To Gift or Not to Gift, That Is the Question
April 8, 2019
Written by Bruce Paulson, CPA, JD, CFP®, Senior Client Advisor; Jennifer Arps, CFP®, Senior Client Advisor; Will Froelich, CFA®, Partner
To gift or not to gift, that is the question. It is less complex than the famed question posed by Prince Hamlet, but still not a simple one for families that hold appreciated assets and are (or may be) exposed to estate tax. Not gifting means keeping the asset or doing something to cause the asset to be included in an estate for estate tax purposes. Gifting means the opposite: making a lifetime transfer to remove the asset and future appreciation from an estate to save estate tax.
Why the dilemma? It is because death brings with it one tax blessing: an income tax cost basis step up on all assets included in an estate. For example, if you have a $1 million gain in Apple stock and you die, the gain is erased to $0. What would have been sold yesterday at a tax cost of nearly $250 thousand ($1 million x 25%) can be sold after you die for a tax cost of $0. This makes it appealing to tempt estate tax fate and hold as much into your taxable estate as possible. The risk, of course, is fate not being on your side and ending up with more estate taxes than originally planned. In the world of estate taxes, “the slings and arrows of outrageous fortune1” can hit unexpectedly hard and fast.
This brief analysis looks at the basic income, gift, and estate tax arithmetic that clients may find useful as they contemplate the question: to gift or not to gift.
There are several reasons why the timing might matter. First, the new 2018 tax law doubled the federal estate tax exemption from $5.6 million to $11.2 million per individual ($22.4 million exemption for a married couple) for decedents passing before 2026. On January 1, 2026, the exemption will return to the pre-2018 exemption levels ($5.6 million per person, adjusted for inflation) unless Congress acts to extend the new exemption amounts. Second, with many assets appearing “rich in price”, what you give and how you give it matters far more than first meets the eye.
What Inputs Should Be Considered?
Ignoring more important client specific goals, facts, and wealth transfer objectives, there are about twenty numeric inputs and assumptions, which are shown on Exhibits A and B. The question of gifting or keeping can generally be answered with arithmetic, but what good are formulas when some of the most sensitive inputs are dependent on an ever-changing political landscape (capital gains rate, estate-gift tax rate, estate-gift tax exemption, etc.)? These have enormous implications to financial models and, in the blink of an eye, can change the entire analysis.
Rules of Thumb
- The more an asset is subject to estate tax (value exceeds exemption), the more appealing it is to gift the asset. It is reasonable to assume the estate tax rate will remain higher than the capital gains tax rate for the foreseeable future. Assuming this to be the case, it makes gifting assets subject to estate tax more appealing.
- The higher the amount of unrealized gain, the more appealing it is to retain the asset. This speaks for itself. The higher gain means a bigger step-up and, therefore, a bigger tax benefit when the gain is erased.
- The higher the expected return on the assets, the more appealing it is to gift. Ditto to what is said in rule #1. Higher returns drive higher values, which makes gifting appealing in a taxable estate scenario.
- The longer the time horizon, the better it is to gift. More time means more time to grow and, hence, a higher value subject to estate tax at death.
- The longer an asset is held after it is inherited (post death), the more appealing it is to gift. The longer an asset is held, the longer it is until the tax liability associated with a sale is paid. Therefore, the present value of the cost is less. Assets held for generations (emphasis on plural) may never incur capital gains tax and, if perpetuity is part of the assumptions, gifting is usually the answer.
- Geography matters. Where you reside (more importantly the owner of an asset) matters greatly. Residents of high tax states like Minnesota, New York, and California have more to think about than residents of Nevada or Arizona, both in terms of income taxes today and, in the case of states like Minnesota, state level estate taxes in the future.
Example – No State Estate Tax
Imagine Juliette, single, age 80, holds $10 million worth of low basis securities with a combined income tax basis of $6 million. Her remaining estate-gift tax exemption is $11.2 million and assume the exemption amount sunsets in 2026, returning to $5.6 million. She asks whether it makes sense to gift her low basis securities to family now, growing at 7%, or retain to obtain the step-up at death. Importantly, Juliette is a resident of Nevada, where there is no state estate or income tax.
