Because of differences between the methods in calculating gift taxes and estate taxes, there is a significant tax advantage to gifting an asset during one's lifetime over transferring that same asset at death. More specifically, the tax advantage is attributable to the different bases on which the two taxes are computed.
Gift taxes are based on the value of the asset being transferred, whereas estate taxes are computed on the value of the entire estate, including the assets that will be used to pay the estate tax. As such, gift taxes are said to be computed on a tax "exclusive" basis, meaning no gift tax is computed on the assets that will be used to pay the gift tax, and estate taxes are said to be computed on a tax "inclusive" basis.
To demonstrate, let's assume a taxpayer who is in the 50% marginal gift and estate tax bracket has an asset worth $1,500,000 that he can gift and use to pay any resulting gift taxes. At this tax rate, he could make a net gift of $1 million to his heirs, and use the remaining $500,000 from this asset to pay the gift tax due on the $1 million gift to his heirs (this assumes the taxpayer has previously utilized all available gift tax exemptions). The gift would have the effect of reducing the taxpayer's estate by $1,500,000.
Alternatively, if the gift had not been made, the $1,500,000 asset would be included in the taxpayer's estate. At a 50% marginal estate tax rate, the inclusion of the $1,500,000 asset in the taxpayer's estate would have the effect of increasing the estate tax by $750,000. Subtracting that from the $1,500,000 asset, the taxpayer's heirs would net only $750,000 from this asset.
What this example illustrates is that even though the gift and estate taxes are unified (i.e., the same marginal tax rates apply to both gifts and transfers at death), the effective tax rates are quite different due to the exclusive/inclusive nature of gift and estate taxes. In our example, although the marginal tax rate was 50% for both the gift and the estate, the effective gift tax rate on our $1.5 million asset was 33%, whereas the effective estate tax rate was 50%.
Put another way, the federal government charged this taxpayer $250,000 in additional taxes for the privilege of holding on to this asset until death, which resulted in $250,000 less to the taxpayer's heirs.
The concepts contained herein are not intended to serve as advice and may have legal, tax and accounting implications. Consult your Attorney and CPA for advice.
CWEB-L-126