Estate-planning professionals will remember the beginning of 2017 as a bit tart, as in “TART,” “Trump’s Attempt to Reform Taxation.” As planners await what will come out of changes in the tax laws, such as, will there be estate tax repeal, no estate tax repeal, loss of step-up in basis, increased exemption amounts and impacts on charitable gifting, the effects of such uncertainty on all aspects of estate planning can be stultifying.
Let’s examine this uncertainty in the context of lifetime taxable gifts.
Lifetime Taxable Gifts
The first $5.49 million of lifetime taxable gifts incur no actual gift tax payment, as it’s covered by the lifetime gift exemption. Thereafter, each $1 made in taxable gifts is subject to a 40 percent tax and gift tax payment.
In an economically rational world, under a unified estate and gift tax system, the making of lifetime taxable gifts could lower the overall estate and gift tax bite and, as such, is a rational planning strategy.
That topic has been expectorated and re-expectorated in scholarly articles quite a few times in the last three decades. The conclusion about the benefits of lifetime taxable gifts isn’t inherently intuitive.
I recall spouting off to a law school class (it was a night class so half the students were already in a persistent vegetative state from their day jobs by the time they arrived at school) that the gift tax system was tax exclusive, while the estate tax system was tax inclusive, or was it the other way around? I then spent the next 60 minutes explaining why paying gift tax could be tax beneficial. I’m fairly certain no student got it; or wanted to get it; or felt good about it.
But, the conclusion and planning is rational.
Example: Dad is the surviving spouse and lives in Florida, where there’s no state estate tax. He has an estate of $10.49 million. His lawyer, who’s a good friend, has assured dad that not only will the lawyer not charge for administration, but also, the lawyer will pick up all debts and other expenses of administration as a “thank you” for all the nice things Dad said about the lawyer during Dad’s life. Hence, Dad’s expected taxable estate is exactly $5 million over the exemption amount, for a tax of 40 percent multiplied by $5 million, or $2 million. This will leave $5.49 million + $3 million ($8.49 million) remaining for his children.
But, Dad is 80 and in poor health. If more than three years before he dies, Dad gifts $8.49 million to his children, this will result in $3 million subject to tax at a 40 percent tax rate, resulting in $1.2 million in tax due. After paying tax and making the gift, he has $800,000 left. If he pays 40 percent on this $800,000 in estate tax, this leaves him with $480,000 ($800,000 – 40 percent tax on $800,000). He then would have given his kids $8.49 million + $480,000, for a total of $8.97 million with this lifetime taxable gift, versus the $8.49 million that he would have left if there were no taxable gifts.
Rationality Isn’t Always Omnipresent
As estate planners, we understand that paying gift tax (and ignoring the time value of money concern with the gift tax paid) is a legitimate planning strategy for those who will pay estate tax. And, we discuss this strategy with clients, getting buy-in on, at most, one out of four occasions.
The question is, when clients want to get more funds to their children and feel that they have enough to live on, why don’t 100 percent of them make lifetime taxable gifts with gift tax payments.
Forrest Gump says, “Irrationality is as irrationality does.”
The answer: We aren’t automatons, acting rationally in all environments. And, we’re certainly not rational when it comes to all economic decisions. Author Michael Lewis has elevated the area of behavioral finance to our consciousness. Books like The Undoing Project: A Friendship That Changed Our Minds have highlighted the somewhat asymmetrical way human beings look at decisions, not as rational actors making objective decisions that maximize our economic well being, but as emotional beings that are influenced by “how we feel” about stuff as much as how it will impact us.
One such principle demonstrated by behavioral finance is myopic loss aversion, in which the pain of losing is much greater than the happiness of winning.
For example, our happiness when our portfolio increases by 5 percent is, say, at X. (Isn’t X always the random variable that stands for all sorts of things? If I were the letter X in the alphabet, given my importance in standing for all sorts of things, I would ask to be moved up, like after B or C, and not stay at the lowly end of the alphabet). But, our unhappiness if the portfolio goes down by 5 percent is (I’m making this up, but it’s somewhere in this neighborhood) 4X. Therefore, a decision that has a 50 percent probability of increasing our portfolio by 5 percent, if it also has a 50 percent probability of decreasing it by 5 percent, may not be made, even though the expected value isn’t negative (it’s zero, so we should be disinterested in making that investment choice).
Returning to the world of gift tax payments (and no, I didn’t torture my students with this behavioral finance concept), we can potentially save $480,000 in our example in estate taxes (after taking into account the payment of gift taxes). But, it costs us the pain of making a tax payment now.
There are different ways to look at this, but one way is as follows: The payment of gift taxes now is a LOSS. It feels very painful to our clients.
The saving of estate taxes in the future is a GAIN (but because it’s in the future, another behavioral finance principle discounts that value at irrationally high discount rates). Even though the GAIN substantially outweighs the LOSS in dollars, the LOSS is more emotionally painful than the happiness of the GAIN. Hence, our clients may not make the gift. (We noted at the beginning that the clients actually wanted to get funds to their children and that they didn’t feel that they needed the money that they would gift.)
Paying Gift Tax Has Been Trumped
We now live in a world where the estate tax system may disappear. If that indeed happens, even if the gift tax system remains, clients won’t want to pay gift taxes. The myopic loss aversion to paying gift taxes would boil up in our clients, much like our anger when we can’t clearly read our texts while driving.
Even though in our current environment, paying gift taxes could save estate taxes, and is therefore a rational strategy, our clients won’t view it this way if, this year or next, the estate tax is repealed. And this is so, even if the estate tax is repealed “temporarily.” Remember, we’re dealing with emotional actors here, those actors being our clients.
Accordingly, strategies that result in the payment of gift taxes have to be put on hold in 2017.
While we wait for the tax change dust to settle, gift tax payment strategies now need to be structured alternatively.
Example: Assume Dad wants to do a sale to a grantor trust, but needs to have $3 million of seed money in the trust for the down payment. Typically, planners would advise Dad to make a gift to transfer these funds to the trust, even if the gift exceeded the lifetime gifting credit and a gift tax would be payable. In 2017, an alternative structure needs to be worked out. This could be third-party financing guarantees by the trust beneficiaries, loans by trust beneficiaries or even a short-term (2-year) grantor retained annuity trust (but keep in mind that the grantor trust then couldn’t be a generation-skipping transfer). If a loan or financing arrangement is used, and the estate tax system isn’t repealed, perhaps the loan or financing structure could be turned into a gift later this year or next.
Happy 2017 Trails
I’ve dedicated this column to payment of gift taxes, essentially saying, “don’t do it in 2017.” The year 2017 is one of change. It could be a year of indecision and a year of focus for us as estate planners. We have to avoid the status quo bias of doing nothing and, instead, approach our planning with two end games in mind: the estate tax system remains, or the estate tax system is repealed. With each traditional planning strategy that we use, there are iterations that work fine under either of these two results, and we shouldn’t be timid about considering these iterations.