Gift Tax Exclusion 101, Part II
In “Gift Tax Exclusion 101, Part I”, we covered the basics of the Annual Gift Tax Exclusion’s general rule and the exceptions. In Part II, we’ll discuss the implications of excess (or taxable) gifting for the Lifetime Gift Tax Exemption and the Personal Estate Tax Exemption; each is set at 5.45 million for 2016.
To begin, let’s consider what these two exemptions are all about. Quite simply, they’re about the transfer of wealth – or rather, limits on tax-free transfers of wealth.
The Gift Tax Exemption and Personal Estate Tax Exemption put limits on the amount of wealth one can give away free of taxation during their life and/or upon death.
The annual gift tax exclusion discussed in Part I, exists to strike a reasonable balance between this public policy which limits tax free transfers of wealth and the freedom of individuals to gift without bureaucratic oversight.
Sounds simple enough, right? However, the fact that there are two separate exemptions can be misleading: the lifetime gift tax exclusion is not an addition, nor is it some kind of loophole to the personal estate tax exemption. In other words, the IRS isn’t letting you essentially double the amount of wealth you can transfer tax free – you can’t make taxable gifts worth up to 5.45 million of your wealth while you’re alive free of tax at death, and then also get an additional 5.45 million of your estate’s assets exempted with the personal estate tax exemption.
It’s really helpful to think of these two exemptions as a combined gift and estate tax exemption because all of the taxable gifts made during your lifetime will be deducted from your 5.45 million personal estate tax exemption. Here’s what it looks like:
Wealth transfer during life: $5,450,000 Gift Tax Exemption
Wealth transfer at death: $5,450,000 Personal Estate Tax Exemption – taxable lifetime gifts
Combined tax exempted wealth transfer during life and at death: $5,450,000
So let’s pull what we’ve covered in Part I and Part II together and bring the concepts to life with some hypothetical scenarios. In honor of (or perhaps in spite of) the upcoming Presidential elections, we’ll let the Trumps and Clintons star in our examples.
Scenario #1: Putting together the Annual Gift Tax Exclusion and the Lifetime Gift and Personal Exemptions
Donald Trump wants to thank his daughter for all the support she’s offered during his presidential bid. He gives his daughter Ivanka a beautiful new Mercedes-Benz G-Class SUV AMG G63 with all the bells and whistles for 165k – a vehicle big enough to hold her family of five. After claiming his annual 14k gift tax exclusion, Donald has made a taxable gift of 151k. Even if Mr. Trump would like to pay the tax now, the IRS won’t let him unless he has already exceeded his lifetime gift tax exemption limit of 5.45 million – in that case he will pay taxes that year on the gift. But let’s assume he has not exceeded the limit; instead, the 151k taxable gift will be deducted from his lifetime gift tax exclusion, currently set at 5.45 million. When Donald passes away, all of the taxable gifts he’s made during his lifetime will be deducted from his 5.45 million personal estate tax exemption . Therefore, if during his lifetime, Donald uses up all of his gift tax exemption, then there will likewise be nothing left of his personal estate tax exemption.
Scenario #2: Seeing how the tax bill pans out at death
Hillary Clinton makes taxable gifts during her lifetime totaling $475,000, primarily to her daughter, Chelsea and grandchildren. This amount is deducted from her personal estate tax exemption. When she passes away, her taxable estate is worth $32,000,000. To determine the tax owed, first calculate the available exemption:
The Personal Exemption for 2016 $5,450,000
Subtract taxable gifts – $475,000
Remaining exemption $4,975,000
Then determine the taxable amount:
Taxable estate $32,000,000
Subtract remaining exemption – $4,975,000
Taxable amount $27,025,000
The bottom line is that, though at first blush the “Gift Tax” sounds scrooge-like and costly, it’s actually just a record-keeping mechanism for IRS to keep tabs on the super wealthy and ensure they aren’t getting around the estate tax. So while you will have the minor inconvenience of filing some additional paperwork for filing your tax return when you exceed your annual exclusion amount, you don’t need to worry about what it’s going to cost you unless you’re looking at giving away more than 5.45 million in your lifetime.