Updated: Mar 8
Lifetime gifting is one of the best ways to achieve legacy planning goals and minimize exposure to transfer taxes. However, for a gifting strategy to be successful, there are certain rules that must be adhered to and planning techniques that should be considered to optimize the tax benefits. We explore general gifting rules and how they apply specifically to life insurance. We encourage our clients to work with qualified estate attorneys and CPAs to help with properly documenting and managing a gifting strategy.
1. What is a "gift" for gift tax purposes?
A "gift" is the transfer of property from one individual (commonly referred to as the “donor”) to another without adequate consideration. This may include the sale or exchange of property, the assignment of life insurance policy benefits to another individual, and the transfer of property or money to a trust. Debt forgiveness, such as forgoing interest on an intra-family loan and below-market loans (i.e. loans that do not charge sufficient interest) are also characterized as gifts for the purpose of the gift tax.1
For gift tax purposes, a gift is considered complete when there has been a gratuitous transfer of property, the property has been accepted by the recipient (also known as the "donee"), and the transfer divests the person making the gift of control, dominion, and title.2
2. How much can be transferred without incurring a gift tax?
Each US citizen and resident can transfer a certain amount of property, during life or at death, without incurring a gift or an estate tax. This amount is commonly referred to as the "lifetime exemption." Once the lifetime exemption is exhausted (i.e., total value of all transfers made exceeds the exemption), a 40% tax is imposed on each subsequent transfer.
The current lifetime exemption is $11,700,000 (for 2021), which is based off a $10M base exemption plus inflationary adjustments. On January 1, 2026, the base exemption is scheduled to reduce to $5M plus inflation, significantly reducing a high-net-worth individual’s ability to make tax-free gifts.
Under portability rules, a surviving spouse can also inherit any unused lifetime exemption remaining at the death of their spouse so long as a portability election is made on a timely-filed federal estate tax return. For example, if Husband dies with $5M of unused exemption, his surviving spouse can elect to add that $5M of exemption (commonly referred to as the deceased spousal unused exemption (DSUE)) to her own lifetime exemption, thus increasing the amount that the surviving spouse can transfer via gift or at death without being subjected to tax.
In addition to lifetime exemption gifts, each person can give away $15,000 (for 2021) to as many individuals as they desire each year without incurring any gift taxes. This type of gift is known as an "annual exclusion" gift and is neither subject to gift tax nor subtracted from the donor’s lifetime exemption.
3. When are gifts subject to the generation-skipping transfer (GST) tax?
The GST tax applies when a transfer is made to a "skip person," i.e. a person who is two or more generations below the donor. For example, a gift from a grandparent directly to a grandchild is considered both a gift transfer and a generation-skipping transfer. The GST tax also applies to transfers at death and transfers to, or distributions from, certain trusts benefitting skip persons.
Like the gift and estate tax rules, GST tax only applies once the GST exemption is exhausted. The current GST exemption is $11,700,000, which is based on a $10M base exemption adjusted for inflation. Transfers exceeding this exemption are subject to a 40% tax on top of any gift/estate taxes that are due.
4. How does lifetime gifting work to minimize exposure to the estate tax?
Implementing a gifting strategy to fully utilize available exemptions can help to significantly minimize or eliminate exposure to estate taxes. Gifting generally decreases the total estate by removing not only the asset itself, but any appreciation on the gifted asset occurring after the gift from the estate.
5. When must a gift tax return be filed?
If a donor makes a gift that exceeds the annual exclusion amount (i.e. $15,000 for 2021) or does not qualify for an annual exclusion in a given calendar year, the donor must file a gift tax return (Form 709) on or before April 15 following the calendar year in which the gift was made. A gift tax return generally also must be filed if the donor elects to split gifts with his/her spouse (see question 15).
