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When Giving Is a Better Tax Strategy than Bequeathing

May 2, 2004

Excerpted from a study by Don Cunningham, Ph.D. and Paul Erickson, J.D.

Cunningham, DonIn a study published in the Journal of Financial Planning in August 2002, we examine two estate planning dilemmas: 1) Is it better to give or bequeath assets and

2) When giving, is it better to give appreciating assets or income-producing assets? Rather than examine the questions from a typical tax planning strategy of minimizing transfer taxes, we examine them from a finance strategy of maximizing family wealth (net worth). We believe this approach is more complete because it also considers income tax effects and the time value of money. Our findings are summarized below and, surprisingly, in some cases are contrary to conventional wisdom.

Our study was prompted in part by the Economic Growth and Tax Relief Reconciliation Act that President George W. Bush signed into law in 2001. It authorized the incremental elimination of the estate tax by the end of 2010. However, unless Congress extends the act, it will expire in 2011 and estate taxes will revert to their former levels.

Even though enduring repeal of the estate tax will require further congressional action, the new law has generated considerable debate. It is prompting individuals with sizable estates and life expectancies of six or fewer years to re-evaluate lifetime giving in comparison to bequests in order to determine which would influence aggregate family wealth more favorably for them.

Under the old law and continuing with the Tax Relief Act, lifetime giving offers numerous tax-minimizing advantages. Annual exclusions of $10,000 per beneficiary, which avoid all transfer taxes, certainly rank at the top of estate planning strategies. Likewise, full use of the unified transfer credit achieves the same no-transfer tax result. Due to the removal of a gift from one's estate, the so-called gift tax is effectively lower than the estate tax. Lifetime giving also removes future appreciation of assets from the list of property subject to estate taxation.

But does the conventional advice to give appreciating assets (rather than income-producing assets) and to give as early as possible (rather than delaying giving) remain valid? Our research has shown that when property income, property appreciation, donor's income tax bracket, beneficiary's income tax bracket, time, and the time value of money are all factored into the give-versus-bequeath analysis, then appreciating assets are not always best for giving, and early giving often provides no advantage. As a result of certain conditions introduced by the Tax Relief Act, a delay in giving until the last possible moment may for some people constitute the most favorable strategy.

By utilizing a standard capital budgeting procedure, we quantify the impact of the give or bequeath decision on family wealth. The process entails: 1) estimating the future after-tax cash flows for all combinations of giving or bequeathing property; 2) taking the present value of each combination at the appropriate after-tax discount rate; and 3) ranking the results in order of highest present value. The strategy with the greatest present value is optimal because it maximizes the preservation of family wealth.

Three assumptions are critical in performing a give-or-bequeath analysis. First, we assume donors save rather than consume all income from property bequeathed that would otherwise be given. This assumption captures the essence of tax-induced giving as compared to benevolent giving. Saving the income implies that donors have "excess" assets on hand, and the income produced is not required to maintain lifestyle; rather, the income is simply saved and serves only to increase net worth. Secondly, we assume both donors and beneficiaries employ a "buy and hold" strategy on transferred property, thereby avoiding unnecessary capital gains taxes. Donors either give or bequeath the property, and beneficiaries hold the transferred property until eventually they either give or bequeath the property. Finally, we assume gifts are not made within three years of the donor's death. Under such circumstances, the gift taxes must be included in the donor's estate, and the gift tax rate and estate tax rate are effectively equal.

Income-producing assets generate income taxes, but appreciating assets do not generate capital gain taxes if donors and beneficiaries do not sell transferred property to third parties. Thus, the only taxes of consequence, besides transfer taxes, are income taxes on the donor's income versus the beneficiary's income. We find that giving appreciating property is not better than giving income-producing property when the donor and the beneficiary are in the same income tax bracket. Income taxes reduce the income of the donor and the beneficiary, but these reductions are exactly offset by adjustments required to convert before-tax discount rates to after-tax discount rates, and adjustments to include non-taxable appreciation when appropriate. Consequently, the present value of the income streams is unchanged when the beneficiary and donor are in the same bracket.

However, a divergence between donor and beneficiary income tax brackets creates incentive to transfer assets from high tax conditions to low tax conditions. Contrary to conventional recommendations, donors in high income tax brackets should not give appreciating property; rather, they should give income-producing property if their beneficiaries are in low income tax brackets.

When a donor in a low income tax bracket (15%) gives to a beneficiary in a high income tax bracket (36%), the transfer of property effectively raises the beneficiary family's income tax bracket because the property's income is taxed at the beneficiary's higher income tax rate. Donors in low income tax brackets should avoid giving income-producing property to beneficiaries in high income tax brackets. Only donors in income tax brackets lower than beneficiaries should adhere to conventional wisdom and give appreciating property; in fact, the more the appreciation and the less the income, the better.

So is giving assets better than bequeathing them? Through 2010, the answer is systematically yes. Regardless of property type, income tax brackets of donors and beneficiaries, and the cost of capital, giving rather than bequeathing assets always maximizes the amount of family wealth preserved.

Is giving appreciating assets better than giving income-producing assets? Surprisingly, no. Although conventional wisdom says appreciating assets are best for giving, our calculations demonstrate that asset type is irrelevant if the donor and the beneficiary are in the same income tax bracket. However, if donors are in income tax brackets higher than beneficiaries, then income-producing assets are best for giving. Only if donors are in income tax brackets lower than beneficiaries are appreciating assets best for giving.

Is giving now preferable to later due to the time value of money? The timing of the gift is greatly affected by changes in the tax law. Under old law, incurring gift taxes as soon as possible was advisable due to the time value of money. The Tax Relief Act of 2001, however, introduced a new wrinkle in the decision-making process: transfer taxes decrease by 1 percent each year from 2002 through 2007. For someone who now has a life expectancy of less than six years, the estate tax rate is fixed as of the date of expected death, but the gift tax rate declines with each year that a gift is delayed. In other words, delaying giving until the last possible moment can be most beneficial.

For donors in the same income tax brackets as their beneficiaries, delaying a gift increases the gain from giving. For donors in income tax brackets lower than that of their beneficiaries, delaying a gift increases the gain from giving, especially when the gift is income-producing property. For donors in income tax brackets higher than that of their beneficiaries, deferring a gift has the least benefit and in extreme cases reduces the gain from giving. Although the delay lowers the gift tax rate, that gain is contradicted by the loss of the beneficiary's lower income tax bracket when income-producing property is not given immediately.

Our research has shown that giving is better than bequeathing for donors who presently have life expectancies of fewer than six years. Determining the best assets to give depends solely upon the differential between income tax brackets of donors and beneficiaries. The Tax Relief Act of 2001 encourages donors to delay giving; the single exception is for gifts of income-producing property by the highest tax bracket donors to the lowest tax bracket beneficiaries. Then, giving immediately constitutes the best strategy.

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Don Cunningham, Ph.D., is a professor of finance and real estate in the Hankamer School of Business and a consultant in stock and mortgage portfolio valuation. For more information about the study, contact Cunningham by e-mail at Don_Cunningham@baylor.edu or by phone at (254) 710-6152.

Paul Erickson is the R.E. & Marilyn Reemer Professor of Accounting. His areas of expertise are taxation of estates, gifts, partnerships, and U.S. international transactions.

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