By: Randall A. Denha, J.D. LL.M.
There are many benefits to making a gift during life to loved ones. However, the major benefit of making gifts is the ability to reduce the value of your estate as well as the estate taxes payable after your death. There are a number of ways to make a gift, some well known and others not quite as popular, but still quite effective. The following are a number of these techniques as well as some insight in navigating the myriad of ways one can gift give.
a. Gifts to Spouses
Gifts to spouses who are U.S. citizens are not subject to gift tax and do not use any portion of the gift tax exemption. Gifts to spouses who are non-U.S. citizens are subject to gift tax but qualify for an annual exclusion amount ($143,000 in 2013; subject to adjustment annually).
b. Annual Exclusion and Health and Education Gifts
The annual exclusion gifting limits are currently $14,000 per spouse (indexed for inflation) or $28,000.00 for a married couple. This amount of money can be gifted to as many people as you wish each year, regardless of whether they are related to you or not.
For education, the exclusion is limited to tuition, and cannot be applied to payments for books, supplies, dormitory and boarding fees, or other similar costs not directly related to tuition. However, the exclusion applies to tuition expenses for full-time or part-time students at any institution that maintains a regular faculty and curriculum and has students in attendance, meaning the exclusion payments can be used for private primary and secondary schools as well, not just higher education.
The tuition money can also be prepaid. You could, for example, choose to prepay tuition for your three grandchildren for the next five (or however many) years, and this would still qualify for the exemption as long as the money is paid directly to the institution, is to be used exclusively for tuition, and is non-refundable. You must also agree to pay any increases in tuition imposed by the school in subsequent years. Be aware, though, of the potential risk with this idea: the child may not end up attending that particular school, or may decide to transfer to another school, and the prepaid money is generally non-transferable. However, if this risk seems unlikely (the child already attends the school and enjoys it), then this may be a good idea.
For medical expenses, the exclusion applies to: expenses incurred for the diagnosis, cure, mitigation, treatment or prevention of disease; expenses for transportation essential to medical care; expenses for prescription drugs; and premiums for medical insurance. Insurance may include regular health insurance and long term-care insurance. However, medical payments must be for tax-deductible items (cosmetic surgery, for example, is not covered by this and so would not count for the exclusion). Note: the exclusion only includes the portion of medical expenses not reimbursed to the donee by insurance.
c. Gift Tax Exemption Gifts
Each U.S. citizen or resident may gift an amount equal to the gift tax exemption during his or her lifetime to one or more donees without incurring any gift or estate tax. This is over and above the annual exclusion. You may choose to give less than this full amount of your gift tax exemption. The advantage of using the full amount of your gift tax exemption during your lifetime is that all income from and appreciation on the gifted asset will also be removed from your estate. Over time, this may result in significant estate tax savings. All gifts in excess of the $14,000 annual exclusion will require the preparation and filing of a gift tax return, even though there may not be any tax due.
d. Outright Gifts
This should be considered for any adult donees. Outright gifts are simple and straightforward, there are no administrative or tax complications involved and legal and accounting fees are generally minimized. The primary disadvantage of outright gifts is that you have no control over the funds after they have been given to the donee unless you pay those funds directly to a third party (educational institution, medical care provider, etc.).
As an aside, to the extent the unearned income of certain children under age 24 exceeds a specified amount ($2,000 in 2013; subject to adjustment annually), the excess will be taxed to the child at the parent’s marginal (highest) tax bracket for federal income taxes. This is referred to as a “kiddie tax.” When making gifts to children under age 24, the investment strategy for the funds given must take into account income that will be produced in order to keep it below the amount which would cause it to be taxed at the higher bracket. Investments in growth assets or those which would produce tax-free income may be advisable.
e. Gifts Into a Custodianship
For any donees who are under age 21, gifts may be made into a custodianship arrangement under the applicable state Transfers to Minors Act. This is an informal, trust-type relationship where the funds are held in the custodianship but are treated as owned by the donee for tax purposes so that no trust tax return is required. A custodianship will terminate at age 18 unless you specify that it will continue until age 21 when you create the custodianship. You cannot continue a custodianship beyond age 21 for gifts made while you are living. A tax return will be required for the donee if his or her income from the gift exceeds the amount that requires a return. (The gift is not treated as income, only the interest, dividends, etc., generated from the gift is treated as income.) The kiddie tax discussed above will apply to any donee under age 24 for federal tax purposes. If you choose this option, you should not be the custodian of an asset you have gifted because it will be included in your estate if you die before the custodianship terminates.
