Lifetime Giving
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Copyright 1992, 1998 - Thomas J. Keating, IV, All Rights Reserved
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Section Two - Tax Objectives
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2.1 The Tax Object of Giving. The
primary object of an effective gift program is to promptly and
substantially reduce the size of the donor's taxable estate. An
additional goal may be to shift future income generated by the
gifted property into the hands of other family members, where
(presumably) it will be subject to lower income taxes.
Accordingly, for maximum effectiveness, the amounts of the
gifts and the composition of the donee group should not be
limited, except for personal considerations. The donor should
not make gifts only out of his excess income; this is
unnecessarily restrictive and is at cross purposes with the
idea of depleting the donor's net worth in order to minimize
estate taxes.
Gifts should be made, or at least considered, up until the
point at which (a) the donor's own financial security is at
some risk, or (b) the donor's remaining estate is small enough
that little or no estate tax will have to be paid.
2.2 Selecting Assets to Give.
In formulating any gift program, an important concern is to
select appropriate assets to be given. The two most important
tax considerations are as follows:
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1. To maximize
future possible estate tax savings from the gift, consider
giving assets which have an unusual potential for growth
in value between the date of the gift and the expected
date of the donor's death.
Accordingly, all other things being equal, equity type
investments should probably be selected in preference
to fixed income investments.
Also, life insurance might be a particularly good
candidate for such gifts, for this reason.
2. To minimize
future adverse income tax consequences for the donee,
consider the "basis", for income tax
purposes, of the assets to be given. Because assets
given away during life do not acquire a "step-up"
in basis (as they would if held until the death of
the donor), the higher the donor's basis in relation
to the current (or anticipated future) worth of the
asset, the more suitable the asset is for lifetime
giving, all other things being equal.
Cash, if available, is the optimum funding medium.
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2.3 Transfer Tax versus Capital Gains Tax.
Many prospective donors express concern at losing the
"step-up" in income tax cost basis which their assets
will achieve if they die while owning them, because, as
previously mentioned, that step-up would be lost if they
give the assets away during their lifetime.
I believe this concern deserves far less weight than it is
commonly given, for these reasons:
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1. The capital
gains tax is wholly elective; if the asset is not
sold the tax is not due. On the other hand, the
transfer tax, being ultimately triggered by death, is
not elective in any practical sense of the word, except
to the extent that the donor has elected to make
non-taxable gifts during his lifetime.
2. The capital gains
tax is a burden upon the donee, who presumably takes
this factor into account in deciding whether or not
to sell the asset.
Moreover, the sale transaction produces the funds which
are needed to pay the tax. The transfer tax is a burden
upon the donor, who may have to sell other appreciated
assets, creating his own capital gains tax liability in
the process, to pay it.
However, see discussion in Section 2.4 below regarding
intentional lifetime payment of transfer tax.
3. The comparative
tax rates substantially favor paying capital gains tax.
At present, in most cases the maximum long-term federal
capital gains tax rate is 20%, the minimum federal estate
tax rate is 37%, almost twice as great.
To be precise, due account should also be taken of any
applicable state and/or local taxes, but the favorable
comparison will generally hold. Also, remember that
capital gains tax is not paid on the entire sale price,
only on that part which exceeds the sellers "cost
basis"; transfer tax is paid on the full value of
the asset.
4. Since the capital
gains tax is elective, gains can perhaps be timed to
occur in years in which they may be offset by unusual
deductions, such as business or investment losses,
substantial charitable contributions, etc.
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2.4 Intentional Payment of Gift Tax.
Special mention should be made of the fact that if the donor (a)
makes a large enough lifetime gift (or series of gifts) to
exhaust his transfer tax exclusion and to cause the payment of gift
tax on the excess, and (b) lives at least three years beyond the
date of such gift(s), the gift tax which was paid by the donor
during his lifetime is removed from the donor's gross estate for
purposes of calculating his estate tax.
Against this benefit should be weighed, of course, the loss of use
of that amount of capital during the period between the gift tax
payment and the due date of the estate tax, but in most cases, given
suitable facts, it will save money in the long run.
The projected estate tax saving is, roughly, (a) the amount of the
gift tax which was paid during the donor's life, times (b) the
donor's anticipated marginal federal estate tax rate.
It must be acknowledged that there is a potential risk in
connection with making taxable lifetime gifts. If assets which
are given away during lifetime have decreased in value between
the date of the gift and the date of the donor's death, the gift
will have proven to be a somewhat wasteful move, as not only will
the basis step-up have been lost but the transfer tax cost will
have been greater than it would have been had the gift not been
made.
There is no way to absolutely eliminate this risk except to
give only assets whose value cannot decrease (e.g. cash), but
there are distinct possibilities of reducing the risk, albeit at
the expense of losing other possible advantages (e.g. using only
non-volatile investments).
2.5 The Power of Simple Arithmetic.
Let us look at the transfer tax savings which might be achieved by
a specific hypothetical family. The assumed facts are that the
taxpayer is a married couple, (a) who have two happily married
children, (b) who have at least ten years left to live, and (c)
whose estates at the time of their respective deaths will be taxed
at a marginal rate of 40%.
They want to dispose of as much property as they can without using
any of their transfer tax exclusion. A simple calculation shows
that they can give away a total of $10,000 x 2 x 4 x 10, or
$800,000, thus saving the family $320,000 in transfer taxes.
If we further assume that the couple also has five unmarried
grandchildren, the gift calculation becomes $10,000 x 2 x 9 x 10,
or $1,800,000, thus saving the family $720,000 in transfer taxes.
Finally, if we additionally assume that the donor couple wishes
to pay for their grandchildren's educational and/or medical
expenses (which they can do with no limitation as to amount) and
that they spend an average of $50,000 per year on those items,
their estates will be further depleted by $500,000, thus saving
the family another $200,000 in taxes.
A very powerful result from a technique which can be illustrated
by fourth grade arithmetic.
2.6 A Misplaced Concern. People
who grow furious at the thought of a 40% tax on their income are
often oddly passive when asked to contemplate a 40% tax on their
capital.
When you consider that a person whose entire living is derived
from investment income generally has a capital worth somewhere
between 8 and 25 times as great as his annual income, it would
appear that his concern for income tax planning is misplaced; he
should be much more exercised about the capital tax than about
the income tax.
A facile explanation would be that the one is a matter of present
harm to him and the other a matter of future harm to others, but
that fails to account for the fact that most wealthy people did
not get that way by being indifferent to the future consequences
of their present acts or omissions.
Perhaps a better answer is that techniques for reducing income tax
are (or at least appear to be) easier to implement and are more
amenable to future change than are techniques for reducing the
capital tax; the former can be undertaken by the client himself,
if he chooses, and later changed at will; the latter require
professional assistance, maybe from several different sources,
and often involve decisions which are irrevocable.
Consider this thought - the tax on your income reduces only this
year's income - the tax on your capital reduces income in all
subsequent years, forever.
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