Reducing Estate Tax by Making Gifts - Cona Elder Law

Reducing Estate Tax by Making Gifts

Making gifts during your life can provide you with tax savings and more.

NOTE: The federal gift and estate tax is being phased out, but its ultimate fate is still a hot political question.

While the estate tax is still in effect -- or if Congress resurrects it after it goes away as scheduled in 2010 -- you may want to take steps to reduce possible estate tax liability at your death. One way to avoid estate tax is to give away property during your life. This provides you with more than just tax savings; you also get to see the recipients enjoy your gifts.

Currently, you can make an unlimited number of $12,000 gifts of cash or other property each year, completely tax-free. To ensure these tax savings, you need remember only that no individual recipient can receive more than $12,000 in a calendar year. If you left the same gifts at your death and they were subject to estate tax, the recipients would see their gifts shrink by at least 39%.

How the Annual Exclusion Works

The $12,000 annual tax exemption rule (called the "annual exclusion") is pretty straightforward. For instance, if you give $25,000 to someone, $12,000 of it is exempt from gift tax. The remaining $13,000 is not. A few more examples:

  • You give $8,000 to a cousin in one year: There are no federal gift tax consequences.
  • You give $16,000 to your grandson in one year: $4,000 is subject to gift tax.
  • You give $8,000 each to your two children: None of that $16,000 is subject to gift tax.

The exclusion amount is indexed for inflation; it rises, in $1,000 increments, as the cost of living does.

Couples: Double Your Exclusion

Couples can combine their annual exclusions, meaning that they can give away $24,000 worth of property tax-free, per year, per recipient. In fact, even if only one spouse makes a gift, it's considered to have been made by both spouses if they both consent. (IRC § 2513.) If you and your spouse give to another couple, you can transfer up to $48,000 tax-free each year.

Example

Joe and Faye, a couple in their late 70s, want to give their son and his wife money for a down payment on a house. They also see this as an opportunity to shrink the estate tax bill that their son -- who will inherit everything -- will eventually have to pay.

Both Joe and Faye take advantage of their $12,000 exemptions to give a total of $24,000 to their son and another $24,000 to his wife. As soon as the first of the year rolls around, they can give away another $48,000 if they're still feeling generous.

Gifts to Your Spouse

All gifts you make to your spouse are tax-free, as long as he or she is a U.S. citizen. If your spouse isn't a citizen, the limit on tax-free gifts is currently $120,000 per year. (Internal Revenue Code § 2523(a).) However, there's seldom a reason to make large gifts to your spouse. If you each own about the same amount of property, you could worsen your tax situation by saddling your spouse with an estate that's so large it will be taxed at his or her death.

How Gifts Can Add Up

Using the annual exclusion repeatedly over a number of years can greatly reduce the size of your estate -- and your ultimate estate tax bill. Let's say you give $7,000 each to your two children, three years in a row; none of this $42,000 is subject to gift tax. Nor would it be subject to any eventual estate tax when you die. If you give $10,000 per year to one person for five years, you've given away $50,000 tax-free. (If you gave the same $50,000 to the same person in one year, you would get only one $12,000 exemption; $38,000 would be subject to tax.)

Timing Your Gifts

To make the most of the annual exemption, keep in mind that it is based on a calendar year. If you miss a year, you can't go back and claim that year's exemption amount. But if you spread a large gift over two or more years, you may escape gift tax complications. For instance, if you give your daughter $20,000 on December 17, $8,000 of it is taxable. You'll have to file a gift tax return (by April 15 of the next year), and you'll use up $8,000 of the total amount you can give away or leave free from estate tax. But if you give your daughter $10,000 in December and wait to hand over the other $10,000 until January 1, both gifts are tax-free.

Giving Away Non-Cash Property

Not only gifts of cash can be spread over several years. You can give away some stocks now, some next year. You can even give real estate in pieces -- physical pieces, if that's possible, or pieces (percentages) of ownership.

Example

Solomon and his wife Rhoda want to give their vacation cabin to their son Gerard. The cabin has a fair market value of $75,000, but their equity is only $40,000 because there is still $35,000 left on the mortgage. In November, Solomon and Rhoda sign a deed transferring the cabin to Rhoda and Gerard as joint tenants, meaning that Rhoda and Gerard each own a 1/2 interest in the property. (Solomon gave Gerard his $20,000 share of the equity in the cabin.) Gerard's gift from his parents is tax-free, because together they can give him up to $24,000 tax-free each calendar year.

