If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To learn the basics of gift and estate taxation.
Prerequisites: ES401: Essential Estate Planning Documents
Handout: Summary of Estate Tax Calculation
Assignment: see below
We are continuing with our discussion of estate planning from our previous class, which should have given you a good basic understanding of some essential documents to have in place for your estate plan.
Today, we’re going to go into a little bit more advanced side of estate planning by discussing gift and estate taxes. While you may never have an estate large enough to pay estate taxes, the existence of the estate tax is the root of many estate planning opportunities, such as various types of trusts. So, it’s important to know the basics so that you have some context when you run across various other estate planning related topics.
Since I didn’t grow up in a wealthy household, the first I had ever heard of the gift tax was during an internship at a public accounting firm. I was shocked that in addition to the federal income tax burden, especially on my wealth clients, the government also required taxes to be paid on essentially this same income again when they give their property to others.
It made absolutely no sense to me until I learned about the estate tax as well, which requires large estates to pay taxes at death. If there was no gift tax, people could just give away all their property before their death and nearly everyone could avoid paying the estate tax.
Gift Tax Exemption
As you might expect, the IRS is not going around levying a tax all on the Christmas and birthday gifts you are giving. They allow a maximum of $14,000 per year per recipient for 2017 without having to file a gift tax return and report the gift. A married couple can give away twice this amount, $28,000, by electing to split the gift. This number is indexed for inflation but hasn’t increased in the past few years.
For example, a widowed grandmother could give away $14,000 to each of her children and grandchildren without incurring any gift tax consequences (or filing a gift tax return). Married grandparents could give $28,000 to each of their children and grandchildren without gift tax consequences or needing to file a gift tax return.
In addition to the annual exemption of $14,000, there is a lifetime exclusion amount of $5,490,000 for 2017. The exclusion applies to both lifetime gifts and your estate at death combined. This essentially allows you to pay up to $5,490,000 in gifts while you’re alive without owing any tax. Essentially, you will be able to choose whether to use the credit while you’re alive or when you die, or some of both.
For example, say that you (a single person) decide that you would like to buy your child a house as a gift in 2017. If you pay $250,000 for the house, you will use $236,000 of your lifetime exclusion ($250,000-$14,000 exemption). You will have $5,254,000 left of your lifetime exclusion to use against your estate if you were to die later this year.
However, note that you will have to file a gift tax return (Form 709) if you make gifts over the exemption amount for the year. The gift tax return will show the IRS that you are using up some of your lifetime exclusion and help you to track this amount from year to year.
In the previous example, you would need to file a gift tax return to report using $236,000 against your lifetime exclusion.
There are several specific exclusions to the gift tax rules. These exceptions do not require that these amounts be reported on gift tax returns and do not use up your unified credit. These include:
- Gifts to your spouse due to the unlimited marital deduction for estates (see estate tax discussion below)
- Gifts to political organizations
- Gifts to charity
- Tuition payments made directly to the educational institution
- Medical payments made directly to the medical facility
While not necessarily excluded, there is another exception worth noting related to education funds. You are allowed to contribute five times the annual exclusion amount to a recipient’s 529 plan without using up your unified credit. Then, no additional gifts would be allowed to that person without gift tax consequences for those five years. However, this is beneficial to superfund these accounts in advance without incurring gift tax consequences. A gift tax return is required to be filed to make this election.
Filing a Gift Tax Return
In order to file a gift tax return, you will need the following information related to the gift:
- Donee’s name and address
- Relationship of donee to donor
- Description of the gift (including CUSIP if the gift was securities)
- Donor’s adjusted basis of the gift (this is important because the donee gets a carryover of basis from the donor)
- Date of the gift
- Value of the gift
Gift tax returns are due on the same due date as individual tax returns, generally April 15th. If you file an extension for your personal tax return, it will automatically extend the time for your gift tax return as well, however, any tax due on gifts needs to be paid by April 15th. A preview of the gift tax return is shown below:
There’s a steep price to pay for dying wealthy in the United States. If you have a large estate, you may pay up to a 40% tax rate on part of your estate. While it seems like a crazy rate, much of a large estate is often unrealized capital gains that have never been taxed to that person.
