Gifts to friends, family members and charities are an effective way of reducing one’s taxable estate. Some gifts are tax free, while others reduce the maker’s (“donor’s”) “Unified Credit”. Charitable gifts produce an income tax deduction.

ANNUAL EXCLUSION GIFTS

Each individual may make annual gifts of up to ten thousand ($10,000) dollars per calendar year per beneficiary without the imposition of Federal gift tax. The right to make annual tax-free gifts is known as the “annual exclusion.” For gifts made in calendar year 1998 and after, the $10,000 annual gift tax exclusion is adjusted for inflation. However, it may be several years before the annual exclusion actually increases since the exclusion will rise only in increments of $1,000 and will be rounded to the next lowest multiple of $1,000 (i.e. if inflation pushes the amount to $10,999, it will be rounded down to $10,000).

The tax code does not limit the number of beneficiaries to whom gifts can be made, nor does it require that the donee be related to the donor. Gifts may be made in cash or other property. To the extent that the gift tax imposed, it is imposed on the donor. Gifts are received by the donee income tax-free.

If annual gifts to a single donor exceed $10,000, the gift tax exclusion covers the first $10,000 and only the excess is “taxable.” However, rather than having to pay tax on the excess, taxable gifts reduce the donor’s Applicable Exclusion Amount dollar for dollar. Each person has a Unified Credit sufficient to allow him or her to leave up to $650,000 (1999) either during life or upon death, free of tax. (The $650,000 Applicable Exclusion Amount will gradually rise to $1 million by 2006). The credit against gift and estate tax is known as “Unified” since taxable gifts made during the donor’s lifetime reduce the credit available at death.

TAXABLE GIFTS

The following example shows the effect of taxable gifts on the Unified Credit: Wendy gifts her son, Sam, $40,000 during 1999 from her separately owned assets. Assuming her spouse, Harry, did not consent to the gift, Wendy is allowed only a $10,000 gift tax exclusion. The remaining $30,000 of the gift is “taxable.” Accordingly, Wendy’s Applicable Exclusion Amount is reduced by the amount of the taxable gift, to $620,000 ($650,000 - $30,000). Thus, Wendy’s remaining Unified Credit allows her to leave $620,000 free of estate tax at the time of her death.

GIFT SPLITTING

A husband and wife may give $20,000 per beneficiary per year. This is true even where the gift is made entirely by one spouse, as long as the other spouse “consents” to the gift. A gift of jointly-owned assets made by only one spouse is automatically deemed to have been made one-half by each spouse. However, in cases where one spouse makes a $20,000 gift from separately owned assets, the spouses together must file IRS Form 709, in order to document the consent of the non-gifting spouse. In the above example, had Harry consented to Wendy’s gift to Sam (by filing Form 709), both Harry and Wendy’s Applicable Exclusion Amount would have been reduced by only $10,000, allowing them to each leave $640,000, free of estate tax, at death.

EXCLUSION FOR EDUCATIONAL AND MEDICAL EXPENSES

In addition to the $10,000 annual gift tax exclusion, there is an unlimited gift tax exclusion for direct payments of the donee’s medical expenses or tuition61. The donor and donee need not be related to qualify either for the unlimited medical or educational exclusions. To qualify, payment must be made directly to the school, doctor or hospital who provides the service. A payment made to the donee will not qualify for the exclusion. A qualified educational organization is one that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students (room and board, supplies, books and other fees do not qualify). Medical care includes expenses for diagnosis, cure, mitigation, treatment, or prevention of disease, as well as medical insurance.

THE MARITAL DEDUCTION

Unlimited tax-free gifts may be made between spouses. The unlimited marital deduction is the mechanism that allows for unlimited transfers between spouses both during life and at death. Unlimited transfers are not permitted where the donee spouse is not a U.S. citizen or where gifts are of a “terminable interest.” A terminal interest is an interest which by its terms will terminate and pass to someone other than the spouse. A classic example of a terminable interest is a gift of lifetime income to a spouse (“life estate”), with the “remainder” passing to children at the death of the spouse. Terminable interests may qualify for the unlimited marital deduction if the gift is made to a trust which qualifies as a “QTIP” trust. Gifts to a non-citizen spouse are limited to $100,000 annually.

THE PRESENT INTEREST REQUIREMENT

To qualify for the annual $10,000 exclusion, a gift must be of a “present interest.” A present interest is defined as the current right of a donee to the unrestricted enjoyment of the gifted asset. For example, Wendy’s $10,000 outright gift to her son Sam, described above, would qualify for the gift tax exclusion. However, a transfer of $10,000 in trust for Sam to be distributed to Sam at the time of his mother’s death, would not qualify as a gift of a present interest, since Sam would have no present right to the property. Sam would have only a future interest in the property, which vests on his mother’s death.

The present interest rule poses special problems for transfers to Irrevocable Trusts. Irrevocable trusts are used to own life insurance insuring the life of the Settlor. Life insurance premium payments are made to the trustee of the Irrevocable Trust, who in turn pays the annual premium to the life insurance company. Transfers to Irrevocable Trusts are certainly gifts, since the donor has made an irrevocable transfer. They are not of a present interest, however, since the beneficiary of a typical Irrevocable Trust will not receive his or her share until the death of the Settlor, when the life insurance death benefit is paid.

