Authors: J. Keith Phifer and Robert F. Lynch, Jr.
As we approach the end of the year, now is a great time for individuals to examine their long-term financial planning goals and to understand and evaluate the tools at their disposal to meet those goals. In this newsletter, we will examine how the federal unified estate and gifting lifetime tax exemption and the federal gift tax exclusion can be powerful tools for all individuals to pass their wealth and business interests on to the next generation.
As many are aware, the Tax Cuts and Jobs Act made significant changes to federal tax law. One such change was increasing the federal gift tax exclusion to $15,000.00. The gift tax exclusion is measured per recipient, meaning a donor can give up to $15,000 per recipient, without the donor owing any gift tax, or needing to file a gift tax return, and without the recipient owing any tax upon receipt. A parent with four children could gift $60,000 in one year to his or her children ($15,000 per child). Furthermore, married couples enjoy the opportunity to double this benefit, as each spouse can gift up to $15,000 to a child ($30,000 total). This amount can be doubled again (i.e., $60,000) for parents of a married child, as the couple can gift $30,000 to their child and $30,000 to the child’s spouse.
This annual gift of up to $15,000 per recipient is “excluded” from an individual’s unified lifetime tax exemption. The unified lifetime tax exemption is the total amount of an individual’s assets that is exempt from either the estate tax or the gift tax (discussed further below). The gift tax and estate tax are graduated taxes that currently range from 18% to 40% of the amount that exceeds a person’s unified lifetime tax exemption. Gifts that are excluded from the unified lifetime tax exemption, therefore, do not count against this total.
It is a common misconception that a person cannot gift more than $15,000 in a year. Any amount gifted over $15,000 in a year simply counts against the person’s lifetime exemption. If a gift exceeds the annual gift tax exclusion maximum, the individual is simply required to file a gift tax return (IRS Form 709) for the amount that exceeds $15,000. Gift tax returns are due the same date income tax returns are due (April 15 of the following year), and the deadline for filing may be extended, just as with income taxes, until October 15.
The Tax Cuts and Jobs Act increased the unified lifetime tax exemption to $11,200,000 per person (accordingly, $22,400,000 for married couples), which greatly increases the value of gifting as an estate planning tool, as this $11,200,000 cap will likely never come into play for many people. Therefore, the potential downside of having less total exemption available at death is significantly lessened for people with a total net worth well under $11,200,000, compared to the benefit of being able to move assets and business interests to the next generation more quickly.
Here is an example of the above:
Suppose a parent gifts $115,000 in a year to his or her child. $15,000 of this gift is excluded from gift tax. The remaining $100,000 of the gift (for which a gift tax return would need to be filed) takes $100,000 off the parent’s lifetime exemption of $11,200,000, leaving $11,100,000 left of the exemption for future gifting use (or to be left available upon the parent’s death for estate tax exemption).
The end of the calendar year provides a special opportunity to plan for two years of gifting essentially at once, as a portion of the gifting can be done as of December 31, 2018 and another portion can be done as of January 1, 2019 (applying the $15,000 exclusion for 2018 to the December gifting and the $15,000 exclusion for 2019 to the January gifting). This provides a unique opportunity to small business owners to gift a substantial portion of their ownership interests in a business to their children relatively quickly. Furthermore, valuation discounts for lack of marketability or minority/non-voting interests allows an opportunity to pass a greater portion of the business owner’s interest that stretches the annual $15,000 exclusion further. For businesses with only one class of ownership interest, Phifer Pinkham, LLC can help create voting and non-voting classes of ownership interests in the business to take advantage of this discount. This benefit is not limited to family businesses, however, as real estate holders can also take advantage of valuation discounts by gifting fractional interests in real estate to move vacation homes and investment properties expediently and cost-effectively to the next generation.
When gifting assets however, there are certain considerations of which a potential donor must be aware. The gifted asset is valued at the fair market value of the asset as of the date the gift was made. The recipient of a gifted asset receives the donor’s tax basis in the asset. By the same token, gifting an asset removes any further appreciation of the asset from the donor’s taxable estate. Therefore, for assets where the donor has a high tax basis, or where the donor anticipates that the asset will appreciate significantly in the coming years, gifting the asset earlier is often advantageous for the donor. Conversely, gifting an asset in which the donor has a low tax basis could have significant unintended tax consequences for the recipient. Because the recipient receives the donor’s low tax basis in the asset, if the recipient were to sell that asset, the recipient could be subject to a significant capital gains tax at both the federal and state level. For low-basis assets then, it may be advisable for the would-be donor to retain such asset for his or her life, as recipients of gifts made upon a donor’s death receive a “stepped up” basis in the asset—the recipient’s tax basis in the asset is “stepped up” to the full market value of the asset at the time of the donor’s death. This means that if the recipient sold that asset soon thereafter, the recipient would likely be subject to zero or very little capital gains tax upon the sale.
There are additional considerations for Massachusetts residents. Massachusetts has only a $1,000,000 lifetime exemption. Furthermore, whereas the federal estate tax applies only to amounts that exceed an individual’s lifetime exemption, once a Massachusetts resident exceeds his or her $1,000,000 exemption, the resident owes estate tax on the full value his or her estate (excluding the first $60,000 by statute) upon his or her death. The Massachusetts estate tax is a graduated tax, and its rates range from 0.8% to 16%.
Massachusetts has no state gift tax. However, for gifts made over a Massachusetts resident’s lifetime that exceed the federal exclusion amount ($15,000) in any year, the amount of such gift(s), is added back to the donor’s estate for purpose of determining the Massachusetts estate tax owed. Therefore, Massachusetts residents considering gifting more than $15,000 per year should pay special attention to the tax consequences of doing so as they relate to the Massachusetts estate tax and evaluate gifting against other possible wealth-transition vehicles.
Effective gift tax planning requires a nuanced understanding of tax law, yet at the same time the cost of legal expenses for executing an effective gift tax plan are often minimal compared to the potential tax savings enjoyed by the donor and the donor’s family. The attorneys of Phifer Pinkham, LLC have a deep understanding of tax law, which means that we can customize your estate plan to suit your particular financial and family circumstances. Please do not hesitate to contact any of our attorneys to set up an in-person or phone consultation to review your estate plan or business succession plan.