For transfers to anyone other than a charity, making gifts in a way that minimizes taxes is actually a very complex process. In deciding whether to make a gift, you must consider the amount of the gift, the type of asset you wish to transfer, to whom it is going to and the basis in the gifted item.
Taxes That Must be Considered When Making Gifts
There are generally six taxes that might be triggered as result of the gift. These include the New Jersey estate tax, the New Jersey inheritance tax, the federal estate tax, the federal gift tax, the capital gains tax and the generation skipping transfer (GST) tax.
I discuss all of these taxes in more detail elsewhere, but to quickly review the general purpose of each tax:
- The New Jersey estate tax is imposed by the state on transfers at death to the extent the decedent's net estate exceeds $675,000 and the money passes to someone other than a charity, surviving spouse, domestic partner or civil union partner.
- The New Jersey inheritance tax is also a tax imposed on transfers at death. However, the inheritance tax is based more upon who the money is going to rather than the amount involved. New Jersey does offer a dollar for dollar credit against its estate tax for any inheritance tax paid.
- The federal estate tax is imposed by the federal government on transfers at death to the extent the decedent's estate exceeds $5,000,000 and the money passes to someone other than a charity or a surviving spouse.
- The federal gift tax is imposed by the federal government on transfers during a person's lifetime to the extent the person's lifetime gifts exceed $5,000,000 and the money is transferred to someone other than a charity or a spouse.
- The generation skipping transfer tax (also known as the GST Tax) is generally assessed by the federal government on transfers during life or at death to a person's grandchildren, or more remote descendants to the extent such transfers exceed $5,000,000.
- The capital gains tax imposed on the sale of appreciated property, stock or similar assets.
What is a Deathbed Gift?
New Jersey defines deathbed gifts as gifts made in contemplation of death (N.J.S.A. 54:34-1(c)). People usually know the deathbed gift rule as the three year lookback rule because gifts made within three years of death are presumed to be in contemplation of death. If a gift is made in contemplation of death, and the gift was over $500, then New Jersey asserts it was really a transfer at death subject to the inheritance tax.
For New Jersey tax purposes, this particular three year rule ONLY appears under the NJ inheritance tax statutes. There is a very different rule for the New Jersey estate tax because the New Jersey estate tax generally follows the federal estate tax for determining what is taxable and what is not taxable. I will discuss this in more detail below.
Since gifts made in contemplation of death are subject to an inheritance tax, and the inheritance tax only applies for transfers to certain beneficiaries, it is important to know how New Jersey classifies the beneficiaries of the gift.
Determining the Class of the Beneficiary
To determine if a lifetime gift will result in a New Jersey inheritance tax, the first thing that you must do is differentiate between gifts made to Class A beneficiaries, Class C beneficiaries and Class D beneficiaries.
Class A beneficiaries include the decedent's spouse, civil union partner, domestic partner, all lineal descendants (such as children, grandchildren and great-grandchildren), all lineal ascendants (such as parents, grandparents and great-grandparents) and step-children. An adopted child, grandchild or great-grandchild is also considered a lineal descendant. Transfers to Class A beneficiaries are exempt from the NJ inheritance tax, meaning there is no inheritance tax on deathbed gifts or transfers at death to such individuals.
Class C beneficiaries include the decedent's brother or sister and son-in-law or daughter-in-law of the decedent even if the decedent's child is also deceased. Class D beneficiaries includes everyone else (most notably nieces and nephews).
If the gift is made to a Class C Beneficiary, and the gift was over $25,000, there definitely will be a NJ inheritance tax if the gift was made "in contemplation of death". If the gift was made more than 3 years prior to the decedent passing, it will not be subject to a NJ inheritance tax.
If the gift is made to a Class D Beneficiary, and the gift was over $500, there definitely will be a NJ inheritance tax if the gift was made in contemplation of death. If the gift was made more than 3 years prior to the decedent passing, it will not be subject to a NJ inheritance tax.
If the deathbed gift is subject to the New Jersey inheritance tax, there will be a tax due of 11-16% of the transferred amount. There is an 11-16% tax on transfers to Class C beneficiaries on the gifted amount in excess of $25,000 and a 15-16% tax on the entire transfer to Class D beneficiaries if the gift is in excess of $500. The more that is transferred, the higher the rate will be.
As an example, assume I owned $5,000,000, and I gifted away $1,000,000 to my nieces and nephews four years ago, $3,500,000 to my nieces and nephews this year and then died within three years, leaving the remaining $500,000 to my two siblings. The $1,000,000 gift to my nieces and nephews would not be subject to a New Jersey inheritance tax because it was longer than three years ago. The first $700,000 of the $3,500,000 deathbed gift to my nieces and nephews would be taxed at a 15% inheritance tax rate ($105,000). The remaining $2,800,000 would be taxed at a 16% inheritance tax rate ($448,000). For the transfers to my siblings, $50,000 will pass free of taxes, and the remaining $450,000 will be taxed at an 11% inheritance tax rate ($49,500). In total, there will be a $602,500 NJ inheritance tax.
For gifts to charity in any amount and gifts of less than $500 to any person, there is an easy answer - it is not subject to an inheritance tax in New Jersey.
Regardless of what classification a beneficiary is in, there MAY BE a New Jersey estate tax and/or federal estate tax if the gift is subject to a three year lookback under the federal estate tax rules or a lifetime lookback if the gifted items are in excess of the annual exclusion amount.
