Paying Gift Tax May Be a Good Thing

Since TCJA was implemented, many taxpayers have taken advantage of the increased lifetime estate and gift tax exemption so much so that many of them have run out of exemption. With less than two years left in our increased exemption environment, taxpayers have choices: (1) maximize their lifetime gifting using the annual lifetime exemption inflation adjustments;(2) make taxable gifts and pay gift tax; or (3) do both (1) and (2).

From 2023 to 2024, the lifetime estate and gift tax exemption increased from $12,920,000 to $13,610,000; while the increase of 690,000 seems substantial – and there is one more coming in 2025 – many taxpayers have an appetite for more gifting but the idea of paying gift tax is unappealing. However, there are some benefits that come along with paying gift tax. Those benefits include: (1) making more transfers which remove appreciation from your taxable estate; (2) the pay gift tax removes the value the donor uses to pay the gift tax from their taxable estate; and (3) provides an income tax benefit to the donees who receive the gift.

An overview of how the gift and estate tax work together will be helpful in understanding the analysis below. In 2024, each donor has $13,610,000 of lifetime (estate and gift tax) exemption available to make transfers to family members, friends, etc. As long as during their lifetime and at their passing, the donor makes transfers equal to or less than $13,610,000, neither they nor their estate, will have to write a check to pay estate or gift tax. What this means, and which is not always clear is that when a person makes gifts during their lifetime, the amount of those lifetime taxable gifts is included in the tax base on their estate tax return. This does cause many potential donors to ask, why bother making lifetime gifts if the amount is included in the taxable base of my estate. The answer is a lifetime gift achieves fixation of value and the subsequent appreciation escapes future gift and estate taxation. For instance, if a person makes a lifetime gift of securities which was worth $500K on the date of the gift and at the time of their death, the securities are worth $1.5M in the hands of the donee, and $1M has been removed from the estate tax base – lifetime gifting removes appreciation. In the foregoing example, if the gift tax was paid on $500K, the tax would have been $200K. If the securities were included in the estate, the tax would have been $600K.

It is also helpful to understand the application of the gift tax and the estate tax. The gift tax is paid on lifetime transfers and is tax exclusive, meaning the donor is obligated to pay the tax – the “net gift” concept, which is where the donee pays the gift tax, is beyond the scope of this article – so the gift received by the donee is not reduced by the tax liability. On the other hand, the estate tax applies to transfers taking effect at death and is tax inclusive, meaning the bequest passing to the beneficiaries bears the tax. It may be helpful to see this mathematically and see the value it takes to pass $1M to a beneficiary. If we assume the transfer will be subject to a flat rate 40% tax rate, is a beneficiary is to receive $1M via a testamentary bequest and the estate property must bear the tax, the estate will need to have $1,666,666.67 of value before tax to get $1M to the beneficiary = [$1,666,666.67 – ($1,666,666.67 x 40%)]. Where to get $1M of value to a beneficiary via a lifetime transfer – where the donor pays the tax – only $1.4M is needed; $1M gift plus $400,000 to pay the tax. The tax exclusive nature of the gift tax plus the removal of the appreciation from the donor’s estate is a is a tax efficient combination.

Taxpayer 1 (“TP 1”) has used up their lifetime exemption and does not like the idea of paying gift tax. On Date 1, TP 1 has $400,000 in cash and holds securities with a fair market value (“FMV”) of $1M and a cost basis of $0. TP 1 dies five years later with the cash of $400,000 and the securities having increased in value to $2M. Assuming flat 40% estate tax rate (in this and all examples below, the gift and estate tax is assumed to be a flat rate of 40%), TP 1 will have an estate tax due of $960,000 as all $2.4M is subject to the estate tax; the one benefit the estate inclusion is that the securities will get a step-up in basis of $2M. However, since the estate tax is tax inclusive, the beneficiaries will only receive $1,440,000 in value ($2.4M minus $960,000) after the payment of the estate tax.

Taxpayer 2 (“TP 2”) has also used up their lifetime exemption but is considering paying gift tax. On Date 1, TP 2 has $400,000 in cash and holds securities with a fair market value (“FMV”) of $1M and a cost basis of $0. TP 2 makes a gift of the securities for $1M and pays the gift tax with the $400,000 in cash. One oft-overlooked nuance is that the payment of gift tax results in an adjustment to the income basis of the property received by the donee. The income tax basis adjustment is proportional to the percentage of the appreciation in the transferred property’ in TP 2’s case, the transferred property will have an adjusted income tax basis of $400,000 = [$400,000 x ($1M / $1M)]. TP 2 dies five years later with the securities having increased in value to $2M. Since the cash used to pay the gift tax and the appreciation of $1M has been removed from TP 2’s estate, only $1M is subject to the estate tax resulting in an estate tax bill of $400,000. TP 2 has only paid $800,000 in transfer tax = $400K in gift tax and $400K in estate tax; a transfer tax savings of $160,000. In addition, the beneficiaries have $2M in value in their hands since TP 2 paid the gift tax. Even if we consider the beneficiaries sell the securities and have to pay income tax, if we assume a 30% tax rate, the beneficiaries still receive net value of $1,520,000 [$2M – (($2M – $400K) x 30%))].

In addition to the removal of the value of the gift tax paid from the donor’s taxable estate, the payment of the gift tax also provides an income tax benefit to the beneficiary. Generally, the donor’s basis is carried over to the donee upon receipt of the gift. However, the donee’s tax basis is increased for all or a portion of the gift tax paid – a future gift in the sense it reduces the donee’s income tax liability when the assets are sold. A simple example of how the basis adjustment for the payment of the gift tax works is as follows: Donor transfers securities with a FMV of $1M in which the donor had a $550K adjusted basis. Since the gift tax is paid on the FMV of the transferred property, the gift tax paid on the transfer is $400K. Since the net appreciation of the transfer is equal to $450K, the adjustment formula is: [($450K (net appreciation) / $1M (FMV of the gift)) x $400K (gift tax paid)] = $180K basis adjustment. The donee’s adjusted basis on the property is now $630K = the $450K of carryover basis plus $180K of the basis adjustment. If we assume and income tax rate of 30%, the additional basis adjustment saves the donee $54K in income tax on the disposition.

Please note, if the donor who pays the gift tax dies within three years of making the gift which gave rise to the tax payable, the amount of the gift tax paid on that gift will be included in their estate.

Properly using present interest gifts to maximize the use of your annual exclusions; inflation adjustments to the lifetime exemption; the educational and medical exclusions should all be explored to maximize your lifetime gifting but consider paying gift tax on lifetime transfers and an advanced gifting strategy as it may be a good thing, too.