Money Talk

Episode 22

Wealth Transfer Tax

Ed might give $15,000 to all Chicago Bears fans. Does Chuck have 150 descendants? Answer: SOMEDAY. Should I write a check to my 50 grandkids? Answer: NO. Should I have 50 grandkids? Answer: NO. The IRS always changes the rules. Should your spouse be a US citizen? Answer: MAYBE.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck LeFebvre: This is Chuck.

Ed Sutkowski: This is Ed.

Chuck: Today we’re going to be talking about the giving away phase and specifically for wealth transfer taxes.

Ed: Chuck, before we get to that, I want to make sure everyone’s on board here. This is after the income taxes, whether they’re federal or state. That’s after FICA, FUTA, payroll taxes, all these taxes we’ve discussed in prior episodes. We’re talking about the accumulation of wealth after the payment of those taxes. Along those lines, 14 States will not tax your pension, IRA and the related distributions. That may be short-lived in light of today’s issues with the virus. Let’s be clear, post income tax wealth transfer. Chuck, let’s talk about the basic gift tax first.

Chuck: Right. Well, let me rewind for just a second because I think there’s an important interplay here that does occur between at least part of the income tax and these wealth transfer taxes, and that’s that. Even though this is post most income taxes, there’s a really critical exception. That’s a big part of the planning process, and that has to do with capital gains, taxes on capital gains, and so to the extent you have accumulated or appreciated assets that have not been sold and therefore no capital gains have been taxed on them. There’s this opportunity at least for certain types of transfers to avoid paying those taxes altogether. That’s, I think, a big part of the planning process here.

Ed: Yes, but I’m speaking of the basic gift tax, the annual exclusions and then the total exemption. Could you kind of focus on that for just a second?

Chuck: Sure, yes. The federal tax system has a unified tax that applies to both gift taxes and estate taxes. They’re unified in a certain sense, even though they’re two separate taxes. The gift tax portion of that applies to any type of transfer that is made during a person’s lifetime, i.e not a transfer that occurs at death. It’s triggered by the completion of a gift in the sense of a gift that is made– In other words, the donor has relinquished ownership of property either by making a direct payment of cash to somebody or transfer a property to somebody or by transferring it into certain types of trusts that will trigger the implications of this gift tax system. Most people are familiar with, even if they might not be familiar with the terminology, most people are familiar with the fact that there’s an annual exclusionary amount that applies, which is currently $15,000 per year per donee. In other words, at any time you’re feeling generous, you can write me a $15,000 check once a year, and that is completely excluded from the implications of the gift tax, meaning you don’t have to report it on a gift tax return. If there’s no tax imposed, it doesn’t have any kind of longterm consequence whatsoever, and a person can write a $15,000 check to as many different people as that person wants to once a year. There’s this exclusionary gift, of which the most commonly used is this annual exclusionary gift of $15,000 per person, but there’s also exclusionary gifts that are in the form of medical payments, which means making a payment directly to a medical provider on behalf of another person or tuition gifts, again, making a payment directly to an educational institution on behalf of another person. Those gifts essentially don’t count, and then any kind of gift that a person makes above that is a “taxable gift”, meaning that you have to keep track of it, you have to record it on a gift tax return. Over your lifetime, you are allowed to make what is a lifetime exempt amount of taxable gifts, which is just under $12 million, say $11,580,000 in this year, that a person can make. Each year, you add whatever taxable gifts you made to however many taxable gifts you made in prior years. Once you exceed that lifetime exemption amount, then you actually have to start paying tax. The tax rate on the excess is 40%. It’s a pretty significant tax rate but it doesn’t kick in until after you’ve made some pretty substantial gifts.

Ed: Well, let me make sure that I understand. Let’s assume this is last year when Chicago Bears were playing the Los Angeles Rams, and there were 50,000 people in the stands. In theory, I could write a check to each of those 50,000 people for $15,000, never filed a gift tax return, and if my spouse had a sufficient amount of money, my spouse could likewise write checks to those 50,000 people of $15,000.

Chuck: That’s right.

Ed: That would not attract a tax. Plus, of course, I can give whatever I like to a charity, and that doesn’t count. Moreover, I can fund political party activities and that doesn’t attract a tax. The point is, this is almost a voluntary tax if you did a little heads up thinking and identifying the prospective people that will receive the property, the donees, it’s really unlimited. Incidentally, I have no intent of giving away $15,000 to each person at a Bears game. This year, if they have the season, there probably won’t be anyone in the stands.

Ed: Having said that, Chuck, is there a special rule that applies if I’m– I want to keep this property in the family forever, so I’d like to set up a trust or I would like to make gifts to remote descendants. In other words, I’m 95 years old, I’ve got the 150 descendants, I was very prolific, including great-great-grandchildren. How do I make those gifts and do I attract a gift tax on transfers beyond my children?

