Families can use a variety of strategies to reduce their estate tax burden. One of those is gifting assets from one generation to the next. By using various exemptions and exclusions, you can gift a certain amount of assets to your family members without triggering gift taxes, thereby reducing the size of your taxable estate. Moreover, gifts to so-called dynasty trusts may insulate gifted assets from estate tax for multiple generations.

One of the primary benefits of lifetime gifts is that of “estate freezing.” In other words, once you’ve made a gift to a beneficiary, any future appreciation of those gifted assets occurs in the hands of the beneficiary and outside of your taxable estate. We often help clients deploy strategies such as GRATs to accomplish these estate freezing goals; the interplay of investment and tax considerations in these matters helps us identify windows of opportunity where we can take advantage of volatility or other market conditions to make notable progress on wealth transfer objectives.

However, are these transfers advisable with low-basis assets that carry a meaningful amount of unrealized capital gains? Generally, no, because your tax basis in a gifted asset carries over to your beneficiary. If you gift a low-basis asset to a beneficiary who eventually sells it, the capital gains tax he or she incurs could offset or even outweigh the estate tax savings achieved by gifting the asset in the first place. In contrast, assets passed to a beneficiary at death receive an adjusted (often referred to as “stepped up”) cost basis equal to the value on date of death, which eliminates unrealized capital gains.

Accordingly, low-basis gifts typically make sense only when your estate tax rate is much higher than your beneficiary’s capital gains tax rate. Historically, estate and gift tax rates were much higher than capital gains rates, so gifts of low-basis assets generally made more sense in the past than they do today. But the differential between the two taxes has narrowed; federal estate tax rates have fallen, and estate taxes in many states have been eliminated, while capital gains taxes have risen at the federal level and in some states.

However, a gift of low-basis assets may still be advisable in some cases. While not an exhaustive list, here are several scenarios in which gifts of low-basis assets may make sense.

When you can retain the income tax liability of the gifted asset. In some situations, you can retain the income tax burden inherent in the gifted asset (both ordinary income tax and capital gains tax upon a sale), even while the economic value of the asset is passed to a beneficiary. A primary mechanism for achieving this result is a so-called intentionally defective grantor trust (IDGT). If you create an IDGT, you are deemed the owner of the trust for income tax purposes, but the trust beneficiary receives the economic benefit of the trust’s assets. If you contribute a low-basis asset to an IDGT and the asset is sold, you would pay the tax on that sale; functionally, this serves as an additional gift to the trust but is not treated as a gift for gift-tax purposes. Essentially, your beneficiary receives a greater net return on the gifted asset than you would because his or her return is not subject to income tax. What’s more, the tax payment reduces your remaining assets and thus lowers your eventual estate tax bill.

When you can discount the fair-market value of the gift for gift-tax purposes. You can discount the value of a gifted asset if the beneficiary will not have administrative control over a received asset and/or they cannot easily sell the asset. Tax law allows discounting in these situations to reflect the lack of control and lack of marketability of the asset. For example, if you hold minority interest in, or nonvoting shares of, a closely held business, you may be able to discount the value of that asset for gift-tax purposes. There are other ways to generate valuation discounts through indirect gifting strategies. For example, publicly traded securities wouldn’t normally be eligible for a discounted valuation, but if you place them in a family limited partnership and gift interests in that partnership to your beneficiaries, you may be able to apply a discounted valuation to the partnership units. Such discounting enhances estate tax savings because the amount of the discount is the functional equivalent of additional post-gift appreciation in the value of the asset.

When it is unlikely the transferred asset will ever be sold. If your beneficiary is highly likely to retain the asset, concerns about capital gains taxes become irrelevant—if those gains are never realized they will never be taxed. Accordingly, any asset viewed as a “family legacy,” such as a family vacation home, could be a good candidate for low-basis gifting.

So, while it is generally better to gift higher-basis assets and to pass lower-basis assets through inheritance, there are also some clear exceptions where it may make sense to consider lifetime gifts, even when the gifted assets are highly appreciated. As is always the case in matters of estate planning, your decisions depend greatly on your unique circumstances, and we consider it our responsibility to help you devise an estate plan that helps your family achieve its specific multigenerational goals. 

 

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.