Reducing Gift, Estate, and Generation-Skipping Taxes

The federal government taxes gratuitous transfers, which are transfers for which the transferees gave less than full consideration for the property. Transference taxes are further classified as either gift taxes, if the transfer was made while the donor was still alive, or estate taxes that may be assessed against the donor's estate after his death, which will lower the amount left for distribution to beneficiaries. There is also a generation-skipping transfer tax (GST) on any gifts to donees who are more than one generation below the donor that is additional to either the gift or estate tax and is equal to the maximum estate tax rate.

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Although gift, estate, and generation-skipping taxes can be pretty hefty, the law allows generous exemptions:

The unified tax credit applies to both gifts and estates and to generation-skipping distributions, so that giving gifts during the donor's lifetime that is greater than the annual exclusion amount reduces the lifetime credit that can be applied to both later gifts and the estate.

Example — Reducing the Estate Tax by Giving Gifts

Assume that the unified tax credit allows $1 million to be transferred tax-free whether by gift or by testamentary transfer. Assume that the parents of Jennifer have $3 million that they want to give to their daughter. Since each of the parents has a unified tax credit of $1 million, they can give their daughter $2 million tax-free, but the remaining $1 million will be subject to gift or estate tax. However, each parent can give a gift equal to the annual exclusion rate annually. So if the gift tax annual exclusion is $13,000, then her parents can give that amount tax-free every year, which would amount to $1 million in less than 40 years. Also, because the estate tax is a progressive tax, with larger estates taxed at a higher rate, using the annual gift exclusion can reduce the size of the estate and lower the applicable rate. So if Jennifer's parents die before transferring all of the remaining money, the estate tax rate will probably be lower.

An advantage of lifetime gifts, even if their value is more than the annual exclusion amount, is that gift taxes are tax-exclusive, in that they are paid independently of the gift itself. So for a gift of $1 million, if the gift tax rate is 50%, then the donor only has to pay $500,000 since that was 50% of the amount gifted. However, estate taxes are tax-inclusive, in that they are paid before any transfers occur. Thus, for a beneficiary to receive $1 million when the estate tax is 50%, there would have to be at least $2 million in the estate.

Trusts commonly use the above exemptions to delay, reduce, or eliminate transference taxes and by taking advantage of other loopholes in the law. Trusts are discussed in other articles on this site; some more obscure methods for reducing transference taxes are discussed below.

Using the Gift Tax Annual Exclusion in Estate Planning

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The annual gift tax exclusion allows several methods of passing property without incurring transfer taxes. One way is to give partial interests to a large number of people or to give a few people partial interests over time. For instance, if you own a piece of real estate and transferred partial interests to a number of beneficiaries, then the value of the property interest can be discounted by about 15%, because no one beneficiary has complete control of the property, which reduces the value of each property interest. However, you must get a professional appraisal of the property value when the 1st property interest is transferred. You may also have to get a reappraisal for subsequent transfers if the property value changes. One way to transfer more property interests without a need for reappraisal is by making one gift in December and another gift in January of the following year.

Another way of transferring partial interests is through the use of a grantor trust, especially for varied assets. By putting the assets in the trust, you retain control over the assets as trustee, but you can give partial interests to your beneficiaries over time tax-free. However, all the beneficiaries of the trust should be within one generation of you. Otherwise, any property transfers that are greater than the annual exclusion to beneficiaries who are more than one generation from the grantor, known as skip persons in tax law, may be subject to generation-skipping transfer taxes when the transfers takes place. The way to avoid GST taxes, for instance, is by naming only your children as beneficiaries in case you die before all of the property is distributed. However, because the GST tax has the same annual exclusion as the gift tax, you can pass property interests or money within the annual exclusion to each of your grandchildren completely tax-free.

Family Limited Partnerships

A family limited partnership (FLP) is an estate planning tool whereby the donor transfers most of his assets to a limited partnership in exchange for shares in the partnership and becoming its general partner, while the donor's family members transfer small amounts for some limited partnership shares. The principle behind using this as an estate planning tool is that the shares distributed to the limited partners are worth less than market value because the limited partners have no control over the assets and because the shares are illiquid since the right to transfer the shares is limited.

Because the shares have limited value, the general partner can transfer large amounts of untaxed wealth gradually by transferring shares that are worth less than the gift tax annual exclusion.

However, the FLP must be a legitimate business — its sole purpose cannot be to save on transference taxes. Initially, the limited partners must give adequate consideration for their shares; otherwise the value of the entire partnership is includable in the decedent's estate.

Expatriation

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Some people try to reduce income and estate taxes by renouncing their citizenship in the United States and becoming a citizen of another country that has little or no income or estate tax. However, §§877 and 2107 of the Internal Revenue Code may require that the taxpayer continue to pay income and estate taxes for at least 10 years after the expatriation unless the principal purpose for the change of citizenship was not for tax purposes, for which the executor of the estate has the burden of proof.

However, the taxpayer will only be subject to these expatriation provisions if the average annual net income tax in the preceding 5 years before ending citizenship was greater than the income level at which expatriation provisions apply — adjusted for inflation after 2004 — or if the taxpayer's net worth was greater than $2 million when citizenship was lost. Moreover, on the day before expatriation, most of the property of the expatriate in the US will be subject to an income tax on the net unrealized gain or loss in the property, as if the property were sold at its fair market value (mark-to-market tax). The amount of any unrealized gain subject to tax is reduced by the exemption amount, but not less than zero.

Income Level at which Expatriation Provisions Apply
YearAverage 5-Year
Income
Exemption
Amount
2017 $162,000 $699,000
2016$161,000$693,000
2015$160,000$690,000
2014$157,000$680,000
2013$155,000$668,000
Source: https://www.irs.gov/instructions/i8854/ar01.html#d0e221

In any case, any income source within the United States will still be taxed, even if the income is received by a non-United States citizen, and any assets located in the United States may also be subject to an estate tax.