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“Discounted” Lifetime Gifts
Can
Reduce The Taxable Estate
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Estate Reduction Through
Lifetime Gifts
With estate tax rates ranging
from 37% to 60%(1), many
people implement an estate-reduction strategy involving
significant lifetime gifts. Some use the $10,000 annual
gift tax exclusion, but significant estate reduction
may require the use of the “applicable exclusion”(2)
for the federal gift and/or estate tax, which is 0set
at $625,000 for 1998 and scheduled to be increased in
several increments until it is $1,000,000 in 2006. Effective
estate reduction involves giving away assets that will
otherwise cause your estate to continue to get larger
through appreciation, growth, and income production.
This article outlines some of the potential benefits
(and challenges) of giving away assets now instead of
waiting until death, with an emphasis on the benefits
of using techniques that produce “discounted”
gift tax values.
The Gift Tax Is Cheaper Than
The Estate Tax
From a tax perspective, lifetime
gifts are better than transfers at death for three reasons.
First, there is no $10,000 annual gift exclusion for
the estate tax. Second, the gift tax is computed on
the net amount gifted excluding the gift tax, while
the estate tax is paid on the entire taxable estate
including the estate tax.(3)
Finally, each gift is valued separately, while the entire
taxable estate is valued as a whole, making valuation
discounts possible for gift tax purposes that are not
available for estate tax purposes.
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Footnotes:
1 The gift and estate tax table
shows the maximum tax rate at 55%, but for estates
over $10 million, there is a 5% surcharge, which
eliminates the benefits of the unified credit
and the lower tax rates.
2 The “applicable exclusion”
is the language added by the 1997 Taxpayer Relief
Act and is used instead of referring to the “Unified
Credit” or “exemption equivalent of
the Unified Credit.”
3 For example, if an individual
in the 55% tax bracket had $1,550,000 to give
away, a lifetime gift would result in $550,000
(55% of $1,000,000) being paid to the IRS and
$1,000,000 to the recipient, whereas a transfer
at death would result in $852,500 (55% of $1,550,000)
going to the IRS and $697,500 (45% of $1,550,000)
going to the recipient.
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“Discounted” Gifts
Are Most Effective
Lifetime gifts can effectively reduce
the taxable estate, but some are more effective than others
at reducing the taxable value of an estate. The best gifts
reduce the taxable estate more than the value of the gift
itself.
- A cash gift eliminates liquid cash
and its potential earnings, but is the least effective type
of gift.
- A gift of appreciating property is
a more effective use of the applicable gift and estate tax
exclusion, since it gives away the potential earnings, plus
the potential appreciation, in addition to the current value
of the gift.
- A gift of undivided interests in
property can be even more effective, since the value of
a fractional share of an asset has a “discounted”
gift tax value of less than its pro rata value. Fractional
gifts over a period of years can transfer the entire property
without subjecting the full value to the gift or estate
tax.
- A gift of minority interests in a
family business entity (corporation, partnership, or limited
liability company) is one of the most effective ways that
gifts can be maximized, especially if the recipient has
no voting control and has restricted powers to sell or otherwise
transfer the business interest. The limited partnership
(LP) and limited liability company (LLC) have become especially
popular because gifts of non-voting interests can reduce
the taxable estate without reducing the donor’s voting
control over the business. Non-voting interests in a family
venture are unmarketable and without control, resulting
in valuation discounts ranging from 10% to beyond 50% discount.
- A gift of remainder interest under
a “qualified personal residence trust” (QPRT)
or a “grantor retained annuity trust” (GRAT) are
statutorily recognized gifts of future interests that are
valued at “discounted” present value based on
IRS-issued
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Potential Obstacles
Gifts
first require two valuations. First, there must be an
appraisal of the underlying assets. Second, except for
QPRTs and GRATs, where the discount is based on IRS
valuation tables, “discounts” for gifts of
undivided interests in property or minority interests
in businesses must be determined by qualified appraisers.
In addition, business entities must be treated as separate
entities, and personal-use assets (such as the family
residence) should not be owned by a business entity
(unless you want to pay rent).
In
recent rulings, the IRS has made it clear that it will
challenge “discounting” of limited partnerships
(LPs) and limited liability companies (LLCs) when:
- business formalities are not
followed;
- there is no business purpose;
or
- the transaction has no purpose
except to reduce estate tax values.
Use
of discounts and Personal Residence Trusts may expire
this year!
In
addition, in February of 1998, the Clinton Administration
recommended to Congress that valuation discounts for
gifts of minority interests in family-held limited partnerships
or limited liability companies (other than active businesses)
be eliminated. The proposals do not affect active businesses,
but are targeted at the “family investment companies”
(i.e., partnerships or LLCs that were created solely
for gift-tax discounts). The Administration’s proposals
will also eliminate the qualified personal residence
trust.
15-Year QPRT
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In its proposal to Congress, the
Administration stated that “the use of family
limited partnerships and similar devices is eroding
the transfer tax base.”
In short, the Administration admitted
that discount-gift planning really works when
it is done right.
Because of the Administration’s
proposals to do away with most valuation discounts
forgift-tax purposes, if you have considered forming
a family investment company or a qualified personal
residence trust, it may be wise to act quickly.
Other “valuation discount”gifts
may be legislated away in the future.
Until the laws are changed, we have a window of
opportunity.
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