Gift Tax in the New Year

In 2013, the annual gift tax exclusion will increase from $13,000 to $14,000 per year.  The annual exclusion gift is the amount of money a person can gift to an unlimited number of people in any one year without reducing his lifetime credit against gift tax.  The annual exclusion gift amount is a subject of tremendous confusion and misconception.  No other subject raises more questions for me from my clients than the annual exclusion gift.

The federal government imposes a gift tax on certain gifts.  The state of New Jersey does not impose a gift tax.  Even though there is a federal gift tax, very few people pay federal gift tax.  The reason very few people pay gift tax is due to the lifetime exclusion against the tax that we all receive.

The lifetime exclusion is currently $5,000,000.  In other words, a person would have to gift more than $5,000,000 before he would ever pay gift tax.  In 2013, if the federal government doesn’t act and we go over the “fiscal cliff,” the lifetime credit against gift tax will be reduced to $1,000,000.  While $1,000,000 is substantially less than $5,000,000, my guess is, most people won’t gift more than $1,000,000.

So, if a person can gift $5,000,000 without paying gift tax, what is the annual exclusion gift about?  Why should I be concerned about only gifting $13,000 a year?

Many people still believe the annual exclusion gift is $10,000, which is what it was for many years.  In the recent past, the annual exclusion gift has risen through an inflation rider in the law from $10,000 to $11,000 to $12,000 to $13,000.  Next year, as stated, the annual exclusion gift will increase to $14,000.

The annual exclusion gift amount is the amount of money a person can gift without reducing his lifetime exclusion.  In other words, if Mr. Smith gifts $13,000 in 2010 to 100 of his friends and family members, he will not reduce his $5,000,000 lifetime exclusion at all; however, if he gifts $13,000 to ninety-nine people and $14,000 to one person, he will reduce his lifetime exclusion from $5,000,000 to $4,999,000.

Only if Mr. Smith were to gift over $5,000,000 in excess of the annual exclusion amount would he ever pay gift tax.  If Mr. Smith did gift over $5,000,000 in excess of the annual exclusion amount, then he would pay gift tax on the amounts over $5,000,000.

In other words, if Mr. Smith gifted $5,014,000 in one year to one person, he would pay gift tax on the $1,000 in excess of the lifetime exclusion ($5,000,000) and the annual exclusion ($13,000).  Any future gifts in excess of the annual exclusion would also be taxable, since Mr. Smith would have used up his lifetime exclusion.

Because of the lifetime exclusion, I often tell people that gift tax is not a concern for them, and they should stop worrying about gift tax all together.  While gifts in excess of the annual exclusion amount do reduce the lifetime exclusion, few people have more than $5,000,000, let alone plan on giving it away.

If you do gift more than the annual exclusion amount to any one person in any one year, then you should file a federal gift tax return; however, no tax is owed.  A gift tax return is an extremely simple tax form and is easy to file.

The bottom line is, if you are thinking about making a gift, don’t let the fear of gift tax get in your way.  Very few people ever pay gift tax because of the extremely high lifetime credit against the tax.

Planning for the Future

At least twice in the past week I have met with a client who has said that they want “simple” documents.  This statement is a recurring one in my practice.  Prospective clients frequently tell me that they want a last will and testament, power of attorney, or living will that they can understand.

Most measure the quality of the document by its length.  A really short Will is a good Will.  A long Will is a bad Will.  The fact of the matter is, a short document does not necessarily equate with a good document.

There’s a famous line, and I’ll paraphrase, that goes, “Sorry to have written you such a long letter, I didn’t have time to write a short one.”  I love that line, and I believe in it.  But as much as I love that line and try and live by it with my writing, the fact of the matter is, not every document can be short, or should be.

For instance, when a client comes to me and asks me to draft a financial power of attorney for them, I could draft a one page document.  The problem is, the person the client names to make financial decisions for them in the event the client cannot make decisions for himself, called the “agent,” can only do for the client those things that the power of attorney document permits him to do.

When you think of all the possible financial transactions that an individual may need to enter, it is simply impossible to address all those transactions in one page.  I have frequently had financial institutions tell me that they will not permit an agent to perform a certain task because that task is not stated in the power of attorney document.

If I drafted the power of attorney, I have always been able to avoid this problem by pointing to language in the document that does permit the agent to perform the task, but there have been times with powers of attorney that other individuals drafted that I cannot point to the appropriate language in the document.

If the power of attorney fails to address the particular transaction that needs to be accomplished, then I have to inform the client that a guardianship proceeding may be necessary.  Most people have powers of attorney to avoid the need to have a guardian appointed for them, so having a poorly drafted power of attorney that doesn’t permit the agent to make all the decisions he may need to make is self-defeating.  For this reason, I always counsel clients to have a very broad power of attorney.