Using these assumptions, but varying a) unrealized gain % and b) life expectancy, holding the asset into the estate is the better “after all tax” outcome in most scenarios. As you can see in the table below, there is a relatively low amount subjected to estate tax (see rule #1) in comparison to the amount exposed to capital gains tax. As an example, $10 million, with unrealized gain equal to 40% ($6 million cost basis), over four years grows to a value of $13.1 million. At death, $1.9 million ($13.1 million – $11.2 million) is exposed to estate tax and, multiplied by 40%, equals $760 thousand of tax. Alternatively, had it been gifted, the $13.1 million would have a gain of $7.1 million ($13.1 million – $6 million) multiplied by 24% equals capital gains tax of $1.7 million. Under these circumstances, Juliette’s heirs are ($1.7 million – $760 thousand) $940 thousand better, post death, by keeping the asset in her estate today (not gifting).
Example – State Estate Tax
Now consider the numbers when Juliette is a resident of Minnesota and exposed to a high state estate tax (16% rate on amounts above $2.7 million). Notice how the presence of another layer of estate tax eliminates or reduces the benefit of keeping assets in her estate. Assuming a time horizon of more than a few years, her cost basis would need to be nearly $0 (100% gain) to make holding anything in her estate worth it. The estate tax is too big of a hurdle, and gifting should be given heavy consideration.
No Exemptions Remaining or Gift Tax Is a Factor
What if Juliette has already used her $11.2 million exemption and still holds highly appreciated assets in her estate? What if the value of assets far exceeds the annual exemption amount and gift taxes need to be incorporated? This further complicates the analysis and, as such, is beyond the scope of this analysis. In general, the absence of an estate tax exemption levels the playing field, and both percentage of unrealized gain (rule #2) and future expected return (rule #3) become very important. When gifting desires far exceed the exemption amount, future expected return (rule #3) remains important, but time horizon (rule #4) is arguably the most important. The models built for this analysis can handle these assumptions, and MRA is happy to assist in building a custom-to-you model that makes sense.
- Gift selection – Being choosy and deciding what to give is key in any effective strategy. Gifting high cost basis assets (low % unrealized gain) with good growth potential remains appealing, as does gifting assets with long time horizons.
- Time – Focus on the timeline. For young clients or assets that will be held long after death, gifting is a good strategy. What does this mean for planning? Start gifting programs now and don’t wait until estate taxes become a problem.
- Grantor retained annuity trusts – Consider using grantor retained annuity trusts to shelter asset growth from estate tax, but cause the asset to be included in an estate should a passing happen during the term of the trust…in other words, when death happens sooner than originally planned.
- Hedging to manage concentration risk – Maintaining a concentrated position to preserve a cost basis step-up at death does not come without risk. It is possible to hedge downside risk, but the cost of hedging should be compared to the tax savings that come with the basis step-up.
- Creative use of debt – Consider using debt to gift cash today, thereby keeping low basis assets in an estate. The right circumstance for this strategy is when a client does not have a long-life expectancy. Lending can be done in combination with a hedging transaction, but further discussion is beyond the scope of this article.
- Creative portfolio construction – Consider using a custom separate account equity index portfolio2 as a way to reduce the income tax liability in moving a portfolio from one or several securities into a more diversified equity portfolio.
Families should “run the numbers” to see whether a lifetime gifting program makes sense. Ultimately, objectives are key and should not override any projection of tax savings. Lifetime spending needs, future market assumptions, projected lifetimes, and preparedness of the next generation are just a few of the many non-tax assumptions that need to be considered. Hamlet is a classic tragedy. Improperly gifting your estate would create a modern day tragedy. MRA is pleased to help you avoid this drama, or other planning issues, by providing integrated “after all tax” advice.
- William Shakespeare, Hamlet, Act III; Scene I