Bracket Shifting Gifts and “Death-Bed Planning” in 2010

August 4, 2010

Death and taxes may both be certain, but in 2010 the rules governing death taxes are anything but certain.  The thought that Congress will permanently repeal the estate tax seems less likely as deficits mount, but whether it will revise the tax rates and unified credit amount remains unclear.  Clients and their advisors must plan for this very significant tax based on their best guess about what the future will hold.  Many clients are opting to wait until Congress acts.

However, one unique opportunity for all donors – bracket shifting gifts – expires at the end of this year.   Moreover, “death bed planning” by its very nature requires making decisions before it is too late.  The phrase “death-bed planning” refers to estate planning for individuals who face a high probability of death within 18 months.  A number of offsetting considerations make planning for these individuals particularly challenging.  With the caveat that Congress can step in and change all of the rules at any time, here are some thoughts about bracket shifting gifts and death-bed planning in 2010.

Bracket Shifting Gifts.

For 2010 the top gift tax rate is 35%.  Most commentators speculate that Congress will keep the estate tax top rate at a level higher than 35%.  It is scheduled to be 55% beginning in 2011.  Absent some Congressional intervention, this creates a unique opportunity for gifts made this year. 

The estate tax is computed based on both lifetime gifts and assets owned at date of death. While lifetime gifts are included in the tax computation, the lifetime gift tax is credited as an offset.  However, this offset is calculated using the date of death estate tax table, not the gift tax tables in effect at the time of the gifts.  When the estate tax and the gift tax are calculated on the same tax rate schedule, this offset is a wash.  As a result and ignoring the time value of money, post-gift appreciation, annual exclusions and other adjustments, the total estate and gift tax imposed is the same whether or not the gift is made.  But in 2010, the gift tax table is not the same as the estate tax table.

Suppose a death-bed donor makes a gift of $2 million in 2010, and Congress revises the top estate tax rate to be 45%.  Assuming no prior use of the unified credit, the donor will owe a gift tax of $350,000.  When the donor dies, however, his or her estate will receive a credit of $435,000 against the federal estate tax.  Without considering any of the other potential benefits such as the annual exclusion, the gift will reduce the combined wealth transfer tax by $85,000.  If Congress imposes a higher top estate tax rate, the savings will be even greater.

One of the adjustments not considered above is the fact that gift taxes paid within three years of death are added back into the federal gross estate.  This inclusion is based on the actual amount paid.  If, in the previous example, the donor lives for three years, the federal gross estate will not include the $350,000 in gift taxes paid, and the tax savings increase to $242,500.

Please note the following:

  • The technique only works if the gift generates gift tax.  Presently, only cumulative taxable gifts in excess of $1 million generate gift tax.  Generally speaking, taxable gifts are those which do not qualify for the annual exclusion or the exclusion for gifts made for healthcare or education directly to the healthcare provider or school.
  • While net gift arrangements can be effective tools, 2010 may not be the best year to consider these, since Congress could retroactively increase the gift tax rate.  This would probably produce unexpected consequences for a net gift structure.  A net gift is a gift which shifts the burden of the gift tax from the donor to the donee and, where applicable, can be a powerful tool for shifting wealth to children and grandchildren.

    Assets with Unrealized Losses.

With the prospect of a nearly 24% capital gains tax rate in 2013, the trade-off between income tax and estate tax considerations become even more difficult to balance.  After 2008, many clients hold assets with a fair market value significantly less than basis.  If such an asset is held at death, the heirs will receive that asset with “stepped-down” basis equal to its date of death value.  If the asset is given to an heir before death, however, the heir will have a split basis in the asset.  For purposes of determining loss, the heir must use the fair market value of the asset on the date of the gift as the basis.  For purposes of determining gain, the heir may use the donor’s basis.  In practice, this means that appreciation after the gift – up to the donor’s basis – will not be taxed.

In a death bed planning situation, the first assets to consider giving are assets with unrealized losses.  The donor may not be able to fully use the capital losses.  It is typically not advantageous to recognize offsetting capital gains, since these gains will all be eliminated as part of the date of death step-up in basis.  Unused capital losses at date of death expire; they are not carried over to the decedent’s estate.

The “step-down” problem is an income tax issue, so giving away loss assets is desirable even in cases where no federal estate tax is likely to be due.  The value of avoiding the step-down is especially important with business interests treated as partnerships for federal income tax purposes.  This category can include limited liability companies as well as general partnerships, limited partnerships and limited liability partnerships.  Not infrequently, these entities have made a § 754 election.  If a § 754 election has been made, a step-down can produce disadvantageous results even if the heir does not sell the interest.

Three Year Inclusion Gifts.

Planners always face a difficult decision when a donor considers making a gift of appreciated property.  If the donor dies shortly after the gift, the estate tax savings will be minimal.  The loss of the step-up in basis, however, can be a substantial cost, particularly with the higher capital gains rate noted above.  The savings achieved by the gift is the estate tax on the appreciation between the date of the gift and the date of death, and the savings achieved by the step-up in basis is typically the capital gain on appreciation between the date the donor acquired the asset and the date of sale.  In many cases, therefore, an analysis of which strategy produces the better result involves comparing the higher-rate estate tax on less appreciation with the lower-rate capital gains tax on more appreciation. 

One technique for dealing with this problem which hedges the risk of an “early” death was to make the gift to a low payment, three year GRAT which had a provision requiring the gift to be returned to the estate if the donor died during the term.  If death occurs within three years, the reversion feature entitles the assets to a step-up in basis.  While every case is different, generally one would not predict the assets to appreciate enough over three years to make the estate tax cost of the reversion exceed the income tax benefit of the step-up.  Of course, the 2010 bracket shift mentioned above makes this equation a closer question for large gifts than in most years.

If it seems desirable to avoid the loss of a step-up in basis, pending legislative proposals make the use of a three year GRAT uncertain.  Instead, the best design for a three year inclusion gift is probably a trust which pays income to the heirs for three years, provides for a reversion during the period, and then terminates.  New section 2511(c) of the Code, in effect for only 2010, confirms that the transfer into such a trust will be treated as a completed gift.  It is probably not desirable to accumulate the income, given the high income tax rate for trusts.  On the other hand, if the donor retains the income for three years, the income tax problem is avoided, but the income distribution right will be valued at zero under § 2702.  The income paid to the donor generates unnecessary estate tax.  Of course, if the donor lives longer than 3 years, the objective will be to have the gift excluded from the federal gross estate, since one anticipates that over the long run, avoiding the tax on the appreciation is more valuable than the savings from the step-up in basis.  Once the reversion feature lapses, the gift remains outside the federal gross estate.