Federal Estate and Gift Taxation of Deathbed Gifts

Often times, a person who is on his or her deathbed will wish to make gifts to family members. A gift is usually considered a deathbed gift if it is made within three years of a person's death. However, except for certain transfers discussed below, when a gift is made is often irrelevent for federal estate tax purposes because there is a lifetime lookback, not just a three year lookback.

Making gifts in a way that minimizes taxes is actually a very complex process. In deciding whether to make a gift, one 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. I will not be discussing advanced topics such as discounted gifts or generation skipping tax transfers in this post.

The Tax Effect of a Gift

To understand the effect of a gift for federal estate and gift tax purposes, we need to start with a short discussion of the current law.

United States citizens and permanent resident aliens currently can give away an unlimited amount to a US citizen spouse or a charity without incurring a gift tax or an estate tax. US citizens and permanent resident aliens can give away up to $5,000,000 to anyone else. This is known as our lifetime exemption amount, unified credit amount or applicable exclusion amount. (Note, transfers to a spouse who is a permanent resident alien are not unlimited, they are capped by the lifetime exemption amount.)

After 2012, this $5,000,000 amount will be reduced down to $1,000,000 unless the legislation is modified. (I think it is highly unlikely that it will go back down to $1,000,000, but $3,500,000 is quite plausible.) Gifts of less than the $5,000,000 lifetime exemption amount will not result in a tax; they merely reduce the donor's exemption amount and the amount the donor can transfer on death.

In addition to the lifetime exemption amount, each person can make annual exclusion gifts without any tax liability. Annual exclusion gifts are also known as 2503(b) gifts. Gifts in excess of the annual exclusion amount (currently $13,000 per donee per year) are taxable for federal gift tax purposes. When I say that gifts in excess of the annual exclusion amout are "taxable", that means the gift reduces the donor's lifetime exemption, or, if the lifetime exemption has been used up, these transfers will result in a taxable gift. Currently, the gift tax rate and estate tax rate are 35%.

To complicate matters, if the donor is married, he or she can "split" the gift with his or her spouse. For example, let's say I gift $7,000,000 to my two children. If I make the gift alone, $26,000 of the gift is sheltered by my annual exclusion amount ($13,000 for each child). The balance, $6,974,000, reduces my lifetime exemption from $5,000,000 to $0 and results in a taxable gift of $1,974,000. At 35%, the tax on this gift would be $690,900. However, if I had split that gift with my wife, we could also use her annual exclusion amount making the taxable gift to the kids only $6,948,000. Additionally, the taxable gift would be split in half, reducing each of our lifetime exemptions to $1,526,000 and no gift tax would be due.

Gift splitting is available to married couples if each spouse is either a citizen or a resident of the United States. (I.R.C. 2513) In other words, you may gift-split with a non-citizen spouse provided he or she is resident alien.

The power of gifting using the annual exclusion exemption cannot be emphasized enough. If you have an elderly widow who has $8,000,000 who gifts $13,000 to each of her children (4),each of her grandchildren (10) and each of the spouses of her children and grandchildren, that widow can give away 28 gifts of $13,000 tax free. That's $364,000. If she does that for 9 years until she dies, she can pass on 100% of her estate to her heirs without any federal estate tax. If she had kept the $8,000,000 until her death, there would have been a $1,050,000 federal estate tax.

To get a better idea of the power of lifetime gifting using the annual exclusion amount, read my blog post on deathbed transfers in New Jersey in which I discuss gifts by Tabitha and Genie.

For all gifts discussed to this point, it would not have mattered when the gift was made. Gifts equal to or less than the annual exclusion amount do not count against the $5,000,000 exemption amount while those in excess of the annual exclusion amount do regardless of when they were made. It is now time to learn about about some special rules.

Gifts of Certain Assets are Subject to a Three Year Lookback Rule

Many people assume, incorrectly, that proceeds from life insurance policies are paid to the beneficiaries free of tax. While this is true that there is no income tax on such proceeds, it is not true for the estate tax. If a decedent OWNS a life insurance policy insuring his or her own life, the entire death benefit is includible the decedent's estate, regardless of who the beneficiary is. If the value of this death benefit plus the decedent's other assets result in the decedent having an estate over the $5,000,000 limit, the overage will result in a federal estate tax unless the estate is entitled to a marital deduction or charitable deduction.

