photo by Ken Mayer
There is a classic piece of estate planning advice for wealthy people that I don’t plan to pull out of my tax-practitioner toolbox for the rest of this year, and maybe not ever again.
That advice is to consider paying gift taxes now in order to reduce estate taxes later. If you have never heard this suggestion before, it may sound silly: Why pay tax sooner rather than later? But it makes sense if you understand how our gift and estate tax system works.
Although they sound different, these two taxes really are pretty much the same thing: a levy imposed on transfers of wealth to younger generations. Transfers between spouses are generally exempt, as long as the recipient spouse is a U.S. citizen or resident. Everybody gets a lifetime exemption amount, called the “unified credit,” which is $5.45 million in 2016. With a scheduled inflation adjustment it will rise to $5.49 million (an increase of $40,000) next year. Wealth transferred to noncharitable heirs, except spouses, is subject to a 40 percent tax above that threshold.
Let’s try to keep things simple. We’ll ignore next year’s scheduled increase in the exemption, and any future increases too. We’ll ignore the annual exclusion amount (currently $14,000), which a donor can give to any and all beneficiaries each and every year without using any of that $5.45 million exemption. We’ll ignore what happens when a spouse is involved in an estate. We’ll ignore tax-free charitable bequests and tax-deductible estate expenses. And we’ll ignore state death taxes too, because only a handful of states still have them.
First let’s suppose we are talking about an unmarried individual whose total estate is $10.45 million, an even $5 million above the exemption amount. If this person dies, the estate tax will be $2 million, because the total estate exceeds the exemption by $5 million and the tax rate is 40 percent. So the heirs will collect a net $8.45 million.
Now, instead, let’s suppose our wealthy benefactor makes a gift of $7.95 million in 2016. The first $5.45 million is tax free. The next $2.5 million triggers a tax of $1 million, which our donor also pays. His remaining estate is $1.5 million after he pays the tax. After surviving three more years (because the law requires this for the strategy to work), our donor dies still in possession of that $1.5 million, which is also taxed at 40 percent. The tax is $600,000. The lucky heirs receive, after tax, an additional $900,000, which when added to the earlier gift makes a total transfer of $8.85 million. Had the donor died without ever making any gifts, the heirs would have received only $8.45 million. We have avoided $400,000 of tax just by adjusting the timing of the wealth transfer between generations.
That’s why this is a classic estate planning strategy. So why stop using it?
Simple: because the strategy only makes sense if you assume that there will be an estate tax in the future. The election of Donald Trump to the presidency, coupled with Republicans’ continued control of both houses of Congress, make this a dubious assumption, at best.
Although nothing is certain, my guess is that the estate tax, and probably the gift tax, will be either repealed or limited to just a token few ultra-high-net-worth families (one of them likely being Donald Trump’s) by legislation that will get through the next Congress. The most probable effective date would be in 2018 or 2019. Since gift taxes paid within three years of death are added back to a decedent’s estate for tax purposes, there would be no benefit to paying gift taxes in the remainder of 2016.
During the recent campaign, Trump called for repealing the estate and gift tax. So did House Speaker Paul Ryan. They differ on some details, primarily due to Trump’s proposal that the forgiveness of capital gains taxes at death be limited to estates less than $10 million. Ryan’s plan would retain the basis step-up that effectively eliminates capital gains tax on inherited assets. Some version of the Trump proposal is more likely to pass, as was the case when the estate tax was temporarily repealed in 2010 for a single year.
Just about the only thing standing in the way of repeal are the 48 or 49 Democrats who will make up a large minority in the Senate. In the past this would have been enough, under Senate rules, to block such legislation from passing, or at least to give the opposition enough leverage to force a significant compromise.
But retiring Senate Democratic leader Harry Reid pretty much nuked his own party’s position when he invoked the “nuclear option” to push some of President Obama’s judicial and administrative appointments through the chamber over Republican opposition in 2013 and 2014, when Democrats still had a majority. Reid limited his rules change to avoid affecting Supreme Court nominees, of which none were pending at the time, and to exclude legislation, which Senate Democrats could not pass without help from the Republican-held House anyway.
Just a few weeks before this month’s election, when Democrats were still confident of Hillary Clinton’s victory, Reid and other Democrats (including her running mate Tim Kaine) talked about expanding the nuclear option so Clinton’s Supreme Court nominees could clear the chamber as well. Now the shoe is on the other legislative foot. Senate Republicans will almost surely nuke any Democratic filibuster of a Trump Supreme Court nominee, assuming the nominee is someone Trump’s own party is prepared to back. And they will nuke Democratic filibusters of what the GOP deems key legislation, no doubt involving Obamacare as well as taxes, unless Democrats pretty much surrender their filibuster weapon unilaterally.
So I think estate and gift tax repeal is likely to get through the next Congress and be signed by President Trump. If that happens, there is no upside to paying gift taxes now. My advice, therefore, is: don’t.