This week, Gail explains the connection between the gift and estate taxes; needless to say, you cannot simply subtract one amount from the other that would make too much sense!

Dear Gail —

My grandfather just passed away and my family is wondering how much is going to be owed in terms of taxes. Several years ago — in 2000 — grandpa decided to start giving away his possessions, thinking this would get them out of his taxable estate and there wouldn't be any estate tax on them. So he changed the deed on his beach house (worth at least $600,000 at the time) and put my parents on it. He also gave them various stocks worth about $320,000. Then he gave me and my brother (each) about $160,000 worth of investments. Unfortunately, grandpa only consulted his tax advisor after he did this and ended up paying thousands of dollars in "gift" tax on these transactions.

Even after giving away more than $1.2 million, he died with an estate worth $2 million.

I understand there's some connection between gift taxes and estate taxes. Does this mean his estate gets credit for the gift tax he paid 4 years ago? I really need someone to explain this is English so those of us who aren't CPAs or attorneys can understand it.

Thanks ,


Dear Charlotte —

First, I'm sorry for the loss of your grandfather. He was obviously not only a skilled investor, he also tried to take care of his family, right up until the end of his life. I'm sure you all miss him. You are correct: there is a relationship between the gift and estate tax. First, each is considered a "transfer" tax, i.e. the tax you pay to transfer ownership of an asset to someone other than yourself. When you transfer an asset to someone while you're alive it is considered a "gift." If possession is transferred after you die, you are giving away part of your "estate."

Not all property transfers are taxable. For instance, this year you are allowed to gift up to $11,000 per person to as many people as you want. (Back in 2000, the limit was $10,000 per person per year.) It is only when you give someone a gift worth more than $11,000 that you have to pay gift tax on the transfer — and even then, gift tax is only due on the amount of the gift that exceeds $11,000. For instance, if you bought a new car and gave your younger brother your old one, which was worth $16,000, you would have made a "taxable gift" of $5,000 ($16,000-11,000 = $5,000). To be perfectly correct, you should file a gift tax return (IRS Form 709) with your income tax for that year.

Please note: gift tax is paid by the person who makes the gift, not the one who receives it.

Similarly, you are also allowed to pass a limited amount of property to others when you die and not owe any tax. The biggest tax break is the so-called "unlimited marital deduction." This allows you to leave as much as you want to your spouse, estate tax-free. The estate tax only kicks in on property transferred to non-spouse beneficiaries upon your death.

The Economic Growth and Taxpayer Relief Act of 2001 ushered in major changes to both the gift and estate taxes. For instance, the tax rate on property transfers has been coming down. The top gift/estate tax rate was 55 percent in 2001; it now stands at 48 percent. (Doesn't that make you feel better?)

In addition, the amount of property you can leave at your death to individuals other than your spouse was increased from $675,000 to $1 million in 2002. This is referred to as the "exemption" amount, because it is the amount of property than can pass to non-spouse beneficiaries exempt (free) from estate tax. This year, the estate tax-free amount is $1.5 million. The exemption amount will hit $3.5 million in 2009.

As you may know, in 2010 the estate tax is eliminated entirely. But be careful: The gift tax does not disappear in 2010. However, the tax rate on gifts that exceed the annual tax-free amount is slated to drop.

To complicate matters further, unless Congress extends the 2001 Act, in 2011 we will revert back to the estate and gift tax rules in effect before this law was passed. For example, the top tax rate again becomes 55 percent and the gift/estate tax exclusion amount drops to $1 million. (Please don't ask me to predict what will happen. I have no idea. I suppose it depends upon what the federal deficit looks like and which party has the upper hand in Washington.)

The thing to remember is, even though your grandfather paid gift tax on the property he transferred to you and your family back in 2000, the amount he gifted at that time is still taken into account when his estate tax is computed. That's because the gift and estate taxes are what's called "unified." Whether you make a taxable gift of something while you are alive or bequeath it upon your death, the tax rate is the same.

The amount you could transfer (to a non-spouse beneficiary) tax-free was also unified. That is, the total exemption (tax-free) amount for taxable gifts and transfers made at death was the same. (This is no longer the case, but it's too complicated to go into here and not necessary for your example.)

Now it starts to get tricky. You cannot simply subtract the exemption amount from the total value of the property that you transfer and then figure the tax on the number you get. That would make too much sense. It would also result in the government collecting less tax.

Instead, first you have to add up all of the (taxable) property transfers that were made — both while alive (i.e. gifts) and at death — and calculate the tax on this total amount. From this you subtract a tax credit — a dollar-for dollar reduction in the taxes you owe- that completely offsets the tax due on the "exempted" amount. You can either use up this credit on lifetime taxable gifts, use it up on property transferred at your death, or a combination of the two.