Chuck: Well, the short answer is this, as long as you keep it simple, meaning you just write checks to each of those people, the answer is this really is very simple, you can write as many checks as you want, it doesn’t matter how far remote those people are to you. Yes, you could write a $15,000 check to each of 35 great-great-grandchildren or 150 great-great-great-grandchildren and the same thing that we’ve been saying is exactly what would apply. What typically occurs is when people start wanting to make gifts to people who are more than a couple of generations down the line, a couple of things happen. First of all, they typically are not writing checks, but they want to do something that is in the form of a trust or some type of a structured program, where the donor is wanting to retain some kind of control, or at least withholding some kind of control from the donee. In other words, maybe you want to give some money to grandchildren, but you really don’t want those grandchildren to spend it. As soon as you get into that category, you run into a situation where the gift may not be a “present interest gift”, meaning if it’s not something that the donee can immediately spend at their own discretion, then this annual exclusionary rule that we’ve been talking about no longer applies.

Ed: Okay, I just want to–

Chuck: Even if the gift is only $5, if the donee isn’t granted the discretion to be able to, essentially, immediately spend it, then that falls into a category, meaning so-called taxable gifts, so you get into that issue. The other thing you get into when you’re talking about descendants that are more distant than children, is then those are considered to be generation-skipping gifts. There’s actually a separate tax that applies to generation-skipping transfers, whether they are during life or at death, and that tax is referred to as the generation-skipping transfer tax or the GST tax.

Ed: Chuck, let me interrupt you for a second. I want to make sure that I understand this. We’ve got the $15,000 player gifts to all the people at Soldier Field watching the Bear game, and that is, we can, 15,000 cash, pay their tuition, pay their medical expenses, give to a charity, and that likewise applies to the generation-skipping transfer tax. In other words, this annual amount, this 15,000 that changes virtually every year, that amount is unlimited, that is irrespective of the identity of the donee. Immediate relative, and of course, that excludes transfers to a spouse. Any spousal transfers as soon as the asset leaves the community of husband and wife, that is, there’s potentially attacks. Inter-spousal transfers are just fine, so to speak, than generation-skipping transfers. In other words, this isn’t the easiest thing in the world. Now let’s talk about basis. Let’s assume, for example, we have a single individual, Chuck. We’ll call him Chuck, for example.

Chuck: Hopefully, he’s a donee, instead of a donor.

Ed: Yes. People have knocked on the doors of the law firm asking to be included in some of these plans. Having said that, let’s assume, just for a minute, you have an asset worth $11,580,000. For what you have an original cost, you purchased it for $580,000, so the potential capital gain associated with that, if transferred to, let’s say, one individual, would be $11 million. What happens when that individual sells that appreciated asset?

Chuck: Yes, so what happens is, if that person acquires it by gift, like this example you’re talking about, then they have the same cost basis in that asset as the donor had. For instance, if our hypothetical person named Chuck receives a gift of property valued at $11,580,000, but having a cost basis of only $580,000, and Chuck immediately turns around and sells that property, then the sale, not the gift, but the sale will trigger the $11 million capital gain, that then gets recognized and is taxed as– Part of the income tax system is the capital gains tax, so Chuck will pay long-term capital gains tax on the recognized gain of $11 million, following that sale. If Chuck does not sell it, then there is no capital gain recognized, and so no tax to pay, but yes, this is an issue when we’re talking about making a gift of property that has substantial appreciation, is that, even though the gift itself may attract no gift tax and no income tax, the gift might carry with it a burden of capital gains tax, as soon as the donee sells that property.

Chuck: Go ahead, Ed.

Ed: -that reduces the value of the gift, in a sense.

Chuck: Yes, it does. Ed, thinking on it, probably is worth pausing here, because we didn’t really say this explicitly, but often people are confused about the following point, which is that property that you receive as a gift is not taxable income. If I get $12 billion in property as a gift from somebody, I don’t have to report that on my income tax return, it’s not income, as far as the income tax system is concerned. When you’re talking about the donor to transfers, the only tax system that’s really implicated on the transfer itself is the gift or the generation-skipping transfer tax system, but not the income taxes and until there’s a sale.

Ed: When there’s a sale, that basis is the basis of the hands of Chuck, the donee and there’s a capital gain tax that you add the holding period of the donor. In other words, if you sold it the day after you received it, but if the donor had held it for more than a year, you get long term capital gain treatment, which is what the 20% plus 3.8% plus whatever in state income tax might be.

Chuck: Right.

Ed: The takeaways, I see it as this is not income to the donee, the old tax basis carries over. You step in the shoes of the donor and you measure that gain by reference to the old tax basis. Now, let’s talk about the estate tax.

