Gift Tax Basics
By
Roy Lewis
May 24, 2002
Many of you 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 was originally $10,000 but which is now $11,000) has been adjusted for inflation since 1998. However, the amount of the exclusion is always rounded to the next lowest multiple of $1,000, so the original $10,000 amount won't increase to $12,000 until the cumulative inflation adjustment is at least 20%. At current levels of inflation, it may be several years before the exclusion rises from $11,000 to $12,000. Just know that the $11,000 exclusion amount is in play for at least 2002 and 2003 ... and likely a few years longer than that.
The exclusion covers gifts an individual gives to each recipient each year. Thus, a taxpayer with three children can transfer a total of $33,000 ($11,000 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 $11,000 per recipient, the exclusion covers the first $11,000 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 $11,000 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 $22,000 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 $132,000 each year to their children and children-in-law ($22,000 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. The IRS prefers that both spouses indicate their consent on each return filed. (Since more than $11,000 is being transferred by a spouse, a gift tax return(s) will have to be filed, even if the $22,000 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 $11,000 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 $11,000 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.
Tuition and medical exceptions
Direct payments of tuition or medical expenses for another person (regardless of if that other person is related to you or not) is not a gift for gift tax purposes. In fact, if you make such a payment or transfer, you're not even required to complete IRS Form 709. But any such payment must be made directly to the school or medial provider directly -- not to the person that will be receiving the education or medical benefits. Payments for books, supplies, dorm fees, and food don't fall under this exception -- just tuition does. But it matters not that the student may be less than a full-time student, since the exception will apply for part-time students. Medical expense would include any type of expense deductible for income tax purposes, including payment of insurance premiums.
"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 $1 million of taxable gifts you make in your lifetime. And while the estate tax is scheduled for repeal in 2010, gift tax transfers will still be subject to the exclusion rules. Since that is still a few years in the future, we'll not dwell on it. Just know that until 2010 this credit 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: Introduction to Estate and Gift Taxes (Adobe Acrobat required).
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
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