Use It or (Possibly) Lose It

Currently, the federal gift tax exclusion amount is $5,000,000. If Congress does nothing, which we know from recent years is a real possibility, the law sunsets on December 31, 2012 and the exclusion amount will drop to $1,000,000. If Congress does act, it is possible (maybe even likely) that the exclusion amount will be lower than $5,000,000. This means that the wealthy may have less than two years to gift significant wealth tax-free.

The Qualified Domestic Trust

As stated in our previous post, the unlimited marital deduction is disallowed for distributions to non-citizen spouses. There is an exception to this disallowance however. A Qualified Domestic Trust (QDOT) can be created whereby property can pass to the non-citizen surviving spouse and qualify for the marital deduction. The QDOT can be created post-death provided that the property is transferred to the trust or is irrevocably assigned prior to the estate tax return due date.

The Unlimited Marital Deduction

There is no estate tax liability for assets passing from a deceased spouse to the surviving spouse. Both Ohio and federal provide for an unlimited marital deduction for the transfer of property between spouses. This is based upon the view that the husband and wife are one economic unit.

The marital deduction applies to transfers during lifetime and at death. The deduction is only for U.S. citizens regarding property passing from one spouse to the other (the citizenship requirement is to ensure that the government can ultimately collect the estate tax from the surviving spouse's estate). This is one reason that estate planning attorneys want to confirm that husband and wife are both U.S. citizens (especially with Ohio's close proximity to Canada).

Technically, the marital deduction simply defers the estate tax and does not avoid it. While an outright bequest of decedent’s entire estate to a spouse will eliminate estate tax at the decedent’s death, the surviving spouse’s estate will be taxed on all of the assets transferred from decedent (that is unless the surviving spouse consumes or gifts away the assets). As a consequence, the marital deduction simply defers the tax to the second estate.

Stepped-Up Basis to be Replaced by Carry-Over Basis

When you purchase an asset, the purchase price becomes your tax basis for that property. If you later sell that asset, your tax basis is used to determine your capital gain or loss for tax purposes.

If you receive property by gift, you take the donor’s basis. For example, Mr. Smith purchases ABC stock for $10 a share. Mr. Smith’s basis is $10 a share and if he sells the stock, his gain or loss would be based upon his $10 tax basis. Mr. Smith, instead of selling his ABC stock, gives his son the stock. His son’s basis is also $10 per share. This is sometimes called a “carry-over” basis, because Mr. Smith’s tax basis carries over to his son.

One benefit of inheriting property from a decedent is receiving a “stepped-up” basis. Pursuant to Internal Revenue Code (IRC) §1014, the basis of property inherited from a decedent is generally the fair market value of the property at the decedent's death, as opposed to the decedent’s cost to acquire the property. For example, Mr. Smith leaves his ABC stock to his son in his will. At the time Mr. Smith passes away, the value of the stock is $25 per share. Although Mr. Smith’s basis was $10, his son’s basis is stepped up to $25.

The benefit of the “stepped-up” basis will not be with us much longer, barring a legislative change. This is because the “stepped-up” basis under IRC §1022 will not apply to decedents’ estates with a date of death after December 31, 2009. Instead, IRC §1022 provides that the property acquired from a decedent shall be treated as transferred by gift. Therefore, when an heir sells the asset, he will be responsible for paying capital gains tax on all the gains that had accrued since the decedent originally acquired the asset.

A Charitable Alternative to Cashing in Your Life Insurance

In our prior post, we addressed the possibility of a life settlement as an alternative to taking the cash surrender value of an unneeded life insurance policy.  Another alternative is gifting the policy to a charity and taking an income tax charitable deduction.  The charity becomes the beneficiary of the policy and the ownership is transferred to the charity as well.

If you do not need an income tax charitable deduction and you do not want to part with the ownership of the policy, you can simply designate the charity as the beneficiary of the policy.  Your estate will receive an estate tax charitable deduction for the death benefit passing to the charity.

When a Restricted Gift is Not a Restricted Gift

As universities feel the pinch of the recession, many of them are looking for sources of money to cover operational expenses.  One important source is endowments.  Universities love unrestricted gifts, because the money is theirs to use as needed to pay faculty salaries, financial aid, and other expenses.  The reality is that most significant endowments are for a restricted purpose.  For example, maybe the donor hopes that the money will be used to bring prominent speakers to the university.  It might be that the donor enjoyed his experience at the college’s radio station and wanted to see it continue.  Perhaps the donor gave expensive works of art for the university to display for future generations.  By the way, these are real-life examples.  See New Unrest on Campus as Donors Rebel, Wall Street Journal.

The donor’s intent is almost always expressed in writing, so what if the university needs it for another purpose?  Should a university be able to use a restricted gift for an unrestricted purpose, or worse, should a university be able to sell the works of art or the radio station?  If the university is in dire financial straits, it may have no choice; however, it should try to honor its benefactor’s intent.  Donor unrest is never a good thing.  You know the saying, “you should not bite the hand that feeds you”.

Timing is Everything

When markets are down, opportunities abound. People interested in reducing the size of their estates can often maximize their gifting during downturns in the market, both real estate and stock. With respect to real estate, one can gift their residence to their children, retaining the right to live in it, by use of a qualified personal residence trust (QPRT). An article by Mike Spector in The Wall Street Journal indicates that, due to the falling value of many homes, this is the ideal time to make such a gift. Another gifting strategy is available for people who have charitable inclinations. A Charitable Lead Trust (CLT) provides that a charity gets the income from the trust for a set term and then the grantor's heirs receive the remainder. A CLT funded with stock that is likely to rebound and appreciate over the long haul is ideal. If you want to skip giving anything to charity, outright gifts of such stock up to the annual exclusion amount of $12,000 is another possibility. You say you don’t like to gift? Consider selling depreciated stock at a loss to offset any capital gains or to a lesser extent ordinary income. If you fail to see the silver lining in these various strategies, you can do what many people are currently doing…wait for the market to rebound.