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A key area of personal financial planning is preparing for the transfer of property during an individual’s lifetime and at death. Although this is not a concern of the majority, minimizing estate and gift taxes is a major financial objective of a number of millionaires and billionaires.

The estate tax or the so-called “death tax” and the gift tax must be considered collectively when working on any estate planning strategy. Understanding the distinction between the two taxes is important to make the most of wealth transfer to the intended recipients.

This article gives you an overview of the basics of estate and gift taxes and how estate taxes work in conjunction with gift taxes. We also give you here a detailed explanation of the importance of doing a valuation for your gift and estate planning.

What is an Estate Tax?

The estate tax is imposed on the transfer of assets such as real estate, cash, and stock that are bequeathed upon the death of the donor.  You are required to file a federal tax return if the value of the gross estate less certain deduction is beyond the exemption amount. The gross estate encompasses the value of all property in which the deceased had an interest at the time of death (real estate, mortgages, notes and cash, stocks and bonds, insurance on the decedent’s life, and jointly owned property). If the property is jointly owned by spouses and of them dies, one half of the value of the conjugal property is included in the deceased person’s gross estate.

What are the Estate Tax Exemptions?

Personal Estate Tax Exemption: This exemption allows the transfer of a specific amount or all of a decedent’s estate tax-free based on the current exemption amount. Beginning 2022, federal lifetime gift tax (estate tax) will go up to $12.6 million (from the current law of $11.7 million) per individual and $24.12 million for a married couple (from the current law of $23.4 million). Read here for more information about the exemptions for 2022.

Marital Deduction: A decedent’s estate can be passed on to the living spouse free of tax given that the spouse is a US citizen and the property is being transferred directly to the spouse ahead of the decedent’s death. Take note that the personal tax exemption applies if the living spouse is a non-citizen.

As a further explanation of how personal and marital estate tax exemptions work, here’s a sample scenario (assuming that this happens under the 2022 personal estate tax exemption);

Mr. M  left an estate worth $26.2 million equally divided between his wife and his daughter (each of them receiving $13.1 million). In this situation, no part of the $13.1 million that Mr. M leaves to his will be subject to the estate tax (for as long as Mr. M’s wife is a US citizen and all the property included in the $13.1 million passes to her outright). Of the $13.1 million that Mr. M leaves to his daughter, $1 million will be subject to the estate tax. 

Other Deductions: Other costs such as specific administrative costs, funeral expenses, claims against the estate, certain taxes, and other indebtedness and charitable donations are included in the deductions against the gross estate.

How to File the Estate Tax Return

The estate tax return must be filed within nine months from the decedent’s passing by either the person in possession of the estate’s assets, the personal representative, or the executor. A six-month extension is allowed but the estate tax must be paid within the given nine months duration (though certain circumstances allow the extension on the payment of it).

What are State Estate Taxes?

Depending on the state where the decedent lived and the location of the real estate or personal property, a state estate tax may be imposed. Click here to know the levy state estate tax and their threshold minimums and the states with no state estate tax. Knowing the law on each state in relation to the property in question is important in evaluating the tax consequences linked with the transfer of the property.

What is a Gift Tax?

The gift tax is levied on the lawful transfer of any type of property to another person during the giver’s lifetime and it applies whether or not the transfer of the gift is intended by the donor. Making a gift means giving a property or money (or the income from a property) without expecting anything (or less than the full value i.e. selling something at less than its full value or making an interest-free or reduced interest loan) in return.

What are the Gift Tax Exemptions?

  • Effective January 1, 2022, gift tax exemption will climb to $16,000 (from the current law of $15,000) per year. This yearly exemption is the combined amount of present interest gifts that be given to any person outside of the lifetime gift tax exemption. Take note that the annual exclusion applies to gifts to each donee.
  • Gifts to a spouse
  • Payment of medical expenses on another person’s behalf
  • Payment of tuition
  • Gifts to charitable organizations
  • Gifts to political organizations for its use

Who Pays the Gift Tax?

While the beneficiary of the gift is not obliged to pay income taxes on the gift, it is the giver of the assets who needs to pay gift taxes. But if later on, the assets received produce income such as earning interest or dividends or collecting rent, then the income from such would be deemed taxable.

How Does the Gift Tax Exemption Work?

Here’s an example of how gift tax exemption work (assuming that this happens under the 2022 gift tax exemption).

  • Z gives a $16,000 worth of gift (cash or assets) to his niece. Based on the amount of the gift, Mr. Z does not need to pay the gift tax. But he still needs to file IRS Form 709 to disclose the gift.
  • If Mr. Z wants to give $16,000 worth of gift to each of his nieces and nephews, he may do so without worrying about paying the gift tax for as long as the amount does not exceed the $16,000 gift tax exemption amount. He may also do this all in the same year without being subject to gift tax.
  • If Mr. Z and his wife both want to give cash or assets gifts to anyone, they may do so without having to worry about paying the gift tax for as long as the combined amount of their gift would not exceed $32,000. The annual exemption is applicable per person.

Understanding the “Fair Market Value”

When determining the value of the gross estate, the fair market value is used and not the value when the assets were acquired. Moreover, fair market value is defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.” (as defined in Regulation §20.2031-1).

Importance of Business Valuation in Estate and Gift Planning

A business valuation in estate and gift planning is important in the process of transferring of wealth and protecting assets as it is a powerful tool in effectively minimizing estate taxes. All the more that valuation is needed given the declining financial performance and market chaos due to the present economic climate to derive further discounts and to better shield your assets. Specifically, a business valuation to support your estate planning helps you to:

  • Know the value of your assets which allows you to better understand how to divide them properly.
  • Be properly informed about your tax liabilities that are applicable to the transfer of your assets. It’s important that you understand the value of the assets that your beneficiaries would receive after tax deductions to ensure that you are not putting an excessive burden to your heirs or recipients.
  • Better understand how the basic exclusion amount works when it comes to large asset transfers.
  • Capitalize on minority interest gifts where you would have control over the discounts to bargain gift interests at a manageable valuation.

The valuation of transferring the interests in a business is subject to a few discounts, thereby reducing the total value of the business or estate transfer which means that the value would go over the basic exclusion (BEA) threshold using a reasonable valuation. The expertise of a professional appraiser like Credo CFOs & CPAs would help you to identify how some factors like marketability, liquidity and reputation for an accurate assessment would prevent you from unreasonably breaking the BEA limit. Apart from doing business valuation, our team is also experienced in assisting clients on legitimate estate planning techniques

For an in-depth discussion of your estate and gift tax planning details and needs, contact Credo team and our team of experts will be happy to help!