Blogs Derek's Tax Blog Pre-Pay Estate Tax
Would you be willing to prepay estate taxes while you are alive, in exchange for a lower tax rate? This is the idea from Washington's own Sen. Maria Cantwell and it could lead to a permanent compromise on the on the Federal Estate Tax. (Dow Jones Newswire)
As anyone who has studied the Roth IRA conversions can tell you, sometime pre-paying a tax makes sense. Pre-paying estate taxes isn't a new idea. In fact we have a special name for it. The Federal Gift Tax. Currently taxable gifts are taxed at the same rate as estates are taxed, but they can still offer an advantage. First, all of the growth on the gift is outside of the estate. Second, the money used to pay the tax can reduce the taxable estate of the taxpayer and thereby reduce the estate tax liability. Senator Cantwell's idea would add the additional benefit of paying the tax at 35% instead of 45%. In addition, for residents of states like Washington that do not have a gift tax, this gift will avoid state estate taxes entirely. To illustrate how this would work, consider the following.
Terry decides to make a $1 million dollar to his son, Steve. Assuming the Senator's proposal was in place, the gift tax on this amount will be $350,000 which would be payable over 5 years. In ten years when Terry dies the $1 million dollar gift to his son would have doubled to $2 million. Since taxes have already been paid, no additional taxes are due as a result of Terry's death.
If Terry did not make the gift the $2 million would be in his estate at the time of his death. Additionally, the tax he paid would also be in his estate, but it would have also doubled and would be worth $700,000. This would bring the total additional taxable amount in the estate to $2,700,000. The combined Federal and State Estate Tax on this amount would be $1,404,750 leaving $1,295,250.
The gift and pre-pay tax strategy means that at the time of Terry's death, his son, Steve, will have $700,000 more ($2,000,000 vs $1,295,250). This is a 54% increase.
The government is happy because they get know tax dollars in the short term instead of uncertain tax dollars at some point in the future. The taxpayers are happy because they pay less tax; right? While the math for this approach makes sense, it faces one near insurmountable: clients hate the pre-pay tax strategy. Of all of my estate tax strategies this one is the least likely to be used. Other practitioner may have different experiences. While the lower tax rate may help sell this strategy to clients, my guess is that 35% is still too high to entice many taxpayers. A rate closer to half of the estate tax rate may work better.
Still, I would welcome a gift tax cut. I would prefer larger annual gift tax exclusions, but lower gift tax rate would help to facilitate earlier generational transfers of excess assets allowing them to be reinvested in the economy.