In terms of federal tax law changes, the last year had much ado but little change. A range of proposals circulated in Washington, including ones to require realization of gains at death, lower the federal transfer tax exemptions, raise the estate tax rate, eliminate valuation discounts and undo the benefits of irrevocable grantor trusts.
As it stands, it’s anyone’s guess whether these proposals will ever become law. But they also don’t seem likely to disappear, as many of them have persisted for years.
Going forward, this can make it difficult to advise clients on the best approach to wealth transfer. The default position for many advisors is to advise based on the rules as they are. But for clients looking out over years or decades as their potential period of wealth transfer, the current rules may seem an insufficient reference in optimizing their decisions.
The alternative approach for many other advisors has been to engage in various forms of contingency planning, including spousal lifetime access trusts, disclaimer planning and other arrangements with potential escape hatches if the tax laws change (or don’t) or the client’s needs or desires change. While this can be good planning in many cases, it often involves complexity that clients otherwise would avoid and requires close attention to future administration.
Five Situations
In this context, below are five situations when making taxable gifts over the current $16,000 gift tax annual exclusion is likely to make sense for clients, despite the ongoing potential variability of our federal transfer tax laws. These situations aren’t the only ones when making taxable gifts will make sense, but they can help you know a good candidate for gifting when you see it.
1. Clients who want to gift. If a client wants to make a taxable gift, the question for the advisor is whether there’s a tax reason to stop them.
Clients may want to make a taxable gift to help a child buy a home or start a business. They may want to bring a child into the ownership of a family business or management of a property. They may want to give a child an asset to promote learning and responsibility. They simply may want to share their wealth in a more significant manner than the $16,000 annual exclusion.
Under the current rules, it’s hard to argue a client should delay for tax purposes a transfer that otherwise achieves a clear personal or family goal. The federal gift tax exemption is as high as it’s ever been. Rates are relatively low. And a range of planning strategies are still available that advisors can help a client make the most of.
If a client hasn’t used their full gift and estate tax exemption amount of $12.06 million, the only tax downside may be filing a gift tax return. Even if a client has used their full exemption, paying gift tax now at 40%, and potentially saving future taxes by decreasing the size of their estate, may not be something they regret.
2. Clients ignoring the step-up in basis. The main tax reason not to make taxable gifts is the step-up in income tax basis. Under current rules, assets transferred at death generally receive a step-up in income tax basis to the value at the time of death. In contrast, assets transferred by gift don’t.
Clients need to be aware of the step-up and its potential tax impact. If a client wants to gift a $2 million property with a $100,000 tax basis, they need a warning. Along with the property, they will be passing $1.9 million in embedded capital gains. If instead they wait and leave the property at death, those gains go away.
But a client may reasonably respond to your warning by asserting that waiting to leave assets at death involves a lot of speculation. Even a client in their 90s may still live another decade. In that period, the step-up may disappear, or the rule may morph, as the proposals in 2021 made clear. Meanwhile, the personal and tax benefits of having made the gift won’t occur.
For these reasons, a client may decide to ignore the sacrifice of the step-up that comes with making a lifetime gift. If that’s the case, making taxable gifts generally is going to make sense for tax purposes, because it moves assets out of the client’s estate and puts future appreciation in the hands of their beneficiaries.
3. Clients with rapidly appreciating assets. The main tax reason to make taxable gifts is appreciation. For clients with estates over the estate tax exemption, there’s 40 cents of tax savings for every dollar of appreciation in the hands of their beneficiaries rather than as part of their estate.
With rapidly appreciating assets, giving early makes all the difference. For founders and entrepreneurs, that can involve start-up interests. For fund managers, it can involve interests in new funds. Executives may double down on the growth they hope to achieve for their company and give stock.
Appreciation also can occur through the accumulation of gifts over time. The value of partial interests in a property will pop when the client gives up control or that final sliver giving full ownership to their beneficiary.
A $1 million gift with nominal basis that appreciates at 25% a year can make up the potential sacrifice of a step-up in basis in four to five years. From there, the overall tax savings will only compound. In addition, strategies like grantor-retained annuity trusts and sales to an irrevocable grantor trust can further enhance the tax savings opportunities, sometimes even without making a taxable gift.
4. Clients with large estates involving high-basis assets who haven’t used their full exemption amount. Under the current rules, the federal estate, gift and generation-skipping transfer tax exemption amounts are scheduled to be cut in half in 2026. If a client hasn’t used their full amount at that time, they’ll lose it as the law stands. A client who makes taxable gifts of $12 million today before the exemption amount drops to, say, $6.5 million in 2026, on paper, saves taxes on the additional $5.5 million of assets they managed to transfer tax-free.
But keep in mind the tax savings of using that “bonus” exemption fade to the extent the exemption amount continues to adjust up with inflation. In addition, if the exemption doesn’t end up cut in half in 2026 (or gets cut only to rise again), use of the “bonus” exemption today may not end up much of a bonus after all.
This uncertainty on the ultimate benefit of using the “bonus” exemption is why the use of high-basis assets is key. If a client gifts cash or other high-basis assets, the potential tax cost of sacrificing the step-up in basis is minimized and the potential tax benefit of using the “bonus” exemption, as well as moving appreciation out of the client’s estate, becomes all gravy.
Gifting of lower basis assets can also make sense. However, it requires a closer look at the numbers, because the potential tax benefit will need to make up the potential tax cost of sacrificing the step-up.
5. Clients who are certain their tax burdens are only going to increase. If a client is certain their tax burdens are only going to increase, another way to look at it is to say the rules appear quite favorable today. If the rules are favorable today, it can make sense to use them by making taxable gifts.
Gifting can be a way to spread income among family members. Gifting may be a way to avoid having assets subject to a wealth tax or mark-to-market capital gains rules. Gifting also may be a way to establish structures like irrevocable grantor trusts or family limited partnerships that may involve additional complications or lesser tax benefits in the future.
Clients engaged in this type of gifting are likely aware of the speculative nature of their endeavor, as well as the risk that strategies they put in place today may be undone by tax rules in the future. Nevertheless, their speculation may align with other personal or financial goals—and the more straightforward tax benefits of gifting—to make it worthwhile.
Evolving Rules
The uncertainty of what the transfer tax rules will be five, 10 or 55 years in the future may not be something to be solved. But in terms of taxable gifts, we can help our clients know the factors that may make their gifts make sense regardless of what the rules may be.
This can help us avoid pretending like the rules are set in stone. It also can prevent us from leading clients into complex planning that they may not be equipped to manage as the rules evolve.
Bryan Kirk is director of estate and financial planning at Fiduciary Trust International.