By James Lang

Attorney/CPA and author of "Retire Secure! Pay Taxes Later"
(Published by Wiley)

The best strategy for those who will likely end up in a taxable estate situation is to take advantage of the annual $12,000 per year per beneficiary exclusion. If the annual gifts of $12,000 per year ($24,000 for married couples if the spouse joins in the gift) are not sufficient because there is still too much money in the estate, further gifts that consume a portion of the entire Federal Applicable Exclusion Amount are often a good idea.

Though annual gifts above $12,000 will eat into the Applicable Exclusion Amount and reduce what may be passed at death without tax, it also transfers out of the estate all the appreciation that would have been in the estate had the gift not been made.

When your gifts exceed the $12,000 annual exclusion amount, the excess is subject to a graduated gift tax with a maximum rate of 45% in 2007. To avoid owing gift tax, you may elect to deduct the excess over and above the $12,000 from your $2 million (in 2007) Applicable Exclusion Amount. This amount changes each year.

Case Study: Taking Advantage of Exclusion to Reduce Gift Tax

Bill Smith chooses to give his son a gift of $62,000. Of that money $12,000 takes advantage of the annual exclusion. The $50,000 is subject to the gift tax. Bill elects to have the $50,000 deducted from his $2 million (in 2007) lifetime Applicable Exclusion Amount rather than pay the gift tax. This leaves him with $1,950,000 that can be used for additional gifts.

It is important to make this election by filing a gift tax return, Form 709. That tells the IRS that the gift consumed part of the $1 million lifetime Applicable Exclusion Amount. Please also note that filing the gift tax return starts the statute of limitations on the gift. This is particularly important in the event that the value of the gift could be open to interpretation, such as a gift of an interest in a family-limited partnership, a piece of land, a business, or any other asset that by its nature is difficult to value.

It is conceivable that some people could use up all of their Applicable Exclusion Amount during their lifetime, depending on the nature of their lifetime gifts to non-spouse beneficiaries. After that point, the portion of the estate that will be subject to estate tax depends on the year in which you die, how much money remains, and how much of the money is tax sheltered.

Let's look at a hypothetical case study:

Jill Hendrick Uses Her Total Applicable Exclusion Amount

Jill, a widow with a pension and Social Security that covers her needs, has $4 million and only one beneficiary, her daughter Lucy. Giving away $12,000 per year to the beneficiary is fine, but it hardly makes a dent in the potential estate tax at Jill's death. The $12,000 per year gifts will not be part of this example. Let's compare Jill giving Lucy $1 million in year one vs. making no gift. Also, assume Jill gets 7% on her investments and she lives 10 years.

To simplify the math, use the Rule of 72 - which roughly holds that Jill's money will double in 10 years. Let's also assume a flat 50% estate tax. If Jill makes the $1 million gift and is left with $3 million, her estate will have doubled to $6 million at her death. If the applicable exclusion is $2 million at that time, Lucy will have to pay estate tax on $5 million. (Total estate of $6 million plus $1 million [the amount of the applicable exclusion amount–consuming gift] minus $2 million [the Applicable Exclusion Amount at Jill's death]). At the 50% estate tax rate, Lucy pays $2.5 million in taxes. In the meantime, Lucy also earned 7% on her $1 million, which is worth $2 million at Jill's death.

Lucy will have $6 million less $2.5 million estate tax plus her $2 million = $5.5 million.

If Jill had not made the gift, her estate would have grown to $8 million. She would have a $2 million exclusion, so Lucy would have to pay tax on $6 million, which would be $3 million. Lucy would be left with $5 million. By making the applicable exclusion amount-consuming gift (commonly referred to as a credit-consuming gift) in the prior example, Jill managed to reduce Lucy's taxes by $500,000.

In the real world, Jill would probably be well advised to make a leveraged gift such as a grantor retained annuity trust (GRAT), a family-limited partnership (FLP), a gift of life insurance, or one of many other gifting techniques. But that is fodder for another article.

In the final analysis, those who could end up facing estate taxes should first consider simple gifts of $12,000 per year and, if that is not sufficient either because there is too much money and/or not enough $12,000 per year beneficiaries, then a "credit consuming gift" is likely a great strategy.