The next calendar year, Rhoda gives her half-share, worth $20,000, to Gerard. Even though only Rhoda makes the gift, the IRS considers it, for tax purposes, to have come from both spouses. Gerard now owns 100% of the vacation cabin.

Gifts to Children

Giving children valuable property before they are adults raises the important question of who will manage the property for the child. If you give a large gift to a child under 18, an adult must be responsible for the money.

Fortunately, it's easy to arrange for an adult to manage the property, by setting up either:

  • an irrevocable child's trust, or
  • a custodianship authorized by state law.

The second way, a custodianship, is easier: You simply name an adult to serve as "custodian" of the money.

Custodianships

Custodianships are authorized under a law called the Uniform Transfers to Minors Act (UTMA), or the Uniform Gifts to Minors Act, one of which has been adopted by every state. All you need to do is appoint a custodian, in writing, and give the property to that person, instead of to the child directly.

The custodian must manage and use the money for the benefit of the child. When the child reaches adulthood (defined as age 21 in most states), he or she gets whatever's left.

Special Gift Tax Rules for Minors

To qualify for the annual exclusion from gift tax, a gift to a minor must satisfy these conditions:

  • The recipient must receive the property outright by age 21. This means that if you set up a custodianship for your child, it must end when the recipient turns 21. That said, the property and its income may of course be spent by, or for the benefit of, a recipient who isn't 21 yet. Similarly, if you create a trust for the child, the trust document must state that the property will be turned over to the recipient by his or her 21st birthday. (But you may also give the recipient the right to extend the trust.)
  • If the recipient dies before age 21, the remaining property must go to the recipient's estate or to someone the recipient named -- for example, in a will. (IRC § 2503(c).)
Example 1

Biff gives a thoroughbred horse worth $30,000 to his niece Brenda, age 16, who loves horses. Biff makes the gift under his state's UTMA, which requires the horse to be legally turned over to Brenda when she becomes 21 -- which is fine with Biff. Biff names Brenda's mother, Josette, as custodian for the gift. They all know that this is only technical, since Brenda will be, and wants to be, responsible for the horse.

The first $12,000 of Biff's gift is free of gift tax. He is assessed gift tax on the remaining $18,000.

Example 2

Oksana wants to be certain that her grandchildren Victor, 12, and Marya, 10, will have money for college. Oksana wants to make the gift now, so that her grandchildren will know their educational future is secure.

To qualify for the annual gift tax exclusion, the money must be turned over to the kids when they reach 21. Oksana names their father as custodian for a $10,000 gift to each child, and specifies that the custodianships end at age 21.

She transfers some more money to a trust for each grandchild, to last until the grandchild is 30. She names their father as trustee. Oksana realizes that by doing this, she will not obtain the annual gift tax exclusion for any money she gives to the trust, because neither child will receive the money outright by age 21. But her concern about giving a 21-year-old a big bundle of money overrides any consideration of tax savings.

(If Oksana were in good health and her grandchildren were a little older, she might just wait until they enter college, and pay their tuition directly; that's also a tax-free gift.)

Think Before You Give

An ambitious program of gift-giving is not for everyone. If parting with assets makes you feel vulnerable, fearful that you will someday be without money you need, don't do it. Or you may decide that your children or grandchildren are not ready yet to appreciate your generosity. But helping a 21-year-old get an education, or the head of a new family buy a house, can give you great satisfaction.

One reason that planned gift-giving has gained in popularity is that people live so much longer than they used to. If you wait until you die to transfer your wealth, the recipients -- for most people, their children -- may be nearing old age themselves. Your financial help will probably be more useful when they are younger.


About the Author Cona Elder Law

Cona Elder Law is a full service law firm based in Melville, LI. Our firm concentrates in the areas of elder law, estate planning, estate administration and litigation, special needs planning and health care facility representation. We are proud to have been recognized for our innovative strategies, creative techniques and unparalleled negotiating skills unendingly driven toward our paramount objective - satisfying the needs of our clients.

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