GIFTING IN A CHANGING TAX LANDSCAPE Do Taxable Gifts Still Make Financial Sense?

GIFTING IN A CHANGING TAX LANDSCAPE Do Taxable Gifts Still Make Financial Sense?

TABLE OF CONTENTS In this white paper: Factors that Determine Suitability of Making Taxable Gifts 1 Charting the New Landscape 2 The Tentative Conclusions 3 Written by: Bryan D. Austin, CFP, CIMA, Director, Financial Planning Christopher P. Cline Senior Vice President, Senior Regional Fiduciary Manager

Gifting in a Changing Tax Landscape Do Taxable Gifts Still Make Financial Sense? In the past, when analyzing whether a client should make taxable gifts, estate planners tended to simply rely on comparing the transfer tax cost of making such gifts with those made at death. Paying the gift tax was assumed to be cheaper than paying estate tax, even though the rate was the same, because gift taxes are calculated on a tax exclusive basis (in other words, the gift tax paid comes out of the estate). If the nominal transfer tax rate was 40%, the taxable gift produced an effective gift tax rate closer to 29%, with the effective estate tax rate at death being the full 40%. 1 This advice used to be sound, and technically hasn t changed. However, after passage of the American Taxpayer Relief Act of 2012 (ATRA), the transfer tax rates only rose modestly between 2012 and 2013 (35% to 40%). At the same time, the top income tax rates for high-net-worth taxpayers increased from 35% to 39.6% for ordinary income and 15% to 20% for capital gains. This, coupled with the new Medicare surtax on unearned net investment income of 3.8% enacted as part of the Patient Protection and Affordable Care Act, resulted in a potential tax increase of 24% on ordinary income and 59% on capital gains. 2 The gap between these new relatively low transfer tax rates and higher income tax rates is much narrower than it has been in many years, which means that the estate planner must now consider the impact of income tax, as well as the transfer tax, from gifts. The planner, in other words, must consider the bigger tax picture, maybe for the first time. This paper explores the factors that determine whether making taxable gifts in today s environment makes financial sense. While there are no absolute guidelines, the old principles that guided the estate planning community in the past are often inadequate today. And some new, tentative guidelines have emerged. Most importantly, however, an estate planner must be comfortable analyzing the impact of both taxes in order to provide truly thoughtful advice. Factors that Determine Suitability of Making Taxable Gifts As always, any estate planning analysis must begin with a family s goals and objectives. Transferring large amounts of wealth to save taxes is not the only consideration individuals have. Very often the emotional issues (loss of control, current and future access to investment funds, and the impact of wealth on family members) are of greater concern. Proper planning carefully takes all of these factors into account. However, assuming that transfer tax planning is consistent with the family s objectives, three primary factors must be considered as part of any financial analysis. These factors are: Basis of the gifted asset Expected return from the gifted asset Opportunity cost stemming from prepayment of gift tax Gifting in a Changing Tax Landscape: Do Taxable Gifts Still Make Financial Sense? 1

