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Gifting Strategies
Asset Valuation
The Annual Gift Tax Exemption
Payment Of Medical Expenses or Educational
Costs
The Marital Deduction
The Gift Tax Return
Tax Rates For Gifts
Splitting Gifts Between Spouses
When Death Occurs Within Three Years
of the Gift
The Income Tax Basis of Assets that
Grow in Value
The Advantages of Gifts
To prevent people from giving away their assets to avoid
the estate tax, the Internal Revenue Code outlines a separate
tax structure to regulate making gifts of assets. An understanding
of that structure is essential to sound financial planning
since there are a number of exceptions, limitations, as
well as advantages and disadvantages to giving gifts.
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Asset Valuation
The fair market value of the asset on the date of
the gift is used to determine its value. This is the
price the asset would be bought or sold for on that
day. If someone makes a gift of 100 shares of stock
and the stock is selling that day for $20 per share,
the value of the gift is $2,000 for gift tax purposes,
though the income tax basis is separate as noted below.
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The Annual Gift Tax Exemption
Each year, a person may give $12,000 in cash and
assets to as many people as they wish. This $12,000
is based on the fair market value of the assets, but
all gifts up to that amount per recipient per calendar
year are exempt from the gift tax. Ann Smith, a hypothetical
person used for illustration purposes, has two children,
and she may give $12,000 to each of them every year.
Each year, then, she is making $24,000 in gifts, and
over a ten year period has reduced her assets by $220,000.
As long as the gifts remain within the $12,000 per year
per recipient limit, they are exempt from gift tax.
Although in the example Ann gave the gifts to her children,
the law permits the gifts to be given to anyone. Similar to
an inheritance, the gifts are not subject to income tax and
cannot be claimed as a deduction by the donor or, generally,
as income by the recipient.
The exceptions in the income tax law are for installment obligations
where the capital gains were legally deferred, for United
States savings bonds, for single premium deferred annuities,
and for retirement benefits, including IRA accounts. If any
of these assets are given as gifts, the donor may be subject
to an income tax liability, but not the recipient. Before
making a gift of any of these, an accountant or tax
attorney should be consulted.
To qualify for the $12,000 exemption, the gift must meet the
Internal Revenue Code requirements for a gift of "present
interest." To meet that requirement, the recipient must
either receive the gift immediately and without any restrictions,
or the gift is restricted until the recipient reaches age
21. If John and Ann Smith want to establish trusts whose assets
their children will receive at age 25, any deposits they make
to the trusts would not be considered "present gifts"
and would not qualify for the $12,000 gift tax exemption unless
the trust contains "Crummey" provisions.
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Payment Of Medical Expenses or Educational
Costs
A person may pay certain bills for recipients in addition
to giving them an $12,000 exemptible gift. The amount of these
payments has no limit and has no affect on the $12,000 gift
tax exemption for either donor or recipient.
Educational costs for tuition can be made in any amount as
long as the payment is made directly to the educational institution.
Payments for books, boarding, travel, or any other payments,
however, are not considered educational costs. When Ann Smith
learns that her granddaughter has been accepted to Pepperdine,
instead of giving her son and daughter-in-law $24,000 to help
pay the costs, she may pay Pepperdine directly for the tuition.
She can give her granddaughter an $12,000 gift, however, as
well as making gifts totaling $24,000 to her parents.
Additionally, virtually all medical costs can be paid as long
as the payment is made directly to whoever provides the medical
service and the medical expense is one which would be deductible
if it were listed as an itemized deduction on an income tax
return. Ann Smith may directly pay an insurance company for
her son and daughter-in-law's medical insurance, or directly
pay any doctor, hospital, or ambulance for their medical charges.
Prescription drugs can be paid for in this way as well, as
can many other medical services or goods. In all cases, Ann's
payments for medical expenses do not reduce her ability to
give her son and all members of his family $12,000 in exemptible
gifts each year.
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The Marital Deduction
As long as the spouse is a citizen of the United States,
a gift of any amount may be given to him or her. John Smith
may make $1,000,000 of his separately held assets community
property, effectively giving his wife a $500,000 gift. There
is no gift tax liability for this gift, and no tax return is
required, either, as long as Ann is a citizen. If she is not,
then as of 2005 only $114,000 in assets can be given to her
as a gift each year. As long as John is either a citizen or
a permanent resident, the gift tax exemptions are available
for him. His wife's citizenship is the only factor that presents
any tax concerns, and that only limits the amount of the gift
exempt from any gift tax.
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The Gift Tax Return
A gift tax return is required whenever someone makes a
gift exceeding $12,000 to one person in any year, or makes
a gift of a "future interest," and is due by April
15th on the year after the gift was made. If Ann gives her
son $25,000 for his birthday on October 31st, she must file
a gift tax return by the next April 15th unless she dies before
that date.
Any gift must be included in the estate for estate tax purposes,
so a gift tax return is necessary and must be filed by the
earlier of the next April 15th or within nine months following
the date of death. If Ann makes a gift to her daughter in
February but dies on April 10th, the gift tax return is due
within nine months of the date of her death. If she dies in
October, however, the gift tax return would be due by the
following April 15th since that date comes earlier than nine
months after the date of her death.
