Effectively using the annual gift tax exclusion.

• Author: Scroggin, John J.
• Position: Part 1

Estate taxes can be minimized by planning with the annual gift tax exclusion. Through the use of numerous examples, this two-part article demonstrates how proper use of the annual exclusion can, over time, move millions of dollars out of the estates of wealthy clients.

The annual gift tax exclusion may be one of the most effective, but least used techniques available to estate planners, perhaps because $10,000 per donee seems such a small benefit. However, when combined with other planning techniques, its use can provide substantial long-term tax savings. This two-part article will explore in detail many of the planning opportunities available.

Example 1: G, a wealthy client, has three married children, each of whom has one child. G is unwilling to make gifts to in-laws. Shown below is the cumulative amount of $10,000 annual exclusion gifts to six descendants G could make over 30 years. After that time, the gifts total $1.8 million,(1) creating a transfer tax savings of $990,000 if G is in the 55% estate tax bracket. If G included in-laws, the total gifts would grow by 50% (i.e., to $2.7 million in 30 years).

Year Gifts' total value 1 $60,000 5 $300,000 10 $600,000 15 $900,000 20 $1,200,000 25 $1,500,000 30 $1,800,000 However, this approach ignores another important aspect of the annual exclusion: moving assets out of a taxable estate on a discounted basis.

Example 2: The facts are the same as in Example 1, except that the gifts were of interests in a family limited partnership (FLP) that held real estate; further, a 35% valuation discount applies. Shown below is the net effect of this increased benefit to the same annual exclusion gifts of $60,000 over 30 years. Column 1 reflects the gifts' unadjusted value; column 2 shows the cumulative gifts after a 35% discount. Using this relatively simple device, almost $1 million more in assets are moved out of the taxable estate in 30 years, saving over $530,000 more in estate taxes for G in the 55% bracket.

Gifts' total value at (1) (2) $10,000 Year annually 35% discount 1 $60,000 $92,000 5 $300,000 $462,000 10 $600,000 $923,000 15 $900,000 $1,385,000 20 $1,200,000 $1,846,000 25 $1,500,000 $2,308,000 30 $1,800,000 $2,769,000 Although almost $3 million is moved out of the taxable estate, there is an additional benefit from the effective use of the annual exclusion: it moves future value out of the taxable estate, stemming from appreciation in the value of the gifted assets and/or income generated by those assets.

Example 3: The facts are the same in Example 2, except that the gifted assets appreciate 5% annually over 30 years. Gift's total value at Year $10,000 annually 35% discount 5% appreciation 1 $60,000 $92,000 $97,000 5 $300,000 $462,000 $516,000 10 $600,000 $923,000 $168,000 15 $900,000 $1,385,000 $2,001,000 20 $1,200,000 $1,846,000 $3,064,000 25 $1,500,000 $2,308,000 $4,412,000 30 $1,800,000 $2,769,000 $6,152,000 Thus, significant benefit can be obtained from moving even small amounts of assets out of a taxable estate. In this case, $60,000 in annual gifts moved more than $6.15 million out of G's taxable estate in 30 years.

Annual Exclusion

The gift tax annual exclusion rules are fairly straightforward. Sec. 2503(b)(1) permits taxpayers to make annual gifts of up to $10,000 per donee, with no limit on the number of donees.(2) The gift must be of a "present interest' in property" defined by Regs. Sec. 25.2503-3(b) as the "unrestricted right to immediate use, possession or enjoyment of property or the income from the property."

According to Sec. 2503(b)(2), the $10,000 annual exclusion is adjusted for inflation after 1998, but only in $1,000 increments (i.e., there must be at least a 10% increase for a change to occur). As of 2001, there have been no adjustments. Gifts covered by the annual exclusion do not reduce the donor's unified tax credit.

Maximizing Donee Exclusions

Most clients use the annual exclusion to make gifts to children and grandchildren. However, few clients have equal-sized family groups. Clients are often concerned that providing $10,000 in annual exclusion gifts to their children with larger families will result in a disproportionate benefit.

Example 4: Y, who is married and in the 55% estate tax bracket, has three married adult children, S, D and T. S and his spouse have two children; D's and T's families each have six children. Y is concerned that S's family will be negatively affected by annual gifts, because D's and T's families are larger. Y would like to maximize annual exclusion gifts, but also wants the three family groups to benefit comparably; Y thus asks about limiting the annual exclusion to $40,000 per family group (i.e., the maximum annual exclusion of the smallest family).

Variation 1--The family exclusion can be maximized at $200,000 ($10,000 to each of 20 family members) instead of $120,000 ($40,000 to each family). If Y and spouse agree to gift split,(3) the total annual exclusion doubles to $400,000. Y can use the unified credit, either during life or via his will, to make additional gifts to S's family. Although lifetime use reduces the available unified credit at death, large annual exclusion gifts increase the overall tax-free dispositions to heirs and can more quickly move an appreciating asset out of a taxable estate.

Variation 2--Y can create a lifetime trust with all descendants as beneficiaries. At least $200,000 should be contributed, using annual exclusions and Crummey(4) withdrawal rights, The trust is divided into three equal trust shares (one for each family), although the Crummey powers among the family groups will differ. A discretionary "spray power" would allow the co-trustees to make income or principal distributions to family members as needed. A special power of appointment would allow the children (S, D, T) to reconfigure the trust for grandchildren at any time before their deaths.(5) At the death of each child, the trust share can be distributed to grandchildren or held in trust for their benefit. The growth in the contributed assets will not be subject to estate taxes at either the parent's or a child's death. Capital gain investments will avoid or reduce income taxes to the trust and/or beneficiaries.

Variation 3--What if D has no children? To the extent annual exclusion gifts (at a potentially discounted value) are made directly to D and spouse, the assets may eventually pass to unrelated parties (e.g., D's surviving...