Chuck: Yes. In a way, this is where the estate taxes dovetails into the gift tax, which is that when you die, one of the things that you have to keep track of is how much cumulatively did you make in taxable gifts during your lifetime. For instance, if a person has made a total of $11 million of taxable gifts during their lifetime and then they die, the estate tax system applies in much the same way as the gift tax system in the sense that there’s an amount that’s exempt. The amount is the same $11,580,000 figure, but they connect to each other in the sense that when you die, you don’t get a new $11,580,000 exemption that you can get away at death, you just get to use up the rest of what you didn’t use during your lifetime. In this example, if someone has already made $11 million worth of gifts during their lifetime and then they pass away, the first $580,000 that passed through their estate is not taxed. But then everything left in their estate after that gets the estate tax imposed at a rate of 40%. Just like with the gift tax, in the estate tax world, any property that’s passing to a spouse is exempt from the estate tax. Any property that’s passing to charity is exempt from estate tax, but the tax will apply to gifts through the estate that go to children, grandchildren, strangers, pretty much anyone in the world other than charities or spouses. With spouses, there’s a special rule if the spouse is not a US citizen, then there’s a separate rule there. We’re really talking about US citizen spouses are treated with complete exemption here.

Ed: I’ll go back, the big issue is tax basis. In the gift tax rate, recall that the donor or my tax basis carries over into the hands of the donee or Chuck. On the other hand, if I’m a sport and die with that same amount of money, my old tax basis then is increased to my day to death value. When sold by Chuck after I’m a ghost, long term capital gain treatment, but no tax because there’s a new tax basis equal to the 11,580,000. As a matter of fact, I had a situation where this gentleman, very well-schooled in this area, was as bizarre as I think we are, and I’m finding this to be attractive, made substantial lifetime gifts when he knew he was about to die of appreciated property. Had he held that property until he was a ghost, there’d been at tax basis step-up but instead, he made a lifetime gift where the tax base is carried over and the donees then, if they sold a property or when they sell the property, would pay this long-term capital gain tax, and so the donees have to do what, they have to die with it so they get the tax base to step-up.

Chuck: That’s what’s referred to as an amateur error, right, Ed?

Ed: Yes.

Chuck: That’s a tax that could have been so easily avoided with essentially no one being harmed at all by doing what you need to do to avoid the tax.

Ed: What could have happened if he wanted to make that gift of $10 million and he owned the bank, in theory he could pledge the stock to borrow $10 million and at least give away the cash and the whole of stock so get a tax base to step-up at death but that didn’t occur. In other words, is it fair to say that the gift tax and the estate tax, the basic or the generation-skipping in both instances, gift, basic and generation-skipping, estate, basic and generation-skipping is a voluntary tax?

Chuck: I think that’s entirely true, and I think the degree to which they’re voluntary– First of all, they’re always referred to as voluntary taxes. I think that of the three, the hardest one to avoid completely is the estate tax. If someone happens to be wealthy enough that their wealth exceeds that $11,580,000 and if they’re unmarried, they really– I mean, there’s fancy ways of doing this, but really, the trick to avoiding the estate tax involves giving money to charity or doing things that are far fancier than that, so you really are altering your estate plan in order to avoid that tax. But the gift tax and the generation-skipping tax are very easily avoided.

Ed: I’m thinking of three bands of folks with wealth. There’s those whose wealth doesn’t exceed 10 million or there’s those more than 10 but doesn’t exceed 50 and there’s folks that have a more than 50. We’ve talked about the income tax to accumulate the money and then giving it away, but if, for example, the Bernie Sanders tax plan, I’m not suggesting I’m an advocate for this, but nonetheless, that tax plan adopted by some of the politicians was to impose an annual asset-based tax, even if you didn’t sell anything. We’ve talked about income tax, keep harping about that because some states do not tax your pension plans, for example, there’s 14 States that don’t tax your pension, but the balance do. We have an income tax and we have a gift tax. We have a generation-skipping gift tax, we have an estate tax, generation-skipping estate tax, but in the meantime, if that had been enacted, we’d have an annual estate tax.

Chuck: Yes, exactly. I think that the reason why those proposals got floated and got a little traction to them is because there’s some frustration in some political circle really the fact that these transfer taxes are so easily avoided and so the idea is, hey, if you make it annual, then it’s going to be pretty hard for people to avoid paying this tax essentially forever. I think that’s why these proposals– Given the way the primary contest has unfolded, I think we’re unlikely to see that idea re-emerge but to the extent it had some traction, I think that’s what the- that’s what the emotional content behind the attraction was.

