October 10, 2023
Quick-Take: Annual Exclusion Gifts
Take-Away: Expect the federal gift tax annual exclusion amount to increase to $18,000 per donee starting in 2024. However, the U.S. Treasury is considering a proposal that would curtail the exploitation of annual exclusion gifts.
Background: Under the Tax Code an individual may exclude from taxable gifts the first $17,000 in transfers of a present interest in property per donee each calendar year. The current estimate is that with raging inflation, the annual exclusion amount will increase to $18,000 per donee starting in 2024. The federal gift tax annual exclusion was created in 1932, and the Legislative intent behind this exclusion was “to obviate the necessity of keeping an account of and reporting numerous small gifts and…to fix the amount sufficiently large to cover in most cases, wedding and Christmas gifts and occasional gifts of relatively small amounts.” You be the judge of whether $18,000 is a ‘small amount.’ Over time, the federal gift tax annual exclusion has become a powerful estate planning tool to transfer substantial amounts of wealth transfer tax-free. Currently there is no limit on the number of donees who may receive an annual exclusion gift from a single donor.
Example: Grandparents with 10 grandchildren can each transfer $170,000 a year in annual exclusion gifts, gift tax-free, $17,000 to each grandchild per grandparent. As a couple, the grandparents can reduce the size of their taxable estate by a combined $340,000, just in one year, through annual exclusion gifts.
ILITs: Often relying upon the annual exclusion gift opportunity, a donor can transfer wealth to an irrevocable life insurance trust (ILIT) which amount(s) are then used to pay the premiums on life insurance policies usually on the donor’s life. A Crummey Withdrawal Right is conferred on the ILIT beneficiaries, giving each of them the right to withdraw the gift into the ILIT that was made on their behalf (a withdrawal right which is seldom exercised by the ILIT beneficiary] to circumvent the required present interest requirement for an annual exclusion gift.
Close-Held Entities: Similarly, the federal gift tax annual exclusion opportunity (coupled with a Crummey Withdrawal Right to circumvent the present interest requirement) is used to transfer partial interests in closely-held entities in which the donee has minimal rights to the enjoyment of the entity-owned property, while effectively giving the donor a high level of retained control.
Proposed Annual Exclusion Gift Changes: The 2024 Treasury Department Greenbook identifies a proposal to limit the use of annual exclusion gifts by a donor. Under this proposal the requirement that a donee receive a present interest to qualify for the federal gift tax annual exclusion opportunity is eliminated. However, in its place would be a new category of transfers that would be created for any transfer to a trust [excluding, however, IRC 2646)c)(2) trusts] and transfers of an interest in a pass-through entity, e.g., an LLC, and “other transfers of property that, without regard to withdrawal, put, or other such rights in the donee, cannot immediately be liquidated by the donee.” Consequently, under this new category of annual exclusion gifts, there would be a $50,000 limit on transfers that could qualify for the donor’s federal gift tax annual exclusion opportunity. In effect, the annual exclusion per donee limit would continue to apply, but the IRS would no longer need to scrutinize whether the donee’s rights in a trust or other entity are sufficient to constitute a present interest in the property, and the amount that can be transferred to, or consisting of, such planning vehicles would arguably be curbed. If adopted, this rule change could seriously frustrate how ILITs are currently funded to maintain their life insurance policies.
Example: Carl creates an ILIT. Carl names his 10 grandchildren as the ILIT beneficiaries. Each of Carl’s grandchildren is given a Crummey Withdrawal Right, to withdraw up to the annual exclusion amount for any transfers made to the ILIT on their behalf. In 2023 the annual exclusion amount is $17,000 per donee. Carl transfers $170,000 cash to the ILIT (in order for the ILIT trustee to pay the 2023 life insurance premium). All of Carl’s $170,000 gift to the ILIT(subject to the beneficiaries’ withdrawal rights) is excluded from the taxable gifts that Carl makes in 2023. [IRC 2503(b).] Suppose, however, that the Greenbook proposal is adopted at the end of 2023. It is now 2024. Carl again transfers $170,000 to the ILIT in order for the ILIT trustee to pay the life insurance premium for 2024. However, now only $50,000 of the $170,000 amount transferred by Cal would be excluded from Carl’s 2024 taxable gifts. Carl will be treated as having made a taxable gift of $120,000 to the ILIT, for which a gift tax will be paid, or Carl’s applicable exemption amount will be used to shelter the gift from taxation. Carl can continue to make direct gifts to his grandchildren in 2024, but following this example, the federal gift tax annual exclusion available to Carl will be limited to $12,000 per donee-grandchild.
Conclusion: Annual exclusion gifts are a powerful tool used to shift wealth gift tax-free and also used to reduce the donor’s estate’s exposure to federal estate and generation skipping transfer taxes. The annual exclusion gift opportunity is so powerful that many in Congress, and clearly in the U.S. Treasury, taking a close look at a tool that can be exploited to avoid most federal transfer taxes.