Gifting ownership in a privately held business can be a smart element of proper estate planning and a strategy to minimize taxes for both yourself and your heirs. However, Congress has historically passed legislation that shifted gift giving amounts and exclusions, making the process to optimize the timing and amount of gifts a bit tricky.
With another potential change on the horizon – a scheduled 2025 sunset of gift tax provisions in the Tax Cuts and Jobs Act – it’s a good time to review current gifting laws to determine whether you should consider taking action in 2023.
Historically, the U.S. government has taxed gifts of a certain value, but there are two primary exclusions: an annual exclusion and a lifetime exemption. Per the annual exclusion, an individual can gift up to $16,000 (in 2022) or $17,000 (in 2023) to as many people as they wish, without these amounts being counted against the taxpayer’s lifetime exemption or being considered taxable. For example, in 2023 an individual can gift $17,000 to 100 different recipients, and these amounts are not taxable.
Then there is the lifetime exemption, which comes into play for gifts greater than the annual exclusions, such as gifts of company ownership. These gifts require the donor to file a United States Gift and Generation-Skipping Transfer Tax Return, and the value of the ownership interest gifted in excess of the annual exclusion counts against the donor’s lifetime exemption.
Once the donor has reached their lifetime exemption amount, they are then required to pay a marginal tax, which increases from 18 percent to 40 percent on the value of the gift as the amount exceeding the lifetime exemption increases. However, keep in mind that even a donor who used all of their lifetime exclusion will still be able to make annual exclusion gifts.
In 2017, The Tax Cuts and Jobs Act (TCJA) increased the lifetime exemption amount for federal estate and gift taxes from $5 million to $10 million (both amounts indexed for inflation), effective January 1, 2018. However, this came with a key provision: the increased exemption sunsets after 2025, at which point the lifetime exemption returns to the pre-TCJA amount of $5 million (indexed for inflation).
In 2023, the per person lifetime exemption will reach $12.92 million, up from $12.06 million in 2022. Per current regulations, this amount is scheduled to be indexed for inflation in 2024 and 2025 before being cut in half in 2026.
It is important to note that the IRS has specified that gift taxes will not be clawed back after this date. In other words, if a taxpayer uses the full value of the current lifetime exemption prior to its sunset, this will not result in an adverse effect regarding future estate and/or gift taxes if the lifetime exemption is lower in the future.
Let’s pretend that U.S. federal gift tax policy remains unaltered, and the gift tax exemption sunsets when scheduled. Additionally, suppose a taxpayer wishes to make a $10 million gift and has made no gifts counting towards their lifetime exemption in the past.
If this gift is made in 2023, the taxpayer will use up $10 million of their $12.92 million lifetime exemption and will not pay any federal tax on the gift. The taxpayer will then have nearly $3 million of their lifetime exemption remaining until the sunset. Once the sunset occurs, this remaining exemption amount will be lost, as the taxpayer’s lifetime gifting amount exceeds the exemption. However, per IRS policy, even after the sunset, the taxpayer will not be penalized on a federal level for having given more than the present exemption amount in the past.
As an alternative, let’s suppose the taxpayer chooses to make this $10 million gift in 2026, after the gift tax exemption has been reduced by 50 percent. Given inflationary increases, the lifetime exemption is expected to be as much as $6.8 million per person in 2026, meaning roughly $3 million of the gift would exceed the lifetime exemption. This $3 million would then be taxed at applicable rates, which could result in a tax liability for the gift giver of more than $1 million.
While there is uncertainty regarding future federal gift tax policy, the current lifetime exemption of $12.92 million is virtually certain to apply for gifts made in 2023. However, policy regarding gift taxes is controlled by Congress, which can change applicable regulations as it pleases. This means that it is possible the federal lifetime gift tax exemption sunset could be eliminated or delayed, or that federal gift tax policy could be changed altogether prior to the planned sunset at the end of 2025. Given this fact pattern, taxpayers who are planning on using a gifting strategy to transfer ownership of their business should carefully consider the timing of their gift.
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