The Estate Freeze (Part 1 of 2 – Continued in “A Crummey Idea”)

This year and next year, most people won’t have to worry about the federal Estate Tax on inheritance (also known as the “Death Tax”) because the Estate Tax Exemption is $5,000,000 for 2011 and $5,120,000 for 2012.  This means that if you were to add up the fair market value of all assets you own at the time of your death, your estate would only need to pay Estate Tax on the amount over the Exemption.  However, unless Congress acts, the Estate Tax Exemption will drop dramatically to $1,000,000 in 2013 and the Estate Tax for any inheritance over that amount will be a 55% tax.  As a result, many more people will have to worry about the Estate Tax as it will affect many more households.

Coupled with the Estate Tax is the Gift Tax.  The idea is to prevent people from gifting away all of their assets before death so that, upon their death, they will not have a high enough estate for the Estate Tax to apply.  The basic idea is to reduce dollar-for-dollar a person’s Estate Tax Exemption for every lifetime gift that is made.  To keep track of this, when certain lifetime gifts are made, you must file an IRS Form 709 Gift Tax return.  However, in order to permit gifts that have nothing to do with Estate Tax planning, Congress created a key exception to the Gift Tax rules known as the “Annual Exclusion.”  The idea is that everybody can gift up to a certain amount (currently $13,000) to each person in the world each year without eating into their Estate Tax Exemption and without needing to file a 709 Gift Tax return.

Although at first glance it may not seem to be an advantage to make lifetime gifts if your Estate Tax Exemption is reduced accordingly, there can be significant advantages.  First, you are able to gift up to $13,000 per person per year as part of your Annual Exclusion without eating into your Estate Tax Exemption.  Second, if you have property that you think will appreciate in the future, better to give it now when it is worth less, take the Estate and Gift Tax consequences now, and then allow all future appreciation to occur in the beneficiary’s estate rather than in your own estate.  This is known as an “estate freeze.”  

This can provide a significant advantage, particularly in the current economic climate where many assets are valued low and should (hopefully) appreciate in the future.  This is especially an advantageous time when the Gift Tax Exemption is the highest in history. However, there are some issues to be cautious about. 

First, if you make a gift of between $1,000,001 and $5,000,000 now, while the Estate and Gift Tax Exemptions are so high, will you owe tax if the Exemptions fall back to $1,000,000 in 2013 as scheduled?  This concept is known as a “claw-back” and pundits argue over whether it would be possible but there is no definitive rule on the subject.  Second, if you make lifetime gifts of Capital Gains assets such as real estate and stocks, you must factor in the loss of the “step-up in basis,” a usually advantageous rule that applies to certain assets that are transferred at death but does not apply to lifetime transfers.

My next blog, entitled "A 'Crummey' Idea," will discuss a type of irrevocable trust that serves as a powerful tool that allows you to take advantage of these gifting principles while still allowing you to retain control.