(Last year, for instance, the "unified" tax credit was $345,800, which equals the amount of tax you'd pay on $1 million worth of transferred property. This also happened to be the amount exempt from tax in 2003. In other words, if you died last year and your total taxable gifts, plus the amount you left to non-spouse beneficiaries at death added up to $1 million, the tax on this amount would have been $345,800. But after subtracting the credit of $345,800, your estate ended up with $0 tax due. Thus, you would have been able to transfer a total of $1million in property- during the last years of your life and after your death — to non-spouse beneficiaries, tax-free.)

Since your grandfather used up some of his "unified credit" amount when he made those gifts back in 2000, you have to figure out how much of the exemption— if any— is left to be applied to his transfers at death. (Hang in there!) I'd like to thank Bill Wagner of the National Underwriter Company, a leading publisher of tax and financial planning books, for his help with the math. (Wagner is an editor of Tax Facts, a major resource for tax professionals.)

To begin, you'll need to find out how much gift tax your grandfather paid when he transferred the beach house and securities. This can be found on Form 709 which was filed with his 2000 tax return. Hopefully, either your grandfather or his tax preparer kept this on file.

Based on the information you've given me, here's a simplified estimate how your grandfather's estate tax will be calculated:

First, calculate the gift tax that was paid on all of the excess annual gifts (i.e. the taxable gifts) made during your grandfather's lifetime. In his case, they were all made in a single year. But if they had been spread out over several, you'd use this same approach.

Total Taxable Gifts:                $1,200,000     (beach house + securities)

Gift Tax in 2000:                       $427,800

Less: Unified Credit available: —$220,550  (in 2000)

Total Gift Tax Paid:                   $207,250*

(Remember: this tax was paid when the gifts were made. Your grandfather gets credit for this when his estate tax is calculated. See * below )

Next, add the value of your grandfather's estate at death AND the total amount of taxable gifts he made while alive. Then calculate, based on the tax rates in effect today how much tax would be due on this total:

Taxable Estate:               $2,000,000

Taxable Gifts:               + $1,200,000

Total Taxable Transfers:   $3,200,000

"Tentative" Tax:               $1,356,800

Less: Gift Tax Paid         —$207,250*

Gross Estate Tax:           $1,149,550

Less: Unified Credit:       — $550,800 (in 2004)


Less:State Death Tax Credit:—$24,900  (federal tax credit for state Inheritance tax paid)**

Net Estate Tax:                    $568,850

Please understand that this is just a rough approximation of what your grandfather's estate will owe. Again, notice that it is the donor (in the case of transfers at death, this would be the decedent's estate) who owes the transfer tax. Often, people will require in their wills or trusts that, in order to take possession of the property they are bequeathed, each beneficiary must pay their proportionate share of the total estate tax. But unless this is made a requirement, the recipient of the property is not personally responsible for any estate tax.

In practice, however, the executor of the estate isn't going to give away all of the assets before he/she has determined how to come up with the cash needed. If life insurance isn't available for this, it can mean selling some of the estate property. Since the executor is generally free to decide which assets are sold, some beneficiaries could get less than they expected. (Translation: It pays to be on good terms with the executor!)

As Wagner points out, because the top estate tax rate is declining and the exemption (tax-free transfer) amount is increasing in the coming years, it doesn't make as much sense as it used to give assets away while you're alive, if you're going to incur gift tax to do so. In an extreme example, imagine gifting $3 million in property this year and paying hundreds of thousand of dollars in gift tax. Then you miraculously defy your doctors' predictions and live another 6 years. Because the estate tax is repealed in 2010, if you had waited, you could have transferred the same $3 million in property at your death, tax-free. It's enough to make you come back from the dead!

Making taxable gifts has become, in Wagner's opinion, "risky" because of the uncertainty of the tax situation. However, he says it "still makes sense to make annual gifts up to the amount excluded from tax ($11,000 this year) or covered by the unified credit."

Then he adds, "If you can afford to."

Reminds me of something I read years ago: "Give until it feels good. Don't give until it hurts." Most people want to give to their families and loved ones. It's natural. But be careful you don't overdo it. Make sure you keep enough of your assets so you can live comfortably and don't feel deprived while you're still around. Your kids, grandkids, etc. will get their share (if you want them to) eventually.

In my opinion, one of the biggest gifts you can give your kids is the knowledge that you don't need to lean on them for financial support.

Hope this helps,


**Not the same in all states. Beginning next year, the state death tax "credit" becomes a "deduction" on the federal estate tax return.

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