Paying some taxes now can save you plenty in taxes later. The key is the type of tax you pay now that could reap long-term benefits.
A basic tenant of most estate planning is the avoidance of, or at least reduction in, payment of taxes to the IRS. One way to reduce an estate tax liability is to reduce the value of an estate through gifting. There are numerous ways to make gifts, even significant gifts, without paying tax. Why, then, would the payment of tax be part of a suggested gifting program?
First, let's take a look at the history involved here. The transfer of wealth through gratuitous transfers of property has been subject to federal tax by the IRS since 1924. It was introduced after Congress realized that Americans were avoiding the estate tax, introduced in 1916, by gifting wealth during life. The gift tax was repealed in 1926, but it was reinstated in 1932. At that time, a donor was allowed to gift $50,000 tax-free during life, and $5,000 per recipient annually. The gift tax rate was three-quarters of the estate tax rate until 1976, when Congress unified the estate and gift tax system.
In 2006, 7,663 returns reporting a taxable gift were filed with the IRS. The taxable gifts in that year totaled $7,360,892,307. Of that amount, $1,653,719,870 was paid to the IRS in gift tax.
That is certainly a significant amount of gift tax.
Not all gifts are created equal, however. Especially in the eyes of the IRS. Any transfer that is for less than full and adequate consideration is taxable. But there are multiple deductions and exclusions:
All transfers to a U.S. citizen spouse and transfers of the first $125,000 to a non-citizen
spouse are free of tax.
Direct payments to medical institutions or individuals who provide medical care to third parties are not taxed.
Direct payment of an individual's tuition to a qualified educational organization avoids the gift tax.
The first $12,000 of a gift per recipient (commonly referred to as the “annual exclusion”) are free of gift tax.
Use of the lifetime credit (currently $1 million) for gifts in excess of the annual exclusion.
Gifts to qualifying political organizations.
In 2008 and 2009, the gift tax rate is 41 percent for taxable gifts between $1 million and $1.25 million, 43 percent for taxable gifts between $1.25 million and $1.5 million and 45 percent for taxable gifts in excess of $1.5 million. But file away this bit of information: In 2010, under current law, the maximum gift tax rate is 35 percent.
This year is also the first year when the estate and gift tax exemptions are no longer the same. Although the gift tax exemption is $1 million, the exemption from estate tax is $2 million. However, use of the gift tax exemption during life still reduces an equal amount of estate tax exemption available at the time of death.
Paying Gift Taxes to Save Estate Taxes
Clearly, the use of deductible or excluded gift transfers can significantly reduce an estate tax liability. An additional benefit to removing the value of assets from the gross estate using the tax-free methods above is the elimination of the taxable income from those assets during life, as well as removing the growth on the assets and the addition to value from the income from the value of the decedent's estate at the time of death.
The value of taxable gifts (those in excess of the deductible/excluded amounts other than those using the lifetime credit above) is included in the value of the gross estate for estate tax purposes. However, the value is calculated as of the date of the gift. Therefore, all post-gift appreciation is excluded from the estate value.
The gift tax is levied on the value of the asset gifted during life. However, the estate tax is levied on all assets included in the decedent's estate, including the amount necessary to pay the estate tax. The funds used to pay the gift tax are not included in the decedent's taxable estate, unless the gift was made within three years of death. That means the payment of gift tax will actually decrease estate taxes if the donor survives for three years after having made the gift.
Worth The Work?
Let's assume, for example, a single individual with a $7 million estate dies in 2008. The estate would pay $2.25 million in estate tax. If that individual gifted $3 million of assets during life, he would have paid $884,200 of gift tax. If he lived more than three years after paying the tax, but assuming 2008 estate tax rates, the $884,200 of tax would be excluded from his estate. Although the $3 million of gifted assets is included in the taxable estate, the estate tax actually would be $1,852,110 — a savings of almost $400,000.
Although it may seem absurd and certainly painful to pay taxes to the IRS, there may be clear economic advantages to doing so.