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THE BASIC TAX STRUCTURE: (1) THE GIFT TAX One important aspect of estate planning to which we have made only passing reference thus far is taxation. The four components are the three federal transfer taxes: the gift tax, the estate tax and the generation-skipping transfer tax (GSTT) plus their less exotic companion, the federal income tax. In this and succeeding articles we will take a closer look at the various members of this rogues’ gallery in turn, spending sufficient time on each to outline its salient and more damaging characteristics as well as some of the ways in which it may be at least partially disarmed. But first a general overview of the three transfer taxes - the estate tax, the gift tax and the GSTT - and how they fit together to present a relatively well-coordinated and loophole-free obstacle to the tax-free transmission of wealth. The gift tax, as its name indicates, is concerned with gifts: gratuitous lifetime transfers. This is not to say that a transfer to which the gift tax applies may not have effects which extend beyond the lifetime of the donor; but it is confined to transfers made during the donor’s lifetime, however protracted their consequences may be. If A places $500,000 in an irrevocable trust for his son for life and then, after his son’s death, for A’s more remote lineage, the likelihood is that A’s descendants will be toasting A’s memory long after A and his son have gone to their rewards. But the creation of the trust was the sole taxable event for gift-tax purposes, regardless of the duration of its benefits. The estate tax is imposed on the passage of property at a decedent’s death. Most commonly, but by no means always, this will be property which the decedent owned in the everyday sense of the word; but the tax is equally applicable to property over which he had sufficient control at his death to be deemed the owner (as, for example, in the case of property over which he had a general power of appointment) or in which, although he no longer owned the property or had any control over it at his death, he had retained an interest which did not cease until he died. A typical illustration of the latter would be A’s creation of an irrevocable trust by the terms of which he was entitled to receive all of the trust income for life, with the remainder going to whomever he had designated. That trust, valued as at A’s death, will be part of A’s gross estate at the time of A’s death just as though A had not made the transfer. The GSTT is designed to prevent the tax-free transmission of property down to someone who is two or more generations below the transferor. Since 1986, the so-called “dynasty” arrangement now falls prey to the GSTT. Thus it is no longer possible, for example, to create an estate tax free trust for successive generations of one’s descendants which is so drafted as to avoid tax as each generation in turn receives the benefits of the trust. Formerly, a wealthy progenitor could create a trust which might start out by providing that his daughter should receive the income during her lifetime, her children should do so after her death, their children in turn should enjoy their great-grandfather’s largesse and so on - not ad infinitum, to be sure, but subject only to the so-called Rule Against Perpetuities. Thus, with careful drafting one could more or less guarantee a trust of some 90 or 100 years’ duration, if not longer, with no estate tax being imposed during the trust’s existence. Under present law, however, the GSTT taxes the transmission of property (including trust income) to anyone of a generation below t he progenitor’s daughter, and does so at the highest estate-tax rate, currently 55% with no run-up through the lower brackets. The gift tax and the estate tax are imposed in accordance with a single progressive rate schedule (beginning at 18% with a top bracket of 55%). One starts out up the ladder with one’s first taxable lifetime gift and, having begun, continues to ascend until one’s estate- tax liability has been determined and paid. However, each U.S. citizen or resident has a one-time exemption from both taxes; at present this amounts to $625,000 and is scheduled to gradually rise to $1,000,000 by the year 2006. So, for example, if Matilda sets up a discretionary trust for her four grandchildren in 1998 to which she transfers, say, $400,000, she will have to file a federal gift-tax return (Vermont, unlike some other states, does not impose a gift tax) but will not be required to pay any gift tax. Should she wish to add to the trust in 1999 (when the exemption will have increased to $650,000), she may do so, again without incurring any gift tax, to the tune of $250,000 ($650,000 minus $400,000). But if, having made a $250,000 addition in 1999, Martha dies during the same year with property valued, for example, at $500,000, her estate will have no estate-tax exemption available to reduce the base for the estate tax. By the same token, if she had died a year earlier, after setting up the trust, her estate would have had the benefit of the $225,000 unused portion of her exemption. In addition to the exemption, the donor of a lifetime gift is entitled to certain other exclusions and deductions. Gifts to charities and to the donor’s spouse are allowed without limit; and subject to an important proviso, one may make tax free gifts of up to $10,000 apiece to as many separate donees as one wishes in any given calendar year. The proviso is that to qualify for the annual exclusion the gift must be a gift of a so-called “present interest”; otherwise it will depend for its nontaxability upon use of the $625,000 exemption or however much of it remains. So, if Matilda had dispensed with the notion of a trust and instead had made her gift outright to her four grandchildren (all of whom we will assume are adults), the picture would have changed significantly. Because the transfer into the trust would have involved Matilda in the making of a gift of a future, rather than a present, interest (more on this later), she would not have been entitled to any $10,000 annual exclusions. But where the trust is eliminated, her gift now becomes four separate outright $10,000 gifts, one to each grandchild, and each such gift is indeed a gift of a present interest - each grandchild may do whatever he or she wishes with the gift, regardless of anyone’s say-so. This means that after applying a $10,000 exclusion to each gift, Matilda needs to use only $360,000 of her $625,000 exemption rather than $400,000. There is another important provision - in effect an exception to the future interest rule noted above - whereby a gift may be made to a trust for the benefit of a “minor” (in this case, under the age of 21, however state law may define minority) and still qualify for the annual $10,000 exclusion. However, such a trust (sometimes known as a “2503 (c) trust”, after the relevant Internal Revenue Code section) must meet the specific statutory definition. Basically, the trust may permit the accumulation of income during the beneficiary’s minority. This would normally disqualify the donor from claiming an annual exclusion, because it would make the beneficiary’s interest a future interest, i.e., one over which the beneficiary has no current unilateral control or right (as distinct from eligibility) to receive anything from the trust, income or principal. But the trust document must provide that upon the minor’s reaching 21, the trust will terminate and all of the remaining principal and income will be distributed to him or her. If the minor dies before reaching 21, the trust must terminate, and the principal and income must go the minor’s estate or, if the trust so provides, as the minor appoints by will (or, even though the minor is not old enough to make a will, to the person designated in the trust agreement as the recipient of the trust in the event of the minor’s failure to exercise the power of appointment). If all of these requirements are satisfied, transfers to the trustee will be treated as transfers of present interests eligible for the $10,000 annual exclusion. Just as the income tax law permits a husband and wife to file a joint return - even though one of the spouses may have no income - the gift tax statute allows a couple to split the gift of either one of them, even though the entire subject matter of the gift came from one spouse and the other contributed nothing. Assume that Alice is wealthy and her husband, Jake, is not. Alice and Jake have three children, two of whom are adults and the third of whom is still in her early teens. In 1998, with Jake’s consent (but not without it) Alice could give away $1,310,000. Here’s how: Alice has made no prior gifts in excess of $10,000 in any one year. She therefore has a full $625,000 exemption; so does Jake. Total available exemption is $1,250,000. Each parent has a $10,000 exclusion available for each child. Total available is six times $10,000. $1,250,000 plus $60,000 equals $1,310,000. Each child could therefore receive $436,666 which in the case of the teenage daughter would be placed in a 2503 (c) trust as described above. Next time, we will outline some of the major features of the estate tax law. The complete list of Christopher Stoneman articles is:
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