Transfers Not Subject to Gift Tax

United States taxpayers pay an estate or gift tax on wealth transfers to the extent that the aggregate value of the transfers, whether upon death or during lifetime, exceeds $12,920,000 in 2023. On January 1, 2026, this exclusion amount is scheduled to be reduced roughly in half. Because of this, many taxpayers are considering utilizing this high capacity to give without taxes by utilizing their exclusion before it is reduced.

In general, any gratuitous transfer is reportable, and will reduce a taxpayer's capacity to transfer wealth without tax, but there are important exceptions. One important exception is the annual exclusion, which I discussed in a prior post, which currently allows each taxpayer to gift up to $17,000 per year per donee. This is perhaps the most widely known mechanism for transferring wealth without any gift or estate tax impact, but there are others as well.

Any taxpayer may make unlimited tuition payments on behalf of any individual without needing to report the gift, pay gift tax, or use their lifetime exclusion. Any such payments must be made directly to the educational institution. Similarly, any amounts may be paid to educational institutions for their general charitable purposes, just as any amounts may be paid to other charitable organizations free of gift or estate tax.

Any taxpayer may generally make payments directly to medical providers for medical payments or medical insurance premiums for others. Not only are such payments free from gift or estate tax, an income tax deduction may be available for the taxpayer, just as a charitable deduction may be available for gifts to charities for the benefit of the public. Finally, gifts to political organizations are generally exempt from gift tax. Using the tools described herein can be effective ways to mitigate gift and estate taxes.

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Reducing Estate Taxes with Annual Exclusion Gifting

Subject to new legislation passed under the Biden administration, United States taxpayers pay an estate tax on death to the extent that the value of their estate exceeds $11,700,000 in 2021; the estate tax is a tax on the right to transfer property upon death. It cannot be avoided by making lifetime gifts to heirs because most such gifts reduce this estate tax lifetime exclusion amount. If the lifetime exclusion amount is exhausted, a gift tax applies in lieu of the estate tax.

In general, any gift is taxable, meaning that the gift will either reduce the lifetime exclusion or require the payment of a gift tax by the donor if the donor's lifetime exclusion has been exhausted. However, there are a number of important exceptions to the rule that any gift is taxable. One such exception is the annual exclusion.

"If a taxpayer makes a gift to another person, the gift tax usually does not apply until the value of the gift exceeds the annual exclusion amount for the year." The annual exclusion is indexed for inflation and is $15,000 in 2021. Under current law, every taxpayer can gift up to $15,000 per year to an unlimited number of donees. Married couples can each make an annual exclusion gift from their own property, essentially doubling the annual exclusion amount. To qualify for the annual exclusion, the gift must be of a "present interest" in property, meaning a gift that the donee can access and use immediately.

An annual exclusion gifting plan can remove significant wealth from a taxpayer's estate over time, thus reducing future gift and estate taxes. For example, a couple with three children and nine grandchildren can potentially gift $360,000 ($15,000 x 2 spouses x 12 heirs) to their family every year without even the need to file a gift tax return. However, there is no requirement that the donee be a family member, meaning that the class of potential donees is only limited by the pool of beneficiaries who the donor wishes to benefit. Annual exclusion gifting should be coordinated with other gifting and tax-mitigation planning but is an important estate and gift tax mitigation tool.

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What Happens When the Estate Tax Exclusion Goes Down?

The Internal Revenue Code imposes a tax on the value of wealthier estates that is payable after the owner passes away. In 2017, an individual could bequeath $5,490,000 to his or her heirs, free of estate tax, while wealth passed in excess of this exclusion amount was subject to an estate tax of 40%. The Tax Cuts and Jobs Act increased the estate tax exclusion to $11,180,000 in 2018, which exclusion amount increases for inflation each year.

The estate tax cannot be avoided by making lifetime gifts to heirs; such gifts must be reported on IRS Form 709 and reduce the giftmaker's estate tax exclusion amount. If the exclusion amount is exhausted, a gift tax applies in lieu of the estate tax. Upon death, the personal representative of the decedent's estate will file IRS Form 706 and add all prior gifts back to the value of the estate owned by the decedent on death as part of the completion of the estate tax return and calculation of the estate tax.

Under the Tax Cuts and Jobs Act, the estate tax exclusion reverts to approximately $5,500,000 in 2026. This reversion could have "retroactively [denied] taxpayers who die after 2025 the full benefit of the higher exclusion amount applied to previous gifts." This possibility arose because the estate tax exclusion amount has never gone down before, and the credit against the estate tax for gifts made when the exclusion amount was high could have been calculated based upon the lower exclusion amount upon death.

