The estate tax and gift tax work together to form a complex tax structure. Presently, both taxes share a $12,920,000.00 basic exclusion amount for each individual and a 40% estate tax rate for 2023. Furthermore, the IRS created the applicable credit amount (also known as the unified credit) that must be used to offset any assessed gift tax or estate tax. Because of this tax structure, very few individuals will pay a gift tax or estate tax. However, the impact of the estate tax and gift tax on your estate depends on the size of your estate.

The Benefit of Portability for a Surviving Spouse

The IRS allows for an additional exclusion for a surviving spouse. If a spouse dies, the unused portion of their basic exclusion may transfer to the surviving spouse regardless of the size of the estate. The Deceased Spousal Unused Exclusion (DSUE) is optional, and if the estate elects to use the DSUE, the executor must file an estate tax return (Form 706).  The DSUE benefits a surviving spouse in the following ways:

1. The DSUE, when added to the basic exclusion amount of the surviving spouse, will form the applicable exclusion amount. The result is a higher exclusion amount for the surviving spouse.
2. The Applicable Credit Amount will increase because the credit amount will be equal to the tax of the higher applicable exclusion amount.

The Applicable Credit Amount

The applicable credit applies to both the estate tax and gift tax. Since the applicable credit is only used to offset any tax assessed, the applicable credit equals the tax on the basic exclusion amount. For 2023, the applicable credit for the basic exclusion amount is $12,920,000.00 X .40 = $5,168,000.00. So, in 2023, $5,168,000.00 in estate tax and gift tax will be offset which exempts $12,920,000.00 from any tax. These amounts increase if the executor elects to use the DSUE for the estate.

The applicable credit works in the following ways:

1. The use of the applicable credit offsets the assessed estate tax or gift tax. No tax is actually paid. 

2. The applicable credit is then reduced by the amount of the assessed tax. This reduces the amount of the credit available to offset any future estate tax or gift tax.

When the applicable credit reaches a zero balance, any subsequent tax requires payment.

The Federal Gift Tax

Generally, the gift tax applies to lifetime transfers of property from the donor to the recipient.  Assessment of the federal gift tax is on the donor of the gift, not the recipient. If the donor of the gift doesn’t pay the assessed gift tax, the IRS will go after the recipient for payment of the gift tax.

The IRS has a general rule that any gift is a taxable gift. However, the IRS does include exceptions. The following gifts are not taxable by the IRS:

1. All property one spouse gives another regardless of the worth. Except if the spouse is not a citizen.
2. All property given to a tax-exempt charity.
3. Gifts made to pay someone’s medical bills and tuition. In this instance, the money must go directly to the provider of the service or the school. Otherwise, the gift is not tax-exempt.
4. Gifts, that are not more than the annual exclusion for the calendar year. 
5. Gifts to a political organization and its use.

The Annual Exclusion

In 2023, the federal gift tax law excludes from the gift tax the first $17,000.00 given to any person in a calendar year. The exclusion applies only to gifts of present interest. Gifts of future interest do not qualify for the exclusion regardless of the gift amount.

In addition, married couples can give up to $34,000.00 to any individual in a calendar year. Each spouse can use their $17,000.00 annual exclusion to give to any individual. This action, referred to as gift splitting, requires the filing of a gift tax return to inform the IRS that each spouse consents to splitting the gift and is not subject to the gift tax. Moreover, gift splitting requires the filing of the gift tax return even if each spouse gives less than the annual exclusion amount.

The Gift Tax and the Applicable Credit

Most people will never actually pay a gift tax because of the applicable credit. Each individual can give up to $12,920,000.00 in lifetime gifts before they pay a gift tax. However, there are triggers that will require a gift tax return, and in some instances, will result in a gift tax. The following are triggers to a gift tax return:

1. A gift given above the annual exclusion amount for the year the gift was given.
2. A gift given of future interest.
3. A couple consenting to splitting a gift.

Except for gift splitting, the IRS will assess a gift tax with the filing of the gift tax return. The gift tax assessed will be offset by the applicable credit and no tax will actually be paid.

