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At the outset I should clarify a term. When I use the term "transfer taxes" I am collectively referring to both the federal gift and estate taxes. Originally, because of lower
relative gift tax rates, it was better to give away property to the kids during life than to wait until death before transferring wealth to the next generation. Then after 1976 we unified
the transfer tax structure by making the transfer tax rate schedules the same for both transfers during life and transfers at death.
But even under the unified approach, it was still beneficial to give away property during life for at least two reasons. Namely, (1) the $10,000 annual exclusion applied only to lifetime
transfers and (2) gifting away appreciating property during life allowed the appreciation accruing after the date of gift to avoid all transfer taxes.
What Is Better Now - To Transfer Wealth During Life Or Later Upon Death?
Those two benefits to gifting still exist (and the amount of the annual exclusion remains the same at
$10,000 per person per year1), but there are some countervailing benefits that now might favor transfers at death over transfers during life.
First, if everything goes according to plan, the estate taxes are in the midst of a total phase-out process whereas there will still be a potential gift tax to deal with for the
foreseeable future. If too much (i.e. > $1 million of taxable gifts) is given away during life, a transfer tax will be imposed, whereas there might never be any transfer tax at all if
the donor waits until death to transfer his wealth.
I use the word "might" for the following two reasons: (1) during the phase-out process, an estate may or may not incur an estate tax depending upon its size relative to the
amount protectable by the constantly increasing unified credit, and (2) we do not yet know whether or not the total phase-out of estate taxes will be permanent since the law contains an
automatic "sunset" provision starting after 2010. This sunset provision may or may not be repealed. I will say more about that later on.
Second, until the phase-out is completed in 2010, there will continue to be a step-up in basis to date of death values.2 In contrast, donees of lifetime transfers take only a transferred
basis from the donor and will usually have to recognize (upon later sale) any built-in gains existing on the date of the gift. Whereas before, people sacrificed the potential step-up in
basis for the avoidance of transfer taxes, now more and more estates will be able to have the best of both worlds - they can get a total step-up in basis and pay no transfer taxes in the
process.
Third, there are some important non-tax reasons to avoid gifting during life which I will discuss later when I talk about spoilage factors.
What Will The New Basis Rule Be In 2010 For Transfers At Death?
Even when the general step-up in basis rule expires in 2010, it will not be lost entirely because the personal
representative or trustee (PR/T) will be given at least $1.3 million of added basis to spread around among the various assets being transferred at death.3 If at death the decedent has any
unrecognized loses that will expire on death, the amount of any such losses will be added to the $1.3 million figure to allocate.4
In addition to the foregoing, with respect to transfers to a surviving spouse, the PR/T will have an additional $3 million of step-up in basis potential.5
These adjustments to basis cannot exceed the fair market value (FMV) of any particular asset at death,6 and do not apply to "income in respect of a decedent."7 But, other than
those limitations, the PR/T will be free to pick and choose how to allocate this basis.
Thus, with respect to most estates, even though the current generalized step-up in basis rule will expire in 2010, the replacement rule will still provide enough step-up in basis potential
to effectively bring basis in most, if not all, assets up to their FMVs at the date of death.
How Much Can Now Be Transferred Free Of Transfer Taxes?
During 2002 and 2003, the protectable equivalence of the unified credit will be $1 million. It will stay there
indefinitely for purposes of the gift tax8 but will slowly rise over the years regarding the estate tax9 in the following manner:
2004-05$1,500,000
2006-08$2,000,000
2009$3,500,000
Then, in 2010 there will be no estate taxes whatsoever. In 2011, however, the changes of the 2001 Act are set to expire which means that the estate tax will come back into existence and
the protectable equivalence of the unified credit from 2011 forward will match that of the gift tax, namely, $1 million.10
What Effect Will The New Tax Law Have On The Basic Estate Planning Strategy?
In order to make some points, we need to review basic estate planning strategy. Traditionally we have
sought to manage the value of a couple's combined estate in order to have it fall within the protection of two unified credits, since each decedent is entitled to his or her own credit.
It was very common for couples to maintain an annual gifting program to their children and grandchildren for the sake of keeping the value of their combined estate below that combined
threshold.
