Friday, September 10, 2021
Proposed legislation that would decrease the federal estate tax exemption and the federal gift tax exemption is raising many concerns among farm and ranch families and associated estate and business planning issues. For farmers and ranchers desirous of keeping the family business intact for the next generation, questions about gifting assets and business interests to the next generation of owners now are commonplace.
Gifting assets before death – Part One of a series - It’s the topic of today’s post.
Federal Estate and Gift Tax - Current Structure
The current federal estate and gift tax system is a “coupled” system. A “unified credit” amount generates and “applicable exclusion” of $11.7 per individual for 2021. That amount can be used to offset taxable gifts during life or offset taxable estate value at death. It’s and “either/or” proposition. Any unused exclusion at the time of death can be “ported” over to the surviving spouse and added to the surviving spouse’s own applicable exclusion amount at death.
However, some gifts are not “taxable” gifts for purposes of using up the unified credit and, in turn, reducing the amount of asset value that can be excluded from federal estate tax at death.
Gifting – The Present Interest Annual Exclusion
Basics. “Present interest” gifts are not “taxable” gifts and do not reduce the donor’s unified credit. The present interest annual exclusion amount is a key component of the federal gift tax. I.R.C. §2503. The exclusion is presently $15,000 per donee, per year. That means that a donor can make gifts of up to $15,000 per year, per donee (in cash or an equivalent amount of property) without triggering any gift tax, and without any need to file Form 709 – the federal gift tax return.
Note: Spouses can elect split gift treatment regardless of which spouse actually owns the gifted property. With such an election, the spouses are treated as owning the property equally, thereby allowing gifts of up to $30,000 per donee. Also, under I.R.C. §2503(e), an unlimited exclusion is allowed for direct payment of certain educational and medical expenses. In effect, such transfers are not deemed to be gifts.
The exclusion “renews” each year and is not limited by the number of potential donees. It is only limited by the amount of the donor’s funds and interest in making gifts. Thus, the exclusion can be a key estate planning tool by facilitating the passage of significant value to others (typically family members) pre-death to aid in the succession of a family business or a reduction in the potential size of the donor’s taxable estate, or both. But, to qualify for the exclusion, the gift must be a gift of a present interest – the exclusion does not apply to future interests.
Note: A present interest gift is one that the recipient is free to use, enjoy, and benefit from immediately. A gift of a future interest is one where the recipient doesn't have complete use and enjoyment of it until some future point in time. “Strings” are attached to future interest gifts.
Gifts to minors. I.R.C. §2503(c) specifies that gifts to persons under age 21 at the time of the gift are not future interests if the property and the income from the gift “may be expended by, or for the benefit of, the donee before attaining the age of 21 years, and will to the extent not so expended, pass to the donee on his attaining the age of 21 years, and in the event the donee dies before attaining…age…21…, be payable to the estate of the donee or as he may appoint under a general power of appointment…”. This provision contemplates gifts to minors in trust with a trustee appointed to manage the gifted property on the minor’s behalf. But, to qualify as a present interest, the gift still must be an “outright” gift with no strings attached.
Whether gifts are present interests that qualify for the annual exclusion has been a particular issue in the context of trust gifts that benefit minors. In 1945, the U.S. Supreme Court decided two such cases. In Fondren v. Comr. 324 U.S. 18 (1945) and Comr. v. Disston, 325 U.S. 442 (1945), the donor created a trust that benefitted a minor. In Fondren, the trustee had the discretion to distribute principal and income for the minor’s support, maintenance and education and, in Disston, the trustee had to apply to the minor’s benefit such income “as may be necessary for…education, comfort, and support.” In both cases, the Court determined that the minor was not entitled to any amount of a “specific and identifiable income stream.” So, no present interest was involved. The gifts were determined to be future interests.
What if a transferee has a right to demand the trust property via a right to withdraw the gifted property from the trust? Is that the same as outright ownership such that the gifted property would qualify the donor for an annual exclusion on a per donee basis? In 1951, the U.S. Court of Appeals for the Seventh Circuit said “yes” in a case involving an unlimited timeframe in which the withdrawal right could be exercised without any time limit for exercising the right. Kieckhefer v. Comr., 189 F.2d 118 (7th Cir. 1951). But in 1952 the U.S. Court of Appeals for the Second Circuit said “no” because it wasn’t probable that the minor would need the funds. Stifel v. Comr., 197 F.2d 107 (2d Cir. 1952). In Stifel, the minor’s access to the gifted property was to be evaluated in accordance with how likely it was that the minor would need the funds and whether a guardian had been appointed.
The “breakthrough” case on the issue of gifts to minors and qualification for the present interest annual exclusion came in 1968. In that year, the U.S. Circuit Court of Appeals for the Ninth Circuit, in Crummey v. Comr., 397 F.2d 82 (9th Cir. 1968), allowed present interest annual exclusions for gifts to a trust for minors that were subject to the minor’s right to demand withdrawal for a limited timeframe without any need to determine how likely it was that a particular minor beneficiary would actually need the gifted property. Since the issuance of the Crummey decision, the “Crummey demand power” technique has become widely used to assure availability of annual exclusions while minimizing the donee’s access to the gifted property.
Gifting – The Income Tax Basis Issue
In general, property that is included in a decedent’s estate receives an income tax basis in the hands of the heir equal to the fair market value of the property as of the date of the decedent’s death. I.R.C. §1014(a)(1). However, the rule is different for gifted property. Generally, a donee takes the donor’s income tax basis in gifted property. I.R.C. §1015(a). These different rules are often a significant consideration in estate planning and business transition/succession plans.
With the current federal estate and gift tax exemption at $11.7 million for decedent’s dying in 2021 and gifts made in 2021, gifting assets to minimize or eliminate potential federal estate tax at death is not part of an estate or succession plan for very many. But, if a current proposal to reduce the federal estate tax exemption to $3.5 million and peg the gift tax exemption at the $1 million level would become law, then gifting to avoid estate tax would be back in “vogue.” However, legislation currently under consideration would change the basis rule with respect to inherited property. The proposal is to limit the fair market at death income tax basis rule to $1 million in appreciated value before death, and apply a “carry-over” basis to any excess. An exception would apply to farms and ranches that remain in the family and continue to be used as a farm or ranch for at least 10 years following the decedent’s death. Gifted property would retain the “carry-over” basis rule.
Another proposal would specify death as an income tax triggering event causing tax to be paid on the appreciated value over $1 million, rather than triggering tax on appreciated value when the heir sells the appreciated property. If any of these proposals were to become law, the planning horizon would have to be reevaluated for many individuals and small businesses, particularly farming and ranching operations.
Still another piece of the proposed legislation would limit present interest gifts to $10,000 per donee and $20,000 per donor on an annual (it appears, although this is not entirely clear) basis.
Note: At this time, it remains to be seen whether these proposed changes will become law. There is significant push-back among farm-state legislators from both aisles and small businesses in general.
Even if the rules change surrounding the exemption from federal estate tax and/or the income tax basis rule at death, and/or the timing of taxing appreciation in wealth, gifting of assets during life will still play a role in farm and ranch business/succession planning. A big part of that planning involves taking advantage of the present interest annual exclusion to avoid reducing the available federal estate tax exemption at death.