In general, when one individual transfers money or property to another and does not receive an adequate return (i.e., makes a gift), the transfer is a potentially taxable event for the transferor. Such transfers made during life are inter vivos transfers subject to the federal gift tax, while such transfers made at death are testamentary transfers subject to the federal estate tax. The federal gift and estate taxes are coordinated by design to tax the transfer of wealth.
Fortunately, most individuals who desire to transfer their wealth during life or at death should have minimal concerns about the gift or estate tax consequences because the Internal Revenue Code allows for an applicable credit amount against the gift and estate tax. The applicable credit amount is commonly referred to as the “Unified Credit” because it is both “unified” (i.e., it is a single amount that is applied to transfers otherwise subject to either the gift tax or the estate tax) and a tax “credit” (i.e., it reduces the amount of tax owed). The amount of the Unified Credit is currently higher than it has ever been while an estate tax is in effect—$12.06 million for 2022—due in large part to a temporary increase provided in the Tax Cuts and Jobs Act of 2017. For married couples, careful planning can ensure that both spouses’ Unified Credits are used, which effectively allows for up to $24.12 million to be transferred tax-free. Therefore, only a small fraction of society is truly at risk of paying a federal wealth transfer tax either during life or at death. Critically, however, the temporary increase in Unified Credit will expire after 2025, at which point the Unified Credit will be cut approximately in half, barring any further changes in the tax law. Further, presidential candidates in recent years have called for massive overhauls of the wealth transfer tax system which could lead to an even more drastic reduction of the Unified Credit.
To understand how the Unified Credit is used over your lifetime and at your death, you must first consider several other exceptions to the gift tax. Not every gift is a taxable gift. For example, there is generally an unlimited marital deduction available for qualified transfers between spouses and an unlimited charitable deduction available for transfers to qualified charitable organizations. Payments for certain qualified educational and/or qualified medical expenses of another person are also not treated as taxable gifts. Furthermore, each year a person can transfer up to the amount of the Annual Exclusion (defined below) to any other person for any reason whatsoever without the transferred amount being treated as a taxable gift.
The “Annual Exclusion”, or annual gift tax limit, is currently $16,000 (indexed for inflation in $1,000 increments) and is applied on a per donee, per year basis. In other words, in 2020 you can make gifts of up to $16,000 to any number of individuals without affecting your Unified Credit. For example, if you gift $16,000 to each of your six (6) children in 2022, no taxable gift will have occurred and your Unified Credit will be unaffected by those gifts, even though a total of $102,000 was gifted. Further, just as married couples can effectively combine their Unified Credits, they can also elect to “gift split,” which effectively allows them to double their collective Annual Exclusion amount to $32,000. Any amount transferred in excess of the Annual Exclusion, however, is treated as a taxable gift (subject the other exceptions discussed above). For example, if you are single and you transfer $20,000 to your child in 2022, then you have made a taxable gift of $4,000. Likewise, if you are married and transfer $35,000 to your child in 2022, and your spouse elects to “gift split,” then you and your spouse have each made a taxable gift of $1,500. Also note that any time you transfer more than $6,000 to an individual in a calendar year, you should file a gift tax return (this is the case even if the gifted amount is not taxable because you and your spouse chose to “gift split,” as the filing of a gift tax return is actually required to make the election to “gift split”).
Each time a taxable gift is made during life, the Unified Credit is essentially decreased by the amount of the taxable gift. For example, if you are a single individual and you gift $76,000 to your child in 2022, then you have made a taxable gift of $50,000 (i.e., the amount by which $76,000 exceeds the $16,000 Annual Exclusion), and you will therefore use $60,000 of your Unified Credit to avoid paying the gift tax. Your available Unified Credit is effectively reduced from $12.06 million to $12 million. If you die in 2022 after making such a taxable gift, you will still be able to transfer assets worth $2 million through your will, trust, or otherwise, estate tax-free. If you made other taxable gifts during life, then the Unified Credit available at your death is further adjusted based on those taxable gifts. After accounting for all lifetime taxable gifts, if the value of your estate exceeds the remaining Unified Credit, you will owe an estate tax on the excess.
If the value of your estate is approaching, or exceeds, your available Unified Credit (after accounting for any taxable gifts which you have already made during your lifetime), meeting with an estate planning attorney as soon as possible could be a crucial step towards reducing your future gift and estate tax burden. By taking advantage of qualified marital, charitable, medical or educational transfers and the Annual Exclusion, along with a plethora of advanced estate planning techniques that are beyond the scope of this blog post, you can maximize the value of your assets that can be passed to your family and friends and minimize taxes. With that said, do not fall into the trap of thinking that you only need to plan towards effective utilization of the Unified Credit if your estate is above $10 million. Remember that the temporary increase in the Unified Credit amount is set to expire after 2025, and there is also risk (particularly after an election) that additional changes to the tax laws could decrease the amount of the Unified Credit even further. By starting the estate planning process sooner rather than later, you may have more options available for effectively taking advantage of the current law.
If you have any questions about the Unified Credit, the Annual Exclusion, or any other aspects of estate planning for estate and gift tax purposes, you may contact an attorney at Thomas, Fisher & Edwards, P.A. at (864) 232-0041.
