The wealthy must hold off on making gifts until December 31 because if they make a gift in 2010 and then die, it would be especially unfortunate-not only would they be dead, but they would have paid the gift taxes unnecessarily.
While I'm making light of an otherwise dark situation, advisors should be familiar with the planning opportunities of the very wealthy. While your niche may not be those with $5 million and up, what happens if you find yourself in a conversation with such an individual?
In other words, December 31 is, ironically, the "drop-dead date" for taking advantage of the 35% gift tax rate. If an ultra-wealthy person does not gift assets in 2010, then next year his or her estate will be subject to estate taxes, which carry a top tax rate of 55%. To avoid paying at that level, your client can make a gift in 2010 and pay a lower tax rate of 35% on the gifted amount. Basically, estate taxes are on sale, says Rothschild.
However, if the client dies in 2010 after making the gift, then paying the sale price-the 35% gift tax-will have backfired because there is no estate tax in 2010. If your client dies in 2010, his entire estate is free of estate taxes. So it would have been better to die without making the gift and paying gift taxes.
There are many variables, however, that make this already confusing situation mind-boggling. Let's break them down to make them easily understood.
Three Year Look-Back
If you die within three years of making the gift on December 31, the benefits of paying the gift tax on December 31 at the 35% rate are undone. The government will treat your estate as though the gift was never made. The gift taxes paid as well as the amount gifted will be added back to your estate and the estate must pay taxes on that money at then-prevailing estate-tax rates. Thus, if the individual making the gift on December 31 dies within three years, he is no better or worse off for it.
For instance, say you have a client with a taxable estate of $10 million. While there is no estate tax in 2010, the estate tax is scheduled to rise to pre-2001 levels, with a top rate of 55%. If your client makes a gift of $4 million on December 31, he reduces his estate by that same $4 million plus the $1.4 million he will pay in gift taxes. Making the gift reduced his estate from $10 million to $4.6 million.
Assuming your client lives more than three years, he'll owe estate taxes on just $4.6 million instead of on the full $10 million. Sure, he still needs to pay the gift tax, but that's at the 35% gift tax rate instead of the 55% estate-tax rate scheduled to be in place three years from now.
However, the three-year look back could come into play. If your client dies within the next three years, the $4 million gift and $1.4 million in gift taxes would all revert to his estate and would be taxed at then-prevailing estate-tax rates.
Client's Age And Wealth
The age and wealth of your client are crucial variables. A client with a $10 million estate in his late 80s may be more inclined to make a December 31 gift than a client with a $5 million taxable estate who is 65 years old. If you are in your 60s and have a $5 million or $6 million taxable estate, Rothschild says, you're not likely to feel comfortable handing away half your net worth because you have a pretty long life expectancy. But someone with $20 million or more, he says, can give away $10 million and still have ample savings remaining.