Usually a couple would form a family trust containing all of their assets. When the first spouse died, the property would be divided into two parts. The decedent's part would be protected
by his or her unified credit and kept in trust until the second spouse died. If the first decedent's unified credit did not effectively protect all of his or her share of the property
from estate taxes, then the marital deduction could be used to avoid all estate taxes at that point. When the second spouse died, through personal consumption and/or gifting during life,
hopefully the unified credit available to cover his or her portion of the trust would be sufficient to avoid all estate taxes at that point.
Then on the second death, the trust would probably terminate and the assets be distributed out to the children and/or grandchildren. While the basis of the assets passing from the second
parent to die would be equal to their FMVs at that parent's death, the assets passing from the first parent to die would be equal to their FMVs at his or her earlier date of death. In
other words, most of the assets belonging to the first spouse to die will probably appreciate in value between the two dates of death and thus, will have some built-in gains in the hands
of the beneficiaries. Those assets do not get a second step-up in basis on the surviving spouse's death.
With this basic understanding, I can now explain a potential change in estate planning strategy. As the unified credit for estate tax purposes continues to rise, fewer and fewer estates
will find it necessary to rely upon two unified credits in order to protect the transfer of wealth to the next generation from estate taxes. In other words, only one unified credit might
be sufficient in many cases.
In such cases, rather than take pains to make sure that the share of the estate belonging to the first spouse to die remains separate and distinct from the estate of the surviving spouse,
it may make sense to purposefully make sure that all of their combined estate ends up in the estate of the second spouse to die since then it will all get a step-up in basis equal to FMV
at the date of that spouse's death.
In other words, whereas we previously worried about under-using the unified credit and over-using the marital deduction on the first death, now we may want to totally rely upon the marital
deduction to avoid estate taxes on the first death and use none of that person's unified credit. Again, this would only apply to those combined estates that we do not expect to exceed the
protectable value of the one unified credit available on the date of the death of the second spouse to die. This would allow us to get a full step-up in basis on all the assets at no
transfer tax cost.
Of course, then as now, this step-up in basis rule would not apply to "income in respect of a decedent" (IRD) - income that has been earned by the decedent prior to death but
which has not yet been recognized for income tax purposes because of the decedent's method of accounting. The recipients of IRD must step into the tax shoes of the decedent and recognize
all associated gains as and when the decedent would have, had he not died before the recognition process was complete.
Will Family Trusts No Longer Be Needed?
Will this mean there will no longer be any need for family trusts for those estates that will be exempt from estate taxes? No, there are
still several good reasons to use trusts to implement an estate plan. I will mention just three here. First, they can provide at least partial "spendthrift" protections to the
beneficiaries. In other words, the assets of the first spouse to die could be protected from the improvident acts of the surviving spouse. For example, the surviving spouse might get
remarried to a scoundrel - a "gold digger" - who might weasel his way into the kids' inheritance; or she might negligently cause a multi-million dollar automobile accident; or
enter into foolish business ventures resulting in bankruptcy, etc. A trust can protect the next generation from such potential problems with respect to the property belonging to the first
spouse to die but probably not with respect to the property belonging to the surviving spouse.
Second, trusts are very useful at implementing delaying provisions. For example, a trust can provide that beneficiaries are not entitled to any distributions until they reach some pre-set
age beyond the simple age of majority. So rather than risk giving an 18-year-old a sizeable inheritance while still relatively immature, the parents can provide for distribution at age
30, for instance. Without such delaying provisions, a beneficiary would normally be entitled to receive his inheritance as soon as he reaches eighteen years of age.
Third, trusts provide more privacy to a family and less potential for costly and time-consuming judicial oversight.
A Non-Tax Advantage of the Recent Tax Law Change
One advantage behind the recent tax law change is that it diminishes what I think used to be a perverse incentive to make
premature gifts during life. As explained earlier, many couples felt compelled to make annual gifts of $10,000 per person per year to their children, in-laws, and grandchildren for the
sake of managing the size of their combined estate in hopes of avoiding all transfer taxes. While this strategy worked wonderfully from a tax planning standpoint, it often times carried
very heavy human costs by way of a spoilage factor.
