RSM Resources

Do you anticipate leaving a taxable estate to your heirs? If so, you can avoid federal tax bites of up to 46 percent by making tax-free gifts each year, effectively lowering the size of your taxable estate.

As with estate taxes, gift taxes are paid by the donor, not the recipient. Gift tax rates are as high as estate tax rates, but there are ways to make some gifts tax-free. Through the gift tax annual exclusion, annual gifts of up to $12,000 per recipient (property or cash) are not subject to the federal gift tax.

Therefore, you can make annual gifts of $12,000 to an unlimited number of recipients. By staying under the threshold and making gifts over a number of years, you can greatly reduce the size of your estate — and thereby the related estate tax when it passes to your heirs.

Here’s a simple example: A father gives $10,000 to each of his three children. Each gift is under the $12,000 threshold and, therefore, is not taxable. As long as no individual recipient receives more than $12,000, no gift tax is due.

A married couple filing jointly can split a gift, which effectively increases their annual exclusion of $12,000 to $24,000 per year per recipient. For example, a couple who gives $20,000 to each of their three children can give the entire $60,000 tax-free.

$1 million lifetime gift exemption

Every taxpayer also receives a $1 million lifetime exemption against taxable gifts. That is, if you exceed the maximum annual exclusion in a year, you may not have to pay any gift tax. Note that you can deduct only the amount exceeding the $12,000 exclusion from the $1 million lifetime exemption. As long as the total of these overages is less than $1million, you will not pay gift tax.

Say you give $20,000 to a friend this year. With the lifetime exemption, the $8,000 exceeding the $12,000 annual exemption will not result in any gift tax. The only consequence is that you have reduced your lifetime exemption to $992,000 from $1 million.

Some financial advisors recommend not using your lifetime exemption, if possible. Here’s why: Any reduction in your lifetime limit will reduce your federal estate tax exemption by an equal amount. Let’s say that, during your lifetime,your annual gift-giving over the annual limit reduces your lifetime exemption to $300,000 from $1 million. You have used up less than your lifetime limit and do not pay any gift taxes, but the $700,000 will betaken from your $2 million estate tax exemption. Therefore, only the first $1.3 million ($2 million less $700,000) of your estate will be exempt from estate taxes. If you have an estate that is subject to estate tax, you will face a delayed tax consequence for making gifts that exceeded the annual gift tax exemption.

It’s important to note that any post-gift appreciation will not be subject to estate taxes. Accordingly, it is important to consult with your financial advisor to determine the pros and cons of using your lifetime exemption.

For a gift to qualify for the annual exclusion, it must be a gift of a "present interest." That is, the benefactor generally can’t postpone the recipient’s use or enjoyment of the gift.

Other exemptions from gift taxes

Not all assets that you transfer to family or friends are subject to gift taxes. Following are some key examples:

Qualified tuition that you pay for someone else (related to you or not). These payments do not require any special IRS reporting. However, you must make them directly to the school, not to the person who will receive the education. Payments for education-related items such as books, supplies, food and other living expenses are not exempt from gift taxes.

Medical expenses paid directly to a qualifying medical provider. Qualifying medical payments include:

• Medical insurance and long-term-care premiums
• Diagnosis and treatment of disease
• Transportation for medical care

Gifts to a spouse.You can give your spouse an unlimited amount of money or property without paying taxes, provided your spouse is a U.S. citizen.

Charitable gifts.Gifts to your place of worship and most charities are exempt from gift taxes. In fact, most are deductible for income tax purposes.

Political contributions. Gifts to political organizations are exempt from gift taxes but not deductible for income tax purposes.

Trusts

Making gifts to certain trusts is another method of protecting assets from estate taxes. However, most trusts are set up for the future benefit of the beneficiary and will not pass the present interest requirement. But under federal tax rules, payments to a Section 2503(C) trust formed to benefit a minor will qualify for the annual exclusion upon meeting three requirements:

• The gift can be expended for the benefit of the minor before age 21.
• Any property not distributed will be transferred to the minor at age 21.
• If the minor dies before age 21, the trust will be included in the taxable estate of the minor.

Life insurance trust

Though not taxable to the recipient as income, life insurance proceeds are considered part of your estate and will be taxed at the same rate as the rest of your assets that are subject to the estate tax. One way to avoid estate tax on life insurance proceeds is to set up a life insurance trust to actually own life insurance on your life. Since the trust acts as owner of the life insurance policy, it will not be taxed as part of your estate. However, gifts to a life insurance trust (frequently used to pay premiums) may reduce your lifetime gift exemption, unless the life insurance trust is a "Crummey" trust. Such trusts are named after the Crummey family, who successfully challenged the IRS for denying them the annual gift tax exclusion.

Crummey trust

The problem with life insurance trusts (and other trusts) is that the$12,000 annual exclusion applies only to gifts in which the recipient has a present interest. With a Crummey trust, your gift can qualify as having a present interest, but with restrictions. In a Crummey trust,when a gift is made to the trust, a beneficiary is notified that he orshe has the right to withdraw the amount of the gift for a period of time (commonly 30 days) after the gift is made. This right to withdraw passes the present interest requirement and thus causes the gift to be a present interest and qualify for the gift tax annual exclusion. If the beneficiary does not withdraw the gift within the 30 days, the gift remains in the trust. Even if the beneficiary decides to withdraw the gift, he or she can withdraw only the amount of the current gift, not the entire trust.

Family limited partnership

If your estate is more than $2 million, you might consider establishing a family limited partnership (FLP). In creating an FLP, parents put assets into a partnership and then give a minority interest to other family members (usually children) while actually retaining control of the partnership. The children receive a percentage interest in the partnership, which, for gift tax valuation purposes, may be subject to a discount due to lack of marketability or lack of control of the partnership. When the estate transfers to the children, the appreciation on the previously gifted partnership interests escapes estate tax. Any interests held by the deceased parent may also be subject to discounts, thus reducing the value subject to estate tax.

529 plans

Contributions to state-sponsored 529 college savings plans also qualify for the$12,000 annual gift tax exclusion ($24,000 for married couples). But a special election specific to 529 plans allows you to contribute up to five years of annual exclusion gifts during the first year, meaning you can contribute up to $60,000 per child ($120,000 for married couples) all at once. This allows you to invest a larger contribution initially and accelerate the growth of the investment earnings. Not only are the contributions exempt from tax, the plan’s earnings are also not taxed. By exempting both the plan contributions and earnings, 529 plans can offer significant tax savings.

Other reasons to make gifts

In addition to gaining you tax advantages, making gifts can yield other benefits to you and your heirs by:

• Reducing probate costs and delays. The general rule is: The smaller the estate,the smaller the probate costs and quicker the probate.
• Shifting asset appreciation to gift recipients, who may be in a lower tax bracket and have access to asset appreciation that will not be subject to tax in your estate.
• Achieving greater privacy by having fewer assets held in your probate estate. Wills are public documents that anyone can view.
• Reducing assets that you have to manage.

Last,and perhaps most important, gifting can be extremely gratifying,allowing you to see your heirs benefiting from your gifts during your lifetime.