Wealth Planning News
Vol. II, No. 2
What Are Transfer Taxes?
Transfer taxes are imposed on wealth transferred from one generation to another via gift or inheritance.
People who do little or only partial planning allow their descendants to pay most or all of the transfer taxes. People who take advantage of planning techniques allow their descendants to drastically reduce or entirely avoid the transfer taxes.
The choice to plan makes the transfer tax a voluntary tax in most cases.
Transfer taxes were designed for two basic purposes: First, to collect some revenue for the federal government; Second, to force the periodic redistribution of wealth away from those who have earned it to those who would like it, are not going to inherit it, and who believe our government will better distribute it through society than your descendants. Congress sees the redistribution of your wealth to society in general as a service performed by your government. And of course a politician running for office can buy votes of many by promising to take money from someone else to give to the voter.
Estate and Gift Taxes
Transfer taxes began with the estate tax. If you died owning property the government took some of it before the remainder passed to your heirs.
One way to avoid the estate tax was to give your wealth to your kids while you were still alive. But the IRS viewed making gifts to your children before death as an "estate tax avoidance" device. So the gift tax was enacted with rates set at 75 percent of the estate tax rates. Certain gifts made in contemplation of death, and later all gifts made within three years of death, were included in your gross estate when you died.
Lifetime giving became even less attractive when the gift tax and estate tax rates were "unified" at the same high rates. But lifetime giving still has two big advantages over retaining property until death: First, there is an estate tax on the estate tax but no gift tax on the gift tax. This idea sounds complicated, but it is really simple to understand:
Second, post-gift appreciation of the gifted property will not be taxed in your estate. So if you give away property worth $1,000 during life, and before you die the value of the property grows to $2,000, you save taxes on the extra $1,000 of growth. The cost of this tax savings is loss of the use of the $1,000 given and loss of use of the growth in value of the $1,000 asset.
Annual Gift Tax Exclusions
Despite the best taxing efforts of the IRS, your elected people in Congress still allowed people to avoid both gift and estate tax if they gave away their property in small annual chunks to different donees like each of their kids. At first the annual gift tax exclusion was only $3,000 per year for each gift beneficiary, and then went $10,000 per year. This amount is now indexed for inflation, but can only grow in increments of $1,000. In 2015 the exclusion is $14,000.
Another way of avoiding the estate tax was to put property in a trust for the benefit of successive generations. The idea was that if your children didn't actually "own" the property when they died, it could not be taxed in their estates. So people with substantial wealth decided to create trusts that would continue for the lives of their children and then when the children died the trusts would distribute the property to grandchildren. Result: The estate tax skipped a generation.
Because the IRS wanted to collect some tax from each generation, it persuaded congress to create the complex generation skipping transfer tax. To summarize this tax very generally, if you transfer property to someone in your children's generation or lower, a GST tax will be imposed if the property would not be subject to the estate or gift tax in that lower generation.
The generation skipping tax is a serious tax. It is always imposed at the highest transfer tax rate. However, each person has an exemption against the GST tax, so ways have arisen to leverage and increase the effectiveness of the GST exemption.
In This Issue
What Are Transfer Taxes
Estate And Gift Taxes
The Marital Deduction
There were tax provisions to let part of your estate pass tax free to your surviving spouse when you died. The amount was formerly limited, but under current law you can leave all you own to a surviving spouse completely free of estate taxes. So if your estate is $2 billion when you die, there will be no tax if you leave it all to your surviving spouse. But when your spouse dies, the entire amount plus any amount of growth in value will be fully taxed.
For Example, assume that the estate or gift transfer tax rate is 40 percent and you want to either give or bequeath $1,000 to someone. If you make a lifetime gift, it will cost you $1,400 (a $1,000 gift and $400 in gift tax). If you make a transfer at death it will cost your descendants $1,666. Applying a 40 percent estate tax rate to $1,666 produces a tax of $666 and leaves $1,000 for your descendants. Change the net amount to $1 million and the savings is $266,666!