Gifting to reduce a taxable estate

Reducing an estate through lifetime transfers is a standard technique. Whether it helps depends entirely on whether the estate would otherwise be taxed.

The threshold question

Ask first whether the estate is actually exposed.

Federal estate tax affects a very small proportion of estates given current exemption levels.

State estate and inheritance taxes affect a broader group, at considerably lower thresholds.

Where neither applies, gifting to reduce the estate produces no tax benefit and forfeits the basis adjustment on any appreciated asset given away.

Which makes it actively harmful in many cases, and it is done routinely by people advised generically.

Where it does work

For estates with genuine exposure, several techniques are effective.

Annual exclusion gifts. The foundation.

Gifts up to the annual amount per recipient, per year, use none of the lifetime exemption and require no return.

A married couple with several children and grandchildren can transfer a substantial amount annually this way, and the effect compounds over years.

Direct payment of tuition and medical expenses, excluded entirely and unlimited in amount, provided payment goes directly to the institution or provider.

This is the most efficient transfer available and it is under-used.

Gifting assets expected to appreciate. The value transferred is measured at the date of the gift, so all subsequent growth occurs outside the estate.

Transferring an asset early in its growth is therefore far more effective than transferring cash of the same value.

Using the lifetime exemption while it is available, given that current law provides for a reduction.

Guidance has confirmed that gifts made while the exemption is higher will not be clawed back if the exemption later falls, which removes a significant uncertainty and makes using it before any reduction attractive for those with substantial estates.

The structures for larger transfers

Beyond outright gifts.

Grantor retained annuity trusts, which transfer future appreciation above a defined rate while returning an annuity to the settlor.

Effective where an asset is expected to appreciate substantially, and the settlor must survive the term for the technique to work.

Sales to intentionally defective grantor trusts, selling an asset to a trust in exchange for a note, which freezes the value in the estate while growth accrues to the trust.

Family limited partnerships and limited liability companies, where interests transferred may be valued with discounts for lack of control and lack of marketability.

These have attracted sustained scrutiny, and the discounts must be supported by genuine business purpose and proper administration.

Irrevocable life insurance trusts, removing policy proceeds from the estate.

All of these involve complexity, cost and irrevocability, and they suit substantial estates rather than modest ones.

The basis trade-off

The consideration that runs through all of this.

Gifted assets carry over the donor's basis. Assets held at death receive an adjustment to market value.

Which means every gift of an appreciated asset trades an estate tax saving for a capital gains cost.

Where the estate tax rate exceeds the capital gains rate, the trade favours gifting. Where there is no estate tax, it is simply a cost.

For estates near the threshold, this calculation should be done rather than assumed, and it frequently favours holding rather than giving.

The practical cautions

Do not give away what you may need. The most common serious error, and gifts are generally irrevocable.

Any programme should be tested against a long life and a substantial care event.

Consider the Medicaid lookback, which operates on entirely different principles and can turn a tax-efficient gift into a period of ineligibility for care funding.

Keep records. Gift tax returns establish how much exemption has been used and should be retained permanently.

Consider fairness between recipients, and whether lifetime gifts will be equalised in the estate.

The review point

Exemption levels change, and a plan built around one set of figures may be unnecessary or inadequate under another.

Anyone with an estate near the threshold should review the position when the law changes, rather than assuming that arrangements made years ago remain appropriate.

General information only, not legal or tax advice. Exemption amounts and rules change — consult a qualified estate attorney.