Take-Away: Much has been written about the importance of taking advantage of the current $11.58 million dollar federal transfer tax exemption, with the focus on the ‘use it or lose it’ principle for lifetime gifts. However, there are, with any estate planning strategy, some potential negative consequences associated with making a large lifetime gift that should always be considered before the decision to make a large gift.

Background: A lifetime gift can result in two negative tax consequences. First, the value of the property that is the subject of the gift could actually decline. Second, if it is a gift of appreciated property and that asset fails to appreciate in value at the expected rate, the estate tax savings on the appreciation could be less than the income tax loss attributable to the income tax basis step-up at that that would have been available had the gift of the asset not been made, i.e. the impact of carryover basis with lifetime gifts.

Value of Gifted Asset Declines: A decedent’s estate tax is calculated on an estate tax base that consists of both the decedent’s estate at death and his/her lifetime taxable gifts that are not included in his/her taxable gross estate. As a result, lifetime gifts do not remove the value of the gifted property from the decedent’s estate. All taxable gifts are included in the decedent’s estate tax base either as adjusted taxable gifts or as gifts that are included in the decedent’s taxable gross estate. Accordingly, if the value of gifted property declines between the date of the gift and the date of the donor’s death, the decedent’s estate tax will be more than would have been the case if the gift had not been made.

  • Example: Donna makes a gift of $11.58 million of common stock in BigCo, Inc to a trust that she established to benefit her children. Donna’s intent is to fully utilize her $11.58 million in federal transfer tax exemption in 2020. [Donna has made no prior taxable gifts before 2020.] Donna pays no federal gift tax on this transfer of BigCo, Inc stock to the trust. Donna dies in 2024. At the time of Donna’s death, the BigCo, Inc stock held in the trust has dropped to only $4.0 million. Assume that Donna has a taxable gross estate at the time of her death of $10.0 million. Due to the way the federal estate tax is calculated, Donna’s estate tax base is the sum of her adjusted taxable gifts [$11.58 million] and her taxable estate at death [$10.0 million] or $21.58 million. Finally, assume that Congress has not messed with the federal applicable exemption amount, and by 2024 the applicable exclusion amount has increased due to inflation to $13.0 million. Donna’s estate tax base will be $21,580,000. The tentative tax on that estate tax base will be $8,577,800. The unified tax credit will be $5,145,800, which leaves a federal estate tax due on Donna’s death of $3,432,000. Had Donna not made the lifetime gift of $11.58 million of BigCo, Inc stock to the trust, her estate tax base at the time of her death would be $14.0 million [$10.0 taxable gross estate + $4.0 million of BigCo, Inc stock.] Donna’s federal estate tax liability on this amount would have been $400,000. Therefore,  Donna’s lifetime gift of the BigCo, Inc stock cost her estate more than $3.0 million in additional federal estate taxes.

Income Tax Basis Step-Up Beats Estate Tax Savings: Most property that is included in a decedent’s estate [other than income in respect of a decedent, like IRAs] receives a new income tax basis equal to the asset’s fair market value at death (or the alternate valuation date.) [IRC 1014.] Property that is gifted during the donor’s lifetime does not normally receive an adjustment to its income tax basis, unless the property is included in the donor’s taxable gross estate at death (which is referred to as carryover basis.) As a result, a lifetime gift generates estate tax savings only on the income and appreciation that the asset generates after the gift is made. In other words, when a donor gives appreciated property, unless the property generates a positive investment return before the donor’s death, the loss of the income tax basis adjustment with regard to the gifted asset will create a net tax disadvantage to the donor’s beneficiaries.

  • Example: The same basic facts as in the prior example. Assume Donna’s income tax basis in the BigCo, Inc stock is $1.0 million before her gift to the trust. The BigCo, Inc stock appreciated after it was transferred to the trust from $11.58 million at the time of the gift to $12.58 million at the time of Donna’s death in 2024. Donna’s lifetime gift saved the trust (and her children) federal estate tax of $400,000 [40% tax on the $1.0 million of appreciation in the stock’s value.] When the BigCo, Inc stock is sold by the trustee, the trust will pay a tax of 23.8% [20% capital gain tax rate + 3.8% Medicare surtax on net investment income] on the gain, or $2,756,040. Accordingly, Donna’s lifetime gift has cost her family $2,356,040 [$2,756,040 capital gain tax less $400,000 in federal estate tax savings.] If the gifted BigCo, Inc. stock had been held by Donna and included in her taxable gross estate, her estate would have paid additional federal estate taxes of $400,000 but would have saved $2,756,000 in income taxes.

Mitigating Potential Negative Tax Consequences: There are a couple of ways these negative tax consequences associated with lifetime gifts can be mitigated, but they are not particularly helpful without the benefit of a crystal ball.

