Paying Gift Tax Now vs. Estate Tax Later

In addition to the annual exclusion, which allows individuals to make annual gifts of up to $14,000 per donee without implicating any taxes, there is another way to utilize gifting to family members to minimize estate taxes upon death.

This strategy applies to estates with a value in excess of the federal estate and gift tax exemption. In 2014, this exemption will be $5,340,000, up from $5,250,000 in 2013. Spouses can generally combine their credit amounts, resulting in the passing of estates worth two times the individual estate and gift tax exemption upon the death of the second spouse. Any estates that are worth less will not be subject to any estate or gift tax.

For estates with a fair market value in excess of the exemption amounts, a tax will apply. The estate tax and gift tax statutes are designed so that the estate tax cannot be avoided by gifting assets before death. If assets in the estate in excess of the exemption amount are gifted during the lifetime of the donor, a gift tax will need to be paid at the same rate as the estate tax.

However, paying gift tax is less expensive than paying the estate tax because paying the gift tax permanently removes the tax paid from the donor's taxable estate. If the taxable gift were not made, the amount that would have been paid in gift tax remains in the taxable estate and is itself subject to the estate tax.

For example, assume the current gift and estate tax rate of 40% and a donor who has previously gifted his or her entire exemption amount. In order to gift $1 million to a donee, the donor will make the gift of $1 million and pay a $400,000 gift tax for a total of $1,400,000.

If the donor had not made the gift before he or she passed away, the estate would include the $1,400,000 and be subject to the 40% tax rate. The donee would only receive $840,000 after the estate tax of $560,000 is paid ($1,400,000 * 40%). In other words, the estate would save and the beneficiary would receive $160,000 more simply because the donor made a gift before death instead of waiting to pass his or her estate afterwards.

Timing is key to the success of this planning technique. Under IRC 2035(b), the taxable estate of the donor includes any gift tax paid on transfers made within three years before the donor's death; accordingly, if the donor dies less than three years after making the taxable gift, the strategy fails. On the other hand, the donor is choosing to accelerate the payment of taxes and give up the use of the money paid as tax. "The donor must survive for three years to avoid the §2035 gross up, but must not survive for so long that the value of the loss of use of the money paid as gift taxes exceeds the value of the estate tax savings." Lischer, 846-2nd T.M., Gifts to Minors