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The great rush is on to complete major gifting in 2012 before the unified credit equivalent amount is reduced from $5.12 million to $1 million in 2013 and thereafter. While planners are focused on transfer tax savings and issues, they must also consider the income tax consequences of the gifts.
Basis Step-Up Issues. Most planners, even those without a strong income tax background, are aware of the trade-off in making a lifetime gift of appreciated property versus transferring such property at death. If a gift is made of the property, the recipient usually receives the same basis that the donor had in the property. If the recipient then sells the received property, it will have to pay income tax on the appreciation that exists in the property, as if the donor had sold it. If the property was held until death and then transferred, the basis of appreciated property would be adjusted at death to the value of the property. This allows the recipient to then sell the property without ever paying income tax on the appreciation that occurred while the decedent owned the property.
Liabilities in Excess of Basis Issues. For those planners that plan on using limited liability company or limited partnership interests to fund 2012 gifts, another income tax issue exists that is not as well-known and is not being widely discussed should be on the review checklist. This involves the transfers of interests in these entities when the entities have mortgage or other indebtedness.
In this circumstance, it is possible that the share of the entity’s indebtedness that is allocable to the transferred interest exceeds the donor’s tax basis in the interest. In that circumstance, a gift of the interest may generate a gain to the donor to the extent that the indebtedness share allocable to the transferred interest exceeds the basis – that is, the donor can be treated as having sold the interest for the amount of the share of the entity indebtedness even though the transaction looks like a gift.
This circumstance is often referred to as a “negative capital account” situation. It typically arises from real estate or other business entities that borrow money and generate tax deductions for the partners or members. These deductions reduce the basis of the owners’ interests, often without an offsetting repayment of the debt or receipt of profits by the entity. Alternatively, the entity may borrow funds and then distribute the cash proceeds to members or partners, again reducing the owners’ basis in their interest while still maintaining the same level of debt in the entity.
Gift tax transfers to grantor trusts may avoid or defer the gain aspects, since the donor/grantor will be treated as still owning the transferred interest for income tax purposes. However, the planning can get tricky to cover the circumstances of death of the participants and beneficiaries. For example, if the grantor trust status terminates by reason of the death of a beneficiary during the grantor’s life, this may trigger a deemed sale at that point in time.
While the above focuses on interests in partnerships and LLC’s, similar issues can also arise if real property or other property is directly transferred if that property is encumbered. Therefore, planners are encouraged to make sure they have their income tax bases covered in addition to transfer tax planning, in making these last minute 2012 gifts. Also, since a transfer at death provides a direct means of eliminating a negative capital account, consideration should be given to finding alternative assets to gift for this reason alone.