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Gifting

By: Robert Moore, Wednesday, March 13th, 2024

Legal Groundwork

Estate taxes are receiving a lot of attention due to the impending reduction in the federal estate tax exemption in 2026.  If Congress does not extend or make permanent the current estate tax exemption, the exemption in 2026 will be $5.5 million per person plus inflation.  The inflation-adjusted estate tax exemption for 2026 is expected to be between $7 million and $7.5 million.  The current federal estate tax exemption for 2024 is $13.61 per person.

The lower federal estate tax exemption will still be high enough for most people to avoid federal estate taxes.  However, some farmers will see themselves move into the federal estate tax bracket in 2026.  People who will find themselves subject to estate taxes due to the 2026 sunset provisions are exploring strategies to help reduce estate tax liability.

One such strategy that may be considered is gifting.  In some situations, gifting can help reduced estate taxes.  In other situations, it may have little effect and have detrimental effects on income tax strategy.  This article will discuss how gifting may or may not help with estate tax liability and the implications of gifting.

Annual Gifts

One gifting strategy to help reduce estate taxes is using the annual gift exclusion.  As stated above, multiple gifts of up to $18,000 can be made without tax to either party.  The gifts can be money, shares in a business entity, real estate or almost any other kind of asset.  The annual exclusion gift can be an effective strategy for those people who have many potential recipients for the gift and/or may be close to or just over the federal estate tax exemption.  Consider the following example:

Grandma has 10 grandchildren.  She calculates that she will be about $200,000 over the estate tax exemption in 2026.  She gifts each grandchild $18,000 in both 2024 and 2025.  The gifts allow Grandma to gift a total of $360,000. 

This gift allowed Grandma to move back under the estate tax exemption and avoid estate taxes. Neither Grandma nor grandchildren will pay gift taxes on the gift.  As the example shows, using the annual gift exclusion can be an excellent way to reduce or eliminate estate taxes.

The primary limitation to the annual exclusion gift strategy is that it may have limited effect for people who are significantly over the federal estate tax limit.  While $18,000 is not a small amount of money to gift, it may be too small to make much of an impact on estate taxes of higher wealth people.  Let’s continue the previous example with a change of facts:

Grandma’s net worth will be $2,000,000 million over the exemption in 2026. 

Even though Grandma can gift $180,000 each year to her grandchildren, it will take 12 years for Grandma to gift away $2,000,000.  Additionally, her net worth will likely increase each year.  In fact, the increase in net worth may outpace what she is able to gift each year.  While annual gifting will always help reduce potential estate taxes, this strategy may only be moderately helpful for higher wealth people.

Lifetime Credit Gift

Another strategy is to make large gifts more than the $18,000 annual exclusion gift.  As discussed above, large gifts can be made without paying gift tax.  However, the estate tax exemption is reduced by the amount of the gift.  So, making lifetime credit gifts are offset dollar-for-dollar by a reduction in the estate tax exemption.  However, this strategy can still be effective when gifting assets that are expected to appreciate in value.  Gifting these assets keeps the appreciation out of the Giftor’s estate.  Consider the following example:

Grandma owns the Smith Farm that sits next to town.  It is currently valued at $1,000,000. She expects commercial development pressure to cause the value of the Smith Farm to increase to $3,000,000 in the next few years.  Grandma decides to gift the Smith Farm to their grandchildren.

Grandma can gift the Smith Farm without paying gift taxes.  Her federal estate tax exemption will be reduced by $1,000,000.  So, the gift itself does not help her estate tax situation.  However, when the Smith Farm increases in value by $2,000,000, that appreciation in value will be assumed by the grandchildren.  Grandma has essentially been able to gift $3,000,000 out of her estate while only using up $1,000,000 of her estate tax exemption.

This strategy may not be the best strategy for assets that will have no or little appreciation.  For a non-appreciating asset, the gift just comes off the estate tax exemption and does not help the estate tax situation.  Again, large gifts work best with appreciating assets.

Capturing the Higher Lifetime Credit

As stated previously, the current lifetime credit gifting allowance is $13.62 million which will decrease by about one-half in 2026.  So, there is an opportunity to make a very large gift now and capture the large gift allowance before it is reduced.  Consider the following example:

Grandma has a net worth of $20,000,000.  She is concerned she will be over the estate tax exemption limit by $13,000,000 in 2026 resulting in around $5,000,000 of estate taxes.  To avoid these taxes, Grandma gifts $13,620,000 of land to her grandchildren in 2024. 

In this scenario, Grandma is able to gift her entire lifetime credit which reduces her estate tax exemption is to $0.  But, when the estate tax exemption is reduced to $7,000,000 in 2026, there will be no claw back of her gift.  That is, her estate tax exemption will remain at $0 and the IRS will not seek to recoup any of the 2024 gift exceeding $7,000,000.  So, Grandma is able to gift $13,620,000 in 2024 and there is no claw back of the extra $6,620,000 in 2026 when the exemption is reduced.  Grandma’s net worth is reduced to $6,380,000, which will be subject to federal estate taxes, but the gift of $13,620,000 will not.

Obviously, this strategy only works for very high wealth individuals.  The person must have enough assets to gift more than the full exemption amount and still have adequate assets remaining to support themselves.  Most people do not have enough wealth to make this strategy work, but for those that do, it can be very effective.

Gifting Has Negative Tax Consequences

Gifting eliminates the opportunity of stepped-up basis at death.  This important concept of stepped-up tax basis at death is a tremendous financial benefit to the beneficiary receiving the asset from the estate.  Careful consideration should be given to this loss of stepped-up basis before a gifting strategy is implemented.  For more information on gifting and stepped-up basis, see the Gifting Assets Prior to Death publication available at farmoffice.osu.edu.

Seek Legal and Tax Advice

Making gifts, particularly large gifts, have significant legal and tax consequences.  Before implementing a gifting plan, be sure to consult with legal and tax advisors to explore all options and to understand the implications of different strategies.  While gifting may seem like a simple solution to estate taxes, gifting is often complicated and has complex legal and tax consequences that should be carefully considered.

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