Legal Definitions - applicable exclusion amount

The applicable exclusion amount refers to the total value of assets that an individual can transfer during their lifetime (as gifts) and at their death (as part of their estate) without incurring federal gift or estate taxes. It acts as a cumulative, lifetime exemption from these taxes for U.S. citizens.

This amount is a specific dollar figure set by law, which can change over time due to legislation and inflation adjustments. It applies to the sum of all taxable gifts made during a person's life and the value of their estate at death. Certain transfers, such as direct payments for someone's medical or educational expenses, or gifts to qualified charities, generally do not count against this exclusion amount.

For married couples, there's a special provision called "portability" that allows a surviving spouse to use any portion of their deceased spouse's unused exclusion amount, effectively increasing their own tax-free transfer limit.

Here are some examples to illustrate how the applicable exclusion amount works:

• Example 1: Using the exclusion for both lifetime gifts and an estate

  Imagine Sarah has an applicable exclusion amount of $13 million. During her lifetime, she gifts $4 million to her son to help him start a business. This $4 million uses up a portion of her exclusion. When Sarah passes away, her remaining estate is valued at $10 million. Since she used $4 million of her exclusion during her life, she has $9 million ($13 million - $4 million) remaining for her estate. Therefore, $9 million of her estate will be exempt from federal estate tax, but the remaining $1 million ($10 million - $9 million) will be subject to estate tax.

  This example demonstrates how the applicable exclusion amount is a cumulative limit applied to both gifts made during life and assets transferred at death.

• Example 2: Exceeding the exclusion with large lifetime gifts

  Consider Michael, who has an applicable exclusion amount of $13 million. Over several years, he makes substantial gifts: $7 million to his daughter for a down payment on a house and another $8 million to his son to invest in a startup. In total, Michael has made $15 million in taxable gifts. Since his applicable exclusion amount is $13 million, he has exceeded this limit by $2 million. This excess $2 million will be subject to federal gift tax at the time the gifts are made, as he has used up his entire tax-free transfer allowance.

  This example illustrates that once the cumulative applicable exclusion amount is exhausted through gifts or estate transfers, any further taxable transfers will incur federal gift or estate taxes.

• Example 3: Utilizing portability for a surviving spouse

  Eleanor and Robert are married, and each has an applicable exclusion amount of $13 million. Robert passes away, having only used $2 million of his exclusion during his lifetime. This means he had $11 million of his exclusion unused. Through the portability election, Eleanor can add Robert's unused $11 million exclusion to her own $13 million exclusion. This gives Eleanor a combined applicable exclusion amount of $24 million ($13 million + $11 million) that she can use to make tax-free gifts during her remaining lifetime or for her own estate upon her death.

  This example highlights the "portability" feature, which allows a surviving spouse to benefit from the unused portion of their deceased spouse's applicable exclusion amount, effectively increasing their own tax-free transfer capacity.