Making gifts in a way that minimizes taxes is actually a very complex process. In deciding whether to make a gift, one must consider the amount of the gift, the type of asset you wish to transfer, to whom it is going to and the basis in the gifted item. I will not be discussing advanced topics such as discounted gifts or generation skipping tax transfers in this post.
The Tax Effect of a Gift
To understand the effect of a gift for federal estate and gift tax purposes, we need to start with a short discussion of the current law.
United States citizens and permanent resident aliens currently can give away an unlimited amount to a US citizen spouse or a charity without incurring a gift tax or an estate tax. US citizens and permanent resident aliens can give away up to $5,000,000 to anyone else. This is known as our lifetime exemption amount, unified credit amount or applicable exclusion amount. (Note, transfers to a spouse who is a permanent resident alien are not unlimited, they are capped by the lifetime exemption amount.)
After 2012, this $5,000,000 amount will be reduced down to $1,000,000 unless the legislation is modified. (I think it is highly unlikely that it will go back down to $1,000,000, but $3,500,000 is quite plausible.) Gifts of less than the $5,000,000 lifetime exemption amount will not result in a tax; they merely reduce the donor's exemption amount and the amount the donor can transfer on death.
In addition to the lifetime exemption amount, each person can make annual exclusion gifts without any tax liability. Annual exclusion gifts are also known as 2503(b) gifts. Gifts in excess of the annual exclusion amount (currently $13,000 per donee per year) are taxable for federal gift tax purposes. When I say that gifts in excess of the annual exclusion amout are "taxable", that means the gift reduces the donor's lifetime exemption, or, if the lifetime exemption has been used up, these transfers will result in a taxable gift. Currently, the gift tax rate and estate tax rate are 35%.
To complicate matters, if the donor is married, he or she can "split" the gift with his or her spouse. For example, let's say I gift $7,000,000 to my two children. If I make the gift alone, $26,000 of the gift is sheltered by my annual exclusion amount ($13,000 for each child). The balance, $6,974,000, reduces my lifetime exemption from $5,000,000 to $0 and results in a taxable gift of $1,974,000. At 35%, the tax on this gift would be $690,900. However, if I had split that gift with my wife, we could also use her annual exclusion amount making the taxable gift to the kids only $6,948,000. Additionally, the taxable gift would be split in half, reducing each of our lifetime exemptions to $1,526,000 and no gift tax would be due.
Gift splitting is available to married couples if each spouse is either a citizen or a resident of the United States. (I.R.C. 2513) In other words, you may gift-split with a non-citizen spouse provided he or she is resident alien.
The power of gifting using the annual exclusion exemption cannot be emphasized enough. If you have an elderly widow who has $8,000,000 who gifts $13,000 to each of her children (4),each of her grandchildren (10) and each of the spouses of her children and grandchildren, that widow can give away 28 gifts of $13,000 tax free. That's $364,000. If she does that for 9 years until she dies, she can pass on 100% of her estate to her heirs without any federal estate tax. If she had kept the $8,000,000 until her death, there would have been a $1,050,000 federal estate tax.
To get a better idea of the power of lifetime gifting using the annual exclusion amount, read my blog post on deathbed transfers in New Jersey in which I discuss gifts by Tabitha and Genie.
For all gifts discussed to this point, it would not have mattered when the gift was made. Gifts equal to or less than the annual exclusion amount do not count against the $5,000,000 exemption amount while those in excess of the annual exclusion amount do regardless of when they were made. It is now time to learn about about some special rules.
Gifts of Certain Assets are Subject to a Three Year Lookback Rule
Many people assume, incorrectly, that proceeds from life insurance policies are paid to the beneficiaries free of tax. While this is true that there is no income tax on such proceeds, it is not true for the estate tax. If a decedent OWNS a life insurance policy insuring his or her own life, the entire death benefit is includible the decedent's estate, regardless of who the beneficiary is. If the value of this death benefit plus the decedent's other assets result in the decedent having an estate over the $5,000,000 limit, the overage will result in a federal estate tax unless the estate is entitled to a marital deduction or charitable deduction.
Under Section 2035 of the Internal Revenue Code, certain assets that are transfered by a person who dies within three years are considered to be owned by the person at his or her death. This rule most significantly applies to the transfer of life insurance policies. So, if a decedent transfered OWNERSHIP of a policy on his life to another party within three years of death, the 2035 rule kicks in and it is considered a taxable deathbed gift equal to the full face value of the policy - not just the value of the policy on the date of the gift.
You should also be aware that the Section 2035 lookback rule also applies to the release of certain interests in trusts and real estate. Additionally, if the decedent paid any gift taxes within three years of death, that will be added back into the donor's gross estate, and the donor will get a credit for the taxes paid. Since these items do not affect most people, I will not discuss them in depth.
Gifts in Which the Donor Retains an Interest or Control
There are many ways to make a gift. I can give you a house or I can draft a deed, keeping a life estate for myself and then giving you the house when I die. I can give you 30% of my company or I can give you 30% of my company and retain the right to vote your stock.
The general rule is that if I make a complete gift, retaining no interest or control, it is a completed gift and will not be includible in my gross estate. If I retain any control or interest, such as a life estate or a right to vote your stock, then the gift, even though complete, will still be includible in my gross estate.
I can also fashion a gift in a manner in which there is a chance that I receive the property back. For example, I can give you a property for your life and then to your father if he survives you, but if he doesn't survive you, I get the property back. If you are much younger than me, there is a small chance that I will get the property back. If you are much older, than the chance I will get the property back is much greater. The probability that I will receive the property back is calculated as of the moment before my death, so the fact that I died before you is irrelevent. If the chance that I would have gotten the property back is greater than 5%, then the value of the property at the time of my death is includible in my gross estate.
What's the big deal if the property is includible in my gross estate if there's a lifetime lookback? Well, let's back to the example in which I transferred a 30% stock interest. Assume that at the time of the gift the 30% interest of the stock was $1,000,000 and at the time of my death that same interest was worth $7,000,000. If I had not kept an interest in the stock, it would have just reduced my lifetime exemption by $1,000,000. By keeping the voting interest, the full $7,000,000 value will be included in my estate resulting in a federal estate tax of $700,000 (35% of $2,000,000).
The Importance of Knowing the Basis of the Gifted ItemAs discussed on my post on deathbed transfers in New Jersey it is wise to know the basis of the property that is being gifted. If the donor is gifting an asset, the recipient receives the gift with the same basis as it had in the hands of the donor. This is known as a carry-over basis.
Accordingly, if the donor gifts an asset that it is highly appreciated, it will result in a substantial capital gains tax when the donee ultimately sells it. If, on the other hand, the donor gave the item to donee on his death, the asset would take on a basis equal to the fair-market value of the property as of the date of the donor's death.
Due to the carryover basis rule, it is usually best not to give away appreciated property during life. It is better to either gift away cash or hold on the the asset until death and have the beneficiaries pay a smaller estate tax.
The Benefit of Making Taxable Gifts
Reading through this post, the benefit of making gifts equal to or less than the annual exclusion amount is quite evident, but you may be asking yourself why anyone would wish to make a taxable gift that uses up a person's exemption amount. Look back to the situation where the donor gave away a 30% interest in stock worth $1,000,000 and that stock grew to $7,000,000. It is much better, for tax purposes, if that grows in the hands of someone other than the person who is likely to die first. This technique is known as an "estate freeze" because reduces the chance of assets growing in the donor's hands.
Filing requirements for Taxable Gifts
You should also be aware that if you do make a gift in excess of the annual exclusion amount, you should file a federal gift tax return (Form 709).