The federal estate and gift tax has long been the cause of confusion, due in part to frequent changes in the law over the past decades. Whether you have an estate plan in place or are just embarking on your planning, it is important to understand the structure of the tax, its current status, and what the future may hold. Consulting with your estate planning attorney will ensure that your plan is in “sync” with current law, and costly mistakes avoided. Many changes in the tax are already on the way, and many others may occur that we can only speculate about at this point. Here is an overview to put it all in perspective.
Federal Annual Gift Tax Exclusion
The first concept to understand is the annual gift tax exclusion. The annual gift tax exclusion for 2021 remains unchanged from last year: $15,000. This is the amount of money that the IRS allows you to give away each year, to as many individuals as you wish, without requiring you to file a gift tax return and without using up any portion of your lifetime unified gift and estate tax exemption (explained in the next section). Married couples may pass double that amount. If your gift to any one individual exceeds $15,000, the excess is deducted from your lifetime federal unified estate and gift tax exemption. If your estate is taxable, making gifts is one way to reduce the size of your estate and pass as much tax-free money as possible to your heirs.
Example 1: Mr. Jones has two sons. In 2021 Mr. Jones gives $15,000 to Son 1 and $15,000 to Son 2. Because these gifts do not exceed the annual gift tax exclusion, he does not need to file a federal gift tax return (form 709). Neither gift will be deducted from his lifetime unified estate tax and gift tax exemption. Mrs. Jones may do the same.
Example 2: In 2021 Mr. Jones gives $15,000 to Son 1 and $25,000 to Son 2. Since his gift to Son 2 is over $15,000, he must report it to the IRS. The $10,000 in excess of the $15,000 exclusion he gave to Son 2 will be deducted from his lifetime unified estate estate and gift tax exemption. The same rules apply to Mrs. Jones if she makes identical gifts.
Important to note:
Gifts of any amount, even over $15,000, made directly to an educational institution to pay for an individual’s tuition, or to a medical institution to pay for an individual’s medical expenses, are not subject to gift tax and do not count against your lifetime exemption.
You may use up to five years of your exclusion, $75,000 ($15,000 x 5 years), to contribute to a beneficiary’s 529 college savings plan. You can do this for as many beneficiaries as you wish.
Do not confuse the $15,000 tax-free annual exclusion with the rules that apply to Florida Medicaid eligibility. Uncompensated transfers in any amount made during the five-year lookback period, even if less than $15,000, must be reported to Medicaid. Medicaid then uses that information to calculate eligibility for benefits and to determine if there is a penalty period during which benefits are not available. Thus, if you make a $10,000 gift to someone during the lookback period, you will still have to report the gift to Medicaid when applying for benefits, although for tax purposes it will not be counted against your lifetime exemption.
Federal Unified Gift and Estate Tax Exemption
In 2021, the federal unified estate and gift tax exemption is $11,700,000 per individual (up from $11,580,000 in 2020). This is the amount you may pass, tax-free, during your lifetime and/or at death. A married couple can pass twice that amount, or $23,400,000. Every dollar over the exemption amount is taxed at 40%. Taxes are levied on the gross taxable estate, which includes trust assets, assets held in the decedent’s name, jointly held property, accounts designating a beneficiary, life insurance, annuities, etc.
As noted above, if you have made a gift over $15,000 to any one individual in any one year, the excess over $15,000 must be reported to the IRS, and the amount over $15,000 is then deducted from your lifetime exemption.
Example: Mr. Jones has made gifts to his children over the years. The taxable portion of those gifts totals $2 million. If Mr. Jones passes away in 2021, that $2 million will be deducted from his lifetime exemption. Thus, the total amount he will be allowed to pass tax free will be $9.7 million ($11.7 million estate tax exemption minus $2 million).
Note that the exemption limit does NOT apply to spouses. A person may pass an unlimited amount to his/her spouse, tax-free.
The 2021 generation-skipping lifetime exemption is also $11.7 million per person. “Skip” persons may be grandchildren, great-grandchildren or even more distant generations yet unborn. Or, gifts may be put into a trust in which all interests are held by skip persons, and no distributions can be made to non-skip persons.