In other words, year after year as the children received such large gifts, they tended to start viewing life in an unhealthy sort of way. They tended to think that a different set of rules
applied to them, anticipating financial security as a matter of right totally unconnected from anything they might choose to do or not do themselves.
These attitudes adversely affected their judgment in many ways. For instance, they often times did not take their educational experience very seriously. They chose weak and relatively
valueless majors in college. They found it difficult to develop good study habits and work ethic. Life seemed to be nothing more than a giant party to many of them - free of personal
responsibility. They had a hard time "growing up" and becoming serious about life.
In addition, many developed unreasonable attitudes towards risk-taking. They tended to migrate toward one end of the risk spectrum or the other - either they became too risk averse, like
the Biblical story of the man who buried his talent in the ground for fear of losing it rather than investing it in the marketplace to earn a return; or they threw caution to the wind and
took extremely high risks like the Hunt brothers who tried to corner the silver market or the Haines underwear heirs who lost their respective inheritances almost as fast as they got them
through excessive risk-taking ventures. The appropriate middle-ground seemed elusive to many of them.
In addition to the foregoing, many became spoiled in the traditional sense. They developed a superiority complex where they thought they were better than others simply because of their
superior relative wealth. We have all known people with such attitudes - they are insufferable annoyances to everyone around them and are almost universally disliked.
One of my professors in law school told a very troubling story about one of his clients. It seems the man had a very successful business as well as other valuable assets. Pursuant to the
advice of his tax planner, he and his wife began an ongoing gifting program to their children using the annual exclusion each year to shield the gifts from gifts taxes. They kept the
business but gave away most everything else. After many years of doing this, unexpectedly his business failed and he was struggling financially. He approached his children and asked for
some of the property back that he had given to them over the years. To his great disappointment and sorrow, they all refused his request saying that they had gotten used to their
financial situations and couldn't stand to part with anything even for such a worthy cause as to help out mom and dad. I can only imagine the type of regrets dad must have felt regarding
the unintended spoilage factor associated with his prior tax-motivated gifting program.
As a parent, I don't want to do this to my children and I don't think most of our clients would either. In my opinion, the first decade of adulthood is very critical to one's future. I
believe that healthy financial struggle during these years is necessary for most people to develop in an optimal fashion. In my opinion, using gifts to help the children get through
school, and perhaps acquire the necessary down payment monies to get them into their starter-homes, can be justified. Beyond that, however, I think it is generally good for them to have
to figure out the rest of their financial lives on their own. Since the new tax law diminishes the perverse incentive to prematurely gift away one's estate to the next generation for the
sake of tax planning, I would consider this to be an advantage over prior law.
The foregoing illustrates a common professional "blind spot" that we need to avoid. As tax-planners, it is very easy to get so engrossed in our quest to reduce our clients' tax
bills, that we ignore what may turn out to be far more important non-tax concerns. We need to take off our tax-saving blinders and increase our non-tax peripheral vision when advising
clients.
Disadvantages of the Recent Tax Law Change
One disadvantage of the recent tax law change regarding transfer taxes is the uncertainty it creates. The tax overhaul has a built-in
sunset provision after ten years. Unless Congress repeals the sunset provision, the changes will terminate starting January 1, 2011. In other words, after a one year hiatus in 2010 when
there will be no estate taxes whatsoever, all of a sudden we will return to the prior estate tax regime where only the first $1 million of a person's property is protected from estate
taxation.
Will Congress repeal the sunset provision? In our current political environment where we are in a costly war against terrorism, our budget surpluses have evaporated, and an economic
recession is at our doors, perhaps we should ask ourselves a different question: might the sunset provision actually be accelerated rather than repealed?
At this point, nobody knows the answers to these questions. But, if I were forced to guess, I would predict that the sunset provision would more likely be accelerated than repealed. After
all, the matter of estate taxes represents a classic political opportunity for stirring up class warfare among the masses.
Since the protectable limit provided by the unified credit has already been raised to $1 million, I suspect that if Congress were to back-peddle on us, we would probably not be forced to
retreat from that number. However, I have serious doubts that it will actually rise any higher than that.
