Lifetime Gifting: Reducing Estate Tax Exposure by Helping Others

Lifetime gifting is a satisfying and generally straightforward method of transferring wealth to the next generation. It also has the additional benefit of reducing your estate tax exposure. For larger estates, estate planning can help alleviate estate taxes; however, it cannot eliminate estate tax exposure entirely. With the federal estate tax rate reaching as high as 40%, you may be looking for ways to minimize your potential estate tax liability so that you can maximize the amount given to people and causes you care about.

Federal Gift and Estate Tax Exemption – What It Is and How It Works

The federal gift and estate tax exemption is an amount that you can gift either during your lifetime or upon your passing without incurring any gift or estate taxes. The exemption is a cumulative amount, meaning that any gifts made during your lifetime will reduce the amount that you can pass free of federal estate taxes upon your passing. Each person has their own lifetime exemption, and married couples can combine their exemption. When the first spouse passes away, any exemption amount that they have not used may be transferred or “ported” to their surviving spouse. The value of the exemption for the first spouse to pass away is frozen at the amount that was in place at their passing.

In 2023, the federal gift and estate tax exemption is $12,920,000 per individual and $25,840,000 for a married couple. These limits are adjusted annually for inflation.

Today’s level of exemption is high by historical standards. The Tax Cuts and Jobs Act (“TCJA”) of 2017 doubled the federal gift and estate tax exemption. However, these amounts are temporary. The provisions of the TCJA call for the current high exemptions to sunset on December 31, 2025. Without further action by Congress, the federal gift and estate tax exemption amounts are set to revert to their 2017 levels, adjusted for inflation, beginning on January 1, 2026.

Until that date, there is a window of opportunity for planning.

Annual Gift Tax Exclusion Can Be Valuable Over Time

Congress has permitted you to give a small amount to as many recipients of your choosing each year without triggering income, gift, or estate tax consequences. This amount is known as the annual gift tax exclusion amount. In 2023, this amount is $17,000 per recipient. If you are married, you and your spouse can gift up to $34,000 per recipient. The annual gift tax exclusion is increased for inflation only in $1,000 increments. In some years, the annual gift tax exclusion does not increase at all.

It is important to note that there is just one requirement that must be met. The gift must be a present interest gift. This simply means that the recipient must have an immediate and unrestricted right to the use, benefit, and enjoyment of the gifted assets.

Over time, a regular practice of making annual exclusion gifts each year can be a quite simple yet powerful technique to reduce the value of your estate and subsequent estate tax liability.

Direct Payment of Medical Expenses and Tuition Has No Gift Tax Consequences

Another way for you to make tax-free gifts is by making direct payment for medical or educational expenses. Payments made directly to a medical services provider for qualified medical expenses or directly to an educational institution for tuition are not treated as taxable gifts. The annual gift tax exclusion amount does not apply, nor does the gift reduce your federal gift and estate tax exemption amount.

Qualified medical expenses include expenses incurred for the diagnosis, cure, mitigation, treatment, or prevention of disease. § 25.2503-6(b)(3). Qualified medical expenses do not include any amounts that are paid for by insurance.

The unlimited exclusion is permitted for tuition expenses of full-time or part-time students paid directly to an educational institution at any grade level. No unlimited exclusion is permitted for amounts paid for books, supplies, board, or other similar expenses that do not constitute direct tuition costs.

Making Significant Gifts – Locking in Historically High Exemptions

In some instances, you may want to gift assets in excess of the annual gift tax exclusion amount. If a gift exceeds the annual exclusion amount, you must file a gift tax return (Form 709) with the IRS when you file your income taxes for that year. No gift tax will be due. However, the gift tax return will be used to track the amount that you gift during your lifetime, which in turn reduces the amount you can transfer free of federal estate tax upon your passing.

In November 2018, the Treasury Department issued Proposed Regulation 20.2020-1(c) addressing potential “clawback” concerns. This stated that making lifetime gifts using the increased exemptions under the TCJA will not cause adverse estate tax consequences should you pass away after 2025 when the exemption returns to pre-TCJA levels. The federal gift and estate tax exemption that was in place when you made the lifetime gift will be used to determine potential estate tax liability. This presents an opportunity to lock in the current, elevated levels of exemption.

For example, let’s say you gift $12,000,000 of assets to your adult child in 2023 when the federal gift and estate tax exemption is $12,920,000. Upon your passing, the federal gift and estate tax exemption has decreased to $7,000,000. Your estate will not be penalized for the making of a lifetime gift in excess of the $7,000,000 federal gift and estate tax exemption in place at that time.

Benefits of Lifetime Gifting

If you believe your estate might be subject to federal estate tax, gifting assets throughout your lifetime can be a powerful way to reduce the amount of taxes ultimately paid by your estate. Lifetime gifting, which we are defining as taxable gifts in excess of the annual exclusion amount, can have advantages for some including:

• The historically high exemption allows anyone who is comfortable that they have sufficient assets to provide for their own needs for their lifetime, to gift assets prior to the sunset of TCJA to lock in the exemption. Lifetime gifting can reduce the family’s future estate tax liability by removing the asset and its future appreciation from the taxable estate. The savings from this strategy could be significant.
• Several states, including Massachusetts, have their own estate or inheritance tax but do not have a gift tax. This provides further incentives for making taxable lifetime gifts, which we will address in a subsequent blog post.
• Lifetime gifting allows the recipient to benefit now from the funds. It also allows you to gauge how the recipients may handle their future inheritance.

Potential Income Tax Consequences or Cost Basis Step-Up: An Important Consideration

As is often the case, there could be negative consequences when making significant gifts during your lifetime.

From an income tax perspective, one downside to consider is the lack of a “step-up” in basis for the recipient of appreciated assets. For example, if you own a stock that has appreciated in value, and you gift that stock to another individual during your lifetime, your own cost basis in the stock will transfer to the recipient. In contrast, unless the laws change, if the recipient inherits the assets upon your passing, the cost basis will be “stepped-up” to its then-current market value. The recipient will only pay capital gains tax on any appreciation that occurs after they receive the assets.

Due to this trade-off, it is important to weigh the estate tax savings against the potential income tax costs. It can also be helpful to think of the types of assets that you could potentially gift. In certain circumstances, it may be more tax-efficient to gift cash or assets with little appreciation in value versus an appreciated security.

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An ambitious gifting program may not be appropriate for everyone. If parting with your wealth makes you feel uncomfortable or fearful that you will someday be without the money you need, proceed with caution. Your priority should be to ensure that you are able to sustain your lifetime spending needs. We can collaborate with your attorneys and tax professionals to help determine the strategies that are appropriate for you and your family.