Reducing the Taxable Estate
Estate-Reducing Techniques: Overview
I. Spending: The first estate-reduction technique is to spend and use up your estate for your own benefit. You earned it; you spend it. You do not have to leave it to anyone. You may want to tell your children or other beneficiaries, “If I leave you anything, it is only because I miscalculated.” Most clients do not want to be so aggressive in reducing their estates, but you may want to be a bit more generous with yourself, and — using one client’s example — “buy a bit of melon in off-season.”
II. Gift Giving: Most estate-reduction tools involve some sort of gift giving. As you know, each person can give up to $14,000 to each of any number of recipients in each calendar year without having to report a taxable gift or use up the applicable exclusion amount ($5,250,000 in 2013). Taxable gifts require no out-of-pocket payment of gift tax until the cumulative total of lifetime taxable gifts exceed the applicable exclusion amount. From a transfer-tax perspective, making lifetime gifts is much more effective than making after death distributions under a will or trust. Consider the following illustration:
A. A lifetime gift of $1 million in the 40% tax bracket would generate a gift tax of $400,000, so the gift and the tax would total $1,400,000, of which the recipients end up with $1,000,000 or 71.4%, making the net transfer tax rate 28.6%.
B. A death-time transfer of $1,400,000 at the 40% rate results in an estate tax of $560,000, leaving $840,000 for the recipients. The true tax rate is 40%.
C. In both examples, the combination of the transfer and the tax totals $1,400,000, but the lifetime gift results in the beneficiaries receiving $160,000 more (and the IRS receiving $160,000 less).
III. Making More Effective Gifts: Some gifts can be more effective than others at reducing the taxable estate.
A. It is common for people to make annual gifts of $14,000 cash to children, grandchildren, and other beneficiaries. This reduces the estate by the amount of the cash and by the amount of its potential earnings.
B. A more effective gift giving technique is to give away appreciating property. This type of gift reduces the estate by the current value of the asset given, as well as by the value of potential appreciation and potential earnings.
C. The best type of gift is a gift that reflects a small value for gift-tax purposes but reduces the estate by a larger value. For example, if you can give a $14,000 gift and reduce your estate by $17,500, $20,000 or more, you have effectively “leveraged” your gift-tax annual exclusion.
D. Examples of “Leveraged Gifts”: Gifts of life insurance, remainder interests, and value-discounted interests are some of the “gift-leveraging” or “gift-maximizing” techniques.
E. Outright Gifts; Gifts in Trust: It is common to make an outright gift to a beneficiary, but it is often appropriate to make gifts through irrevocable trusts. Irrevocable trusts are discussed more fully in the article entitled “Irrevocable Trusts”.
IV. Making Large Gifts: Because the federal estate tax applicable exclusion was scheduled to revert to $1 million in 2013, some people with large estates made gifts to use some or all of their full $5 million exclusion in 2012. Making large gifts is particularly effective if the assets given have a low current value that is expected to appreciate over time. The 2012 gifts were frequently made out of a fear that the exclusion would be forever lost. Since Congress enacted the American Taxpayer Relief Act on 1/1/2013, all of that was made moot. The applicable exclusion for estate and gift tax remains “permanently” at $5 million, adjusted for inflation since 2011. Thus, making large gifts should be motivated by one’s estate planning goals, and not by fear of a disappearing exclusion. (“Permanently” means it is permanent until Congress changes its collective mind. It mostly means that it is not subject to some automatic adjustment that is already scheduled.)
NOTE: This memo provides general information only and does not contain legal, accounting, or tax advice. For brevity, this memo is oversimplified and should not be relied on for any particular situation.
Our experienced attorneys can help with your estate planning needs.