6. What are the income tax consequences of a gift?
When property is received as a gift, the recipient is generally required to take the donor’s basis. This is commonly referred to as "carryover basis." Generally, a donor does not have to recognize income tax when gifts are made, although there are some exceptions such as when the gifted asset is subject to a loan in excess of the donor’s basis, or when gifting a specific asset type triggers income (such as gifting a deferred annuity that is in a gain position). The recipient of the gift does not have to include the value of the gift (no matter the amount) into income for income tax purposes.
7. What types of property are ideal for gifting?
Certain property may be gifted for several reasons, many of which are not tax motivated. For gift and estate tax planning, however, gifting property that is likely to appreciate in value such as real estate and life insurance, may be beneficial to remove future appreciation from the donor’s estate. If the donor is in a higher income tax bracket than the recipient, gifting income-producing property may also be beneficial from an income tax standpoint. Additionally, property that may qualify for certain discounts such as a lack of marketability or lack of control discount, such as an interest in a small business, may be ideal property to gift during life. Before gifting real estate, stock or business interests, or any asset subject to a loan or other transfer restrictions, taxpayers should consult with tax counsel to ensure that such a gift does not have unintended consequences.
Additionally, if property has already appreciated significantly in value, taxpayers should consult with their advisors to determine if the estate tax benefits of making a gift outweigh the income tax benefit of retaining the asset until death and receiving a "step up" in basis on the asset (except for certain assets such as IRAs, qualified plans and deferred annuities). Particularly in a tax environment where fewer individuals are subject to a federal estate tax but are looking to mitigate income taxation, this type of basis planning becomes especially important.
Taxpayers should also consider other non-tax aspects of making a gift, such as the recipient’s personal and financial situation, whether the recipient is a minor, if the recipient may be subject to claims of creditors or divorce, etc. Trust ownership may be favorable to help manage many of these issues and achieve the donor’s objectives more effectively.
8. Will there be a "clawback" of gifts made during life if the exemption amount is lower at death than at the time the gift was made?
The Tax Cuts and Jobs Act of 2017 temporarily increased the exemption amount for gift, estate, and GST tax purposes from $5M per person to $10M per person (adjusted for inflation). Under the provisions of the Act, this increase in exemption is scheduled to revert to a $5M exemption on January 1, 2026, taking into account inflation from 2018- 2025.
Because of the way the estate tax is calculated, there was concern that to the extent a taxpayer made gifts during life sheltered by a larger exemption than what is available at the time of death, those gifts could be brought back (i.e., "clawed back") into his/her taxable estate and subject to an estate tax. On November 26, 2019, the IRS issued final regulations to clarify and confirm that taxpayers making gifts made during the current period of increased exemptions (between 2018- 2025) do not need to be concerned about these gifts becoming taxable at their death.3
Example Edward makes a lump sum gift of $8M in 2021 (when the exemption is $11,700,00) to an irrevocable life insurance trust (ILIT) for the benefit of his children. He dies after 2025, when the exemption has returned to $5M, adjusted for inflation. For illustrative purposes, assume the exemption at his death is $6.5M and he has a total taxable estate equal to $10M. To calculate the estate tax due, gifts made during life are added back, resulting in a total estate of $18M for estate tax purposes. Without the regulations clarifying the issue of "clawback," the $18M estate would be subject to estate tax with only a $6.5M exemption (the exemption available at date of death) to reduce the estate tax liability. However, under the regulations, Edward’s estate will now receive the higher of (1) the estate tax exemption available at death or (2) the exemption used to make gifts during life that resulted in no gift tax being due. Here, that exemption would be $8M, which is the amount of exemption used during life to shelter the gift, for which no tax was due.
9. What is the "Goodman Triangle" and how does it cause gift taxation?
Life insurance contracts are somewhat unique in that there are three distinct parties that may be associated with a policy: the policy owner, the insured, and the beneficiary. When these parties are all different, unexpected gift tax liability may result. This three-party scenario is commonly referred to as a "Goodman Triangle" after the 1946 case, Goodman v. Commissioner.4
In a situation where a life insurance policy is owned by one person on another’s life and names a third party (who is not the owner’s spouse) as the policy beneficiary, the death benefit will be treated as a taxable gift from the poli