Executive Summary
Lifetime gifting is a widely accepted technique for managing potential exposure to future estate taxation. The purpose of the strategy is not just the obvious "if I give it away while I'm alive, I can't be taxed on it when I die" - due to the fact that both gifting and estate taxation share the same single lifetime exemption amount that is protected from taxation. Nonetheless, gifting can still be highly effective, because once the asset is transferred, all future appreciation is in the hands of the donee, and not the donor; as a result, the value of the asset is "frozen" at its value on the date of gift in terms of its cumulative gift and estate tax impact. And with the gift tax exemption recently increased to $5 million - and only until the end of 2012, after which it is scheduled to lapse back to $1 million - many estate planners are counseling clients to make some big gifts while they can. There's just one problem: it's not clear whether a future reduction in the gift and estate tax exemption could indirectly cause a so-called "recapture tax" on prior gifts.
The inspiration for today's blog post comes from a series of questions I've received recently about estate planning in 2011, and what might happen if the gift and estate tax exemption is in fact reduced in the future. The problem arises from the methodology by which estate taxes are actually calculated at death.
The rules (slightly simplified) under the tax code require that when determining estate taxes at death, all prior lifetime gifts must be added back to the gross estate to calculate the potential liability, and the gross gift and estate tax exemption is applied against that amount. The purpose of the rules is, in essence, to ensure that the estate is taxed at the highest marginal rates, as shown in the example below.
James made lifetime gifts of $100,000 (using a portion of his lifetime gift tax exemption), and passes away with a total estate of $10M. When determining his estate taxes due, the requirement to add back prior gifts means that his total estate is actually $10.1M, to be reduced by his $5M estate tax exemption. As a result, when looking up his tax liability against the estate tax tables, his prior gift fills the bottom estate tax brackets for the first $100,000, and the remainder of his $10M of assets starts at the 30% estate tax rate, and then fills the higher brackets from there. As a result, James uses a $5M exemption for gifts and estates against his $10.1M estate, resulting in taxation on the remaining $5.1M (which is exactly the same as dying with a $4.9M remaining estate tax exemption against a $10M estate); the difference, though, is that while prior gifts aren't actually taxed again, they nonetheless do fill up the bottom brackets so that the estate at death (and above the exemption) is taxed at the higher brackets stacked on top.
However, a problem arises if someone has made significant prior gifts - e.g., if he used his entire $5M exemption - when the future exemption is lower. The individual may have gifted $5M previously, but if the estate tax exemption is only $1M when he/she dies, the results shift.
Harold passes away with a $4M estate having made $5M in prior gifts. In theory, he fully utilized his gift tax exemption during life, and only the remaining $4M in his estate is subject to estate taxes. However, if the standard calculations are applied, Harold has a gross estate of $9M (including prior gifts), offset by only a $1M current exemption... resulting in an estate tax liability on the remaining $8M! Because the exemption wasn't still $5M when Harold died, the add-back of prior gifts suddenly re-incurs an estate tax on prior gifts that were previously exempt!
Many tax commentators have suggested that this is how a direct application of the current tax rules would occur; as a result, making large gifts in 2011 and 2012 might not actually escape taxation as typically believed!
It's worth noting, though, that the real purpose of that calculation, is just to add back in prior gifts to determine the tax bracket to which the estate should be subject (by using prior gifts to fill the lower brackets, so the remaining estate at death must “stack on top” at higher estate tax brackets); it was never a calculation intended to “recapture” an actual tax liability on prior gifts, although one can legitimate make the case that this is what might result if the formula is applied as it exists now.
On the other hand, there are some interpretations from commentators from Leimberg Information Services that suggest if the sunset provisions are read literally, then all prior gift and estate tax provisions sunset, which means when you calculate the estate tax liability at death (using the 2013 rates), you might also reasonably calculate all the prior gifts using the same 2013 exemption and tables, and the end result is that you would calculate assuming the prior gift was taxable (even though it actually wasn’t, because it “would have been” given the sunset that says those rules have now “disappeared”). If the prior gift was taxable, you can also add back prior taxes paid to the calculation (so that you don't pay taxes twice on the same already-taxed gift), and as a result the estate tax at death really would just be on the estate itself at death and the recapture tax would not occur.