Who Pays? Right Now, Very Few
If you are like the vast majority of Americans, you don’t have to worry about estate tax… not now, anyway. At the tax exemption’s present generous levels, only a miniscule percentage of estates are subject to estate tax. In fact, the Tax Policy Center of the Urban Institute and Brookings Institution estimates that in 2020, only about 1,900 estates will be taxed. That is less than 0.1% of the 2.8 million people expected to pass away this year. Opponents of the estate tax often refer to the estate tax as the “death tax,” which sounds like it affects everyone, but clearly, at this moment, nothing could be farther from the truth.
But…You Could Find Your Estate Taxable When the Exemption Decreases
In the future, individuals whose estates are not currently taxable may find that situation changed. The Tax Cuts and Jobs Act of 2017 calls for the unified gift and estate tax exemption to “sunset.” On January 1, 2026, the exemption will return to its pre-2017 levels, decreasing to $5.6 million per person. This will catch many more estates in the tax net. Of course, Congress may act even before that date to lower the exemption to whatever amount it chooses – perhaps even lower than $5.6 million – a real possibility given today’s massive federal deficits. Many political, legal and economic prognosticators anticipate this is precisely what will happen. If you are planning your estate, it’s recommend that you embark on a program of gifting starting now, while the exemption level is still high.
No “Clawback” After 2026
If your estate is taxable and you have made gifts based on the exemption rates under the 2017 Tax and Jobs Act, you do not have to worry that the IRS will claw back those gifts if the exemption level is lower upon your passing. In November 2019 special rules were announced that will permit the prior higher exemption to be applied. It will also be applied to an exemption that a spouse claims through the portability provision (explained in the next section).
Portability: Surviving Spouse May Take Deceased Spouse’s Unused Exemption
A surviving spouse may transfer to him/herself any unused portion of the deceased spouse’s estate tax exemption. Under this “portability” rule, the personal representative (executor) or trustee of the decedent’s estate is required to file a federal estate tax return for the decedent, and take the portability election, even if the decedent’s estate owes no tax at that time. Electing portability is advisable as a hedge against future reductions in the exemption. It should also be strongly considered when the surviving spouse is significantly younger than the deceased spouse, as there are many years in which the estate can grow to a taxable level.
Example: Mr. Jones is married. He passes away in 2021. His gross estate is $8 million and not taxable. He has made no taxable gifts during his lifetime but leaves the $8 million in a credit shelter trust. He therefore has not used $3.7 million of his lifetime exemption ($11.7 million minus $8 million). The personal representative files a form 706 (estate tax return) for Mr. Jones and opts for portability on the form. This entitles Mrs. Jones to the additional estate tax exemption of $3.7 million when she passes away. The $3.7 million will be added to her own exemption, whatever that may be, at the time of her death.
State Estate Taxes
Florida does not impose its own estate tax, but several states do. If you are a Floridian and end up relocating to such a state, for health, family or other reasons, it is important for you and your estate planning attorney to consider that possibility as you structure your estate plan. At this writing, these states levy an estate tax on residents:
District of Columbia
Misconceptions about Probate and Estate Tax
There is a common misconception that only taxable estates go through probate. This is not the case. All assets that are held in the decedent’s name alone, without a death beneficiary, must be probated. There are many steps you can take to avoid probate, such as naming co-owners, putting your assets in trust, etc. But the fact that your estate is not taxable does not keep your estate out of probate. Similarly, an estate that passes outside of probate may still be subject to estate taxes. The two are unrelated.
How Can Your Attorney Help You to Minimize or Eliminate Estate Tax?
Consult with your estate planning attorney. Depending on your situation, it may be advisable to make gifts now, either directly or through an irrevocable trust, in order to take advantage of today’s higher exemption rates before they expire in 2026 (or sooner, depending on congressional action). Making gifts to charity is another tax-minimizing or tax-eliminating option that can be explored. Continue to review your estate plan periodically so you can be sure it is structured to take best advantage of the constantly changing tax code, and remains up-to-date with respect to any changes in your family, financial and health circumstances.