and to each of their children's spouses, the couple could give away a total of $180,000 ($15,000 × 2 × 2 × 3) each year without using any transfer tax exemption. Just one year of annual exclusion gifts would reduce the expected Illinois estate tax due to $234,286 – a tax savings of $51,428 from just one year of gifting. If the couple was also subject to the federal estate tax, which combines with the Illinois estate tax to produce an effective tax rate of nearly 50%, the tax savings would be even greater.
Gifting to Trusts
Many clients wish to gift assets to their children in trust rather than outright to provide creditor protection and estate tax benefits. Generally, gifts to trusts aren’t eligible for the annual exclusion. However, if the beneficiaries of the trust have the unilateral right to withdraw a portion of the assets gifted to the trust each year, then under the famous (in estate-planning circles, at least) case of Crummey v. Commissioner (397 F.2d 82, 9th Cir. 1968), gifts to the trust are eligible for the annual exclusion – greatly expanding the usefulness of annual exclusion gifting.
Your clients can use 529 plans to further exend the power of annual exclusion gifts. If a donor makes a proper election on a gift tax return, he can "frontload" up to five years' worth of annual exclusion gifts in a single year and use no transfer tax exemption. Thus, for example, an individual could give up to $75,000 in one year to a 529 plan for a grandchild, and a married couple could give up to $150,000, treating the entire amount as annual exclusion gifts for that year and the following four years.