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Basic Gift Tax Issues

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By Roy Lewis

Many people are curious about the "gift tax exclusion" and how it really works. Some still believe that a gift is deductible by the person making the gift (the donor), and taxable to the person receiving the gift (the donee). This is absolutely not true. Gifts (not to be confused with charitable contributions, which have their own separate rules) are neither deductible by the donor, nor taxable to the donee.

Each person is allowed to gift a specific amount that will not trigger any gift or estate tax issues. This specific amount is called the gift tax exclusion.

Why gift money?

Gifting money can be a very effective way to transfer substantial amounts from your estate, free from gift and estate taxes, to your children or other loved ones. This technique of estate tax planning can drastically reduce your taxable estate after your death, and could thereby reduce your associated estate taxes.

The amount of the annual gift exclusion, which is currently $10,000, has been adjusted for inflation after 1998. However, the amount of the exclusion is always rounded to the next lowest multiple of $1,000, so the $10,000 amount won't increase to $11,000 until the inflation adjustment is at least 10%. At current levels of inflation, it may be several years before the exclusion rises to $11,000. In fact, this $10,000 limitation is in effect for 2000 and 2001.

The exclusion covers gifts an individual gives to each recipient each year. Thus, a taxpayer with three children can transfer a total of $30,000 ($10,000 each) to them every year free of federal gift taxes. If the only gifts made during a year are excluded in this fashion, there is no need to file a federal gift tax return. If annual gifts exceed $10,000 per recipient, the exclusion covers the first $10,000 and the excess is taxable. Further, even taxable gifts may result in no gift tax liability thanks to the unified gift/estate credit (which we'll discuss below).

At this point, it should be noted that gifts made by a donor to his spouse are gift-tax-free under separate marital deduction rules. So, if you are considering making a gift of property or cash to your spouse, understand that the annual $10,000 exclusion will not apply to you.

Gift-splitting by married taxpayers:
If the donor of the gift is married, gifts made during a year can be treated as a "split" between the husband and wife, even if the cash or gift property is actually given by only one of them. By gift-splitting, therefore, up to $20,000 a year can be transferred to each recipient by a married couple because their two annual exclusions are available.

Example:
A married couple with three married children can transfer a total of $120,000 each year to their children and children-in-law ($20,000 for each of the six separate recipients).

Where gift-splitting is involved, both spouses must consent to it. Consent should be indicated on the gift tax return(s) the spouses file. IRS prefers that both spouses indicate their consent on each return filed. (Since more than $10,000 is being transferred by a spouse, a gift tax return(s) will have to be filed, even if the $20,000 exclusion covers the gifts. So, be aware that if you elect gift-splitting, you'll need to file Form 709 (Annual Gift Tax Return) if more than $10,000 is being given to a single recipient in any year.

The "present interest" requirement:
For a gift to qualify for the annual exclusion, it must be a gift of a "present interest." That is, the recipient's enjoyment of the gift can't be postponed into the future. For example, if you put cash into a trust and provide that Alan is to receive the income from it while he's alive, and Bob is to receive the principal at Alan's death, Bob's interest is a "future" interest. Special valuation tables are consulted to determine the value of the separate interests you set up for each recipient. The gift of the income interest qualifies for the annual exclusion because enjoyment of it is not deferred, so the first $10,000 of its total value will not be taxed. However, the gift of the other interest (called a "remainder" interest) is a taxable gift in its entirety.

Exception to present interest rule:
If the recipient of a gift is a minor, and the terms of the trust provide that the income and property can be spent by or for the minor before he reaches age 21, and that any amount left is to go to the minor at age 21, then the annual exclusion is available (that is, the present interest rule will not apply). These arrangements (called Section 2503(c) gifts because of the section in the tax code that permits them) allow parents to set assets aside for future distribution to their children, while taking advantage of the annual exclusion in the year the trust is set up. The most common of these types of arrangements are Uniform Gifts to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts. But, be aware that there are "Gift Trusts" being promoted that do not meet the exception to the present interest rule. These types of "Gift Trusts" require the donor to file a gift tax each year in which a gift is made, regardless of the amount of the gift.

"Unified" credit for taxable gifts:
Even gifts not covered by the exclusion and, thus, taxable might not result in a tax liability. This is because a tax credit wipes out the federal gift tax liability on the first $675,000 of taxable gifts you make in your lifetime. (The $675,000 amount, which applies in 2000 and 2001, will gradually rise to $1 million by 2006. See the table in the Unified Credit chapter of IRS Publication 950 for the specific amounts each year.) This credit, however, applies both for gift and estate tax purposes (that's why it's called "unified"). Thus, to the extent you use it against a gift tax liability, it is reduced (or eliminated) for use against the federal estate tax at your death.

As you can see, using gifts in an overall estate plan can get complicated, and you should really consider using the services of a qualified tax/estate pro to assist you with your overall estate planning. But, I hope that the above will clear up some commonly misunderstood issues regarding gifts. If you would like additional reading on gift and estate taxes, check out IRS Publication 950.
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