I think it is appropriate to do some guessing here, since it will have an impact on our professional advice regarding gifts. If I fully expected the estate taxes to be repealed once and
for all, then I would be inclined to advise most people to avoid substantial gifting during life for the reasons discussed earlier.
However, if I expected the unified credit to become frozen at $1 million of protectable value, then I would only seriously consider recommending some sort of gifting program regarding
those estates which can be expected to exceed $2 million in value (the protectable value of two unified credits) on the date of death of the second spouse to die.
So what should we advise regarding estates that are already over this amount or are expected to be by the date of death of the second spouse to die? I would still be hesitant to recommend
a gifting program to the next generation, again, for the reasons discussed earlier regarding spoilage. Rather, I would recommend the client consider charitable giving which brings me to
the next potential disadvantage of the recent tax law change.
In my opinion, charitable giving is a wonderfully beneficial thing. It significantly helps to sustain civilization. Churches, universities, hospitals, schools, charitable foundations,
various community projects, etc. rely upon charitable giving to survive. Without these civilizing institutions, we would quickly retreat into barbarism.
What effect will the discontinuance of the estate tax have on charitable giving in general? Faced with the prospect of Uncle Sam taking, for questionable purposes, a sizeable part of
wealthy estates, many people could be expected to choose instead to give to the charity of their choice, expecting far greater societal good to result in the process. If we take away the
tax incentive to give to charity upon death, will people still be as inclined to make such gifts and bequests?
While our first impression may be that doing away with estate taxes will significantly reduce charitable giving in general, such may not in fact turn out to be the case. After all, the
same fear existed when we started reducing the top marginal tax brackets for income taxes. As the tax rates fell, the after-tax cost of charitable giving effectively went up.
Nevertheless, charitable giving continued to increase year after year. Perhaps it would have increased faster than it did had the income tax rates not fallen - that is subject to debate -
but at least we know that it did not actually decrease over that time period.
So, at this point, we do not know what effect the estate tax changes will actually have on charitable giving. If if it does turn out to have a negative impact, then I would call that a
disadvantage.
One Last Plug For Charitable Giving Instead Of Giving The Children Too Much Inheritance
In order to support the cause of charitable giving, I would like to share part of my
father's story. When my father was ten years old, his father died. My grandmother, who never remarried, had to raise her four children on very meager earnings. Consequently, my father,
early on, saw education as his ticket out of poverty. He dedicated himself to his studies and skipped two grades in school. Having skipped so many grades caused him to be the perpetual
runt of the class throughout his high school days at Provo High. Despite all the teasing he must have had to endure, he remained focused. He actively participated in many school
activities, including the debate team. He and another student placed second in the state in the two-man competition, but he always put the blame on himself for not coming in first.
At the end of his senior year, the school had its annual awards assembly where various students were recognized for their scholastic achievements. The very last award to be presented each
year was the Mangum scholarship - a four-year scholarship to BYU to the number one male student at Provo High. To my father's great surprise and delight, his name was called as the winner
of this coveted scholarship. I can only imagine the exquisite feelings of exultation he must have felt as he walked up to the podium amidst a standing ovation from his fellow classmates -
the class runt had won the crown. Without that scholarship, his chances for obtaining a higher education would probably have vanished on the spot.
Whoever by the name of Mangum endowed that scholarship, he or she opened up a world of opportunity to a very promising but indigent lad. My father's life was literally blessed by the
generosity of that wonderful benefactor. The name Mangum will always carry a special meaning to my family as well as the families of all the other beneficiaries of that scholarship over
the years.
Unfortunately, the scholarship awarded to my father was the last four-year scholarship given under the Mangum name since the earnings generated by the endowment were insufficient to
maintain itself in a four-year format. Sadly, from then on, it became only a one-year scholarship.
After BYU, my father attended law school at the University of Michigan and later became a very successful tax attorney in Los Angeles. Ever-grateful to the generosity of the Mangum family
for the opportunities their scholarship had given him, when he had acquired the necessary financial means, he contacted them and asked if he could contribute sufficient funding to the
endowment to return the scholarship to its original four-year status. They were very delighted at the offer and gratefully accepted.