Even if you think This doesn’t apply to me, I advise keeping it in the power of attorney, because the fact of the matter is, you never know.  Many clients who want documents with very few words tell me that they have a very simple life, but thing is, the client isn’t planning for their life as it exists now.

As their lives exist now, these clients don’t need a power of attorney.  The client is capable of making decisions for himself.  By signing a power of attorney, the client is admitting that someday his life may be different, so the client should realize that there may be things his power of attorney agent needs to do for him that he has never done for himself.

Similarly, with a Will, a client might say, “I just want everything to go to my children.  My Will can be two pages long.”  In most cases, the client is right.  The client will probably predecease his children, all the children will get along well enough during the administration of his estate that no great problems will arise, and his Will could be very short.

But you never know.  A child may predecease the client.  The children may end up fighting one another over real or imagined issues.   A creditor may make a false claim against the estate for services that were supposedly rendered to the decedent.  The Will should be drafted to address the possibility of these issues, not only to address the issues that will arise if all goes perfectly well.

While it is good to be concise with many matters in life, when planning for future possibilities, it is often better to take a broad approach.  The fact of the matter is, none of us can predict the future.

Tax Planning for Married and Unmarried Clients

“What can I do to save my family from taxes when I die?”  This is a question that I often hear from clients, and the answer is different based upon the marital status of the client.

If a married couple is asking the question, there is a way in which their last wills and testaments can be drafted that will save the couple a significant amount of estate tax.  If a single person is asking the question, gifting may be the only viable answer.

Currently, a New Jersey resident faces two distinct estate taxes—federal estate tax and New Jersey estate tax.  While the New Jersey estate tax is based upon the federal estate law as the law existed in 2001, the two taxes have nothing to do with one another, and an estate may have to pay both taxes, if the estate is valuable enough.

New Jersey estate tax is imposed if the gross value of the estate exceeds $675,000.  The gross estate includes all assets that the individual dies owning including the death benefit of life insurance.  The federal estate tax is imposed if the gross value of the estate exceeds $5,000,000, though that may change in 2013.

Because the federal estate tax credit equivalent (that is, the $5,000,000) is so high, most of the clients I meet have New Jersey estate tax issues, not federal estate tax issues.  Though, as mentioned, an estate could pay both federal and New Jersey estate tax.  For instance, if a person died with $6,000,000 in assets, his estate would have to pay federal and New Jersey estate tax.

Let’s assume that Mr. and Mrs. Smith come to see me, and they have an estate worth $1,000,000, which includes the value of their home, their brokerage accounts, IRAs, and life insurance policies.  The Smiths have a New Jersey estate tax issue.

If the Smiths have simple Wills—Wills that simply leave everything to each other then their children –a New Jersey estate tax will be imposed upon the death of the second-to-die spouse.  The New Jersey estate tax is about 10% on average, so on a $1,000,000 estate, the tax will be approximately $32,000, after the $675,000 credit is applied to the estate.  The Smiths could avoid this tax by employing a rather common tax planning technique in their Wills.

In order to eliminate this tax, the Smith would have trusts drafted into their Wills.  The problem with a married couple having simple Wills is that there is no tax between spouses, so Mr. Smith could die and leave $20,000,000 to Mrs. Smith and there would be no tax.

But, because there is no tax, the Smiths don’t use Mr. Smith’s $675,000 credit when he dies, and after he dies, his credit is lost forever.  The Smiths then have a doubling up of their estate in Mrs. Smith’s name and are left with only one $675,000 credit, Mrs. Smith’s credit.

If the Smiths have their Wills drafted so that up to $675,000 in assets passes to a trust for the second-to-die spouse, then they will use both $675,000 credits.  For instance, when Mr. Smith dies, up to $675,000 in assets passes to a trust for Mrs. Smith’s benefit.  Because those assets passed to a trust, and not directly to Mrs. Smith, the assets passing to the trust use up Mr. Smith’s $675,000 credit.  This is true even though the trust is for Mrs. Smith’s benefit and even if Mrs. Smith were the trustee of the trust assuming the trust is drafted correctly.

Now, when Mrs. Smith dies, she doesn’t die owning $1,000,000 in assets, she dies owning only $325,000 in assets, the difference between $1,000,000 and the $675,000 in assets that passed to the trust.  Since neither Mr. Smith nor Mrs. Smith die with more than $675,000 in assets, there is no tax imposed on either of their estates.  Their children now avoid the $32,000 in tax, and Mrs. Smith had the benefit of the couple’s money her entire life.

This kind of planning cannot be done with a single person.  So, if Mrs. Smith comes to me after Mr. Smith dies and assuming Mr. Smith had a simple Will that left Mrs. Smith her entire estate, my advice might be that Mrs. Smith’s only method of reducing the estate tax for her children is to make gifts.  There are all types of gifting methods, but a common, and simple, technique involves giving $13,000 a year to anyone person you wish to benefit and repeating this gift each and every year.