LIFETIME GIFTS VERSUS TRANSFERS AT DEATH

The federal gift tax rates and estate tax rates have been and will remain the same under current law. Unless the repeal of the estate tax actually takes place, one can transfer more assets with lower gift and estate tax consequences through lifetime gifts than with testamentary gifts (bequests through a will). During one's lifetime, one can take advantage of the annual gift tax exclusion that is not available to a testamentary gift. During one's lifetime, one can make gifts of property that will appreciate. Keeping the appreciation out of one's estate lowers the estate tax consequences on the transferred property.

With the possible repeal of the estate tax, one must also give greater consideration to lifetime gifts versus testamentary gifts. One must also consider the effect of capital gains tax on the gift, a tax that may now be greater than the estate tax. There is no step-up in basis for lifetime gifts. Once the estate tax is repealed, the step-up in basis on testamentary transfers will be limited. (Remember that under current law, however, the estate tax will be repealed for one year only--2010.)

When appreciated property is transferred by gift, the recipient's "cost" (basis) of the property is the same as that of the donor (even though the recipient didn't pay anything for the property). This means that the recipient must declare any gains as taxable income when he or she sells the property in the future. When property is transferred due to the death of the donor, the recipient receives a basis in the property at its current value, which was used to compute the value in the gross estate. This is called step-up in basis. If the recipient sold the property immediately for the current value, there would be no capital gains for income taxes. With the scheduled repeal of the estate tax in 2010, there will be a modification of step-up in basis, too. The income tax basis of property owned by a person at death will no longer be permitted an unlimited "step up" to its fair market value on the day he died. Instead, a basis step-up of only $1.3 million will be given, with an additional $3.0 million in step-up allowed on property passing to a surviving spouse.

Example 1: Dad gives Junior 1,000 shares of stock in a corporation. (There are no federal income tax consequences to Junior unless and until he sells for a gain.) Junior sells it the next year at the market price of $60 per share, for a total to him of $60,000. Dad had paid only $50 per share two years ago. What is Junior's gain? In reality, Junior has "gained" $60,000 he did not have before. But he takes Dad's basis of $50,000 (the price Dad paid), so Junior's income taxable gain will be only $10,000 ($60,000 - $50,000.) This, of course, would have been Dad's true profit had he kept the stock himself and sold it.

The basis of inherited property, however, which the beneficiary will use to calculate taxable gain if he or she sells, takes a "step up" to the fair market value of the property on the date of the estate owner's death. So, if the beneficiary sold the inherited property immediately for its fair market value, there would be little or no taxable gain. It was, therefore, possible to completely protect a lifetime of appreciation in value from capital gains income taxation. The 2001 law put a limit on the basis "step-up" benefit, as we will see after the following example, which remains valid:

Example 2: In 1994, Dad bought 1,000 shares of stock in XYZ Co. for $1 per share, for a total of $1,000. His tax basis is simply the price paid. Assume he dies and leaves the stock to Junior in 2003, when it is valued at $75 per share, for a total of $75,000. This becomes Junior's basis in the stock. It has been stepped up, and Junior will recognize no income taxable gain if he sells at that price. Nice!!

Persons contemplating a gift of property that has already appreciated significantly in value might take issue with the above general observations. Their argument might be, "Sure, if I give this stock away now, my child will lose the benefit of the step-up in basis, and will have to pay more income tax when the property is sold. But that tax will probably be at the 20 percent rate for capital gains. On the other hand, if I hold onto the property until death, my child gets the (eventual) income tax advantage of the basis step-up--but the property remains part of my estate. And IF we assume my estate will be large enough to be hit with estate tax, that tax begins at a rate twice as high as my child's capital gains rate."

The 2001 tax law makes it difficult to determine exactly which type of transfers will be more tax efficient.

Each person's credit against the estate tax is $1.5 million in 2005 and $2 million in 2006. The estate tax itself is set for total repeal after 2009. But the law repealing the estate tax is scheduled to be in effect for only one year--2010; after that, the pre-existing law returns. The gift tax credit equivalent (exemption) is not set to go past the current $1 million, and no repeal is planned.

To get it right, one would also have to know in which year one was going to die.