Treasury Regulation Section 20.2010-1(c) resolved this uncertainty. In summary, individuals maintain the benefit of having made gifts utilizing the estate tax exclusion in a year when the exclusion was higher than it is at death. One of the examples in the regulations assumes that a never-married individual made lifetime taxable gifts of $9 million and paid no gift tax at the time because the gifts were made when the exclusion was $11.4 million. Upon death, the exclusion amount was $6.8 million. The example concludes, "Because the total of the amounts allowable as a credit in computing the gift tax payable on [the] gifts (based on the $9 million of basic exclusion amount used to determine those credits) exceeds the credit based on the $6.8 million basic exclusion amount allowable [on death, the credit] is based on a basic exclusion amount of $9 million..."

In other words, taxes are saved by making gifts during a time when the exclusion amount is high, as it is now, if death ultimately occurs when the exclusion is low. The exclusion amount will go down at the end of 2025 but could go down more than it is scheduled to, and sooner, under the Biden administration. Accordingly, for many wealthier taxpayers, the time to make gifts is before the end of this year.

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50 States' Disclaimer of Property Interests

A disclaimer is the refusal to accept the right to receive property. Disclaiming a property interest is an estate, gift, and generation-skipping tax avoidance technique allowed by Section 2518 of the Internal Revenue Code, and the right to disclaim is codified in each states' statutes. A disclaimer is also useful where a person simply does not want the property they would otherwise receive.

The Uniform Law Commission has completed a uniform Disclaimer of Property Interest Act that has been adopted by 20 jurisdictions; a prior version has been adopted by 11 jurisdictions. The American College of Trust and Estate Counsel has an old but somewhat useful summary of each states' law on this matter located here.

Below are current references to each states' property interest disclaimer statutes. This post will be updated as laws change; please comment below if you come across any incorrect or outdated information:

Alabama  Ala. Code § 43-8-290	Illinois  755 ILCS 5/2-7	Montana  §72-2-811, MCA	Rhode Island  R.I. Gen. Laws § 34-5-1
Alaska  A.S. § 13.70.010	Indiana  I.C. § 32-17.5-1-0.2	Nebraska  Neb. Rev. Stat. § 30-2352	South Carolina  S.C. Code § 62-2-801
Arizona  A.R.S. § 14-10001	Iowa  Iowa Code § 633E.1	Nevada  N.R.S. § 120.100	South Dakota  SDCL § 29A-2-801
Arkansas  Ark. Code § 28-2-201	Kansas  K.S.A. § 59-2291	New Hampshire  RSA § 563-B:1	Tennessee  T.C.A. § 31-1-103
California  Ca. Prob. Code § 260	Kentucky  KRS § 394.035  KRS § 394.610	New Jersey  N.J.S. § 3B:9-1	Texas  Tex. Prop. Code § 240.001
Colorado  C.R.S. § 15-11-1201	Louisiana  La. C.C. § 947	New Mexico  N.M.S. § 46-10-1	Utah  Utah Code § 75-2-801
Connecticut  Conn. Gen. Stat. § 45a-578	Maine  18-A M.R.S. § 2-801	New York  N.Y. Est. Powers and Trusts Law § 2-1.11	Vermont  14 V.S.A. § 1951
Delaware  12 Del. C. § 601	Maryland  Md. Code, ET § 9-216	North Carolina  N.C. Gen. Stat. § 31B-1	Virginia  Va. Code § 64.2-2600
District of Columbia  D.C. Code § 19-1501	Massachusetts  Mass. Gen. Laws ch. 190B, § 2-801	North Dakota  N.D.C.C. § 30.1-10.1-01	Washington  RCW § 11.86.011
Florida  Fla. Stat. § 739.101	Michigan  M.C.L. § 700.2901	Ohio  R.C. § 5815.36	West Virginia  W. Va. Code § 42-6-1
Georgia  O.C.G.A. § 53-1-20	Minnesota  Minn. Stat. § 524.2-1101	Oklahoma  Okla. Stat. tit. 60, § 751  Okla. Stat. tit. 84, § 22	Wisconsin  Wis. Stat. § 854.13
Hawaii  H.R.S. § 526-1	Mississippi  Miss. Code § 89-21-1	Oregon  O.R.S. § 105.623	Wyoming  W.S. § 2-1-401
Idaho  Idaho Code §15-2-801	Missouri  §469.010, RSMo	Pennsylvania  20 Pa.C.S. § 6201

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Bequests to Charity and Tax Apportionment

Many individuals wish to leave a specific amount of money or particular property to their heirs and the rest of their estate to charity. While this seems straightforward, administering this plan can become complicated when the estate is subject to the estate tax.