The Federal Estate Tax

In general, an estate tax return must be filed when the gross value of the estate plus any taxable gifts exceed the basic exclusion amount for the year of the death. Most people won’t have to file an estate tax return because of the high exclusion amount. However, for wealthy estates that exceed the basic exclusion amount, the IRS offers some relief. Once determined that an estate tax return is required, the IRS allows the following deductions from the gross estate to calculate the taxable estate:

1. Funeral expenses paid out of the estate.
2. Debts the decedent owed at the time of death.
3. The marital deduction, which exempts from estate tax, all property left to a spouse except for a non-citizen spouse.
4. The charitable deduction, which exempts from estate tax, all property left to a tax-exempt charity.
5. The state death tax deduction exempts any estate, inheritance, legacy, or succession taxes paid to any state or District of Columbia as a result of the decedent’s death in the year 2005 and beyond.

In addition, the IRS will allow the DSUE and the applicable credit to help reduce or eliminate any estate tax owed. The use of the DSUE and applicable credit for the estate tax requires a filing of the estate tax return. Here are the triggers to require a filing of an estate tax return:

1. The gross estate plus taxable gifts exceed the basic exclusion amount.
2. The executor elects to use the DSUE for a surviving spouse.
3. To determine how much of the applicable credit is available to use against any estate tax owed.

The Estate Tax and the Applicable Credit

If an estate owes an estate tax, the use of the remaining applicable credit will eliminate the tax or  reduce the amount of tax owed.  As mentioned above, once the applicable credit has a zero balance any subsequent estate tax or remaining estate tax requires payment.

For a surviving spouse, if the estate elected to use the DSUE, the higher applicable exclusion amount will apply and the applicable credit will increase.

State Estate Tax and Gift Tax

Except for Connecticut, states don’t impose a gift tax. However, many states impose an estate tax which may include federal taxable gifts in determining the need for an estate tax return. In Massachusetts, for example, the basic exclusion amount is $1,000,000.00 and the tax rate is a graduated tax rate that can peak at 16%. Furthermore, federal taxable gifts are added to the gross estate value. So, if the gross estate value plus federal taxable gifts exceed the basic exclusion amount of $1,000,000.00, a state estate tax will result. So, in some states, the federal taxable gifts are a factor in determining the state estate tax.

For states that do impose an estate tax, the IRS allows a deduction in the amount of the state estate tax paid. The use of the state death tax deduction along with other allowable deductions determines the federal taxable estate.

For a list of states that impose an estate tax click here.

The Impact on your Estate

There’s no impact if the value of your estate is less than the basic exclusion amount. You won’t have to file an estate tax return, and a gift tax return is unlikely. Most people are not going to give away over $17,000 per year, nor are they going to give over $12,920,000.00 in a lifetime. As long as you give gifts of present interest and follow the guidelines given, you will never have to file a gift tax return or an estate tax return.

If you are a wealthy individual, the impact on your estate can be extreme without elaborate estate planning. You will have to play a shell game with the IRS to avoid paying a healthy portion of your estate in taxes.

You can reduce exposure to the estate tax and gift tax in the following ways:

1. Take advantage of the numerous deductions and exclusions the IRS allows.
2. Start a gift giving program using the gift giving guidelines mentioned above under The Federal Gift Tax. 
3. Hire a team of professionals to form tax saving irrevocable trusts.

The level of impact the taxes will have on your estate depends on the depth of your wealth. If the value of your estate is barely above the basic exclusion amount, it’s possible to avoid any taxes using the three tactics above. However, if your estate is well above the basic exclusion amount, it will be hard for you to avoid paying any estate tax or gift tax. Only with a team of expensive, talented professionals could such a happening be possible.

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Note:

Refer to the article Tax Returns and the Date of Death to understand the tax returns and when they are due.

References:

IRS Publication 559 Survivors, Executors, and Administrators

IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return

Estate and Gift Taxes-IRS.gov