What is the Gift Tax and what do they mean when they say the $5 million exclusion expires on January 1st?
The federal gift tax is a tax you are required to pay when you transfer money or property to someone other than your spouse (if a U.S. citizen) and you receive nothing or less than the value of the transfer in return. Congress created the gift tax to preclude wealthy individuals from avoiding the estate tax by giving away their assets before they die. The person who gives a gift must file a gift tax return and pay any tax due.
The gift tax exclusion, which is the amount under which you are not required to pay a gift tax, is $5.12 million this year. This exclusion does not include and is in addition to the $13,000 annual exclusion that allows anyone to give anyone else up to $13,000 without filing a gift tax return and without paying a gift tax. The big deal that everyone is talking about is the fact that the $5.12 million exclusion will revert to $1.0 million at the beginning of 2013, along with the fact that the gift tax rate will increase from 35% to 55%. For example, Joe Plumber, a single man, owns a business valued at $2 million, a house worth $1 million, and a retirement account worth $1 million. If Joe wanted to give his business to his son Joe Jr. today, he would simply file a gift tax return reporting the gift. He would owe no tax. But if he waits until next year, he would have to pay a gift tax of $550,000.
The gift tax is integrated with the estate tax, which also has an exclusion of $5.12 million this year that will drop to $1 million on January 1st, 2013. If Joe were to die this year, his estate would owe no estate tax. If Joe dies after January 1, 2013 his estate will owe as much as $1,650,000 in estate tax, calculated by subtracting the $1 million exclusion from his $4.0 million estate then multiplying the resulting $3.0 million by 55%. Joe’s son would be forced to sell Joe’s house or business to pay that tax.
If Joe were to give his $2.0 million business to Joe Jr. this year when the exemption is $5.12 million and die next year when the exemption is $1.0 million, his estate tax liability is uncertain. That’s because lifetime gifts are added back to the estate on the estate tax return. In order for Joe’s estate to avoid estate tax on the $2.0 million gift, the estate would have to be allowed a credit in the amount of tax on a $2.0 million gift in 2012. It is unclear if this credit would be allowed, or if the credit would be limited to $1.0 million.
Estate and Gift Tax laws are complex and future changes to the laws are unpredictable. If you are concerned, you should seek professional advice now -- before it’s too late. Competent estate planners can suggest various strategies including limited liability companies, family limited partnerships, and various types of trusts to help protect your loved ones from paying confiscatory taxes and losing a home or family business.