The federal gift tax rates and estate tax rates have been and will remain the same under current law. Unless the repeal of the estate tax actually takes place, one can transfer more assets with lower gift and estate tax consequences through lifetime gifts than with testamentary gifts (bequests through a will). This is due, in part, to the fact that the dollars used to pay the estate tax—but not the gift tax—are themselves part of the estate and are therefore taxed. By contrast, dollars used to pay the gift tax during one’s lifetime are generally not subject to gift or estate tax.

Additionally, during one’s lifetime, one can take advantage of the annual gift tax exclusion that is not available to a testamentary gift. During your lifetime, you can make gifts of property that will appreciate and/or produce income. Keeping this appreciation and future income out of one’s estate lowers the estate tax consequences on the transferred property. Finally, gifts made in payment of the donee’s qualified medical or tuition expenses are excluded from gift tax, regardless of the amount of the payment, if made directly to the medical or educational instituion.

With the possible repeal of the estate tax, one must also give greater consideration to lifetime gifts versus testamentary gifts. One must also consider the effect of capital gains tax on the gift, a tax that may now be greater than the estate tax. There is no step-up in basis for lifetime gifts. If the estate tax is repealed in 2010, as scheduled under existing law, the step-up in basis on testamentary transfers will be limited. (Remember that under current law, however, the estate tax will be repealed for one year only—2010.)

When appreciated property is transferred by gift, the recipient’s "cost" (basis) of the property is the same as that of the donor (even though the recipient didn’t pay anything for the property). This means that the recipient must declare any gains as taxable income when he or she sells the property in the future. When property is transferred due to the death of the donor, the recipient receives a basis in the property at its current value, which was used to compute the value in the gross estate. This is called step-up in basis. If the recipient sold the property immediately for the current value, there would be no capital gains for income taxes. Note that if the current law remains unchanged and the estate tax is repealed for one year in 2010, there will be a modification of step-up in basis, too. The income tax basis of property owned by a person at death will no longer be permitted an unlimited "step up" to its fair market value on the day he died. Instead, a basis step-up of only $1.3 million will be given, with an additional $3.0 million in step-up allowed on property passing to a surviving spouse.

Example 1: Dad gives Junior 1,000 shares of stock in a corporation. (There are no federal income tax consequences to Junior unless and until he sells for a gain.) Junior sells it the next year at the market price of $60 per share, for a total to him of $60,000. Dad had paid only $50 per share two years ago. What is Junior’s gain? In reality, Junior has "gained" $60,000 he did not have before. But he takes Dad’s basis of $50,000 (the price Dad paid), so Junior’s income taxable gain will be only $10,000 ($60,000 – $50,000.) This, of course, would have been Dad’s true profit had he kept the stock himself and sold it.

The basis of inherited property, however, which the beneficiary will use to calculate taxable gain if he or she sells, takes a "step up" to the fair market value of the property on the date of the estate owner’s death. So, if the beneficiary sold the inherited property immediately for its fair market value, there would be little or no taxable gain. It was, therefore, possible to completely protect a lifetime of appreciation in value from capital gains income taxation. The 2001 law put a limit on the basis "step-up" benefit, as we will see after the following example, which remains valid:

Example 2: In 1994, Dad bought 1,000 shares of stock in XYZ Co. for $1 per share, for a total of $1,000. His tax basis is simply the price paid. Assume he dies and leaves the stock to Junior in 2009, when it is valued at $75 per share, for a total of $75,000. This becomes Junior’s basis in the stock. It has been stepped up, and Junior will recognize no income taxable gain if he sells at that price. Nice!!

Persons contemplating a gift of property that has already appreciated significantly in value might take issue with the above general observations. Their argument might be, "Sure, if I give this stock away now, my child will lose the benefit of the step-up in basis, and will have to pay more income tax when the property is sold. But that tax will probably be at the relatively low rate for capital gains. On the other hand, if I hold onto the property until death, my child gets the (eventual) income tax advantage of the basis step-up—but the property remains part of my estate. And IF we assume my estate will be large enough to be hit with estate tax, that tax begins at a rate twice as high as my child’s capital gains rate."

The 2001 Tax Relief Act makes it difficult to determine exactly which type of transfers will be more tax efficient.

To get it right, one would also have to know in which year one was going to die.