The reason is explained in Treas. Reg. § 20.2055-3(a)(1): "If a residuary estate... is bequeathed to charity, and by the local law the Federal estate tax is payable out of the residuary estate, the deduction may not exceed that portion of the residuary estate bequeathed to charity as reduced by the Federal estate tax... [T]he resultant decrease in the amount passing to charity will further reduce the allowable deduction."

Stated differently, the estate tax deduction is based on the amount actually available for charitable uses, which amount is reduced by estate taxes. This "results in a circular, or interrelated, computation because the reduction in the charitable deduction in turn increases the taxes payable that again reduces the charitable deduction and so forth. The calculation must be run until the additional taxes zero out."

This problem can be avoided through careful drafting by either "structuring the charitable bequest as a pre-residuary rather than a residuary bequest" or not allowing for the apportionment of the estate tax on any property set aside for charity. Under the Uniform Estate Tax Apportionment Act, which has been adopted by a handful of states, "charitable beneficiaries generally are insulated from bearing any of the estate tax;" however, this is generally overridden by a tax apportionment clause in a will or trust. Every client must understand their options for apportioning estate taxes (not to mention other inheritance taxes) and the impact the apportionment will have on their distribution scheme.

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Irrevocable Trust Planning

Individuals with substantial assets can utilize a number of techniques to minimize gift and estate taxes. These techniques include making lifetime transfers of assets using irrevocable trusts. This post will describe some of the irrevocable trust planning techniques for income-producing assets. Such trusts will name an "income beneficiary," who will be entitled to the income generated by the asset and a "remainder beneficiary," who will be entitled to the asset itself after a defined period of time.

One way to classify such trusts is by how the income of the income beneficiary is calculated: In general, income is calculated as either a fixed amount (an annuity) or as a fixed percentage of the net fair market value of the trust assets (a unitrust amount). Another way to classify these trusts is whether they involve a charitable beneficiary. Finally, with respect to charitable trusts, the charitable beneficiary can be either the income or the remainder beneficiary. These different trusts can be described using the following chart:

	Annuity Income	Unitrust Income
Charitable Lead Trusts (CLTs)	Charitable Lead Annuity Trust (CLAT)	Charitable Lead Unitrust (CLUT)
Charitable Remainder Trusts (CRTs)	Charitable Remainder Annuity Trust (CRAT)	Charitable Remainder Unitrust (CRUT)
Grantor Retained Trusts (GRTs)	Grantor Retained Annuity Trust (GRAT)	Grantor Retained Unitrust (GRUT)

In summary, a CLAT and a CLUT both provide a charity with income for a period of time, in the form of an annuity or unitrust amount respectively, with non-charitable beneficiaries receiving the remainder interest when the income period ends. A CRAT and a CRUT are similar, except that the charitable beneficiary receives the remainder interest at the end of the income period, during which either an annuity or unitrust amount is paid to non-charitable beneficiaries. Finally, a GRAT and a GRUT provide for both an income interest and a remainder interest to non-charitable beneficiaries. Future posts will discuss the situations in which each of these trusts are typically used.

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Pass Wealth Tax Free by Marrying a Descendant?

As I discussed in a previous post, some states ban close relatives from marrying with gender-based consanguinity statutes on the premise that same-sex unions are unlawful. For example, Mississippi law states:

The son shall not marry his grandmother, his mother, or his stepmother; the brother his sister; the father his daughter, or his legally adopted daughter, or his grand-daughter;... and the like prohibition shall extend to females in the same degrees. All marriages prohibited by this subsection are incestuous and void. Miss. Code Ann. § 93-1-1(1).

This statute does not prohibit a son from marrying his father; but this possibility was foreclosed by Miss. Code Ann. § 93-1-1(2), which prohibited marriage between persons of the same gender. The state of Massachusetts has a similarly-worded statute, but in Goodridge v. Department of Public Health, the court legalized same-sex marriage but addressed the statutory language. The court stated in a footnote that "the statutory provisions concerning consanguinity or polygamous marriages shall be construed in a gender neutral manner."

Today's Supreme Court decision of Obergfell v. Hodges holds that the Constitution requires states to license a marriage between two people of the same gender. It does not mention consanguinity or contain any limiting language like Goodridge, yet it applies to all states, including Mississippi and a handful of others with gender-based consanguinity statutes.