The form used to file the gift tax is Internal Revenue Service
form 709, but there is no matching California form.
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Tax Rates For Gifts
Gift taxes are identical to the estate tax rates. In addition
to the annual $12,000 per year, per recipient exemption, everyone
has a lifetime $1,000,000 exemption, so although filing a gift
tax return may be required, only rarely are any taxes due.
If John Smith makes a gift to his son
of $112,000, after subtracting the $12,000 exemption,
$100,000 of the gift is taxable. The gift tax return,
which is required and must be filed to report the gift,
will show nearly a $21,000 gift tax, but no tax is due
because of the unified tax credit.
With the 1976 change in the tax system, which combined
the estate and gift tax rates in a single "unified
tax system," the advantages of making gifts that
exceed $12,000 per year have been substantially reduced.
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Splitting Gifts Between Spouses
One spouse may have a great deal of separate property
and may wish to make gifts of $24,000 to each of his or her
children. Since that amount exceeds the $12,000 per recipient
per year exemption, making those gifts would normally trigger
the necessity of filing a gift tax return. Federal law, however,
permits "gift splitting" with a spouse, which means
the $24,000 can be considered as if half of it came from each
parent. As long as the total doesn't exceed $24,000 per recipient,
no taxable gift results, and no gift tax return needs to be
filed. To split the gift between the spouses, a special federal
gift tax form, form 709, needs to be filed by both spouses,
with each indicating the gift should be treated as coming
equally from each of them.
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When Death Occurs Within Three Years of the Gift
Before the 1976 tax law changes, if someone died within
three years of making a gift, the value of the gift had to
be included in full in his or her taxable estate. Currently,
gifts are no longer returned to the person's estate unless
that person, as donor, retained some control over the gift
such as the right to revoke it, to change it, or give it to
another person.
If someone makes a gift, pays a gift tax, and dies within
three years, then the tax that was paid is returned to the
estate. If Ann Smith gives her son a gift of $1,261,000, she
is allowed an exemption of $12,000 which results in a taxable
gift of $1,250,000. After allowing for the $1,000,000 lifetime
exemption, a gift tax of $102,500 is due and paid. If Ann
dies within three years of making the gift, the value of the
taxable gift, $1,250,000, and the amount of tax paid, $102,500,
are both returned for a total of $1,325,500 added to her estate.
If she lives longer than three years after making the gift,
only the amount of the gift, $1,250,000, is returned to her
estate. In both cases, a credit for the $102,500 gift tax
paid through the estate tax return can be made.
The advantage to making a substantial gift is that the value
of the gift is locked when the gift is made. As long as no
conditions are attached to the gift, that value is the one
used for accounting at the time of death. If Ann's gift from
the earlier illustration was shares of stock worth $1,261,000
but those had risen to $1,500,000 several years later when
she died, when the assets are returned to her estate they
still carry the original gift tax value. The increase in value
from the date of the gift to the date of her death, $250,000,
is a tax savings.
When the assets involved in a gift increase in value between
the date of the gift and that of the death of the donor, there
can be substantial financial benefits.
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The Income Tax Basis of Assets that Grow in Value
The recipient of a gift doesn't get to use the same simple
formula for determining the gift's value that the donor does,
the fair market value as of the date of the gift. The recipient
gets to use the same value the donor would use on his or her
income tax, but does not get to use the fair market value
as of the date of the gift. Thus, if John Smith gives his
daughter $10,000 worth of stock that he purchased years ago
for $3,000, and she holds onto the stock until John dies,
it would get a new value at that time. If the stock is worth
$10,000 when John died, then his daughter would use that amount
as her income tax basis and the $7,000 capital gain would
be ignored. This method of accounting, however, is not true
if the stock was a gift. If the daughter sold the stock, she
must use her father's cost basis of $3,000 since, for income
tax purposes, assets do not get re-valued at the time of death.
The point is that the recipient's cost basis is the smaller
of either the donor's basis or the current fair market value.
If John's cost was $12,000 but the value at the time of the
gift is only $10,000, the recipient's cost basis is $10,000.
If the asset increased to a value of $15,000 when the gift was
made, the recipient's cost basis is the $12,000 John originally
spent. The lesson is to never give away any asset that has decreased
in value since the capital loss will be forfeited.
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The Advantages of Gifts
Giving annual gifts of $12,000 is an excellent way to
reduce the total value of an estate and save estate
taxes. Unless the assets are left to charitable organizations,
if the estate is valued at over $1,500,000 to $3,500,000,
there will likely be estate taxes owed at death. The
annual gifts of $12,000 per year will not be returned
to the estate unless some interest or control is retained
on them, so they can be considered permanently removed
from the estate. The assets will not be put back into
the estate if full and complete gifts are made, even
if the donor dies hours after making the gifts.
If the assets are expected to increase in value, gifts greater
than the $12,000 exemptible amount may be worthwhile since the
added value will remain outside of the donor's estate. The gifted
property or assets will not receive a new evaluation at the
time of death, however, so income tax considerations should
be carefully weighed after consulting with your accountant and
estate planning attorney.
THE MAMOLA LAW FIRM, APC is conveniently located throughout Orange County. For additional information, please contact us at (949) 333-6543.
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