Because the Tax Cuts and Jobs Act (TCJA) has put the estate, gift and generation-skipping transfer (GST) tax exemptions at record-high levels, far fewer taxpayers are worrying about these taxes. But the high exemptions currently are available only through 2025. And Congress could pass legislation that reduces the limits sooner. So whether or not you’d be subject to estate taxes under the current exemptions, it’s a good idea to consider if you can seize opportunities to potentially lock in tax savings today. Those same opportunities might not be available in the future.
While the TCJA keeps the estate tax rate at 40%, it has doubled the exemption base amount from $5 million to $10 million. The inflation-adjusted amount for 2019 is $11.4 million.
Without further legislation, the estate tax exemption will return to an inflation-adjusted $5 million in 2026. So taxpayers with estates in the roughly $6 million to $11 million range (twice that for married couples), whose estates would escape estate taxes if they were to die while the doubled exemption is in effect, still need to keep potential post-2025 estate tax liability in mind in their estate planning.
The gift tax continues to follow the estate tax, so the gift tax exemption also has increased under the TCJA. Any gift tax exemption used during your lifetime reduces the estate tax exemption available at death. Using up some of your exemption during your lifetime can be tax-smart, especially if your estate exceeds roughly $6 million (twice that if you’re married).
You also can exclude certain gifts of up to $15,000 per recipient in 2019 ($30,000 per recipient if your spouse elects to split the gift with you or you’re giving joint or community property) without depleting any of your gift and estate tax exemption.
Warning: You need to use your annual exclusion by Dec. 31. The exclusion doesn’t carry over from year to year. For example, if you don’t make an annual exclusion gift to your grandson this year, you can’t add $15,000 to your 2020 exclusion to make a $30,000 tax-free gift to him next year.
The generation-skipping transfer (GST) tax generally applies to transfers (both during your lifetime and at death) made to people more than one generation below you, such as your grandchildren. This is in addition to any gift or estate tax due. The GST tax continues to follow the estate tax, so the GST tax exemption also has increased under the TCJA.
The GST tax exemption can be a valuable tax-saving tool for taxpayers with large estates whose children also have — or may eventually have — large estates. With proper planning, they can use the exemption to make transfers to grandchildren and avoid any tax at their children’s generation.
Even before the TCJA, many states imposed estate tax at a lower threshold than the federal government did. Now the differences in some states are even more dramatic. To avoid unexpected tax liability or other unintended consequences, it’s critical to consider state law. Consult a tax advisor familiar with the law of your particular state.
If one spouse dies and part (or all) of his or her estate tax exemption is unused at his or her death, the estate can elect to permit the surviving spouse to use the deceased spouse’s remaining estate tax exemption. This exemption “portability” provides flexibility at the time of the first spouse’s death, but it has some limits. Portability is available only from the most recently deceased spouse, doesn’t apply to the GST tax exemption and isn’t recognized by many states.
And portability doesn’t protect future growth on assets from estate tax like applying the exemption to a credit shelter (or bypass) trust does. Such a trust offers other benefits as well, such as creditor protection, remarriage protection, GST tax planning, and possible state estate tax benefits.
So married couples should still consider these trusts — and consider transferring assets to each other to the extent necessary to fully fund them at the first death. Transfers to a spouse (during life or at death) aren’t subject to gift or estate tax as long as he or she is a U.S. citizen.
Giving away assets now will help reduce the size of your taxable estate. Here are some strategies for tax-smart giving:
Choose gifts wisely. Consider both estate and income tax consequences and the economic aspects of any gifts you’d like to make:
- To minimize estate tax, gift property with the greatest future appreciation potential.
- To minimize your beneficiary’s income tax, gift property that hasn’t appreciated significantly while you’ve owned it.
- To minimize your own income tax, don’t gift property that’s declined in value. Instead, consider selling the property so you can take the tax loss and then gifting the sale proceeds.
Case Study: When “taxable” Gifts Save Taxes
Carol has an estate of $12 million. In 2019, she has already made $15,000 annual exclusion gifts to each of her chosen beneficiaries. She’s pleased that the gift and estate tax exemption has essentially doubled and, with future inflation adjustments, might be enough to protect her entire estate. But she’s in good health and believes she’ll live beyond 2025. So she’s concerned about having substantial estate tax exposure, especially considering that her assets likely will continue to appreciate. Her tax advisor suggests that she make some gifts beyond annual exclusion gifts this year.
So Carol uses $6 million of her gift tax exemption to make additional “taxable” gifts. Therefore, her estate can’t use that amount as an exemption. But she protects at least $6 million from gift and estate tax, even if the exemption drops below $6 million during her lifetime. She also removes future appreciation from her estate.
If the assets, say, double in value before Carol’s death, the gift will essentially have removed $12 million from her estate. This amount escapes the estate tax.
She does, however, need to keep in mind her beneficiaries’ income tax. Gifted assets don’t receive the “step-up” in basis that bequeathed assets do. This means that, if beneficiaries sell the assets, their taxable capital gains will be determined based on Carol’s basis in the assets. So their capital gains tax could be higher than if they inherited the assets.
Plan gifts to grandchildren carefully. Annual exclusion gifts are generally exempt from the GST tax, so they also help you preserve your GST tax exemption for other transfers. For gifts to a grandchild that don’t qualify for the exclusion to be tax-free, you generally must apply both your GST tax exemption and your gift tax exemption.
Take advantage of valuation discounts. If you own a business, you can leverage your gift tax exclusions and exemption by gifting ownership interests, which may be eligible for valuation discounts. So, for example, if the combined discount is 25%, in 2019 you can gift an ownership interest equal to as much as $20,000 tax-free because the discounted value doesn’t exceed the $15,000 annual exclusion.
Another way to potentially benefit from valuation discounts is to set up a family limited partnership. You fund the FLP with assets such as public or private stock and real estate and then gift limited partnership interests.
Warning: The IRS may challenge valuation discounts; a professional, independent valuation is recommended. The IRS also scrutinizes FLPs, so be sure to properly set up and operate yours.
Pay tuition and medical expenses. You may pay these expenses without the payment being treated as a taxable gift to the student or patient, as long as the payment is made directly to the provider.
Make gifts to charity. Donations to qualified charities aren’t subject to gift tax. They may also be eligible for an income tax deduction, but this deduction may benefit fewer taxpayers than in the past.
Trusts can provide significant tax savings while preserving some control over what happens to the transferred assets. For those with large estates, funding them now, while the gift tax exemption is high, may be particularly tax-smart. Here are some trusts to consider:
A qualified personal residence trust (QPRT). It allows you to give your home to your children today — removing it from your taxable estate at a reduced gift tax cost (provided you survive the trust’s term) — while you retain the right to live in it for a certain period.
A grantor-retained annuity trust (GRAT). It works on the same principle as a QPRT, but allows you to transfer other assets; you receive payments back from the trust for a certain period.
A GST — or “dynasty” — trust. It can help you leverage both your gift and GST tax exemptions. And it can be an excellent way to potentially lock in the currently high exemptions while removing future appreciation from your estate.