Over the years, my father would oftentimes plan a trip to Provo around the time of the annual award ceremony so that he could be in the audience and see the awarding of the scholarship. As
he watched the winner's excitement, no doubt with his eyes moistened by a tear or two of gratitude, he relived that special day in his early life when he was the one walking up to the
podium to accept the prize - the prize that was so critical to his future and which was only made possible by the generosity of someone he didn't even know.
When my mother died in 1986, in honor of her, he endowed a similar four-year scholarship in her name for the number one female student from Idaho Falls High to attend Utah State
University, both of which were my mother's alma maters.
He derived great joy from his participation in both of these scholarships. He inspired some of his friends to do the same thing regarding their alma maters and they too reveled in the
experience.
If my father had not done what he did regarding those scholarships, where would his money have otherwise gone? Probably to me and my siblings. Do I think his money was well-spent?
Unquestionably yes. He did far more good for society by spending it the way he did than by giving it to me.
So as you advise your clients about gifting, I hope you will keep this story in mind and pass it along. It is very easy to do too much for our children to their unintended detriment, but
we can never do too much for society in supporting the civilizing institutions that sustain it.
Parent-Child Heart-to-Heart Talks
Those clients who decide to follow my father's lead (and even those who don't) should probably be advised to talk to their children as each
enters high school and caution them against expecting large inheritances. They should stress to their children that they will have to make it through life largely on their own efforts. In
discussing why the parents are taking such a position, they should explain the various spoilage factors discussed above that would probably otherwise come into play in a negative way in
the lives of the children.
Consequently, the children should be advised to be very careful about how they approach their educational opportunities. Among others, the following general rules should be discussed: (1)
greater scholastic effort generally produces higher grades, (2) higher grades generally mean better opportunities both from the standpoint of what university one can attend and one's
ultimate career opportunities, and (3) personal choices concerning majors carry vastly different natural economic consequences upon graduation. The quicker a child can be made to see that
his personal financial destiny lies in his own hands, the better.
What General Rules Should People Observe When They Make Gifts/Bequests To Their Children?
I doubt most people would be inclined to give all of their property away to charity.
They are probably going to want to give something to their children but, in deciding how much, they should probably err on the side of modesty rather than extravagance lest they risk the
spoilage problem discussed above being transferred down to the grandchildren's level. Also, they should take care to be equal in the treatment of their children lest they inject
unnecessary family discord among siblings. Of course, special dispensations for handicapped children would be justifiable.
Parents should think twice about passing a family business down to the kids. Forcing the kids to be tied together financially is a recipe for serious family disharmony. Invariably they
will perceive each others' relative contributory worth differently causing jealousies and even hatred to develop. Even if this does not occur among the children, it will probably occur
among the grandchildren.
I think parents generally should plan to have their family business sold upon death and let the children go their separate ways. If one or more of the children wish to buy the business at
fair market value from the estate, then that is fine so long as they recognize the potential dangers right up front.
I heard a business advisor once recommend that every business owner should seek, as one of his goals, to position his business in such a way as to be saleable at a moment's notice. Every
potential business decision should be evaluated in light of its probable impact on the saleability of the business. With that mindset, business owners tend to make better overall business
decisions than they otherwise would without such a goal. I think that is sound advice.
Not only would such efforts make the business more valuable along the way, it would also facilitate the problem arising at death that I just discussed-the surviving family members would
have more options to go their separate ways upon the decedents' death if his or her business were immediately saleable at that point in time.
In closing, one will note that I have discussed more non-tax issues than tax issues regarding gifting. What I am trying to get across is the idea that the most important part of estate
planning probably revolves around non-tax concerns. Accordingly, advisors should broaden their perspective of the role they play in the estate planning process.
Footnotes
1. I.R.C. Sec. 2503(b).
2. I.R.C. Sec. 1014(f).
3. I.R.C. Sec. 1022 (b)(1)(B).
4. I.R.C. Sec. 1022(b)(1)(C).
5. I.R.C. Sec. 1022(c).
6. I.R.C. Sec. 1022(d)(2).
7. I.R.C. Sec. 1022(f).
8. I.R.C. Sec. 2505(a)(1).
9. I.R.C. Sec. 2010(c).
10. See sunset provisions embedded in I.R.C. Sections 2001 & 2010.
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