f. Gifts Into a Minor’s Trust
A Minor’s Trust provides similar benefits to the custodianship but is more expensive to create and a separate trust tax return, or Form 1041, must be filed annually. The kiddie tax can be avoided to the extent that income is accumulated and not spent (which generally means that none of the funds in the trust would have been spent). As long as trust income does not exceed $2,450 (in 2013; adjusted annually), the federal tax rate will be at 15% or the lower federal tax rate applicable to individuals. To the extent that income is considered distributed to the minor (e.g., because, for example, funds were used to pay for the minor’s educational costs), the kiddie tax must be taken into consideration. Finally, to the extent trust income that was taxable at the trust level and not passed through to the minor exceeds $11,950 (in 2013; adjusted annually), the trust would begin to approach the highest tax rates that income would be taxable for individuals. One benefit of a Minor’s Trust over a custodianship arrangement is that the trust can provide that it will continue until a specified age (e.g., 30) or for a much longer period of time. One downside to the Custodial arrangement is that there is no guarantee that a child turning age 21 will not terminate the trust, but parental (or grandparental) persuasion may be utilized to convince the child of the wisdom of not terminating the trust at age 21.
g. Gifts to a 529 College Savings Account
A donor can make gifts to a College Savings Account that will be used to pay qualified higher education expenses incurred by a beneficiary in the future. The donor can decide when and by whom the funds are received and has the right to reacquire the funds, subject to penalties. Gifts to a College Savings Account do not qualify for the special exclusion for qualified gifts to educational institutions, but they do qualify for the annual exclusion. Donors are allowed to make up to 5 years’ worth of annual exclusion gifts at once by making an election on a gift tax return.
How Does One Value Gifts?
The value of the gift is determined on the date the gift is made. For example, if you purchased stock for $1,000 and it was worth $14,000 on the date you gifted it to the donee, you would be using up your full $14,000 annual exclusion in that year for that donee. As to the donee, the basis that he/she receives is called carry-over basis. So, by way of example, if donee sells the asset for $20,000 then the taxable gain is 19,000 (20,000 less 1,000 basis) and that is what the income-tax is computed against.
Can We Further Reduce The Value Of A Gift?
Of course adjustments to value can be made when the donor gifts a fractional interest in real property or closely-held entities to reflect the lack of marketability of the fractional interest and/or a minority interest. For interests in closely-held entities, an adjustment to value may also be made if the entity would incur a tax liability from the recognition of built-in gain in its underlying assets. Such “discounts” reduce the value of the gift. To the extent permitted, it is wise to maximize discounts as best we can. These discounts are on the Government chopping block so it’s important to use them while you can.
Additional adjustments to value are also made when the donor retains an interest in the gifted property for a period of time. In such cases, the value of the gift is the actuarially determined value of the donee’s right to receive the property after that period of time has passed, often a small fraction of the current fair market value of the property. Examples of gifts to trusts that use this technique include Grantor Retained Annuity Trusts (“GRAT”), where the donor makes a gift of an asset to the trust and retains a fixed dollar annuity for a period of time, and Qualified Personal Residence Trusts (“QPRT”), where the donor makes a gift of a personal residence (or a partial interest in the residence) to the trust and reserves the right to use the residence for a period of time.
Disadvantages To Making Gifts?
Despite the power of gifting and the mathematical dent that occurs in ones overall estate, there are a few disadvantages. These disadvantages may not be applicable in your particular situation. For example, legal, accounting and appraisal fees are often incurred when making gifts and, sometimes, a gifting program will require these expenses to be incurred annually. Gifts of property are generally more costly than cash gifts and gifts of publicly traded securities because of valuation issues which must be resolved and because they require more documentation to complete the gift. If property is held until death, it will receive a new tax basis equal to the date of death value (referred to as a step up in basis) for purposes of depreciation and determining gain or loss on sale. When property is gifted, the donee receives the donor’s basis in the property and the gifted property will not get a new stepped up basis on the donor’s death.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.