When Gifting Assets for Estate Tax Planning Purposes, Consider Possible Adverse Income Tax Effects on Your Heirs
A plan of lifetime gifting of assets from one generation to the next is an often used technique to help reduce estate taxes in the estate of the donor (the one gifting the assets), but this strategy may come at adverse income tax cost to the donees (receivers) of such gifts. Both the estate tax effect on the donor and the income tax to the recipients needs to be considered when embarking on an asset gifting plan, particularly if those assets have substantially increased in value since they were purchased by the donor.
For those whose estates exceed the current total Federal Estate Tax Exemptions, a gifting plan is an integral part of their estate tax planning. Under current law, the 2024 individual federal estate tax exemption is $13.61 million per person, and $27.22 million per married couple. Clearly taxpayers with a net worth or combined net worth in excess of those amounts need to carefully consider a plan of lifetime gifting of assets for estate tax planning purposes. But note that the current estate tax exemptions are scheduled to sunset or expire at the end of 2025. If Congress does not otherwise act to extend the current (or somewhat different) exemption amounts, the Federal Estate Tax Exemption will return to the amounts under prior law, which when adjusted for inflation will be in the range of $6.0 to $7.0 million for each person, and $12.0 to $14.0 million per married couple. Taxpayers with a net worth or combined net worth in excess of these lower amounts also need to be aware that a plan of gifting may be advisable now in order to take into account the lower Federal Estate Tax Exemption amounts in 2026 and beyond.
When considering a gifting plan as a way to reduce the donor’s estate taxes, consideration of the income tax effects of such gifts on the recipients need to be taken into account to make sure the gifting plan does not wind up costing the family more income taxes than the estate tax savings achieved. This may occur because of the concept of basis (or cost) of the gifted assets in calculating the total taxes (estate and income) that may be incurred by the family as a result of the gifting plan.
When a capital asset (stocks, bonds, real estate, etc.) is sold at a profit the seller of the asset pays income tax on the difference between the sale price of the asset and the basis (or cost) of the asset. If the asset has been held long enough, that gain on the sale of the asset is a long-term capital gain taxed at more favorable income tax rates. In the case of gifted assets (which may ultimately be sold by the recipients of the gift), the recipient takes the donor’s (giver’s) basis or cost in the asset to calculate the recipient’s income taxable gain. This is called a “carry over” basis, meaning that the recipient of the gift uses the donor’s basis (or cost) when calculating his or her taxable gain from the profit on the sale of the asset when/if the gifted assets are sold by the recipient.
For example, if parents gift stock that the parents paid $200,000 for to the children, then the children have to use mom & dad’s cost basis of the stock ($200,000) when the children sell the stock. Let’s say the stock is worth $1,000,000 at the time of the gift. And assume the stock has grown in value to $1,100,000 by the time the children sell it after the gift. The children would have to pay capital gains income tax on $1,100,000 (current value) minus $200,000 (their parent’s cost basis), or a gain of $900,000. So, even at long-term capital gains rates, the children would pay income tax on a gain of $900,000 at roughly 20% (long-term capital gains rates) or roughly $180,000 in income taxes when they sell the asset.
At the same time, the estate tax savings on this same gift (assuming the parents’ estate is large enough that they would be subject to estate taxes in the first place) would be roughly 40% of the gain on the value of the asset from the date of the gift to the date of the sale (assuming annual gift tax exclusions have already been used by the parents). In the foregoing example, the gain from the date of gift to the date of sale is only $100,000 – that is the gain from $1,000,000 to $1,100,000. At a 40% estate tax savings rate, the estate tax savings would be roughly $40,000. So, clearly, saving $40,000 in estate taxes would potentially cost the family $180,000 in income taxes, so this would not be a good tax trade in the gifting plan.
By contrast, if the parents leave that same $1,000,000 in stock to the children in their wills or trusts as their passing, then under current law the children would take the date of death value of the stock (not the parent’s cost basis) as their cost basis. This is called a “stepped up” basis. In this example, the date of death value is $1,000,000 so the children’s cost basis would be $1,000,000 as well. Now the children’s income tax gain on a sale would be $1,100,000 minus $1,000,000 or $100,000. A long-term capital gain tax of roughly 20% would cost the children only about $20,000 in income taxes whereas in the gifting plan in the example above would cost the family a net tax of $140,000 ($180,000 - $40,000). So in this case, inheriting the assets would save the family substantial total taxes as opposed to the gifting plan.
There are many factors which would go into this type of calculation, including the effective use of annual gift tax exclusions, state estate taxes, certain valuation discounts for gifts, etc.) for which experienced estate planning attorneys can assist in order to determine whether a gifting plan is better or worse than an inheritance plan from an overall tax perspective for a particular family and particular assets for consideration for the gifting plan.
Summarized here are some general points to consider when considering a gifting plan for estate tax savings purposes (of course there may be other personal considerations to a gifting plan which have nothing do to with saving taxes, so those reasons may still make gifting worthwhile):
1. Generally speaking, couples with a current gross taxable estate of less than $12.0 million do not need to worry about a gifting plan for estate tax purposes, at least at the Federal Estate Tax level, even after the current estate tax law expires at the end of 2025.
2. Couples with a current gross taxable estate between $12.0 million and $27.0 million need to actively consider whether or not a gifting plan makes sense for them as we face the real possibility of a reduction in the current estate and gift tax exemption amounts. If a couple is willing to make very large gifts, the next year and a half represents a real opportunity to take advantage of the larger exemption amounts before they expire.
3. For couples in states that have their own state estate tax regime such as Maryland, the effect of saving state estate taxes needs to also be factored into the estate tax gifting plan. For example, Maryland’s estate tax exemption is currently $5,000,000 per person and $10,000,000 per couple. However, Maryland does not have a separate gift tax regime. So 100% of gifts will escape taxation at the passing of parents, not just the appreciation on those gifted assets.
4. When considering assets to be used in an estate tax gifting plan, choose assets which have a relatively high cost basis compared to the value of the assets at the time of the planned gift. For example, gifting an asset with a value of $1,000,000 with a cost basis of $900,000 would be a much better gift candidate that the assets referred to above with a $1,000,000 value and a $200,000 cost basis.
5. When considering assets to be used in a gifting plan, choose assets that you anticipate will appreciate or increase the most in value from the date of the gift to the date of passing of the parents.
6. The younger the donor (giver) of the assets the better since there will be a longer time threshold for the gifted asset to appreciate between the date of the gift and the date of passing of the donor. This is because the gain in the value of the asset between the date of the gift and the date of passing is essentially what value will escape estate taxes (assuming the parents have otherwise effectively used annual gift tax exclusions and their estate exceeds the then-current Federal Estate Tax exemption amount).
The older the donor of the assets, the less likely the gift will save all that much in estate taxes since there may not be a long time horizon between the date of the gift and the date of passing (the opposite of the situation in #5, above).
Of course we recommend careful consultation with experienced estate and tax planning advisors such as legal counsel, accountants, bankers, valuation experts and others in order to discuss and understand the value of your assets, estate tax exposure and the structure of any proposed gifting plan for estate tax savings.
McNamee Hosea has an experienced team of estate and tax planning partners and associates who have handled hundreds of millions of dollars of estate planning over many years who can assist you with an analysis, transaction structure, documentation of all types of estate, gift and tax planning projects. Contact Attorney, Mick Jernigan for more information.