Beyond that, there’s certainly clear public policy reasoning to not actually apply this kind of de facto recapture tax on prior gifts made in good faith when the gift tax exemption amount was higher. Consequently, regardless of any interpretation of the code, if Congress allows a reversion to some lower gift tax exemption amount beyond 2012, they can always still at least append a technical correction onto the existing rules that prevents this indirect recapture of unpaid gift tax from occurring, without otherwise changing the gift and estate tax exemption going forward from whatever lower level it turns out to be. It’s also worth noting that, notwithstanding all the fears, we haven’t actually lowered a gift or estate tax exemption amount after raising it for many, many decades now (as it’s generally viewed as bad public policy), although without a doubt Congress could do so if they wanted.
It’s also worth noting that even if the recapture does occur, it’s not actually a net negative. The gift still freezes the estate at the value at the time of gift, instead of the time of death (removing all appreciation between the time of gift and the time of death from the equation). The worst case scenario is an individual with $5M today gifts all $5M, has an estate of $0, and dies with that estate in 2013 with a reduced $1M exemption, and with the recapture ends out paying estate taxes on the $4M excess (per the example with Harold, above). But this is the same estate tax that would have been paid if the individual just kept the $5M until 2013 and died with it anyway. So the client doesn't pay more tax than he/she would have for estate tax purposes anyway because of this (in fact, the amount owed is less {assuming assets grow over time}, because the estate was frozen at the value of the gift in 2011). So what the client pays in the recapture scenario is not a tax that wouldn’t have paid at death anyway; what is paid is simply a tax the client “thought” he/she was going to avoid, but didn't. So that doesn’t mean it’s bad to do the gift though; there’s little downside, and still all of the potential benefits.
In fact, the biggest issue with the recapture - since the actual tax would have been owed either way - is the potential for tax apportionment issues that can arise at death if the beneficiaries of the estate are different.
For example, Jenny has $2M, and gifts $1M to the son from her first marriage, with the remaining $1M to pass at her death to the children from her second marriage. If she dies in 2013, and the exemption has dropped to $1M, and her prior gifts add back and get taxed indirectly, her estate owes 55% estate taxes on the last $1M. This means her estate only has $450,000 left over, to pass to her children from her second marriage (the beneficiaries of the estate), who in essence just paid the gift taxes on the first son’s prior gift from their own inheritance!
So some attorneys are looking at ways to apportion potential future tax liabilities on prior gifts (should they arise), to avoid family strife issues like this (when the recipients of gifts are different than recipients of the remainder estate).
In the end, it seems the likelihood of a lower exemption truly triggering a recapture of prior gift taxes is low. We have little precedent for actually reducing the gift exemption below a prior level, there’s a case to be made that sunset would make it a moot point anyway, and either way Congress can (or likely would?) apply a patch to fix this particular problem if they otherwise do drop the exemption and the sunset interpretation doesn’t hold. Yes, Congress does do a lot of things that we sometimes disagree with and makes some pretty contorted laws, but they do ultimately do so with particular public policy goals, and allowing this kind of recapture serves little public policy purpose at all; it seems a low probability scenario.
Nonetheless, it is necessary to explain the issue and the risks to any client seriously looking at potential significant-gifting strategies like this, and it’s worth at least spending a little time thinking about how tax apportionment issues would be handling if the situation does arise and the gift beneficiaries differ from the estate’s remainder beneficiaries.
So what do you think? Are you counseling affluent clients to make large gifts for estate planning purposes while the gift tax exemption is raised to $5M? Are you concerned about the exemption dropping to a lower level in the future? How is this influencing your estate planning conversations with clients?
Another thing not being considered plays into one of your case studies:
“The worst case scenario is an individual with $5M today gifts all $5M, has an estate of $0, and dies with that estate in 2013 with a reduced $1M exemption, and with the recapture ends out paying estate taxes on the $4M excess (per the example with Harold, above).”
If he gifted the money in 2011 and the laws revert in 2013, and dies in 2013 without a penny to his name, his estate would owe estate tax on $4 million and yet have no money to pay to tax.
Will they then go after the gifted property?
Well, I’ll grant the purpose of the illustration was not to literally impoverish him. But IRS would certainly seek to recover from any property he actually DID keep (he has to live on something!).
In the extreme, I suppose they could conceivably pursue the gift recipients though, as this could technically be construed as a fraudulent transfer of property deliberately intended to render the individual unable to pay his (tax) debts. I’ll grant that’s a little extreme, but not beyond the realm of possibility I suppose.