Under Section 2035 of the Internal Revenue Code, certain assets that are transfered by a person who dies within three years are considered to be owned by the person at his or her death. This rule most significantly applies to the transfer of life insurance policies. So, if a decedent transfered OWNERSHIP of a 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 equal to the full face value of the policy - not just the value of the policy on the date of the gift.

You should also be aware that the Section 2035 lookback rule also applies to the release of certain interests in trusts and real estate. Additionally, if the decedent paid any gift taxes within three years of death, that will be added back into the donor's gross estate, and the donor will get a credit for the taxes paid. Since these items do not affect most people, I will not discuss them in depth.

Gifts in Which the Donor Retains an Interest or Control

There are many ways to make a gift. I can give you a house or I can draft a deed, keeping a life estate for myself and then giving you the house when I die. I can give you 30% of my company or I can give you 30% of my company and retain the right to vote your stock.

The general rule is that if I make a complete gift, retaining no interest or control, it is a completed gift and will not be includible in my gross estate. If I retain any control or interest, such as a life estate or a right to vote your stock, then the gift, even though complete, will still be includible in my gross estate.

I can also fashion a gift in a manner in which there is a chance that I receive the property back. For example, I can give you a property for your life and then to your father if he survives you, but if he doesn't survive you, I get the property back. If you are much younger than me, there is a small chance that I will get the property back. If you are much older, than the chance I will get the property back is much greater. The probability that I will receive the property back is calculated as of the moment before my death, so the fact that I died before you is irrelevent. If the chance that I would have gotten the property back is greater than 5%, then the value of the property at the time of my death is includible in my gross estate.

What's the big deal if the property is includible in my gross estate if there's a lifetime lookback? Well, let's back to the example in which I transferred a 30% stock interest. Assume that at the time of the gift the 30% interest of the stock was $1,000,000 and at the time of my death that same interest was worth $7,000,000. If I had not kept an interest in the stock, it would have just reduced my lifetime exemption by $1,000,000. By keeping the voting interest, the full $7,000,000 value will be included in my estate resulting in a federal estate tax of $700,000 (35% of $2,000,000).

The Importance of Knowing the Basis of the Gifted Item

As discussed on my post on deathbed transfers in New Jersey it is wise to know the basis of the property that is being gifted. If the donor is gifting an asset, the recipient receives the gift with the same basis as it had in the hands of the donor. This is known as a carry-over basis.

Accordingly, if the donor gifts an asset that it is highly appreciated, it will result in a substantial capital gains tax when the donee ultimately sells it. If, on the other hand, the donor gave the item to donee on his death, the asset would take on a basis equal to the fair-market value of the property as of the date of the donor's death.

Due to the carryover basis rule, it is usually best not to give away appreciated property during life. It is better to either gift away cash or hold on the the asset until death and have the beneficiaries pay a smaller estate tax.

The Benefit of Making Taxable Gifts

Reading through this post, the benefit of making gifts equal to or less than the annual exclusion amount is quite evident, but you may be asking yourself why anyone would wish to make a taxable gift that uses up a person's exemption amount. Look back to the situation where the donor gave away a 30% interest in stock worth $1,000,000 and that stock grew to $7,000,000. It is much better, for tax purposes, if that grows in the hands of someone other than the person who is likely to die first. This technique is known as an "estate freeze" because reduces the chance of assets growing in the donor's hands.

Filing requirements for Taxable Gifts

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 709).

Deathbed Transfers in New Jersey

Often times, a person who is on his or her deathbed will make gifts to family members in an effort to reduce the potential taxes owed.

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:

1. 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.


2. 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.


3. 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.


4. 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.


5. 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.


6. The capital gains tax imposed on the sale of appreciated property, stock or similar assets.

As you may have noticed, only four of the six taxes named above are directly attributable to a transfer being made as the result of someone dying. The reason that a lifetime gift can be taxed at the donor's death is because New Jersey and the federal government have lookback provisions. Lookback provisions basically say that if you make a certain kind of transfer, the government can tax it at your death even if you gave the money away during your life. As you can imagine, this creates a host of problems including finding a way to pay for the tax.

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:

1. 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;


2. 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.

B. You should also be aware that the Section 2035 lookback rule also applies to certain interests in trusts and real estate. This does not affect most people, so I will not discuss them here.

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.

Summary

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.

Simple, right?

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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.