You can’t understand the relevance of the gift tax unless you have an understanding of the estate tax, so we will start there.
Basic Federal Estate Tax Parameters
Wealth preservation is key for high-net-worth individuals, and very successful people have to confront a threat in the form of the federal estate tax. The rate of the estate tax is a whopping 40 percent, so it can significantly erode your legacy.
There is a federal estate tax exclusion that represents the amount that can be transferred before the tax would potentially be levied on the remainder. In 2022, the exclusion was $12.06 million, and it has been upped to $12.92 million this year due to an inflation adjustment.
Portability and Spousal Transfers
Portability is a term that describes the ability of a surviving spouse to use the exclusion that was allotted to their deceased spouse. Traditionally, the estate tax exclusion was not portable, and many people contended that this was not fair.
Why would they make this argument? In many if not most cases, both partners in a marriage contribute to the accumulation of wealth. If the exclusion of one spouse dies along with them, there is just one exclusion to apply to the combined efforts of two individual taxpayers.
This changed when the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853) was enacted. It included a provision that made the exclusion portable in 2011 and 2012, and this feature was retained when the American Taxpayer Relief Act was enacted at the end of 2012.
The portability feature has survived some other tax reform bills since then, so it seems as though it is going to be a permanent fixture.
Another positive provision for married couples is the unlimited marital deduction. You can transfer unlimited assets to your spouse free of taxation, but in order to use this deduction, your spouse must be an American citizen.
The reason why this stipulation is in place is that a citizen of another country that receives a tax-free inheritance could return to their country of citizenship without paying the estate tax.
When a citizen inherits a large estate tax-free because of the marital deduction, the IRS will still be looming after their death. The deduction essentially staves off the inevitable.
Federal Gift Tax
You would logically consider lifetime gift giving as a way to sidestep the estate tax, and this was possible when the estate tax was first enacted in 1916. The gift tax was installed in 1924 to put an end to the practice, and it was repealed in 1926.
People took advantage of the loophole for another six years, but in 1932, the gift tax was reenacted. It has been in place continually since that time, and it is unified with the estate tax.
The $12.92 million exclusion that we have in 2023 is a unified exclusion that applies to large gifts that you give while you are living and the estate that will be transferred after your passing.
However, this is not the only exclusion they you can use to give tax-free gifts. There is also an annual gift tax exclusion. You can utilize it to give a certain amount to an unlimited number of people in a given year before you would have to tap into your unified exclusion to give the gift tax-free.
It has gone up a couple of times recently because of the high rate of inflation after staying steady at $15,000 for a few years. At the present time in 2023, the annual gift tax exclusion stands at $17,000 per gift recipient.
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