An estate tax return is required if the total estate plus taxable gifts is more than the lifetime exclusion, which is $5,490,000 for 2017. An attorney is generally the best person to assist in filing the required estate tax return.
Estate Tax Basics
Similar to the basic formula for the personal income tax, the estate tax follows a similar format in calculating taxes owed. These items are discussed in further detail below.
- Your gross estate is the value of all your property including bank accounts, brokerage accounts, cars, real estate, businesses, intellectual property rights, etc. There are other complicated rules, such as including certain life insurance benefits as well.
- Funeral expenses include the cost of a memorial program, burial, etc. Administrative expenses include expenses for administering the nonprobate assets (such as the part of the estate in a trust, etc.).
- All debts owed by the estate such as loans, mortgages, medical expenses, etc are subtracted from the estate. Taxes from the person’s final individual tax return are also subtracted as well as property taxes accrued until the date of death.
- Casualty and theft losses are subtracted from the estate using the same rules as for federal income tax purposes.
- Current law allows an unlimited marital deduction, meaning any assets that are transferred to a spouse are not subject to estate taxation.
- Charitable contributions are also deducted, similar to the way they are deducted on a personal tax return. However charitable contributions are limited to 50% of your adjusted gross income on an individual tax return, but are not limited for an estate tax return.
- There is a state death tax deduction that allows you to deduct state estate taxes in addition to the taxes subtracted above.
- Because there is a unified credit ($5,490,000 for 2017) that applies to both gift and estate taxes combined, all gifts already applied against the unified credit need to be added back to the estate in order to reapply the unified credit and calculate estate. This is what is meant by “adjusted taxable gifts after (post-1976).
At this point, you’ve reached the tax basis for calculating the tentative estate tax.
To calculate the estate tax, you use a graduated tax table similar to the one used for individual taxes. The tax rates for an estate ranges from 18% of estates less than $10,000 to 40% of estates over $1,000,000.
To the tentative tax calculated above, you subtract the amounts already paid on post-1976 gifts (remember the lifetime exclusion is combined for both gift and estate tax purposes). Then, you subtract additional credits. This is where you will subtract what is called the “unified credit”, which is essentially the $5,490,000 lifetime exclusion converted to tax liability based on the estate tax brackets. If you haven’t used up any of your lifetime exclusion, the unified credit will be $2,141,800.
There is a summary of the estate tax calculation in the handout for this class.
Filing an Estate Tax Return
Estate tax returns are due (with payment of any estate taxes) within 9 months of the decedent’s date of death. A 6-month extension can be obtained as well if needed. A preview of the estate tax return Form 706 is shown below:
There are several states that require estate tax returns as well. They include the following: Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey (will be repealed in 2018), New York, Oregon, Rhode Island, Vermont and Washington. Many of the states follow the federal exemption amount, but others have lower exemptions.
Both gift and estate taxes are levied for the privilege to transfer property. With good tax planning and strategical use of trusts, you can minimize your tax burden. If you have a large estate or expect to in the future, you should meet with an estate attorney to set up a structure that will minimize your tax burden.
EXAMPLE: THE SMITH FAMILY
Jim & Mary Smith do not currently have the need for any advanced gift tax or estate tax planning. Putting the documents in place from the previous class will be sufficient for them in estate planning for the time being.
Your homework assignment is to research any additional aspects of the gift or estate tax that you wish.
- IMPROVING – Go through the class reading above.
- INVESTED – Calculate your expected estate based on the information above.
- UNSTOPPABLE – Meet with an estate planning attorney to discuss any additional information needed to minimize gift and estate taxes if necessary for your situation.