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Factors to
Consider Before Making Gifts
By Michael Curtis and Eiko Itoh
This
article is designed to provide 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”, a tax imposed on various types of
transfers of wealth from one person to another.
Advantages of Making Gifts.
The major benefit
of making gifts is the ability to reduce the value of an estate (and thus the
estate taxes payable after death) in a variety of ways. Annual exclusion gifts and gifts for medical
and education expenses reduce estate taxes without any significant cost or
expense to the donor because they do not utilize any portion of the gift tax or
estate tax exemption. Gifts which
utilize all or a portion of the gift tax exemption are advantageous because
they reduce estate taxes by removing the income and all subsequent appreciation
of the property gifted from the donor’s estate.
Although the estate tax exemption increased above $1,000,000 in 2004
(reaching $3,500,000 in 2009), the gift tax exemption remained at
$1,000,000. Absent a change in the law,
this means that gift taxes must be paid for lifetime gifts valued at more than
$1,000,000.
Gifts can also
significantly reduce the value of the property retained when giving a
fractional interest in property while retaining a fractional interest because
of appropriate adjustments to value for such gifts (e.g., lack of marketability
discounts for the interest given and the interest retained). Significant transfer tax savings can also 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 do 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, which
includes the funds that will be used to pay the taxes. Thus, gift taxes are “tax exclusive” while
estate taxes are “tax inclusive.” Further, if the donor lives for 3 years after
paying the gift tax, the gift taxes paid will not be included in the donor’s
estate.
Disadvantages of Making Gifts.
The
major disadvantages of making gifts are the costs and expenses incurred and the
potential income tax to the donee on the built-in gain of the property
gifted. These disadvantages may not be
applicable or important in any given situation.
Legal, accounting and appraisal fees are often incurred when making
gifts and an annual gifting program can 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. Because the expenses incurred making gifts
also reduce the value of the donor’s estate, there is a tax benefit associated
with such expenses.
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.
Each
individual donor can give up to $13,000
per year per person without using up any portion of the donor’s gift tax
exemption. This is referred to as an
annual exclusion gift. In order to
qualify for the annual exclusion, the 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 are not present interests unless there are
special provisions in the trust that qualify such gifts for the annual
exclusion. One type of trust that
qualifies for the annual exclusion is a Minor’s Trust. A Minor’s Trust must terminate, or provide
the beneficiary with the power to terminate the trust, when the beneficiary
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 grants him or her, after the gift is
made, the right to withdraw and receive outright the specified amount of the
gift (generally limited to the annual exclusion amount). This withdrawal power is sometimes referred
to as a “Crummey power” and the trusts are referred to as “Crummey trusts.”
Special Exclusion for Educational and Medical
Gifts.
In
addition to the annual exclusion gifts, there is a special rule that permits
the payment of certain education expenses (primarily 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 annual exclusion gift
and do not utilize any portion of the gift tax exemption. Gifts to college savings accounts (commonly
referred to as “529 Plans”), on the other hand, do not qualify for the special
exclusion for gifts to educational institutions, but they do qualify for the
$13,000 annual exclusion.
Lifetime Gift Tax Exemption.
Each
U.S. citizen or resident may gift an amount equal to the lifetime gift tax exemption
to one or more donees without incurring any gift tax. This is over and above the annual exclusion
and special exclusion gifts mentioned above.
The advantage of using all or a portion of the gift tax exemption during
one’s lifetime is that all income from and appreciation on the gifted asset
will also be removed from the donor’s estate.
Over time, this may result in significant estate tax savings. All gifts in excess of the annual exclusion amount
will require the preparation and filing of a gift tax return, although there will
not be any tax due unless the taxable gifts cumulatively exceed the lifetime
gift tax exemption.
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 a larger
annual exclusion amount.
Kiddie Tax.
