Take-Away: A few weeks back I wrote a piece that rhetorically asked why wealthy clients were not actively using their enhanced $11.4 million federal gift tax exemption, in light of the 2025 sunset along with the media attention given to Bernie Sanders’ campaign bandwagon proposal to dramatically shrink the gift tax exemption to $1.0 million. A recently published article provides an empirical, or quantifiable, justification to act now to make large lifetime gifts using the donor’s enlarged gift tax exemption, along with the penalty-cost associated waiting just a single year before making a large lifetime gift.

Article: Singer and Stone, “A Taxing Dilemma”, Trusts & Estates, July 2019.

Article’s Premise: Using a quantitative analysis, the estimated value to the donor’s beneficiaries (the carrot) or the estimated cost of waiting to make a gift for one year (the stick), can motivate a high net worth individual to make a large taxable gift prior to the sunset of the current increased gift tax exemption from federal gifts (and estate) taxes. This financial incentive is often necessary to overcome human nature to wait until the last minute prior to acting before a deadline (or sunset.).

Assumptions: In order to quantify the tax savings with a lifetime gift, or the lost opportunity associated with waiting a year in before making lifetime gift, several assumptions were made by the authors.

  • Donor’s Total Asset: $50 million (sufficient scale that enables the donor to make a large gift and pay income taxes if a grantor trust is used to receive the gift)
  • Expected Annual Pre-tax return: 7.0% (assumes the gifted assets in the grantor trust are invested 85% in equities, 15% in fixed income)
  • Annual Realized Capital Gains/Dividends: 4.3% (assumes 2% dividend yield, plus 1/3 annual turnover in the trust’s portfolio)
  • Federal long term capital gains/dividends tax rate: 23.8% (includes the 3.8% Medicare surcharge/tax)
  • State and local tax rate: 10.7% (authors are from New York, so they included the New York City resident income tax)
  • Federal estate tax rate: 40%
  • New York estate tax rate: 16% (assumes a New York State resident).

Caveat: Since Michigan does not impose a state estate tax separate from the federal estate tax, and Michigan’s income tax rate is 4.25% (not New York’s 16% tax), the transfer tax savings will be less if the large lifetime gift is made by a Michigan resident. Nonetheless, the tax savings associated with a large lifetime gift still provide a dramatic incentive for a wealthy Michigan resident to consider a large gift using their available gift tax exemption.

Example- Benefits of Making the Gift Now: The high net worth individual who resides in Michigan makes a gift of $10 million. In 30 years (2049), those gifted assets will provide a benefit of $16 million to the donees (or $8.8 million if that gross benefit amount is adjusted for future inflation.) If the lifetime gift is made by the Michigan resident to a grantor trust for income tax purposes, where the trust settlor pays the trust’s income taxes, the benefit of this lifetime gift increases to $26.5 million to the trust beneficiaries by 2049 (or $14.6 million if that gross benefit amount is adjusted for inflation.)

  • “Thus, for a high new worth client with the capacity to use the incremental exemption through 2025, for every one dollar ($1.00) he gives, he may create almost four dollars ($4.00) in additional wealth for beneficiaries.”

Example- Cost of Waiting One Year to Make the Gift: The high net worth individual makes a $10 million gift, and the gifted assets appreciate 7% in the next year. That appreciation creates an additional $700,000 after the first year of the gift that is outside the donor’s estate by virtue of the gift. The donee-beneficiaries will receive the compound growth on that $700,000 over each of the next 29 years. Just waiting one year could ‘cost’ the donees $1.0 million in wealth over that period. If a grantor trust had been used by the donor, the loss of wealth to the trust beneficiaries over 29 years would be about $2.0 million on the loss of that initial $700,000.

  • “The cost of waiting one year to make the taxable gift will reduce its value to the donor’s beneficiaries by between $1.0 million and $2.7 million over a 30-year period depending on the gift and estate tax regime in which the donor resides and the use of a grantor trust.” [The $2.7 amount is if a grantor trust had been used to receive the gift and the donor was a resident of a state that imposed a state estate tax (not Michigan.)]

Amount of the Gift: This article also addressed the donor’s capacity to make a sizeable lifetime gift. Skipping over the multitude of variables to be considered (along with the three pages of their discussion on this topic), the authors concluded, again using their quantitative analysis, that the prospective donor should set aside capital of at least 33 times his/her annual spending amount, to identify what amount of excess capital that he/she could feel comfortable gifting without jeopardizing their future cash flow needs.

Conclusion: This article was a helpful way in which to quantify why making a large lifetime gift using the donor’s available gift tax exemption amount makes a lot of financial sense. It gets beyond the regular use it or lose it mantra that I am guilty of chanting.