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FACTORS
TO CONSIDER BEFORE MAKING GIFTS
By Eiko Itoh
This article
is designed to provide you with a general overview of the major gift, estate,
and income tax consequences of making non-charitable gifts. In this article we will refer to the gift tax
exemption, the estate tax exemption and the generation-skipping transfer tax
exemption even though the Internal Revenue Code uses the term “applicable
exclusion amount” because the term exemption is frequently used and more
generally understood conceptually.
Further, gift taxes, estate taxes and generation-skipping transfer taxes
are sometimes referred to collectively as “transfer taxes”, the tax imposed on
various types of transfers of wealth from one generation to another.
Advantages of Making Gifts.
The major benefit of making gifts is the
ability to reduce the value of your estate (and thus the estate taxes payable
after your death) in a variety of ways.
Annual exclusion gifts and gifts for medical and education expenses reduce
estate taxes with virtually no cost because they do not utilize any portion of the
gift tax or estate tax exemption amount.
Gifts which utilize all or a portion of the gift tax exemption reduce
estate taxes by removing the income and all subsequent appreciation of the
property gifted from your estate. The estate
tax exemption is $5,000,000 for persons dying in 2011 and 2012, and the
lifetime gift tax exemption is also $5,000,000.
Absent a change in the law, this means that gift taxes must be paid if
you make gifts valued at more than $5,000,000 during your lifetime. Unless Congress takes action before the end
of 2012, the estate tax exemption and the gift tax exemption will both return
to $1,000,000 in 2013.
Gifts can also significantly reduce the value of the
property retained if you give a fractional interest in property while retaining
a fractional interest. Gift and estate
taxes are taxes on the transfer of wealth.
As a result, significant transfer tax savings can be realized by making
taxable gifts in excess of the gift tax exemption because gift taxes are based
on the value of the gift and to not include any gift taxes payable as a result
of the gift. Estate taxes, on the other
hand, are based on the value of the taxable estate, including the funds that
will be used to pay the taxes. Thus,
gift taxes are “tax exclusive” while estate taxes are “tax inclusive.”
Disadvantages of Making Gifts.
The major
disadvantages of making gifts are the potential costs incurred and the income
tax on the built-in gain of the property gifted. These disadvantages may not be applicable or
important in your particular situation.
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 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.
Annual Exclusion Gifts.
You can
give up to $13,000 per year per person without using up any portion of your
applicable exclusion amount. In order to
qualify for the $13,000 annual exclusion, a gift must be made outright to the
donee or in such a manner that the gift would otherwise be includable in the
donee’s taxable estate if the donee were to die. It must also be a present interest. Generally, gifts in trust do not qualify for
the annual exclusion unless there are special provisions to qualify the trust
for the $13,000 annual exclusion. One
type of trust that qualifies for the annual exclusion is a Minor’s Trust. A Minor’s Trust must terminate when the child
attains age 21. Another way of
qualifying a trust for the annual exclusion is to provide the donee/trust
beneficiary (in the case of a minor, this can be a guardian or custodian for
the donee) with a withdrawal right that authorizes him or her, within a
specified period (commonly 30 to 45 days) after the gift is made, to withdraw
and receive outright the full amount of the gift (generally limited to the $13,000
amount). This withdrawal power is
sometimes referred to as a “Crummey power” and the trusts are referred to as
“Crummey trusts.” The term came from the
name of the taxpayer in the tax case that held that such withdrawal rights
qualified for the annual exclusion.
Special Exclusion for Educational and Medical Gifts.
In
addition to the $13,000 annual exclusion, there is a special rule that allows
you to pay tuition for a donee directly to the educational institution. There is also a specific provision that
allows you to pay for medical expenses for a donee. In addition to medical expenses, you may pay
for medical insurance on behalf of an individual. Medical expenses and insurance payments must
be made directly to the providers. You
cannot simply reimburse the donee for these expenses. These exclusions for tuition and medical
expenses do not count as a part of the $13,000 annual exclusion and do not
utilize any portion of your applicable exclusion amount.
Applicable Exclusion Amount Gifts.
Each U.S.
citizen or resident may gift an amount equal to the gift tax applicable
exclusion amount 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 and special exclusion gifts mentioned
above. You may choose to give less than
this full amount of your gift tax applicable exclusion amount. The advantage of using the full amount of
your gift tax applicable exclusion amount 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. If you
are contemplating making gifts in order to use up all or a portion of your gift
tax applicable exclusion amount, we should discuss the amount of your remaining
gift tax applicable exclusion amount as well as the appropriate assets to be
gifted. All gifts in excess of the $13,000
annual exclusion will require the preparation and filing of a gift tax return,
even though there may not be any tax due.
Kiddie Tax.
To the
extent the unearned income of certain children under age 24 exceeds a specified
amount ($1,900 in 2011; 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.” In California, the kiddie
tax applies to unearned income only of those children under age 14 for state
tax purposes. 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.
Valuation of Gifts.
The value
of the gift is determined on the date the gift is made. Your basis in the gift
is not relevant for purposes of determining its value. Therefore, if you purchased stock for $1,000
and it was worth $13,000 on the date you gifted it to the donee, you would be
using up your full $13,000 annual exclusion in that year for that donee. There are special rules regarding the
computation of gain or loss on the sale of gifted property. If you have specific questions regarding
these areas, we would be happy to talk with you about them.
With the above as a background, the gifting alternatives
that you may wish to consider are as follows:
(a)
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.).
(b)
Gifts Into a Custodianship. For any
donees who are under age 21, gifts may be made into a custodianship arrangement
under the California Uniform 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 14 for California tax purposes and to certain
donees 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. Selecting
a minor’s parent as custodian can also have adverse estate tax consequences so
you should discuss with us the persons who are appropriate to act as custodians
before you proceed.
(c)
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 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 $2,300
(in 2010; 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 $11,350 (in
2011; 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) if the minor does not elect to
terminate the trust within a 30 or 60-day period after reaching age 21. 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.
(d)
Gifts Into a Crummey Trust. The
Crummey Trust is the most expensive trust to create and has the most expensive
annual administration costs because of the need to file annual trust tax
returns and to prepare and distribute withdrawal right notices every time a
gift is made. The withdrawal rights are
generally very effective because everyone understands that it is not in
anyone’s best interest to exercise the withdrawal right and, as a result, you
may create a trust that will continue beyond age 21 and still qualify for the
annual exclusion. The tax rules that
affect the donee and the trust are the same as are applicable to the Minor’s
Trust. There are also very complex
potential estate tax consequences to the beneficiary of the trust if the
withdrawal rights exceed $5,000. We will
discuss this issue with you in greater detail if you wish to consider
establishing a Crummey Trust.
If you are going to be making annual exclusion gifts of $13,000,
and these funds are likely to be used for education, we can advise you as to the
least complicated method of making such gifts initially.
Bargain Sales.
If you
enter into a sale transaction with a child or relative for less than the fair
market value of the property, the difference between the purchase price and the
fair market value will be considered a gift.
Internal
Revenue Service Circular 230 Disclosure
Please
note that any discussion of or advice regarding United States tax matters
contained herein (including any attachments hereto) does not meet the
requirements necessary to be a “covered opinion” as defined in Internal Revenue
Circular 230, and, therefore, is not intended or written to be relied upon or
used and cannot be relied upon or used for the purpose of avoiding federal tax
penalties that may be imposed or for the purpose of promoting, marketing or
recommending any tax-related matters or advice to another party.
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