These factors are of varying importance in different situations, as discussed below. Basis of the gifted asset. The income tax consequence to a taxpayer from the sale of an asset is determined by subtracting the adjusted cost basis of the asset from the sale amount. Cost basis is simply the amount paid to acquire the asset, with adjustments that include depreciation, losses or income attributed to the owner of a business asset, and capital improvements. Generally, the recipient of a gift takes the donor s cost basis in the asset, increased by a portion of the amount of any gift tax paid by the donor. 3 For property acquired at death, the cost basis of the asset is adjusted to the fair market value of the asset on the date of death (or alternate valuation date, generally six months after date of death). 4 As a result, higher cost basis assets are generally a better choice for gifting (unless the recipient is in a significantly lower tax bracket than the donor). Assets received at death, on the other hand, receive a date-of-death basis adjustment, virtually eliminating capital gain. In the real world, however, assets that may be appropriate for gifting often have little to no cost basis. The logical question then is when would it be appropriate to gift a low basis asset? Expected return from the gifted asset. Expected return looks simply to the estimated growth rate of an asset after the date of the proposed gift. A common question is whether the donor is better off holding the asset until death (subjecting it to a potentially substantial estate tax), or giving that asset away and allowing it to grow in the beneficiary s possession. Although expected return is a critical factor, in this new environment, it cannot be viewed in isolation (as discussed further below). Opportunity cost stemming from prepayment of gift tax. A donor who pays gift tax on a gift obviously loses the opportunity to invest those tax dollars. An asset with a modest growth rate of approximately 7% could potentially grow four times the original balance over a twenty-year period, resulting in a substantial cost to parting with that asset. In investment circles, opportunity cost is used to compare investment choices; for taxable gifts, it refers to the growth rate of assets in the donor s estate. Though they seem similar, expected return and opportunity cost are slightly different. For example, assume two different donors. Donor 1 is considering whether to make a taxable gift of publicly traded securities, while Donor 2 is considering a gift of a privately held company that is growing rapidly in value. For Donor 1, the opportunity cost is equal to the expected return, because Donor 1 could have used the amount paid in gift tax to invest in more of the same securities. On the other hand, the opportunity cost to Donor 2 is much lower, because the gift asset is finite in nature. Donor 2 can t go out and buy more of the closely held business with the cash otherwise used to pay gift tax. As will be shown below, opportunity cost fluctuations change the impact of basis when making certain taxable gifts. Two final thoughts about opportunity cost. First, in this context it refers only to the lost opportunity to generate a return on the gift tax dollars paid, not to the lost opportunity of the gifted asset itself. Second, the opportunity is ultimately lost to the beneficiary of the gift, not the donor. The analysis in this paper assumes that the donor does not need either the gifted asset or the gift tax paid on the gift, so the lost opportunity is not relevant to the donor. This is different from the opportunity cost analysis for investments, which looks at whether the owner of an asset should invest his or her money in one or more different ways. Charting the New Landscape Before ATRA, the analysis about whether to make taxable gifts was simple: if you can afford it (and it is consistent with your nontax goals), do it, because the gift tax is cheaper than the estate tax (even though the nominal rates are the same). That statement remains true, and yet the significant changes to the income tax require a more detailed analysis. Basis, expected return, and opportunity cost all play a role. The only way to demonstrate the impact of these factors is to run the numbers. This paper will first analyze the effect that basis and expected lifetime return have on the decision about making taxable gifts. Then in the second analysis, the impact of opportunity cost will be added to the mix. In both scenarios, the following assumptions will be made: The donor will already have given away his or her full federal exemption amount, so that each dollar given in these scenarios will generate a federal gift tax liability. A transfer tax rate of 40% will apply for gifting and estate tax purposes. The federal capital gains tax rate of 20% plus the Medicare surtax of 3.8% will apply to the sale of any asset. The gifted asset will be held during the donor s lifetime and sold immediately after the donor s death. 2 Gifting in a Changing Tax Landscape: Do Taxable Gifts Still Make Financial Sense?

The donor will survive more than three years after the date of the gift. Inflationary adjustments to the transfer tax exemptions, along with the impact of additional post-gift basis adjustments like depreciation, will be ignored. These analyses only reflect the federal tax impact. State tax law must also be considered, adding another level of complexity to the analysis. Scenario 1: When expected return equals opportunity cost. In this first scenario, opportunity cost is assumed to be equal to expected return from the gifted asset, which means that this scenario looks at only two variables: basis and expected return of the gifted asset. The analysis is contained in Table 1, which compares giving away the asset and paying gift tax versus holding the asset until death. The table requires a little explanation. The first four columns show the effect of the donor holding the asset until death, while the next three columns show the effect of the donor making a gift, and paying the gift tax (so that the total of the gift plus the tax equal the $10 million retained in the first column). The final column, labeled Basis Breakeven for Same Net to Heirs is the most important because it shows the basis needed for the beneficiary or heir to be at least as well off from the gift as he or she would have been had he or she simply inherited the asset at the donor s death. The basis in this column is expressed as a percentage of the asset s total fair market value, determined at the date of the gift. The math behind the tables is attached in the Appendix. The table shows that, as the expected return of the gifted asset increases, the gifted asset must have a higher basis to financially justify making a taxable gift. This result is surprising, because it frustrates the old assumption that higher expected returns always justify making taxable gifts. Scenario 2: Opportunity cost is 75% of expected returns. This second scenario varies from the first only in that the opportunity cost in this scenario will be 75% of the expected return from the gifted asset. So if the expected return of the gifted asset is 100%, the opportunity cost for this analysis will be 75% (Table 2). Comparing the final column in Scenario 1 with that in Scenario 2, it appears that, when opportunity cost is significantly less than the expected return from the gifted asset, basis becomes less of a factor. This will be the case, for instance, when the donor is giving away an interest in a closely held business that s about to increase significantly in value (perhaps because a sale is imminent). However, some basis is still needed to offset the income tax due from later sale. Consistent with the first scenario, as expected return increases, basis is still an important factor, even though it becomes less of a hurdle to taxable giving. The Tentative Conclusions To begin with, the conclusion is there may not be a solid conclusion. The old view that taxable gifts are always better because they are tax exclusive whereas estate tax is tax inclusive, although still technically accurate, Table 1 Asset Held to Mortality Taxable Gift Beginning Ending Estate Tax Net to Heirs Beginning Gift Tax Ending Basis Breakeven for Same Net to Heirs $10,000,000 $10,000,000 $4,000,000 $6,000,000 $7,142,857 $2,857,143 $7,142,857 0% $10,000,000 $20,000,000 $8,000,000 $12,000,000 $7,142,857 $2,857,143 $14,285,714 42.8% $10,000,000 $30,000,000 $12,000,000 $18,000,000 $7,142,857 $2,857,143 $21,428,571 97.2% $10,000,000 $40,000,000 $16,000,000 $24,000,000 $7,142,857 $2,857,143 $28,571,428 151.82% Gifting in a Changing Tax Landscape: Do Taxable Gifts Still Make Financial Sense? 3

