Taking Advantage of Tax-Free Gifting

If you are fortunate enough to have a large estate – one large enough to be subject to the estate tax upon your death – you might be considering ways to give away some of your wealth to your family and loved ones now, thereby reducing the estate tax when you pass on.

Frequently, taxpayers think that gifts of cash, securities, or other assets they give to other individuals are tax-deductible; in turn, the gift recipient sometimes thinks income tax must be paid on the gift received. Nothing can be further from the truth. To fully understand the ramifications of gifting, one needs to realize that gift tax laws are interrelated with estate tax laws, and Uncle Sam does not want you giving away your wealth before you pass away to avoid the estate tax. For 2017, Uncle Sam allows $5.49 million (lifetime estate tax exclusion) to pass to your heirs’ estate tax free, and any excess amount is subject to an estate tax as high as 40%.

Amounts you gift prior to your death reduce the lifetime estate tax exclusion and will therefore subject more of your estate to taxation.

The law does provide exceptions where gifts can be made without reducing the lifetime exclusion, including the following:

  • $14,000 each to any number of individuals during every tax year. The amount is periodically adjusted for inflation, but the amount for 2017 is $14,000. The recipient does not have to be a relative and can be a minor.
  • Directly pay medical expenses. This applies to amounts paid by one individual on behalf of another individual directly to a medical care provider as payment for that medical care. Payments for medical insurance qualify for this exclusion.
  • Directly pay education expenses. This applies to amounts paid by one individual on behalf of another individual directly to a qualifying educational organization as tuition for that other individual. The tuition can be for any level of schooling – elementary, secondary and post-secondary. Costs of room and board aren’t eligible as direct payments, nor are contributions to qualified tuition programs (also known as Sec. 529 plans), which have their own gifting rules not covered in this article.

If the gift giver is married and both spouses agree, gifts to recipients made during a calendar year can be treated as split between the husband and wife, even if only one of them made the cash or property gift. Thus, by using this technique, a married couple can give $28,000 a year to each recipient under the annual limitation discussed previously.

Gifting Techniques:

High-Wealth Individuals – If you are a high-wealth individual who would like to pass on as much to your heirs as possible while living without reducing the lifetime exemption, you could directly pay your heirs’ medical expenses and education expenses in addition to annual gifts of cash or property of up to $14,000. You may want to do this, even if you are not a high-worth individual, to avoid having to file a gift tax return.

Medical Expenses – Except in rare circumstances, you cannot deduct the medical expenses you pay for another person, and they cannot deduct the expenses either, since they did not pay the expenses. Thus, careful consideration should be given regarding whether you make the gift directly to the individual, subject to the $14,000 annual limit – which would allow the recipient of your generosity to pay the medical expenses and claim the medical deduction on his or her tax return – or whether you pay the medical expenses directly. If the medical expenses you want to pay are greater than $14,000, then you could always gift $14,000 to the individual and pay the balance directly to the care provider(s) to avoid reducing your lifetime exclusion. Under rare circumstances, the recipient who will benefit from your gifts may qualify as your medical dependent, under which circumstance you would be able to deduct the medical expenses if they had been paid directly to the doctor, hospital or other provider.

Education Expenses – When you pay the qualified post-secondary education tuition for another individual, it does not mean – as is usually the case for medical expenses – that someone cannot benefit taxwise. Tax law says that whoever claims the exemption for the student is entitled to the American Opportunity Credit or Lifetime Learning Credit for higher education expenses if they otherwise qualify.

Gifts of Appreciated Property – Consider replacing your cash gifts with gifts of appreciated property, such as stock for which you have a “paper gain.” When you gift an appreciated asset, the potential gain on the asset transfers to the recipient. This works for individuals, except for children who are subject to the kiddie tax, which requires the child’s income to be taxed at the parent’s tax rate if it is higher than the child’s rate. It also works great for contributions to charitable organizations. Although not subject to the gift tax rules, not only does an appreciated asset gifted to a charity get you out of reporting any gain from the appreciation, but you also get a charitable tax deduction equal to the fair market value (FMV) of the asset. The deduction for these gifts is generally limited to 30% of your adjusted gross income (AGI), but the excess carries over for up to five years of future returns.

Please call this office if you need assistance with planning your gifting strategies.

Treasury Department and IRS Proposed Regulations May Cause Family-Controlled Entities to Lose Estate-Planning Discount

The Treasury Department and IRS released proposed regulations, which, if finalized, will reduce the valuation discounts when transferring interests in family-controlled entities among family members.

Valuation discounts are frequently used to lessen the value of interests in closely-held entities for estate, gift and generation-skipping transfer tax purposes. These discounts allow a greater amount of property to be transferred to younger generations, by using less of taxpayer’s estate/gift lifetime exclusion. The proposed regulations affect the value of the interests transferred, but not the entities themselves, by reducing or eliminating the ability to apply valuation discounts in certain circumstances. The proposed regulations were issued on August 4, 2016.

In order to be affected by the proposed regulations, the following three criteria must apply:

  1. Family member owners of entities which are corporations, partnerships, LLCs or other arrangements deemed to be a business entity;
  2. Entities which are controlled by family members before and after a transfer:
    • LLCs or other entities:
      • at least 50 percent of the capital interests in the entity or arrangement; or
      • at least 50 percent of the profit interests in the entity or arrangement; or
      • an equity interest with the ability to cause the liquidation of the entity or arrangement in whole or in part.
    • Corporations:
      • at least 50 percent of the total voting power of the equity interest of the entity; or
      • at least 50 percent of the total fair market value of the equity interests of the entity.
    • Partnerships:
      • at least 50 percent of the capital interest in the partnership; or
      • at least 50 percent of the profits interest in the partnership; or
      • a general partner in a limited partnership regardless of their ownership percentage.
  3. Controlled by the transferor and/or family members. Family includes, for this purpose, the spouse of the transferor, any ancestor or lineal descendant of the transferor or their spouses, and any brother or sister of the transferor and their descendants and spouses. If the owner is an entity, look through the entity to the individual owners. If the owner is a trust, look through the trust to current beneficiaries.

These are complex regulations that determine the impact of changes in voting rights, and restrictions could occur when transferring interests in business entities, either by gift during a taxpayer’s lifetime or by bequest at death. These are generally provsions built into shareholder or partnership agreements that indicate the rights of transferees in the interests they receive. This is compared to the rights, powers and restrictions the transferor might have had prior to the transfer. Changes to these rules will substantially limit the transferor’s ability to reduce the value of the interest transferred.

The new valuation rules will generally apply to transfers occurring after the date the final regulations are published. That date will not occur prior to December 1, 2016.

All individuals who might be affected should identify any potential opportunities for lifetime transfers of property that can still use the discounting benefits before the regulations become final. It is also important to determine the impact of the rules on future estate tax liabilities. Business ownership agreements and your current estate planning documents should be analyzed and reviewed.

Contact Us

Contact a Tarlow partner at 212-697-8540, with any questions regarding this article, or any of your estate planning needs.