Ed: The issue I see is that the total of the wealth transfer taxes, not income, wealth transfer taxes is less than 3% of the revenue. Is that about right? Maybe even less than 2% it’s insignificant and with these increases in the exclusion amount and these opportunities to make these gifts to all the Bears fans, the number of returns that are filed every year is declining and the amount of wealth or revenue that’s achievable by the government by virtue of the imposition of these taxes are declining. What’s the reason for the tax? Well, you’ve expressed it in part and the other part is redistribution of wealth.

Chuck: This tax system appears to me– First of all, if you’re an advocate for the imposition of these kinds of taxes, you could question whether the exemption amounts being what they are today have made the whole process self-defeating. Perhaps if what we had was a three and a half million dollar exemption or a five million dollar exemption, instead of an exemption that was approaching 12 million dollars, we wouldn’t have the argument that there is so little revenue being collected. The truth of the matter is, even when the exemption levels were quite a bit lower than they are today, it was still a fairly small part of the total revenue haul by the IRS. I think that what’s going on with these taxes is and always has been, even when Roosevelt first advocated imposing the estate tax, the idea behind it was a social engineering tax versus something that was really designed to contribute significantly to federal revenue. The engineering, it seems to me, occurs not so much by collecting wealth from wealthy decedents and then pushing that wealth through the federal government to redistribute it, but by triggering behaviors by wealthy families that cause them to, for instance, consider more charitable donations as part of their estate planning. It seems like there’s an awful lot more of that that happens than there is of tax being collected.

Ed: Yes. Stepping back for a second here. This tax gift in a state or for that matter, there’s also an inheritance tax. Some states, Maryland poses both in estate and an inheritance tax, inheritance taxes imposed on the right to receive the property. The gift in the estate tax is imposed on the right to give it away. A strange distinction, but wouldn’t really think about that if you were a normal human being. Tax on the right to give it away and a tax on the right to receive it. Having said that, that tax is imposed irrespective of the identity of the source of the wealth. In other words, that tax is imposed, irrespective of whether you inherited it, whether you earned it, whether you’ve suffered in periods of depression, that is economic depression. It’s democratic in the sense of irrespective of how you get it, you’re going to pay a tax. This idea of redistribution expressed by Thomas Piketty in his bestselling book, Capital in the Twenty-First Century, addresses the redistribution issue. It would be nice if it were just put on top of the table. This is a tax to cause wealth to be redistributed. You get a whole new area of why this tax should be redistributed and are the folks that own the property better equipped to determine the appropriate destination for the asset charities or outright or whatever or should it go through the government and the government determined the application of these funds? That’s for another day. The bottom line is, I think, remember inner spousal transfers are excluded, so the real issue isn’t so much when one person dies, the focus is on the death of the survivor. Then you must make sure that when the first spouse is a ghost, the assets are set up in such a way that those assets will not be taxed again when the surviving spouse passes and issues of tax basis carry over, step up, transfers during lifetime or death. In other words, it appears to be a complicated system. For most people, it is because you look at your tax return every year on your coffee table, typically, you don’t have the entire revenue code and think about dying every year. It’s a punishment for living. Is that fair, Chuck, or am I overstating these observations?

Chuck: Well, I think that– I’m not sure if I’m ready to sign off on referring to a tax as a punishment when you’re not actually talking about the tax penalty. I think that there’s definitely something here that involves singling out wealthy families for a special tax that is very explicitly not directed at, either poor or really what most people would consider to be middle-class families. Yes, I think it does feel punitive when you’re facing this particular tax. It can sneak up on people. You and I both dealt with clients where, particularly– You see this a lot with the farm families where they aren’t aware. They don’t think of their property in terms of its dollar value. It seems to be almost a universal aspect of the way farming families think of their property, is they think of it in terms of the number of acres. In their mind, that doesn’t really translate into a dollar amount, versus the federal government looks at those acres– The federal government doesn’t care how many acres that you’re talking about, they just care about what the fair market value of the property is. Suddenly, you can have a family where you talk to them and they’re, “What are you talking about? I only have a 3000-acre farm. That’s not–” It’s only 3000 acres, they’re not thinking of it in terms of how many millions of dollars the property is worth. To them, this is very salt of the earth. Look, I’ve worked my entire life to develop this. See, I’ve never cheated anyone, this has been, getting up at 5:00 in the morning and taking all these financial risks and living through the time in the 1980s when everyone was going bankrupt and you didn’t know whether you were going to be able to keep farming and taking on these huge debts year after year and now, all of a sudden, I’m being told that I’m one of the rich people. It doesn’t feel that way.

Ed: Chuck, one of our next episodes, we will deal with this in more detail, that is the farmer, the entrepreneur, the guy, that girl that started this terrific business and then the owner of marketable securities and bracket. The owners under 10 to 50 and more than $50 million. Let’s adjourn this presentation bearing in mind and one of our next episodes we’ll talk about, give it away, why, when and how.

Chuck: Perfect.

Ed: Good deal.

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