Client Alert – A Strategy to “Extend” the 2012 Gift Tax Exemption
This Alert outlines a strategy for locking-in the current federal gift tax exemption amount, which stands at $5,120,000 for the remainder of 2012 and is not likely to reach such levels again in the foreseeable future. Without legislative action, the exemption will fall to $1,000,000 at the end of the year. The strategy will be especially attractive to clients who are reluctant to part with enough of their wealth to take full advantage of the current $5,120,000 exemption.
In simple terms, the strategy involves a gratuitous promise to make a transfer of property at some future point in time. Such a promise will constitute a completed gift for federal gift tax purposes, thus allowing current use of the gift tax exemption, provided the promise constitutes an enforceable contract under applicable state law. Under Pennsylvania law, which happens to be favorable, a promise like this can be enforceable, though a properly drafted agreement is required.
To illustrate, a donor who gratuitously promises to transfer $5,120,000 to his or her children in 10 years may immediately take advantage of the gift tax exemption on his or her 2012 gift tax return, as long as the donor’s children may legally enforce the promise.
The strategy takes advantage of the way in which the federal estate and gift taxes work together and, especially, of an IRS Revenue Ruling dealing with that interplay. In short, the federal estate tax is determined by calculating the tentative tax on the combined value of a decedent’s taxable estate and lifetime gifts (i.e. so-called “adjusted taxable gifts” are “added back”). The estate then takes a credit, under I.R.C. § 2010, equal to the tentative tax on the prior gifts at the then-current tax rates.
Generally, in the context of a gratuitous promise to transfer property, an issue would arise were the donor to die before the transfer is in fact made to satisfy that promise. The donor's estate would include the property underlying the promise (because it hadn’t been given away), yet the estate would not be entitled to a deduction for the outstanding obligation because the obligation was not the subject of a bona fide contract (the deduction would be denied by I.R.C. § 2053(c)(1)(A)). Further, under the formula outlined above, the property underlying the promise should hypothetically be “added back” to the donor’s estate to the extent the promise is a taxable gift. This would artificially inflate the value of the taxable estate by effectively “double-counting” the property underlying the promise. First, it is actually part of the donor’s estate (and cannot be deducted) and, second, by the letter of the law it is to be “added back” into the estate as an adjusted taxable gift.
Enter Rev. Rul. 84-25, in which the IRS ruled that (1) the gratuitous transfer of a legally binding promissory note is a completed gift under I.R.C. § 2511; (2) where the promise remains unsatisfied at the promisor’s death, no deduction is allowable for the promisee’s claim; and, most importantly, (3) the completed gift is not treated as an adjusted taxable gift in computing the tentative estate tax.
Thus, while the assets are part of the estate and the obligation cannot be deducted, the prior completed gift is not added back as an adjusted taxable gift. The Ruling prevents the "double-counting" conundrum, but solidifies a valuable planning opportunity whereby a donor can "lock in" a favorable exemption amount before it expires. In other words, a donor can promise to make a gift and currently utilize the gift tax exemption to shield the value of that promise from gift tax. Even if the gift is never actually made during the donor’s lifetime, the promise does not create an estate tax problem thanks to the Rev. Rul. 84-25.
Where the donee/beneficiary is a "friendly" party, satisfaction of the promissory gift can be made at a future time that is advantageous to both the donor and the donee. Cases and IRS guidance have made it clear that as long as a promise or transfer objectively fits the definition of a gift, it will be treated as a gift regardless of the donor's subjective motives and regardless of the donor’s actual intent to fulfill the promise. That said, the transaction should not be arranged as a sham transaction. Certain formalities must be followed and the promise should involve a transfer that the donor intends to eventually effectuate in all events, as the beneficiary will be paid out of the donor’s estate if the promise is not satisfied during the donor’s life.
As with many gifting techniques, this strategy is not without risk. Nevertheless, it represents a valuable opportunity, especially for individuals who are not currently comfortable making an outright gift of a large sum of money or other property, but who are nevertheless looking to take advantage of the current, unprecedented gift tax exemption level before the end of 2012, after which time, it is likely gone forever.
The Tax and Estates Practice Group at White and Williams stands ready to discuss this strategy, or any other, in the context of your personal estate planning. Please feel free to contact:
Kevin Koscil (215-864-6827; email@example.com),
Bill Hussey 215-864-6257; firstname.lastname@example.org), or
Suzanne Prybella 215-864-7188; email@example.com).
IRS Circular 230 Notice: To ensure compliance with certain regulations promulgated by the U.S. Internal Revenue Service, we inform you that any federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code, or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein, unless expressly stated otherwise.