Accordingly, in these states, there is no law preventing an individual from marrying a close relative, as long as they are the same gender. Furthermore, it is unclear what rationale a state would have in removing the right of same-sex relatives to marry. The ability for wealthy individuals to pass their estate to an heir by marrying the heir and benefiting from the unlimited marital deduction is a compelling tax planning opportunity.

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The Bypass Trust: To "B" or Not to "B"?

For many years, estate planners recommended planning that involved an "A/B trust" structure whereby assets of the first spouse to die equaling the estate tax exemption in value would end up in a trust to preserve that spouse's estate tax exemption. This prevented the surviving spouse from being "left with the couple's assets, but only their own individual exemption." Depending on a number of factors, this strategy could potentially save millions of dollars in estate taxes.

The costs of this trust, which is known by many names including a "B Trust," "Credit Shelter Trust," "Family Trust," or "Bypass Trust," are not insignificant. The surviving spouse's access to the assets of the B Trust are necessarily restricted, tax returns must be filed each year the trust is in existence and has income, legal responsibilities are imposed on the surviving spouse or a non-spouse trustee for trust management, and there is no step-up in basis for the B Trust assets at the surviving spouse's death.

Until recently, these costs could easily be justified by the potential estate tax savings. After the American Taxpayer Relief Act, however, the law allows the deceased spouse's unused exclusion amount to be transferred to the surviving spouse without the need for a B Trust. The unused exclusion must be calculated, and an election to transfer the unused exclusion made, on a timely filed estate tax return of the first spouse to pass away.

Rev. Proc. 2014-18, effective January 27, 2014, allows for an extension of time to make this "portability" election for decedents who passed away in 2011, 2012, or 2013 and who were survived by a spouse. Such elections, made in conjunction with the filing of an estate tax return, must be filed by December 31, 2014.

There are still benefits of a B Trust, namely, asset protection for the assets held by the trust, asset appreciation value that is excluded from estate tax, and greater certainty that the bequests contemplated by the first spouse to die will be carried out. However, the estate tax benefits to the B Trust have been reduced.

While it a good idea for everyone to review their estate plan every few years anyway, it is particularly appropriate for those with A/B trust provisions included in a revocable trust package to review whether that is still appropriate. For surviving spouses stuck managing a B trust that is no longer justified, it is appropriate to have the trust reviewed to see if it can be modified to better achieve that spouse's objectives.

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Gay Marriage Cases Yield Estate Tax Planning Opportunities

Some of the court decisions on the issue of gay marriage are creating estate tax loopholes that could allow wealthy individuals to pass their estate to their heirs tax free. Every state restricts close relatives from marrying. However, the language of some states' statutes technically only prohibits opposite-sex relatives from marrying, but with a definition of "marriage" that only includes male-female unions.

Consider the statute in Massachusetts, which contains the traditional definition of marriage and provides that "No man shall marry his mother, grandmother, daughter, granddaughter, sister, stepmother, grandfather’s wife, grandson’s wife, wife’s mother, wife’s grandmother, wife’s daughter, wife’s granddaughter, brother’s daughter, sister’s daughter, father’s sister or mother’s sister." There are corresponding provisions for women.

In Goodridge v. Department of Public Health, the court acknowledged this language and said in a footnote that "the statutory provisions concerning consanguinity or polygamous marriages shall be construed in a gender neutral manner." However, the statute has not been updated despite ample opportunity for the legislature to do so. Given this, it is at least arguable that, as Phillip Greenspun pointed out, a "grandfather [could] marry his grandson, give his spouse/grandson a tax-free spousal gift of $25 million, and then get a no-fault divorce after a couple of years."

In contrast, the Connecticut legislature did amend the gender-based consanguinity provisions in its marriage statutes. Shortly after the case of Kerrigan v. Commissioner of Public Health was handed down, the legislature passed Public Act No. 09-13. This act replaced the language "No man may marry his mother, grandmother, daughter, granddaughter, sister, aunt, niece, stepmother or stepdaughter, and no woman may marry her father, grandfather, son, grandson, brother, uncle, nephew, stepfather or stepson" with the following: "No person may marry such person's parent, grandparent, child, grandchild, sibling, parent's sibling, sibling's child, stepparent or stepchild."

It is unclear what rationale Connecticut or any state would have in removing the right of same-sex relatives to marry. As has been astutely pointed out, "[T]he biological rationale for the consanguinity rules makes no sense in the context of two women or two men, as there simply can be no progeny produced between them, and hence there is no possibility of in-breeding."