is not sufficient. The analysis must now be much more tailored and nuanced. So even though it was always true that running both the estate and income tax numbers was critical, it is now indispensable. Having said that, there are a few new observations to be taken from the analysis. When opportunity cost and expected return are roughly the same, basis becomes a more significant factor. This would be the case, for example, when the donor is planning on making a large gift of publicly traded securities. The growth rate of the gifted assets will be the same as the opportunity cost associated with the gift tax paid, because the donor can always choose not to make the gift and pay the tax, but rather invest those tax dollars in the same portfolio. In this case, the donor s age plays an important role. A 40-year-old entrepreneur who has just sold a business will have a long remaining life expectancy. This greatly increases the expected return of the assets and therefore the amount of basis needed in the gifted assets for the taxable gift to provide a net benefit. Table 1 shows that, if the assets grow threefold over the donor s lifetime (which is a reasonable expectation for younger donors), the basis in the asset would have to be over 90% of its value. This may be the case when a gift is made of post-sale business proceeds shortly after the sale of the business. The other interesting aspect to this analysis is that making taxable gifts of higher basis assets that don t have a lot of growth potential (bare land or vacation homes, for example) may be a good idea. This seems counterintuitive at first, but it makes sense if you think of this kind of gift as isolating the estate tax savings from the income tax headwinds. As the gap between expected return and opportunity cost widens, basis becomes less significant. The impact of basis on the analysis drops significantly if the opportunity cost with respect to the gift taxes paid drops relative to the expected return. Take our same young entrepreneur: if business interests are gifted prior to a sale, rather than post-sale proceeds, the opportunity cost drops relative to expected return. This is due to the significant asset growth between the date of gift and the date of sale. Note that a client can artificially lower opportunity cost by using valuation discounts. The valuation discounts reduce the applicable gift tax due and artificially create the significant increase in value post-gift that a gift in a business might bring. Obviously, valuation discounts also reduce total basis in the gifted asset, and are not viewed favorably by the Internal Revenue Service. This type of planning requires careful financial analysis in addition to advice from tax and legal counsel. Finally, make the gifts for the right reasons. If this analysis has demonstrated anything, it s that the outcomes of taxable gifts are not necessarily positive in all cases, viewed purely from a tax perspective. The most important decision is whether the larger gift makes sense from a non-tax perspective. Larger gifts of this sort can be used to transition business interests, help beneficiaries start businesses of their own, or provide support for those who may need it. These are the types of goals that should be the primary focus of gift planning. Table 2 Asset Held to Mortality Taxable Gift Beginning Ending Estate Tax Net to Heirs Beginning Gift Tax Ending Basis Breakeven for Same Net to Heirs $10,000,000 $19,285,714 $7,714,286 $11,571,428 $7,142,857 $2,857,143 $14,285,715 0.56% $10,000,000 $28,571,429 $11,428,572 $17,142,857 $7,142,857 $2,857,143 $21,428,571 13.17% $10,000,000 $37,857,143 $15,142,857 $22,714,286 $7,142,857 $2,857,143 $28,571,428 25.77% 4 Gifting in a Changing Tax Landscape: Do Taxable Gifts Still Make Financial Sense?