  • Disclaimers: Consider a taxable gift by the donor to an irrevocable trust. The trust could contain provisions that: (i) give the trust  beneficiary the power to disclaim his/her interest in the trust; and (ii) provides that in the event of a qualified disclaimer by the trust beneficiary (within 9 months of the gift) the trust property returns to the donor. If the disclaimer is made within 9 months of the gift, and the disclaimer is effective under Michigan law [MCL 700.2901 et seq], and the beneficiary received no benefit prior to his/her disclaimer, the property is returned to the donor. The gift tax rules will treat the gift as if it had not occurred. [IRC 2519.] Accordingly, if during the 9-month ‘disclaimer’ period the value of the gifted property declines, the beneficiary may foresee a tax benefit in making a qualified disclaimer, effectively returning the gifted asset to the donor. While the decision to make a qualified disclaimer for tax planning lies with the trust beneficiary and not the donor, the donor might still draft the trust anticipating the possibility of a disclaimer.
  • Qualified Terminable Interest Property: When a married donor makes a gift to a trust that is eligible for QTIP treatment, the donor (not the trust beneficiary) retains the power to decide whether the gift will be taxable or not, and the donor can exercise that power at any time between the time of the gift and when the federal gift tax return [Form 709] is due. When the federal gift tax return is filed, if timely filed, the donor can make an election to treat the gift as eligible for the federal gift tax marital deduction. [IRC 2523(f).] Consequently, a gift to a trust established for a spouse in December 2020, will not have to be reported until October 15, 2021, so the donor has until that due date in order to decide whether the gift will be taxable or not. Therefore, if the asset that is transferred goes down in value, the donor-spouse can make a QTIP election and protect the gift from the federal gift tax by use of the unlimited marital deduction.
  • Grant a Testamentary Power of Appointment: The terms of the trust instrument could give a person other than the donor or a beneficiary of the trust a power to appointment over trust principal, but not trust income, and the authority to revoke that testamentary power of appointment at any time. As such, the power holder could confer on the donor a testamentary power of appointment and cause the inclusion of the gift in the donor’s gross taxable estate. This power to give the donor a testamentary power of appointment would only be exercised if the power holder believed that the inclusion of the gifted assets in the donor’s taxable estate would more than likely reduce future combined federal estate and income taxes.

IRC 2001(b):  If the donor holds a testamentary power of appointment over the trust’s assets at the time of the donor’s death, the trust property will be included in the donor’s gross estate at its date of death value. [IRC 2038.] Restated, the trust assets will not be included in the donor’s estate tax base as an adjusted taxable gift at its date of gift value. [IRC 2001(b).] The power of appointment that is conferred on the donor does not have to be a significant power. For example, the Supreme Court has held that the power of appointment conferred on the donor might be merely to change the time of the trust beneficiary’s enjoyment of the trust’s property. Lober, 246 U.S. 335 (1953,)

IRC 1014:  The income tax basis of the property held in the trust would be adjusted to its date of death value.

IRC 2038: If the testamentary power of appointment is never conferred on the donor, the possibility that one might be conferred on the donor is insufficient, standing alone, to cause the trust assets to be included in the donor’s estate tax base. IRC 2038 does not apply to cause estate inclusion for a power, the exercise of which on the date of the donor’s death is subject to a contingency beyond the donor’s control. [Treasury Regulation 20.2038-1(b).] Estate inclusion only occurs if the testamentary power of appointment is actually conferred on the donor and is still held at the time of the donor’s death.

IRC 2036: While IRC 2036 applies to powers that are subject to contingencies beyond the donor’s control (unlike IRC 2038), IRC 2036 does not apply to powers over property that do not affect the enjoyment of income received or earned during the donor-decedent’s lifetime. [Treasury Regulation 20.2036-1(b)(3).] This is why the testamentary power of appointment that could be conferred on the donor is limited to a power over trust principal, but not over trust income that would be earned after the gift to the trust.

IRC 2035(a): If the donor was given a testamentary power of appointment, and later relinquished that power of appointment within three years of his/her death, the property that was subject to that power of appointment would still be included in the donor-decedent’s estate tax base, to the same extent that such property’s value would have been included in the estate had it not been relinquished. [IRC 2035(a) and IRC 2038(a.] However, if the donor-decedent’s power was terminated without any action taken by the donor-decedent, i.e. it was revoked by the person who held the power to confer or revoke the testamentary power of appointment, then the 3-year ‘pull- back’ rule of IRC 2035(a) will not apply.

Conclusion: The motivation behind most lifetime gifts of significant value is to remove that existing wealth and the expected future wealth (income from and appreciation of the gifted assets) from the donor’s tax base, either without paying federal gift or GST tax, or by paying those transfer taxes at lower rates than are expected to be in effect at the time of the donor’s subsequent death .Current circumstances strongly encourage the use of large lifetime gifts, due to the low interest rates, depressed asset values that have resulted from the pandemic, the very high federal transfer tax applicable exemption amounts, and the growing fear that some conventional estate planning strategies like GRATs, IDGTs, carryover basis on death, and dynasty trusts may soon disappear with a change in administrations in Washington D.C. While there is plenty of ‘upside’ to making a large lifetime gift at this time, there could be possible tax disincentives to make a gift at this time that need to be factored into any decision to make a large taxable gift. Consider including some modest mitigation strategies if the gift is to be made to a trust.