Federal Estate and Gift Taxes – Cousins, But Still Different

Take-Away: There are many similarities to the federal estate tax and the federal gift tax. However, one big difference is that the gift tax is tax inclusive while the estate tax is tax exclusive. The result is that a lifetime taxable gift is more tax efficient as opposed to waiting until death to transfer an asset.

Background: Both the federal estate tax and the federal gift tax have long histories. Over the decades these two taxes have had different rates, different exclusion amounts and different means of calculation. The U.S. Supreme Court long ago has held that these two taxes were in pari material, i.e. they must be construed together. Commissioner v. Wemyss, 324 U.S. 303 (1945). This was said back when the two taxes were separate and distinct systems. However, since 1976, and unification of the federal transfer tax system, the two tax systems are much more alike. An individual now has a unified federal gift and estate tax credit, currently $11.58 million, that can be used either to shelter lifetime gifts from the federal gift taxation, or saved and used at the time of the individual’s death to shelter federal estate taxation. Both taxes, gift and estate,  are subject to a flat 40% federal transfer tax. This uniformity of the coupled unified rate structure and the unified transfer tax credit tends to remove most of the incentives to make lifetime gifts. However, there are a couple of important distinctions, often not fully appreciated by individuals who debate making a lifetime gift or waiting to transfer their wealth at the time of their death.

Income Tax Basis: IRC 1015 requires a carryover income tax basis for lifetime gifts of property. In contrast, IRC 1014(a)(1) provides a step-up, or adjustment in the income tax basis to date-of-death value, for transferred assets that are subject to the federal estate tax. This distinction is something a prospective donor needs to seriously consider in the decision whether, or not, to make gifts immediately before death.

Inclusive v Exclusive: For a long time now federal gift taxes have been tax-exclusive. When a lifetime gift is made, the donor pays the gift tax with funds other than those that are transferred to the recipient. The donor is primarily liable to pay the federal gift tax. [Treasury Regulation 25.2511-2(a).] In contrast, the federal estate tax is tax-inclusive, which means there is a tax imposed on the amount of estate tax that is paid to the federal government, i.e. a tax is imposed on the tax dollars.

Comparative Examples: The following examples show the difference between the exclusive v inclusive approaches.

Gift Tax: Assume no transfer tax exemptions are available. Autumn gives to Karen $1,000,000. The amount of the  federal gift tax on Autumn’s gift is $400,000. Karen receives $1,000,000. The US Treasury receives from Autumn $400,000. The $400,000 paid to the US Treasury by Autumn is not subject to the federal gift tax. Because there is no ‘tax on the tax’ the federal gift tax is considered to be tax-exclusive.

Estate Tax: Assume no transfer tax exemptions are available. Autumn holds onto the $1,000,000 until her death. Autumn’s entire estate is bequeathed to Karen. Autumn’s taxable estate is $1,400,000. The amount of the federal estate tax due on a $1,400,000 estate is $560,000. Karen, the beneficiary of Autumn’s estate, only receives $840,000, which is $160,000 less than what Karen would have received had Autumn made the lifetime gift to Karen. That $160,000 difference is exactly equal to the unified transfer tax at 40% assessed on the amount of the gift tax, i.e. $400,000.

Excluded from Income Tax: In either situation, where Karen receives the amount as a lifetime gift, or she receives the amount as a testamentary bequest, the amount received will not be included in her taxable income. [IRC 102.]

Income Tax Basis: Karen will receive more with a lifetime gift than receiving an inheritance from Autumn, but the amount that Karen receives as a gift from Autumn will be subject to a carry-over income tax basis.

History: Because of this difference in treatment of these two federal taxes, since the late 1940’s the US Treasury has continuously proposed to include all federal gift taxes paid in the donor’s transfer tax base to calculate the donor-decedent’s federal estate tax liability. Congress has only responded to this proposal in 1976 when it amended IRC 1035 (the old gifts in contemplation of death Tax Code section) by adding a new subsection [IRC 2035(b)] that brings into the donor-decedent’s gross estate the amount of the gift tax that were paid on lifetime gifts made by the donor within three years of the donor-decedent’s death. Gift taxes that were paid by the donor-decedent more than three years prior to the donor-decedent’s death are excluded from being ‘added-back’ to the donor-decedent’s taxable gross estate. [The strange gross estate inclusion rules under IRC 2035 will be covered in a latter ‘missive.’]

Lifetime Gifts Preferred: Thus, while the federal transfer tax exemption is now unified, and the federal transfer tax rate is the same (40%), the overall federal transfer tax system is not really tax neutral. Rather, it creates a preference for lifetime gifts over testamentary transfers because the gift tax is tax-exclusive for gifts made more than three years before the donor’s death. A possible rationale for this systematic preference for lifetime gifts is the belief that lifetime gifts enhance capital formation and risk taking, critical to a healthy economy. It has also been suggested that the justification for the tax-exclusivity of gifts made more than three years before the donor’s death is that the differential operates as a discount for the ‘early payment’ of tax within the federal transfer tax system. Whether these rationales are accurate or not is not the point. The point is that it is much more tax efficient to make a lifetime gift than a testamentary transfer of the same amount- if the lifetime gift is made, and the gift tax paid,  more than three years before the donor’s death.

Conclusion: For those individuals who are contemplate their use of the federal transfer tax exemptions now, prior to the November Presidential election, the tax-exclusive nature of federal gift taxes should be an important consideration and an additional motivation to act in 2020 to make a large transfer of wealth. Even if the gift tax laws do not change after the November election, the payment of a gift tax in 2020 would start the 3-year ‘clock’ running to keep the gift tax amount from being added back to the donor-decedent’s tax base for estate tax calculation purposes.