The present interest problem inherent in Irrevocable Trusts was solved in a court case involving a taxpayer named “Crummey.” The Crummey case established the rule that if the beneficiaries of an Irrevocable Trust are given notice of contributions to the trust and are given an opportunity for a limited but reasonable period (typically 30 to 60 days), to withdraw their pro-rata share of the contribution, the transfer will be treated as a present interest. This “Crummey” power converts a taxable future interest gift to a gift of a present interest, and is one of the primary reasons for the popularity of irrevocable trusts to this day.

TRUSTS FOR MINORS

A special exception to the normal present interest rule applies in the case of gifts in trust for the benefit of minor children. IF

1. the donee of the gift is a minor;
2. the terms of the trust provide that trust income and principal must be spent exclusively for the minor prior to the minor’s attainment of age 21;
3. all remaining trust assets are to be paid to the minor at age 21; and
4. in the event of the death of the minor the trust assets are to be paid to the estate of the minor, then the annual exclusion is available despite the fact that the gift would otherwise be of a future interest.

The trust may also contain a clause permitting the donee to extend the term of the trust to beyond age 21. This exception allows parents to qualify for the gift tax exclusion when they set assets aside in trust for future distribution to their children.

CHARITABLE GIFTS

Charitable gifts are income tax deductible. Such gifts also remove the gifted asset from the estate of the decedent. The income tax deduction on charitable gifts is limited by the type of gifted asset, the type of charitable organization receiving the gift and the adjusted gross income of the donor. See Q18 for a complete discussion of charitable gift vehicles as well as the income tax deduction limits that apply to charitable gifts.

GRATS and GRUTS

GRATS and GRUTS present an opportunity to gift appreciating assets at a low gift tax cost. Basically, a GRAT (grantor retained annuity trust) and a GRUT (grantor retained unitrust) allow the donor to gift assets at a discount. Under both a GRAT and a GRUT, the donor retains an income interest for a period of years or for life, with the donee receiving the remaining trust assets (“remainder”) at the end of the term. The gift is valued as of the date of the creation of the GRAT or GRUT. Since the gift is of the remainder, which is to be paid at a future date, the remainder is discounted. Using IRS tables, the discount is determined by subtracting the value of the income interest from the value of the transferred asset. GRATS and GRUTS work best when funded with appreciating assets since the actual appreciation of the assets may far exceed the IRS discount rate (see example below).

Unfortunately the benefits of a GRAT or GRUT are lost if the donor fails to live to the end of the income term. Therefore, the duration of the trust must be carefully chosen to ensure that it is shorter than the life expectancy of the donor. However, the fact that the discount is directly tied to the retained income term (the longer the term the greater the discount), makes choosing a longer term tempting. The IRS has imposed rather strict rules relating to the calculation of the income interest retained by the grantor.

Where the asset to be gifted is the donor’s personal residence, the retained interest is the right of the donor to live in the home for a term of years or for the donor’s life. Such arrangements are known as Personal Residence Trusts (PRTs) and Qualified Personal Residence Trusts (QPRTs). Under a PRT or QPRT, the donor gifts his or her home to a named beneficiary (usually children) while retaining the right to live in the home. As with GRATs and GRUTs, the gift is valued as of the date the arrangement is created and discounted to account for the donor’s retained interest. Tremendous tax savings can be achieved where the home is in a highly appreciating area.

FOR EXAMPLE:
Dad is a 65 year old widower. He lives in a $300,000 home which has been appreciating at a historic average of 6% per year. Dad would like to live in the home ten (10) more years and then move to senior housing. Dad creates a QPRT gifting his home to his children while retaining the right to live in the home for ten (10) years. Based on IRS tables, the value of the gift to the children is $128,154. The value of the home when received by the children in ten (10) years will actually be $537,254 (based on 6% annual growth). Note that the tax benefits of the entire arrangement are wiped out if Dad fails to live 10 years.

PLANNING STRATEGY

An important estate planning strategy for larger estates is to make taxable gifts of assets expected to appreciate in the future. Naturally, taxable gifts are those in excess of $10,000 ($20,000 for married couples) per beneficiary per year. Taxable gifts remove the future appreciation of the gifted assets from the estate of the donor. The Unified Credit is not indexed for inflation (notwithstanding the fact that 1997 legislation resulted in the gradual increase of the Unified Credit from $600,000 to $1,000,000 from years 1997 to 2006). Holding appreciating assets only results in losing ground as assets of the estate continue to appreciate while the Unified Credit remains static. Donors employing the taxable gift strategy should consider utilization of a Family Limited Partnership or Family Limited Liability Company to allow the donor to continue to control the gifted assets and to take advantage of the valuation discounts available for such transfers.

The estate tax benefits of gifting appreciating assets must be weighed against loss of the stepped basis which would have been available had the asset been held by the donor until death. However, gifting appreciating assets will almost always be advisable in light of the fact that the maximum capital gains rate is only 20% compared with the 55% estate tax rate. Also, the estate tax is due within 9 months of death while the capital gains tax is due only when the asset is sold, which could be many years after the donor’s death.