To
the extent the unearned income of certain children under age 24 exceeds a
specified amount,
the excess will be taxed to the child at the parent’s marginal (highest) tax
bracket for federal income tax purposes.
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 (“fair market value”)
of the gift is determined on the date the gift is made. The basis of the property given is not
relevant for purposes of determining its value.
Therefore, if publicly traded stock was purchased for $1,000 and it was
worth $10,000 on the date it was given to the donee, $10,000 of the annual
exclusion amount would be used in that year for that donee. There are special rules regarding the
computation of gain or loss on the sale of gifted property.
Numerous
tax cases (beginning in 1969) have permitted various adjustments to the value
of property that is not publicly traded.
The most common adjustments to value are discounts for lack of
marketability, discounts for minority interests and valuation adjustment for
built-in capital gains. When making
gifts of property where such adjustments to value are appropriate, it is
required that an expert appraisal be obtained to quantify the appropriate
adjustment. This typically results in
two appraisals for the property gifted:
one for the value of a 100% interest in the property; and one for the
appropriate discount.
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.
Alternative Methods of Making Gifts.
(1)
Outright
Gifts. These types of
gifts should be considered for 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 the donor does not have any control over
the funds or property once given to the donee unless the gift is paid directly to
a third party (educational institution, medical care provider, etc.) for the
donee’s benefit.
(2)
Gifts to
a College Savings Account (529 Plan).
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.
(3)
Gifts
Into a Custodianship. For donees who
are under age 21, gifts may be made into a custodianship arrangement under the
California (or other state) Uniform Transfers to Minors Act. This is an informal, trust-type relationship
where the funds are held by a person other than the donee in the custodianship where
the donee is treated as the owner for tax purposes so that no trust tax return
is required. A custodianship will
terminate at age 18 unless it is specified that it will continue until age 21
when the custodianship is created. You
cannot continue a custodianship beyond age 21 for lifetime gifts. A tax return will be required for the donee
if his or her income from the gift and any other sources exceeds the amount
that requires a return to be filed. 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. Donors should not act as the custodian for
gifts they make because the value of the assets in the custodianship
attributable to the gift by the donor will be included in the donor’s estate if
the donor dies before the custodianship terminates. Selecting a minor’s parent as custodian can
also have adverse estate tax consequences that must be discussed with the
donor’s tax advisers before establishing the custodianship.
(4)
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 $8,200 (in 2010; 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 beneficiary turning age 21 will not terminate the trust,
but parental (or grandparental) persuasion may be utilized to convince the beneficiary
of the wisdom of not terminating the trust at age 21.
(5)
Gifts
Into a Crummey Trust. The Crummey
Trust is a more complex type of trust to create than a Minor’s Trust and has more
annual administration costs than other types of gifts because of the need to
file annual trust tax returns and to comply with the withdrawal rights granted
each time a gift is made. Crummey Trusts
permit the creation of trusts 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.
Bargain Sales.
Sale
transactions with a relative for less than the fair market value of the
property treat the difference between the purchase price and the fair market
value as a gift. Care should be taken to
avoid bargain sales in most instances. A
full discussion of ways to structure sales to family members is beyond the
scope of this article.
Below-Market Interest Rate Loans.
Loans with
below-market interest rates are generally considered to be “gift loans” because
the lender is considered to have made imputed transfers of the forgone interest
to the borrower. The amount of the gift
depends on the type of loan made, and there are certain de minimus and other
exceptions to “gift loan” treatment. A full discussion of ways to structure loans to
family members is beyond the scope of this article.
Note: Because of Congressional inaction, there is
currently in effect a one year moratorium of the federal estate and
generation-skipping transfer tax for 2010.
As a result, many of the benefits of gifting must be weighed against the
uncertainty surrounding the future federal estate and generation-skipping
transfer tax laws. This article has been
prepared on the assumption that through Congressional action or inaction the
moratorium will be lifted or will expire and the estate and generation-
skipping transfer taxes will be reinstated.
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