The state of Iowa chose to remain silent on this question; its statute declares as void any marriage between "a man and his father's sister, mother's sister, daughter, sister, son's daughter, daughter's daughter, brother's daughter, or sister's daughter" (and vice versa) in Iowa Code Ann. § 595.19. The court in Varnum v. Brien did not mention 595.19 or consanguinity and the legislature has not updated the statute since. As such, Iowa has seen fit to allow close same-sex relatives to marry; accordingly, an unmarried woman can marry her daughter and pass wealth to her tax free.

With the 10th Circuit currently considering whether to overturn traditional marriage laws in multiple states, it will be interesting to see how or if it approaches the varied consanguinity provisions within its jurisdiction. Oklahoma is poised to become another state with an estate-tax loophole.

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Valuation Discounts

One of the primary objectives of estate planning is to arrange for the transfer of wealth to the next generation at the lowest possible cost. For large estates, the most significant cost is the gift and estate tax. These two tax regimes are essentially a single tax imposed on total lifetime gifts plus the value of property transferred at death. As mentioned in a previous post, gifting during lifetime can be part of an estate planning strategy.

For a gifting example, assume a gift tax rate of 40% and a donor who has previously utilized his or her entire tax exemption and who desires to make a gift of $1,000,000 of a $4,000,000 investment in a publicly-traded company.

After making the gift of the $1,000,000 asset, the donor will pay a $400,000 gift tax. Obviously, a key factor in the calculation of the gift tax is the valuation of the stock that is the subject of the gift. In this case, the valuation is straight-forward because the stock is easy to sell and has a ready market.

However, consider the gift of a small, privately-owned family business. In this case, the value of the asset will reflect the fact that there is not a ready market for the business; it is more difficult to sell. In addition, the value of a minority interest in a private business will reflect a lower value if the owner does not have managerial control.

For planning purposes, both the "lack of control" and "lack of marketability" discounts can be effectuated in not only the small, privately-owned family business context, but also for nearly any other asset. For example, suppose that the owner of the $4,000,000 stock investment first transfers the stock into a limited partnership. Subsequently, if the owner transfers a 25% limited partnership interest to a donee, the value of the gift for gift tax purposes will be less than $1,000,000.

This is because there is not a ready market for a privately-owned partnership interest. Furthermore, instead of owning $1,000,000 worth of publicly traded stock outright, the donee merely owns a 25% limited interest in a private partnership. Since the donee lacks managerial control over that interest, it does not matter that the underlying asset is publicly-traded stock; the lack of control discount would apply in addition to the lack of marketability discount.

If the total valuation discount in this case works out to be 30%, this results in a gift valuation of $700,000 instead of $1,000,000. This results in an accompanying gift tax of $280,000 instead of $400,000, an immediate cash savings of $120,000 simply by utilizing the limited partnership.

Source: Valuation, Jonathan C. Lurie and Edwin G. Schuck, Jr., The American Law Institute - American Bar Association Continuing Legal Education, 2008

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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

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Defective Grantor Trust Overview

Irrevocable trusts are an essential part of sophisticated estate planning. Such trusts are normally used to hold assets that have been gifted or otherwise transferred by a grantor. Assets within irrevocable trusts, including future appreciation, are not included in the grantor’s estate for estate tax purposes.

A standard irrevocable trust is treated as a separate entity for income tax purposes and will be taxed on the income at the trust level. However, if an irrevocable trust is “defective,” the deemed grantor of the trust will be taxed on the income of the trust instead. This means the trust is disregarded for federal income tax purposes; such trusts are known as “grantor trusts.”

An intentionally defective grantor trust can be an effective planning technique for several important reasons. First, as with any irrevocable trust, the assets held within the trust are generally protected from creditors.

Second, since the trust is not a separate taxpayer, a sale to the trust by the grantor is not a recognizable transaction for income tax purposes and no gain will be recognized. Such a sale is often structured as an installment sale with a promissory note that has a self-cancelling feature effective upon the death of the grantor. This results in the balance of the note being excluded from the estate of the grantor; similarly, any increase in the value of the asset will also occur outside of the grantor’s taxable estate.

Third, since income generated by the irrevocable grantor trust is taxed to the grantor, the payment of that tax liability by the grantor is, in effect, a gift-tax free benefit to the trust and ultimately to the trust's beneficiaries. Since the trust is irrevocable, the trust principal will not be included in the taxable estate of the grantor. Therefore, the grantor can transfer assets into the trust by sale without the recognition of an income tax event, not have the trust assets included in his or her gross estate at death, and continue to reduce the value of his or her estate by the income tax payments on the trust income.

Although President Obama's current budget proposal would eliminate the value of using intentionally defective grantor trusts as an estate planning strategy, such trusts currently remain a useful tool.

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