In my last column, I commented on how the fiscal cliff legislation made the estate and gift tax exemption (the amount that can be gifted during life or transferred upon death without any estate or gift tax) permanently high at $5,000,000 adjusted for inflation. I mentioned how this much higher permanent exemption made the majority of A/B Trusts unnecessary as an estate tax planning tool. The higher permanent exemption affects many other areas of estate planning, including lifetime gifting.
In addition to the estate tax (which is a tax applied to the value of an estate at death) there is also a gift tax. The idea behind the gift tax is to prevent families from averting the estate tax by making lifetime gifts, thereby reducing the size of their estates upon death. The general rule is that each lifetime gift of $1.00 reduces the donor’s estate tax exemption by $1.00. For example, if Gwen gives away $250,000 during her lifetime and she dies in a year when the estate tax exemption is $1,000,000, her estate tax exemption is reduced to $750,000. While there are exceptions to this general rule, most notably the annual gift tax exclusion (currently $14,000 per donee / per year), every lifetime transfer needs to take into consideration the reduction of the estate tax exemption.
Although the estate and gift tax exemption has been in flux for over a decade, there was always a good possibility that the estate and gift tax exemption would return to as low as $1,000,000. This meant that lifetime gifting – even if it had nothing to do with estate tax planning – had the possibility of negatively impacting the donor’s estate tax exemption. As a result, gifting had to be limited and carefully measured.
Now that the fiscal cliff legislation has made the estate and gift tax exemption permanently $5,000,000 adjusted for inflation (the 2013 estate and gift tax exemption is $5,250,000), most middle class households will not be affected by the estate and gift tax as their estates are far below the exemption. As a result, most families are able to make significant lifetime gifts without having to worry about how those lifetime gifts will impact their estate and gift tax exemptions. This creates new gifting and overall estate planning opportunities that previously were not available.
A common estate planning problem occurs when an asset is titled jointly between on adult child and a parent for “convenience purposes” with the “understanding” that upon the death of the parent, the child will “do the right thing” and distribute the asset equally to the other children. Historically, this would create an estate and gift tax problem for the adult child who was on the account. Although the understanding between the family members was that the asset really belonged to the parent and it should be divided equally, legally the asset belongs solely to the adult child. By distributing equal shares to the other children, the adult child would be making gifts, thereby reducing his/her estate and gift tax exemption.
When the exemption was low, this could create a serious estate planning problem. Now that the exemption is permanently high, it might not matter to the adult child if he/she uses hundreds of thousands of dollars of estate and gift tax exemption as long as his/her estate is not likely to exceed $5,250,000 upon death.
As parents accumulate wealth and have more than then need to live comfortably, they might start to be concerned that old age and future medical problems might create long term care or other health care needs that would put their hard earned assets in jeopardy. They might like the idea of gifting a significant portion of their assets away while they are still free of medical problems and have no debts on the horizon. The higher estate and gift tax exemption allows them to give much more of their estate away in this situation without significantly impacting gift tax or estate tax rules.
The permanently high estate and gift tax exemption created by the fiscal cliff legislation changes many fundamental assumptions about estate planning. Whether or not it is good policy, it greatly frees up estate planning and creates new opportunities. We have only begun to understand how an ostensibly simple rule change can have dramatic impact on many areas of planning.