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B. Gift and Estate Tax

B. Federal Gift and Estate Tax law in a nutshell

Prior to the tax law changes taking effect in 2002, ALL transfers of money or property (outright, or by Will or Trust) – during life or at death – were subject to a single, Federal Unified Gift and Estate Tax system. Since the estate tax – but not the gift tax – is set for repeal after 2009, however, it may no longer make sense to talk about a “unified” system. Fortunately, the new law still allows some significant transfers to be excluded from the estate tax, while it lasts, and the gift tax, which we are stuck with. In addition to those exclusions, presented later, each person has a general exemption, or shelter against the federal gift and estate tax.

For many years, that sheltered amount had been $600,000, but it began increasing for persons who died in 1998. For those dying in 2006 – 2008 the “standard” sheltered amount is $2.0 million. Pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001, the “exemption amount” – the amount sheltered from estate tax, but not from gift tax is supposed to continue to increase through 2009, after which the estate tax itself is scheduled for elimination. (Let’s see if that actually happens!!)

Meanwhile, the amount sheltered from gift tax was increased to $1 million per person in 2002, but does not rise further. Till then, the maximum rate on the taxable portion of gifts and estates will be decreased, as well.


– Remember, the tax on lifetime gifts is NOT set for repeal, and the increase in the sheltered amount is much less than what is now scheduled for transfers of property occurring after death. The exemption for lifetime gifts – each person’s sheltered amount – previously has been equal to whatever the shelter was that year for the estate tax. But the shelter for lifetime gifts went up to $1 million in 2002 and will stay there, under current law.

– There is a “self-repeal” feature in the 2001 tax law. All the benefits and breaks automatically end after 2010. Unless further legislation is passed, we’ll then revert to the 2001 status quo!

The law prior to the 2001 changes called for an eventual increase in the gift and estate tax shelter to $1 million, so most observers feel that figure will prevail after 2010 if the estate tax repeal is allowed to expire and no new tax relief is enacted.

Since congressional predictions of huge and everlasting budget surpluses have proved to be ridiculous, this appears to be a distinct possibility. Therefore, large estate owners, for the greatest chance of obtaining the maximal estate tax benefit, should plan to die during 2010. The estate tax will have been fully repealed on the last day of 2009, and the repeal won’t be repealed till the end of 2010!

Lifetime gifts, if they do not qualify as one of the tax exclusions below, begin to “use up” the above-listed exemption (the tax shelter). Whatever portion of the $2.0 million (for 2006 – 2008) that is not used for lifetime gifts is available to protect your estate at death. So, assuming you have not used any of the shelter by making non-excludable lifetime gifts, no federal tax is due on the first $2.0 million of your estate. But then, rates begin at 37%, and go to 50% (to be reduced to 45%, in steps, until elimination of the estate tax after 2009.

Other exclusions from federal gift and estate tax:

$12,000 annual exclusion per donor for gifts. This amount had previously been $10,000, then $11,000, but was adjusted for inflation (as it will be in the future), effective January 1, 2006. Cash and/or property worth up to $12,000 can be given without tax consequences to each of an unlimited number of recipients. ($24,000 per year, per recipient, if both spouses give.)

These gifts do not count against the $1.0 million shelter against federal gift tax or the $2.0 million shelter against federal estate tax. They require no paperwork, and are income tax-free (as are all gifts) to the recipient.

To qualify, the gift to each donee must be outright – a present right to spend or use the property with no strings attached – not a promise of a future benefit. This requirement means that most gifts in trust do not qualify. (The exceptions are presented later.)

Illustration: A husband and wife sell a house to their son for $50,000, when it is worth $120,000. A $70,000 gift has been made ($120,000 – $50,000). The parents elect to split it, so that both of their $12,000 annual gift tax exclusions can be used. This $24,000 combined exclusion results in a taxable gift of $46,000 to the son ($70,000 – $24,000). A federal gift tax return should be filed, but no tax is now due. Instead, because the gift has been split, each parent uses $23,000 of his/her $1 million lifetime gift tax shelter to “protect” the gift from all tax. The son pays no tax on the gift. (True gifts of any size are always free from federal income tax.)

Assuming this has been their only taxable gift to anyone, each of the parents will then have a shelter of $977,000 remaining to shield future lifetime gifts from federal gift tax ($1.0 million – $23,000). The gift tax return that has been filed with no payment allows IRS to keep track. (Note that the $23,000 gift also uses up part of each parent’s $2.0 million shelter from federal estate tax.)

TIP: The above situation – where parents want to help their children buy a house – is common. A better way to handle it might be to sell the house to the child at full price. Then, each year the parents can make a $24,000 gift, in the form of debt forgiveness. By doing it gradually, the parents can take advantage of each of their annual $12,000 exclusions (using the 2006 figure for the annual gift tax exclusion), and not waste any of their two $1 million shelters.

Unlimited marital deduction from gift and estate tax. Assuming your spouse is a U. S. citizen, gifts of any size to your spouse – lifetime or at death – do not “use up” any of the $1 million gift tax shelter, and are not included in the tax calculation. (Lifetime gifts to non-citizen spouses have a much lower limit – $120,000 in 2006. There are also much different rules pertaining to the marital deduction available to these couples, and they should seek legal counsel from an attorney familiar with this situation.)

BEWARE ! But be careful if the combined marital estate is approaching the amount of the “standard” shelter ($2.0 million for 2006 – 2008). Many married couples avoid valuable tax planning by reasoning as follows: They think, “Fine, our combined estate is well over $2.0 million, but each of us only owns half, so each of our estates is too small for federal estate tax to kick in at all. And even if our estates were much larger, each of our simple Wills leaves everything to the surviving spouse, so there won’t be any federal estate tax due anyway, because of the unlimited marital deduction.”

That’s all true – upon the death of the first spouse. But what happens when the second spouse finally dies? (For simplicity, assume the second death is also in 2006 – 2008.) At that point, he/she will still have a $2.0 million shelter, but only one – his/her own. The shelter of the first spouse to die was not used and has been lost. So, an additional $2.0 million of family wealth that could have passed tax free to the couple’s heirs, will instead be subject to federal estate tax. The proper plan to make use of both “standard” $2.0 million (for 2006 – 2008) estate tax shelters is discussed later.

BEWARE ! – if you have an old Will drawn in a community property state. Prior to 1982, the unlimited marital deduction from federal gift and estate tax did not apply to community property. In other words, one could not pass to the surviving spouse, entirely tax free, his/her half interest in marital property, as could be done in a common law state. Obviously, a Will drafted then is not likely to take advantage of current law. Because the unlimited marital deduction is a focal point of estate planning, such Wills should definitely be reviewed and revised.

Unlimited exclusion for gifts made in payment of another’s medical or tuition costs. Payments must be made directly to the institution, not just earmarked for this use and given to the beneficiary.

Gifts to charity. The IRS has a list of qualified charities, including all the “household names.”

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