Consider whether you should max out your gift tax exemption

Take advantage of the annual exclusion

Make annual exclusion gifts without giving up control

Leverage the annual exclusion by giving appreciating assets

Think twice before giving highly appreciated assets

Leverage your tax-free gifts with an FLP

Making gifts to loved ones today provides many benefits

One effective way to reduce your estate tax exposure is to remove assets from your estate before you die. As long as you can make the gifts without incurring gift tax, you’ll be no worse off taxwise — and if the gifts allow you to remove future appreciation from your estate, you likely will be much better off. Plus you’ll have the pleasure of seeing your loved ones enjoy the gifts.

Consider whether you should max out your gift tax exemption

Cumulative lifetime taxable gifts up to the gift tax exemption amount (see the Chart “Gift and estate tax exemptions and rates”) create no gift tax, just as assets in an estate less than or equal to the available estate tax exemption amount create no estate tax. But note that this is on a combined basis. In other words, if you make $200,000 of taxable gifts during your life, the amount of assets in your estate that will avoid estate taxes will be reduced by $200,000.

Because many assets appreciate in value, it may make sense to make taxable gifts up to the lifetime gift tax exemption amount now — if you can afford to do so without compromising your own financial security. If you can’t afford to give the full $5.45 million, even smaller gifts can substantially reduce the size of your taxable estate by removing future appreciation. (See the Case Study “When ‘taxable’ gifts save taxes.”)

Also remember that each spouse is entitled to his or her own exemption. If a couple uses up their gift tax exemptions by making $10.90 million (the $5.45 million mentioned above times two) in taxable gifts and after five years the assets have increased in value by 50%, they’ll have removed an additional $5.45 million from their combined taxable estate without incurring any gift or estate tax liability.

Take advantage of the annual exclusion

Taking advantage of the annual gift tax exclusion is a great way to reduce your estate taxes while preserving your exemptions and keeping your assets within your family. Each individual is entitled to give as much as $14,000 per year per recipient without any gift tax consequences or using any of his or her gift, estate or generation-skipping transfer (GST) tax exemption amount. The exclusion is indexed for inflation, but only in $1,000 increments, so it typically increases only every few years.

Go to the Case Study “The early bird catches the tax savings” to see the dramatic impact of an annual gifting program.

Make annual exclusion gifts without giving up control

To take advantage of the annual exclusion, the law requires that the donor give a “present” interest in the property to the recipient. This usually means the recipient must have complete access to the funds. But a parent or grandparent might find the prospect of giving complete control of a large sum to a child, teen or young adult a little unsettling. Here are a couple of ways around that concern:

Take advantage of Crummey trusts. Years ago, the Crummey family wanted to create trusts for their family members that would provide restrictions on access to the funds but still qualify for the annual gift tax exclusion. Language was included in the trust that allowed the beneficiaries a limited period of time in which to withdraw the funds that had been gifted into the trust. If they didn’t withdraw the funds during this period, the funds would remain in the trust. This became known as a “Crummey” withdrawal power.

The court ruled that, because the beneficiaries had a present ability to withdraw the funds, the gifts qualified for the annual exclusion. Because the funds weren’t actually withdrawn, the family accomplished its goal of restricting access to them.

The obvious risk: The beneficiary can withdraw the funds against your wishes. To protect against this, you may want to explain to the beneficiaries that they’re better off not withdrawing the funds, so the proceeds can pass tax-free at your death. Your tax or legal advisor can counsel you about other ways of drafting the document to protect against withdrawals.

Establish trusts for minors. An excellent way to provide future benefits (such as college education funding) for a minor is to create a trust which requires that:

  • The income and principal of the trust be used for the benefit of the minor until age 21, and
  • Any income and principal not used be passed to the minor at age 21.

A trust of this type qualifies for the annual exclusion even though the child has no current access to the funds. Therefore, a parent or grandparent can make annual exclusion gifts to the trust while the child is a minor. The funds accumulate for the future benefit of the child, and the child doesn’t even have to be told about the trust. Warning: The child must be given full access to the trust assets once he or she reaches age 21.

Leverage the annual exclusion by giving appreciating assets

Whether you’re using your lifetime exemption or your annual exclusion, gifts don’t have to be in cash. Any asset qualifies. In fact, you’ll save the most in estate taxes by giving assets with the highest probability of future appreciation. (Take a look at the Chart “The power of giving away appreciating assets”.) Cathy gave her daughter a municipal bond worth $14,000. During the next five years, the bond generated $550 of income annually but didn’t appreciate in value. (Note that this amount is hypothetical and is used as an example only.) After five years, Cathy had passed $16,750 of assets that would otherwise have been includable in her estate.

But suppose Cathy gave her daughter $14,000 in stock instead of the bond. If the stock generated no dividends during the next five years but appreciated in value by $7,000, Cathy would have given her daughter $21,000 of assets — and taken an additional $4,250 out of her estate.

Think twice before giving highly appreciated assets

A recipient usually takes over the donor’s basis in the property gifted. If you give your child an asset worth $14,000 but that cost you $8,000, your child will generally take over an $8,000 basis for income tax purposes. Therefore, if your child then sells the asset for $14,000, he or she will have a $6,000 gain for capital gains tax purposes.

This gain could potentially be avoided if you bequeath the asset instead. At your death, your assets generally receive a new federal income tax basis equal to the date-of-death fair market value. Going back to our example, if your child receives the $14,000 asset as a bequest, he or she could sell it for $14,000 and have no gain for income tax purposes. His or her income tax basis would be $14,000 instead of your $8,000.

So where possible, it’s better to make lifetime gifts of assets that haven’t yet appreciated significantly and save highly appreciated assets for bequests.

Leverage your tax-free gifts with an FLP

Family limited partnerships (FLPs) can be excellent tools for long-term estate planning, because they can allow you to increase the amount of gifts you make without increasing the gift tax cost. FLPs are special because they may allow you to give assets to your children (and other family members) at discounted values for gift tax purposes. You can apply either your lifetime exemption or your annual exclusion to the gifts.

Here’s how an FLP works: First you select the type of assets (such as real estate or an interest in a business) and the amount (based on the gift tax exemption and annual exclusion) and place them in the FLP. Next you give some or all of the limited partnership interests to your children or other family members you’d like to benefit.

The limited partnership interests give your family members ownership interests in the partnership, but no right to control its activities. Control remains with the small percentage (typically at least 1%) of partnership interests known as general partnership interests, of which you (and possibly others) retain ownership. The result is that you can reduce your taxable estate by giving away assets (the partnership interests), without giving up total control of the underlying assets and the income they produce. In addition, because the limited partners lack any control, these interests can often be valued at a discount. When making a gift of an FLP interest, obtaining a formal valuation by a professional business appraiser is essential to establish the value of the underlying assets and of the partnership interests.

Warning: Because the IRS frequently challenges FLPs, caution is needed when implementing them. Fortunately, court cases have provided insights into how to structure and administer an FLP that will survive IRS scrutiny. •


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