Certain Transfers are Automatically Subject to a Three Year Lookback for Estate Tax Purposes
Under Section 2035 of the Internal Revenue Code there is a limited three year lookback that most significantly applies to life insurance policies transferred within three years of death.
A. Life Insurance: If you learn nothing else from this post, make sure you learn this:
- If a decedent OWNS a life insurance policy insuring his or her own life, the entire death benefit is subject to both the New Jersey estate tax AND the federal estate tax. Many people assume life insurance proceeds are tax free. While this is true for income tax, it is not true for estate tax. The only relief is if the beneficiary is a charity, a surviving spouse, a civil union partner or domestic partner because then the estate may be entitled to a deduction;
- If the decedent transferred OWNERSHIP of the policy on his life to another party within three years of death, the 2035 rule kicks in and it is considered a taxable deathbed gift.
Gifts in Excess of the Annual Exclusion Amount
Currently, each United States citizen and permanent resident alien can give away $13,000 to as many donees as he or she wishes. This is known as the federal annual exclusion amount or 2503(b) exclusion. Gifts in excess of the federal annual exclusion amount result in a "taxable gift". Usually there is no immediate out of pocket expense though because New Jersey does not have a gift tax and the federal government will only institute a gift tax if the sum of these gifts exceeds the lifetime exclusion amount (currently $5,000,000).
When calculating the New Jersey estate tax, we are required to look not just at what a person owned when he or she died, but also the taxable gifts that the decedent made over his or her lifetime.
In most situations, if the decedent's taxable estate, including prior taxable gifts, is in excess of the New Jersey estate tax exemption amount (currently $675,000), there will be a New Jersey estate tax. However, there is a big difference in the tax depending upon whether the decedent died with estate over the $675,000 threshhold or died with an estate under the $675,000 threshhold, but is deemed to have an estate in excess of $675,000 due to the lookback provisions.
As an example, assume I owned $5,000,000, and I gifted away $4,500,000 to my daughters and then died in 2012 as a widower, leaving the remaining $500,000 in my estate to my children. Normally, there would be no estate tax on a New Jersey estate of only $500,000, but we must add back the prior gifts. Even adding back the prior taxable gifts, it would only produce a $10,000 NJ estate tax. (To learn how this is calculated, you will need to prepare a 2001 Form 706 federal estate tax return and a New Jersey estate tax return. I will discuss this in future post, entitled "Deathbed Transfers in New Jersey - Advanced")
To realize the benefit of making this gift, you should know that if I had died with the entire $5,000,000, my estate would have to pay a $391,600 New Jersey estate tax. In years past, nobody would give away more than a $1,000,000 because that was the old lifetime gift limit for federal gift tax purposes. Any gifts above $1,000,000 were taxed at a very high gift tax rate. However, with a $5,000,000 lifetime federal gifting limit and no New Jersey gift tax, there is ample opportunity for planning to avoid or drastically reduce the New Jersey estate tax.
You should also be aware that if you do make a gift in excess of the annual exclusion amount, you should file a federal gift tax return (Form 706). If a lifetime transfer is in excess of the federal annual exclusion amount, it could lead to a federal estate tax or a federal gift tax at some future time. To minimize this possibility, you should try to structure gifts over longer periods of time and for an amount equal to or less than the annual exclusion amount. To read more about this, see my article entitled: Federal Estate and Gift Taxation of Deathbed Gifts.
The Importance of Knowing the Basis of the Gifted Item
It is important to know the basis of the property that is being gifted. If the donor is gifting cash, the basis is exactly the amount of the gift. If the donor is gifting property or stock, it may be unwise to make the deathbed gift because there could be substantial built-in capital gains.
When property is gifted away, the donee usually takes the property with a basis equal to that of the donor's basis. (For more on basis, see my post on Understanding Basis.) If the donor keeps property until his or her death, the recepient will receive the property with a new basis equal to the fair market value of that property on the date of the death. This is often referred to as a step-up in basis rule, although in this economy it may be a step-down in basis.
Let's assume I give away a real estate property worth $4,500,000 to my daughters shortly before I die to save on the New Jersey estate tax. If my basis in the property was only $1,000,000, the kids will take the property with that same basis. If my kids sell it immediately after I die for $4,500,000, there will be a 15% capital gains tax on the $3,500,000 of built in gain. This will produce a federal capital gains tax of $525,000 and probably a New Jersey income tax of $315,000. As discussed above, the New Jersey estate tax would have only been $391,600 if I had held onto the property.
Due to the carryover basis rule, it is usually best not to give away appreciated property during life. It is usually better to pay a smaller estate or inheritance tax than to risk losing the step-up in basis on the decedent's death.
In summary, large deathbed gifts are not necessarily going to be taxed after the donor passes. Whether there will be a New Jersey tax on a deathbed gift is based upon whether the transaction has occurred in the last three years, to whom the item is being gifted, the type of asset being gifted and on the size of the donor's net estate after factoring in prior gifts.
When all is said and done, even if there is a New Jersey tax (estate or inheritance), large gifts made to Class A beneficiaries prior to death and large gifts made to Class C and D beneficiaries more than three years prior to death will greatly reduce the overall estate and inheritance tax liability unless the donor is making a gift of a highly appreciated asset.
I want to give a special thank you to Martin Bearg, Esq., Rekha Rao, Esq., Rebecca Esmi, Esq., and to individuals at the New Jersey Transfer Inheritance Tax Branch (who wish to remain anonymous) for taking the time to speak with me about this and helping me to gather my thoughts.