Appendix To determine whether it is beneficial to make taxable gifts, an analysis must compare the total cost of making a lifetime gift with the total cost of making the same transfer at death. It is critically important to analyze the cost not only to the donor (mainly in the form of transfer tax) but also the costs that impact the donee that receives the asset (mainly the income tax). Thus, the formulas can be expressed as follows: Net to Heirs for Assets Transferred on Death = (FV A + FV O ) - ET Net to Donee for Assets Transferred During Life = FV A - (FV A - B S ) * IT A = Asset Identified for Transfer E[R A ] = Expected Total Return from Identified Asset FV A = Future Value of Identified Asset = A+(A* E[R A ]) O = Opportunity Asset Retained = Gift tax that would have been paid E[R O ] = Expected Return from Opportunity Asset Retained FV O = Future Value of Opportunity Retained = O+(O*E[R O ]) ET = Estate Tax GT = Gift Tax IT = Income Tax B S = Basis of Gifted Asset = Donor s Basis of Gifted Asset increased by a portion of GT paid related to the net appreciation in the gifted asset compared to its fair market value Example Analysis with Assumptions A = $7,142,857 E[R A ] = 200% O = $2,857,143 E[R O ] = 200% ET = 0.4*(FV A + FV O ) GT = 0.4*(A) = $2,857,143 IT = 0.238(FV A - B S ) B S = Donor s basis equal to 0.5 of A. Donee s basis = Donor s basis increased by.5(gt) Net to Heirs for Assets Transferred on Death = (FV A + FV O ) ET Net to Donee for Assets Transferred During Life = FV A - (FV A - B S ) * IT FV A = $7,142,857 + ($7,142,857*200%) = $21,428,571 FV A = $7,142,857 + ($7,142,857*200%) = $21,428,571 FV O =$2,857,143 + ($2,857,143*200%) = $8,571,429 B S = 0.5($7,142,857) + 0.5($2,857,143) = $5,000,000 ET = ($21,428,571 + $8,571,429)*0.4 = $12,000,000 IT = 0.238($21,428,571 - $5,000,000) = $3,910,000 Net to Heirs = $30,000,000 - $12,000,000 = $18,000,000 Net to Donee = $21,428,571 - $3,910,000 = $17,518,571 Gifting in a Changing Tax Landscape: Do Taxable Gifts Still Make Financial Sense? 5

To learn more about additional Abbot Downing insights, please contact your relationship manager or visit www.abbotdowning.com. Investment Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Endnotes 1 To transfer $1 million by gift, the gift tax would be $400,000. Therefore, it takes a beginning balance of $1.4 million to make a $1 million taxable gift. If the same $1.4 million was transferred at death, the estate tax would be $560,000. The $560,000 estate tax is actually included in assessment of the tax. 2 Pub.L. 111 148. Generally, the Medicare surtax applies to the lesser of net investment income or modified adjusted gross income exceeding $250,000 for married taxpayers and $200,000 for individuals. 3 IRC 1015(d). The basis adjustment for gift tax paid is determined by multiplying the gift tax paid by a fraction. The fraction is the amount of the gifted asset s net appreciation over its fair market value at the time of the gift. 4 IRC 1015(d). There are certain exceptions for assets receiving a step-up in basis. For example, items that are characterized as income in respect of decedent (e.g., annuities, retirement accounts) do not receive an adjustment in basis. Abbot Downing, a Wells Fargo business, provides products and services through Wells Fargo Bank, N.A., and its various affiliates and subsidiaries. The information and opinions in this report were prepared by Abbot Downing and other sources within Wells Fargo Bank, N.A. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Abbot Downing s opinion as of the date of this report and are for general information purposes only. Abbot Downing does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal and tax advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. The implementation and maintenance of certain strategies and techniques in this presentation may require the advice of consultants or professional advisors, other than Abbot Downing. Additional information is available upon request. 2015 Wells Fargo Bank, N.A. All rights reserved. Member FDIC. ECG-1245835 590837 (Rev 02, 5/pkg) A Wells Fargo Business