The current state of affairs, where less than 0.1% of Americans pay any taxes to the federal government on their estates, is unlikely to last forever. However, you may be able to benefit your heirs using today's laws even if you expect to live past the age of 100.
The relevant strategy involves shrinking the size of your estate by giving money or other assets of value to your heirs while you are alive and the laws are favorable. Instead of leaving behind an oversized estate that the government is likelier to tax, you leave behind a smaller estate that is less likely to be taxed.
At this time, nobody can yet promise that this strategy works. In theory, the government could attempt to “claw back” some or all of the money you try to save. But many attorneys who have examined the legislative history of the 2017 tax reform law have determined the chances of the government imposing taxes retroactively is low.
Besides legal and financial advantages, in my experience giving gifts to loved ones can have many practical benefits. For example, you get to see the joy on a grateful loved one's face with your own eyes. There are also potential drawbacks, however, such as losing control over your assets too early.
1. Practical Considerations Before Making a Big Gift
Putting aside the issue of whether taxes can be avoided, each client should consider his or her personal needs before making this irreversible decision. Once you make a gift, you cannot change your mind. If you worry about not having enough money to live a comfortable life, you may want to keep your assets for your own use.
If you think the recipients of your generosity may someday make poor choices, then you should probably think twice before making an outright gift. You may want to create a trust with conditions for beneficiaries that encourage good choices. Gifts to irrevocable trusts can often have the same tax advantages as gifts to living persons.
It is also worth noting that, in some cases, avoiding the estate tax by giving gifts will result in a higher capital gains tax, provided the gifts are sold during the recipient’s lifetime. The cost basis for gifts is that of the donor; he or she may have obtained the assets at a value significantly below their present value. The basis for assets transferred through a will, on the other hand, is the fair market value at the time of transfer, which means an asset’s increase in value prior to the time of transfer is not taxable as capital gains.
While in most cases the benefits of avoiding paying the estate tax outweigh losing the step-up in basis for the capital gains tax, this is not the case for everyone, particularly where low-basis assets increase in value dramatically (e.g. Washington, D.C. real estate purchased decades ago may have increased in value manifold).
Unless you are a financial expert, it is worth discussing your specific situation with a qualified financial advisor. For example, an advisor well-versed in wealth management may be able to help you evaluate whether, based on your investment plans, tax savings realized in the present have more value than tax savings realized in the distant future.
2. The Possibility of Tax Clawback for Big Gifts
Put simply, if you make a sizeable gift to your loved ones before 2026 and pass away during or after that year, there is no law on the books. This fact introduces an element of uncertainty when making long-term plans for how and when to distribute your assets.
Some lawyers worry the government may try to retroactively impose taxes on gifts of a size not currently taxable. Last year’s tax reform legislation explicitly sought to avoid this outcome by instructing the Treasury Department to issue regulations that preclude clawback. But some lawyers believe the Treasury Department lacks sufficient authority to safeguard the taxpaying public against future confiscatory tax policies.
Several influential politicians have called for a 70% federal tax on inherited wealth above the lifetime exemption. So, suppose that someone who has exhausted the lifetime exemption chooses to leave you a gift of $10,000. If some politicians have their way, the government could demand as much as $7,000. One would hope lawmakers refrain from this course of action even if they perhaps have legal authority to pursue it.
3. How has Tax Clawback Been Handled Before?
About five years ago, the issue of clawback taxation for estates briefly made headlines. It was unclear then, as it is now, whether a gift made in the past can give rise to new taxes based on new laws enacted after the gift was made (just because the donor happens to be alive).
A Senate bill was introduced to forbid clawback taxation, due in part to the sentiment that the government should not reach back in time to tax people for past actions; but many commentators on both sides of the political aisle felt the legislation was insufficiently detailed to address complex legal issues.
Rather than attempt to create detailed legislation, Congress deferred to the IRS. Congress has asked the IRS to create regulations that carry out the purposes of the tax code as written, but there is no widespread agreement about what those purposes are. My own reading of the legislative record and of the law itself suggests that there should be no taxes on lifetime gifts in excess of the taxes that existed at the time when those gifts were made.
But other lawyers would argue that the legislative record, which is naturally quite muddled given the convergence of viewpoints necessary for any substantial tax deal, creates room for alternate interpretations. We cannot be sure until the IRS makes an official determination.
Taking action sooner rather than later may be advisable, since lawmakers have the power to lower the federal exemption threshold anytime they want.
It is possible that the IRS may attempt to retroactively tax gifts using some kind of clawback rule. However, many attorneys, myself included, believe such action would most likely fall outside the IRS’s authority granted to it by Congress. So, while you should plan for the possibility of a retroactive tax (e.g., have money on-hand if the IRS asks for it), chances are your beneficiaries will derive substantial benefits from avoiding the tax.
Even if the IRS does apply taxes on gifts retroactively, appreciation of the gifts since the time they were received would not be taxable. Moreover, because Washington D.C. and Maryland have no local or state gift tax, residents can probably avoid estate or inheritance taxes at the local or state level by gift-giving.
Therefore, if you want to make life better for those you love and you are in possession of assets which you can live happily without, now is perhaps an opportune time to make the big gift of a lifetime or the first in a series of planned gifts.