Could 2011 & 2012 Gifts Come Back to Bite the Grantor?

But under the new law, the tentative estate tax will be reduced by the exclusion amount ($3.5 million) and tax rate (45%) applicable at the time the gift was made. Under this calculation, the tentative estate tax will be reduced by the full $675,000 [($5 million - $3.5 million) x 45%]. This results in the estate avoiding any additional estate tax on the lifetime gifts.

How the new estate tax calculation affects 2011/2012 gifts

As illustrated by the example provided in the previous section, changes in the estate tax could reduce the utility of a gift by causing the decedent's estate tax to be increased by some percentage of lifetime taxable gifts. For instance, if the calculations under the Tax Relief Act are kept in place (the tentative estate tax is reduced by the amount of gift tax that would have been paid at the time of death and not the amount of gift tax actually paid), but the gift tax rate and exclusion amount are reduced, the decedent could end up paying estate tax on lifetime gifts that were already taxed under the gift tax regime.

This fact could cause the savviest of your clients to ask: Should I wait to make lifetime gifts until Congress gets the transfer tax situation worked out?

Why 2011/2012 Gifts Make Sense Regardless of What Congress Does with the Estate, Gift & GST Taxes

Answering the question of whether to make gifts in 2011/2012 or to wait until Congress sorts out the transfer tax comes to down to pure speculation. For your more conservative clients, it's a question of what the worst case scenario would be for the estate, gift and GST taxes.

What's the worst case scenario if a lifetime gift is made instead of leaving property in the estate?

Within reason, perhaps the worst case scenario would be for the Congress to keep the new tentative

estate tax calculation provisions in place while increasing the exclusion amount—to, for instance, $6,000,000—and lowering the estate tax rate—to 25%, for example. In that case, a $10 million gift made when the exclusion amount was $5 million and the gift tax rate was 35% would have resulted in gift tax liability of $1.75 million at the time of the gift. If the grantor dies when the estate tax rate is 25% and the exclusion amount is $6,000,000, the tentative estate tax would be reduced by only $1 million [($10 million - $6 million) x 25%] to account for the lifetime gift, even though the gift tax paid at the time of the gift was $1.75 million. As a result, $750,000 of the $10 million lifetime gift will be subject to estate tax at the time of death—a kind of double tax.

But even if this unlikely worst case scenario comes to pass, what's the alternative? If the decedent kept the $10 million in her or his estate until death, the estate tax on the amount would come to $1 million [($10 million - $6 million) x 25%]. In the case of the prior gift, the decedent would have paid $1.75 million in gift tax at the time of the gift and then would have been taxed an additional $187,500 ($750,000 x 25%) on the gift in the estate. The total transfer tax in that case would be $1,937,500—almost double the tax the decedent would have paid had she or he kept the "gift" until death and paid the estate tax on the amount.

Does this worst case scenario mean that gifts in 2011/2012 are too risky?

The tentative answer—again, fueled entirely by speculation—is that the worst case scenario (an increase in the exclusion amount and a decrease in the tax rate) is unlikely. The Republicans were able to push the Tax Relief Act compromise through Congress only because they agreed to limit its duration to two years. It's hard to imagine Congress agreeing to a further increase in the exclusion amount and a decrease in the tax rate when they reconsider the issue in 2012.

And even if the exclusion amount is increased and the tax rate is decreased in the future, there's still the fact that a lifetime gift removes the gift from the estate and allows it to appreciate without the appreciation being taxed in the older generation's estate. So even if the transfer tax paid on the gift is doubled by making the lifetime gift in the worst case scenario, if the value of the gifted property doubles between the time of the gift and the decedent's death—which isn't an unlikely scenario if 20 years elapse between the gift and the grantor's death—the net transfer tax paid on the gift will be about the same in both scenarios.

What's the likely consequence if a lifetime gift is made instead of leaving the property in the estate?

Although the worst case scenario described above could result in more transfer tax liability for the grantor, the worst case scenarios is fairly unlikely. So what's the net result if a lifetime gift is made and the more likely scenario plays out in Congress? What if the estate tax remains the same or the exclusion amount decreases and the rate increases?

If Congress extends the current transfer tax regime ($5 million exclusion, 35% rate), and the grantor dies while the estate tax is still in operation at current amounts and rates, the lifetime gift will not increase transfer tax liability. And if the tax rate is increased or the exclusion amount is decreased, the grantor's estate tax liability will not be increased by the lifetime gift.

The next two years offer your clients an unprecedented opportunity to gift their assets to the next generations while incurring minimal transfer tax liability. Most of your clients will be unaware of this opportunity, and this article can be used as a framework for running through the calculus of 2011/2012 gifts with them. But even if they decide that lifetime gifts are not for them, they'll be impressed with your knowledge and ability to help them manage their financial futures.

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See also The Law Professor's blog at AdvisorFYI.