That is the question we have been hearing from clients for the last few months that are still on the fence about gifting their unused exemption amount. The hesitation is justified after all, gifting a sizable amount of wealth should be carefully considered. We saw a flurry of activity at the end of last year with clients gifting their available exemption. If you chose not to make a gift last year and are still hesitating, the opportunity provided by the Tax Cuts and Jobs Act of 2017 (“2017 Act”) may not be lost.
Thanks to the 2017 Act, the federal estate and gift tax exemption amount was doubled from $5,000,000 to $10,000,000 (adjusted annually for inflation). For 2021, the inflation adjusted federal estate and gift tax exemption amount is $11,700,000. The higher exemption amount we have enjoyed since 2018 will expire (sunset) at the end of 2025 under the terms of the 2017 Act. With unprecedented government spending to combat the pandemic and a Democratic President and Congress (technically the Senate is 50/50 but a tie is broken by the Vice President), we expect the sunset of the 2017 Act before the end of 2025 or, worse yet, acceleration of the sunset and a reduction of the exemption amount below $5,000,000. That brings us back to the original question, is it too late to make a gift of your unused exemption?
The power of gifting assets during life is that both the value of the gift and the future appreciation are excluded for estate tax purposes. Most clients considering a substantial gift are not willing to completely give up control , instead preferring an irrevocable trust to be the recipient of the gift so that their wishes can be carried out in life and beyond the grave. For a married couple, the trust is typically for the lifetime benefit of the donor’s spouse. The spouse has access to the income and principal of the trust, if needed, and at the spouse’s death the assets continue in trust for children or other beneficiaries.
There has been a lot of buzz about retroactive application of new legislation but our concerns are more broad based. A nuance most clients do not realize is that the taxation of a gift made early in the year is based on the law in effect at the end of the year. If an irrevocable trust is created and funded with $11,700,000 in February 2021, the full exemption is utilized and zero gift tax is due, right? What if legislation is passed in November 2021 accelerating the sunset of the exemption amount back to $5,000,000? Are you in the clear since the gift was made nine months before the law changed? Not necessarily.
Under the Internal Revenue Code, the estate and gift tax is a unified system. Determining the amount of the federal exemption available for a gift made in February is based on the exemption which would apply “if the donor died as of the end of the calendar year.” What does this mean exactly? The gift you made in February is a taxable gift of $6,700,000 ($11,700,000 minus $5,000,000 exemption) and, at a 40% tax rate, that is a sizeable tax bill no one wants to be surprised with. Any planning undertaken this year should have flexibility built-in to take any tax law change into consideration. There are several creative ways for your attorney to incorporate flexibility into an otherwise irrevocable gift.
The first option was discussed above and involves the donor creating an irrevocable trust for the initial benefit of the donor’s spouse. A properly drafted trust may qualify for the unlimited marital deduction which would defer the tax until the death of the spouse beneficiary. A gift made in 2021 is reported on a gift tax return that must be filed by April 15, 2022. This allows the donor spouse to take a wait and see approach and only claim a marital deduction for the taxable portion of the gift, if any. Essentially, this gives the taxpayer options to decide what path to take based on how any new legislation is applied.
Another option is to base the amount of the gift on a formula equal to the donor’s remaining exemption “as finally determined for federal gift tax purposes.” The trust would initially be funded with the full exemption amount but if the law changed before the end of the year, the amount of the gift is capped at the new exemption amount and the excess would be redirected as provided in the trust. For example, the excess assets could be distributed to charity and qualify for a charitable deduction or to the donor’s spouse and qualify for a marital deduction.
There are many other creative ways to incorporate an escape hatch into this type of planning, none of which are simple and all of which require a clear understanding of your objectives and a keen understanding of the tax implications. It is not too late to do this type of planning but you should not delay consulting with your estate planning attorney. If you do not have an estate planning attorney, please reach out to us, we work with a number of excellent attorneys in each of our markets that we can introduce you to.
Is it too late to make a gift of my exemption?
By Grace Gutierrez
Vice President & Private Wealth Advisor, Trust