Gift splitting is the opportunity for those with high net worth to pass their wealth to their children or other beneficiaries using the exemptions of a spouse who may not have as high a net worth as the donor spouse. Some background may be necessary. I may oversimplify in order to make the issues a little easier to understand.
We now have in place an estate tax with a present exemption or lifetime exclusion amount of $2 million as of 2008. In 2009, it is scheduled to increase to $3.5 million. In 2010, it disappears, so that is the best year for a wealthy person to die for estate tax purposes. If they live to 2011, the lifetime exclusion returns to the former $1 million.
Of course, we expect there to be a change in this structure after the next election. We assume the Republicans would like to completely eliminate the gift and estate tax. We assume the Democrats would like to have the tax cover a greater number of wealthy persons to redistribute the country's wealth and raise funds for social programs. As attorneys, we try to minimize any tax through legal strategies given to us by Congress.
In order to prevent wealthy persons from giving away their wealth to their children prior to their death, even sometimes when on their deathbed, there is a gift tax. Whereas the lifetime exclusion used to be the same as the lifetime exclusion for the estate tax, when the government began to raise the limits on the estate tax, they capped the gift tax exclusion at $1 million. It is also important to understand that any gift tax exclusion used during a lifetime is subtracted from the estate tax exclusion. For example, if a person gave a gift of $700,000 to his children before he died, the estate tax exclusion this year would be reduced by that amount to $1.3 million.
If a person can afford it, there are good reasons for gifting the maximum $1 million to his or her children as early as possible. If they give away $1 million this year and die several years later when the $1 million as invested had grown to $2 million, only the original $1 million gift would be deducted from their lifetime exclusion and the $1 million in appreciation would escape taxation at death.
Better yet, if they gift the amount to a life insurance trust which purchases a $10 million second-to-die policy on the couple, they may pay perhaps $100,000 a year for the next 11 years until both are deceased. First, their estate will be reduced by the $1.1 million paid in insurance premiums. Second, the entire $10 million will not be subject to estate tax, assuming the trust is properly drafted and administered.
Some of the $100,000 yearly gifts could be subject to gift tax and reduce their lifetime exclusions. The goal is to use their annual exclusions which this year is set at $12,000 per person. If they have two children and three grandchildren, one donor can make the five $12,000 gifts which would meet the requirements of the annual $12,000 exclusion for $60,000, so only $40,000 would be subject to gift tax. Because there is the $1 million exclusion this year, and assuming it continues, $440,000 would be the amount of their lifetime gifts over the 11 years, which would reduce their lifetime exclusion to $1.54 million and cause around $200,000 of additional estate tax.
One way to avoid this $200,000 in estate tax would be to make a gift splitting election on their gift tax return. This would allow the other spouse who did not make the gift to be deemed the maker of half the gift. This would utilize her $12,000 per person annual exclusion, enabling the couple to give up to $120,000 to the five beneficiaries, without using their lifetime exclusions. They would still have some additional gifting potential of $20,000 after making the $100,000 gift to the insurance trust out of which the trustee would make the premium payments when the crummy notice rights expired.
The decision to make the gift splitting election should be carefully considered, especially in second marriages or in unstable marriages. If the election is made, it imposes joint and several liability for any gift tax and penalties that may be due. The innocent spouse doctrine contained in the income tax area will not be available in the gift tax area. If the gifts exceed the annual exclusions, it will reduce the lifetime exclusions of both spouses equally.
To use the gift splitting opportunity, there are several requirements, which must be met. At the time of the gift, both spouses must be U.S. citizens or resident aliens, that is, they must be subject to gift tax. They both must be living at the time of the gift. They must be married at the time of the gift, and if they subsequently divorce, neither remarries prior to the end of the calendar year. Both spouses must consent to the gift splitting on the 709 gift tax return, generally on each spouses return.
Gift splitting also requires that the donor spouse does not create a general power of appointment over the gifted property in the consenting spouse, which may be done by the language of any trust to which the property is gifted. If gift splitting is elected it applies to all gifts made by the spouses during the calendar year.
Suppose one spouse had used his $1 million lifetime gift exclusion in prior years to his children, while his wife has used none of her lifetime exclusion. At the beginning of the year they give $24,000 to each of their five children and 10 grandchildren, using $360,000 of their annual exclusion. They elect to gift split. Later that year the wife gifts $1 million to a lifetime dynasty trust for her two children and grandchildren intending to use her $1 million unused gift exclusion.
Unfortunately, all gifts must be split if the election is made so the gift would be deemed made one half by each spouse. The gift would use only half of her lifetime gifting exclusion, but the gift would cause over $200,000 in gift taxes to be due from the husband because he had already used his lifetime gift exclusion by his prior gifts to his children before his marriage to his present wife. Both spouses would be responsible for the taxes.
However, a gift is not available for gift splitting if the consenting spouse has an interest, such as an income interest, which is unascertainable at the time of the gift and thus not able to be subtracted in calculating the value of the gift. The drafter of the trust must determine whether the gift qualifies for gift splitting because of the lack of inclusion of this provision and thus causes $200,000 in additional gift taxes now due, or whether it contains an interest for the consenting spouse and thus is not eligible for gift splitting, although all the other gifts of $360,000 would qualify for gift splitting and allow the couple to double up on the $12,000 allowed for each donee. The $1 million gift to her dynasty trust would thus use her lifetime gift exclusion, without gift splitting.
Electing to split gifts requires coordination between the spouses and their advisors. It has both tremendous potential to save taxes when passing wealth to the next generation or a trap for the unwary if all the information is not provided to the advisors. Although I realize that most readers are not wealthy enough to be concerned and thus do not write about such complicated subjects often, some of our readers do indeed qualify for such gift splitting treatment and should understand the basics so they can discuss their options with their attorneys and tax preparers.
—William Edy is a certified financial planner and tax attorney and a certified elder law attorney in Lee County. He may be contacted online for article ideas and questions. Since e-mail is not secure, do not send personal confidential information in your e-mail. This article should not be a substitute for advice from your own attorney.
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