I’m nowhere rich enough to worry about the US Estate Tax, but it’s 3am and I’m bored, so I got to thinking…
Mister Richie McRichguy is really old and wants to pass his massive fortune to his heir, Junior. If he gives it to Junior now directly or after his death, it’s subject to the Estate Tax.
However, there’s a $13,000 exclusion on gifts each year. Well, surely that’s just a drop in the bucket for this massive estate, so how can this help? Well, if rich guy had 10 heirs, he could give $13k to each one. And if the 9 other heirs gave $13k to Junior, he will have effectively given $130k tax-free to Junior.
So he just needs a larger number of intermediary heirs and his entire fortune is funneled to Junior tax-free, right? Where’s the problem with this idea, or is it an actual loophole?
In 2013 it is scheduled to go down to 1 million. But the OP raises an interesting scenario that is probably legal, although in order for it to work, it requires a level of trust between multiple people that is usually not found in reality.
A. The go-betweens don’t have to be heirs, considerably expanding the pool.
B. Spouses can split gifts, allowing up to $26,000 in gifts per year. Is Mr. McRichguy married?
C. The expected losses from some people not passing on their gifts would have to be greater than just paying the taxes.
I’ve recently read some books on estate planning where there is this weird mentality. Do anything, pay anything to avoid paying a single cent in taxes. Never mind if this ends up as a net loss. Never mind if the taxes are going to be trivial (if they exist at all) for most people. A penny to the government is a major sin. Pay a lawyer to set up a trust, pay a financial planner to game things, pay a bunch of people, but don’t pay Uncle Sam.
This shows up a lot in the gift tax schemes. They never talk about giving over $13,000. So what if you end up giving someone $13,001? The tax on that $1 isn’t going to kill you. Isn’t the goal of a gift sort of, you know, to give someone something? Not as a tax dodge?
The problem is that a gift can’t have strings attached. If the intermediaries are required to pass the money along to Junior, the money they receive is not a gift and is not covered by the exclusion.
ftg, I think there are some people who get irrational about the gift tax, but I think there are more people who believe they’re providing this amazing gift to their heirs, and then the heirs discover that half of it will go to the government instead.
If you think of the other costs that parents pay so that their kids and grandkids will have a good life, the costs of estate planning are cheap.
As for the 13,000 vs 13,001 issue - at the very least, the cost of that extra $1 is a requirement to file an extra tax return. Even if it costs you nothing in tax (and it won’t until you get over a lifetime exclusion limit), I can’t imagine very many people are looking for the opportunity to spend more time filling out tax forms.
Life insurance is another way. The payout is tax-free if it is set up right. However, the premiums may count against the $13,000 that can be given to beneficiaries. I’m not sure about that.
You haven’t really found a loophole, since a loophole implies you are circumventing the intended rules, but what you describe is the intent of the annual gift tax exclusion.
There are ways to take advantage of the gift tax that are a little bit more ‘loop holey’. For example, you might own an apartment building worth $100,000. Instead of gifting an interest in the property directly you make the owner of the apartment building a LLC you own.
Then you give an heir to be a share of the LLC worth $13,000. Except, you tell the IRS that ownership of 13% of an LLC that owns a $100,000 apartment building isn’t worth $13,000. You have no control of the business, the operating agreement was written to preclude you from selling your share, etc. In short, the illiquidity of the LLC share makes it worth less than if you just owned the underlying asset.
Therefore, you can gift your would-be heirs a 20% interest in the LLC that owns the $100,000 apartment building and tell the IRS that share is worth $13,000.
Of course it’s not like you can decide what it’s worth and be completely unchallenged. If you get greedy the IRS can challenge your valuation and you might lose.
If you’re rich enough that the estate tax even applies at all, then your heir is getting at least $5 million, plus a sizable percentage of whatever you’re worth beyond that. I’d say that counts as a pretty amazing gift, and well beyond what most of us get from our parents chipping in for college.
That’s a good point about the trust aspect. But that happens all the time in business. Oftentimes, a business is put in a position where they can rob you, but at a cost to their reputation. So the business decides it is worth more to have future customers than to rob a single customer once.
Similarly, a business could be formed to serve all the rich old guys with estate tax issues. If they don’t come through, it costs them future business. If one of the intermediaries keeps the $13k, they are cut out of the business forever. Since acting as an intermediary is extremely easy and involves no work, few people would want to kill the goose that lays the golden eggs.
The service just needs to charge enough to pay off everyone involved, which is surely less than the cost of the estate tax itself.
Especially if the $1 million is tied up in assets (like houses, artwork or a family business) that you want to keep, rather than sell to pay taxes. In a place like California, a $1 million house is not even all that fancy. (Heck, the 1100-sq ft 3-bed 2-bath I grew up in sold for $560,000 in 2005).
The IRS would certainly collapse the gifts into a series of taxable gifts from Richie to Junior, that being the economic substance of the transactions. You may want to take a look at Wikipedia on the step transaction doctrine, Step transaction doctrine - Wikipedia.
Not if the intermediary parties that Mr. McRichguy is trusting to funnel the money to Junior are not actually obligated to do so. The first requirement for a series of transactions to trigger the doctrine is the “binding commitment test,” which would not apply in the OP’s example.
I don’t know the specifics but you can set up an irrevocable trust, with your heirs as the beneficiaries and avoid having to go into probate or paying estate tax. For a large estate, avoiding probate is a big deal as it can be up to 5% of the estate assets.
Now, an irrevocable trust isn’t a tax free vehicle, the trust itself has to pay income taxes for example. Further, if you just start gifting funds into a trust that exposes you to the same problems you might have if you were trying to avoid the estate tax by gifting funds to your relatives prior to death (basically you’d run into the gift tax.)
Further, money received from the trust beneficiaries will be considered some form of income to the beneficiary. But you can definitely use an irrevocable trust to avoid paying the high 55% estate tax rate but instead have your heirs only pay a relatively modest top marginal income tax rate on income received from the trust.
No, the step transaction doctrine can also apply if the mutual interdependence test or the intent or end result test is satisfied, and it seems pretty clear that in fact the end result test would be satisfied. Under the end result test, the step transaction doctrine will be invoked if it appears that a series of separate transactions were prearranged parts of what was a single transaction, cast from the outset to achieve the ultimate result.
The IRS could also disregard the initial gifts as lacking economic substance, a doctrine that is often applied in combination with the step transaction doctrine.
I don’t know if this still holds, but way back 50 years someone told me that every DuPont gave the maximum tax-free gift (which was $10K in those days, a lot more than $13K today) to every younger DuPont. Since there were lots of DuPonts, this was an effective method of transferring their holdings to the next generation free of tax.
Until the Reagan administration, the limit was $3k per person per year. Reagan raised it to $10k. Inflation has pushed it to its current limit of $13k.
I agree some people get irrational about this and lose all perspective. I read one person who wrote that the estate tax rate was the worst part about dying.
Seriously? You’re going to die and your biggest concern is your tax situation? That’s ahead of wondering if your life had meaning? It’s ahead of how your death will affect your family? It’s ahead of questions about the afterlife?