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Gift and Estate Tax LifeBack Tax
One of the most controversial taxes in the United States is the estate tax, levied at the federal level as well as in thirteen states. While income tax applies to income obtained during the year, estate tax applies to any property or assets transferred to your heirs after your death. This tax is based on a deceased person's right to pass on their assets, so it is collected on the whole estate, not on each heir's portion of inheritance.
To prevent taxpayers from avoiding the estate tax by giving away their property before they die, the Internal Revenue Service (as well as the state of of Connecticut) also levies a gift tax. For tax purposes, any property or assets transferred without receiving something of equal value is a gift, including interest-free loans or forgiven debts. Only gifts of at least a certain size are taxable. Gift tax also does not apply to gifts between spouses, tuition or medical expenses (if paid directly to the educational or medical institution), political donations, or deductible charity donations, regardless of their amount. Usually, the gift recipient does not owe tax.
The IRS also collects a third, less-often mentioned tax called the generation-skipping tax, or GST for short. Generation-skipping tax applies to gifts or inheritances transferred directly from a grandparent to a grandchild, skipping the parent's generation to avoid paying estate or gift tax twice. GST also applies to gifts between unrelated persons if the recipient is at least 37.5 years younger than the gift-giver. A grandparent may be exempt from generation-skipping tax if the parents are already deceased. Note that generation-skipping tax only applies to transfers of property that are already taxable for estate or gift tax purposes.
Each taxpayer has an exemption that allows them to pass on their assets up to a certain limit without facing estate tax. When you die, the government calculates the value of your gross estate, including cash, securities, bank accounts, life insurance, business assets, and other property. Your estate is only taxable if its total value is greater than the exempt amount. This is intended to protect smaller and moderate-sized estates from taxation. Mortgages and certain other deductible debts can further reduce the taxable portion of your estate.
To avoid nickel-and-diming taxpayers for small, minor gifts, a gift is only taxable for gift tax and GST purposes if it exceeds a certain threshold for the given tax year. For 2019, you are only required to file a gift tax return if you gave someone more than $15,000 total during the year. This is called the annual exclusion, and is applied per recipient per year. In other words, if you give away $40,000, but split it evenly between four friends for $10,000 each, your gifts are still tax-exempt because each friend received less than the $15,000 annual exclusion. On the other hand, if you give someone $10,000 and an additional $13,000 a month later, your gift-giving to that person totals $23,000, exceeding the annual exclusion by $8,000, so $8,000 of your gifts to that person are taxable.
That said, even if you must file a gift tax return, you won't necessarily owe gift or generation-skipping taxes. Since gift tax and GST exist to enforce collection of estate tax, any taxable gifts during your lifetime are simply taken out of your estate tax exemption. The IRS calculates this by adding your lifetime taxable gifts to your gross estate at the time of your death. Your combined estate and taxable gifts are only taxable for the amount that exceeds the exemption. This shared exemption is sometimes called the lifetime gift exemption or the unified tax credit.
On the other hand, this also means that the more taxable gifts you make during your lifetime, the less of your estate is tax-exempt after your death. For this reason, some taxpayers may choose to pay off gift tax or GST during their lifetime to save the unified tax credit for their estate after death. Married couples may also combine their gift and estate exemptions, effectively doubling how much of their assets they can pass onto their heirs without owing tax.
Estate, gift, and generation-skipping taxes are the subject of numerous debate today. For taxpayers saving up their wealth to ease financial burdens for their descendants, estate and gift taxes appear to be an unfair cash grab by the government, not to mention double taxation on income. Proponents claim that such taxes help to remedy wealth disparities not reflected by income levels, while critics point out that estate tax generates less than 1 percent of the federal government's revenue.
The IRS levies estate, gift, and generation-skipping taxes at a massive 40 percent rate. (Officially, estate and gift taxes use a graduated system with rates ranging from 18 to 40 percent. However, due to the size of the unified credit, all taxable estates fall in the highest bracket, so they are always taxed at the top rate of 40 percent.)
Forturnately, thanks to recent tax reform legislation, only a small subset of taxpayers will need to worry about estate or gift tax. In 2017, the Tax Cuts and Jobs Act drastically increased the size of the unified tax credit, doubling the base amount from $5 million to $10 million, prior to adjustment for inflation. For 2019, the unified tax credit is set at $11.4 million, well above the average taxpayer's net worth. This makes it very unlikely for the majority of taxpayers to owe estate, gift, or generation-skipping taxes at the federal level.
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