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.

Who Controls the Funds in a Section 529 Plan?

This question frequently arises: Who controls the funds held in a Section 529 qualified tuition account? These accounts can become quite large, as they are limited only by the projected cost of a college education, and those costs will vary between state plans. Some states base their maximums on the cost of an in-state, four-year education, but others use the cost of the most expensive schools in the U.S.—including graduate studies. Most have limits in excess of $200,000, and some can reach $475,000 or more. Thus, it is only natural that those who fund an account would be concerned about who controls the account’s distributions. This is especially true when grandparents or others are making contributions to an account that is limited only by gift-tax considerations.

Some parents will simply save money for their minor children’s college costs in a custodial account; these accounts become the children’s property once they reach the age of majority, depending upon state law, which is usually 18 or 21. At that point, the parents lose control. Unlike these child custodial accounts, Section 529 plans are not irrevocable gifts: The parent or other account owner retains control.

Generally, the same person who contributed the money controls the Section 529 account. This doesn’t have to be the case, however. Someone else, such as a grandparent, could make a donation but name the child’s parent as the account owner, or a parent could establish the account and allow others to contribute to it.

Money cannot be removed from the account without the permission of the account owner. If the child (the designated beneficiary of the plan) decides not to go to school, the account owner can simply change the beneficiary to another “family member,” a term that, for the purposes of beneficiary changes, can refer to the beneficiary’s sons, daughters, brothers, sisters, nephews and nieces, certain in-laws, and any spouse of any of those individuals—but not the spouse of the original beneficiary.

This rule for beneficiary changes gives parents and other donors the flexibility to use the funds for the family member who needs them the most. For example, if a designated beneficiary decides not to attend college or receives a full scholarship, another child can be named (as long as the new child is a member of the family). Alternately, if funds remain in the plan after a child has finished school, a younger family member can be named as the beneficiary for the balance.

There are no tax issues if the transfer is within the same generation or an older generation of the family, such as changing the beneficiary to a sibling of the original beneficiary. However, if the transfer is to a beneficiary in a younger generation, the transfer is considered a taxable gift from the old beneficiary to the new beneficiary, and a gift tax return will need to be filed.

If you have questions related to Section 529 plans and how they might be used to save for a child’s future education, please call us.

Cutting the IRS Out of Your Gifts

If you are financially well off, you may want to gift money or property to family members or others you care about. There are some gift tax issues you should be aware of so that you can avoid gift tax issues. Oh yes, the government even taxes gifts if they are large enough, so it is best to know the rules; otherwise you may end up making a gift of taxes to the IRS.

The gift tax rules provide two exclusions from gift tax, the annual exclusion and the lifetime exclusion:

Annual Exclusion — The annual exclusion is periodically inflation adjusted and is currently $14,000 per individual. Thus you can give $14,000 a year to as many individuals as you wish without any gift tax or gift tax return filing requirements.

Lifetime Exclusion — On top of the annual exclusion, there is a lifetime exclusion that is linked to the estate tax exemption, which is also inflation adjusted, and for 2016 is $5.45 Million. Thus, in addition to the $14,000 annual per donee exclusion, there is a $5.45 Million exclusion that applies to the aggregate of all gifts in excess of the $14,000 per year per donee gifts.

There are complications to utilizing the lifetime exclusion. You must file a gift tax return to claim the lifetime exclusion, and the amounts of the lifetime exclusion used as an exclusion from gift tax will be tracked on any gift tax return(s) filed and will reduce the estate tax exemption. So for example, if in 2016 you make a gift of $3,014,000 to your child, and you haven’t made gifts in the past that exceeded the annual per donee gift tax exclusion, you will pay no gift tax, but you will have reduced your remaining lifetime exclusion to $2.45 Million. If you make more large gifts in the future that use up your remaining lifetime exclusion, not only will you then be subject to gift tax on the excess gifts, but at your passing, and assuming the value of your estate is large enough to be subject to estate tax, you will have no estate tax exclusion left to offset the estate’s value, so it will all be subject to estate tax.
CAUTION
The estate tax rates and the lifetime exclusion have long been a political football. They date back to 2006, when the lifetime exclusion was $2 Million. Congress can change the current $5.45 Million exclusion at any time. In fact, Democratic presidential candidate Hillary Clinton has proposed reducing the exclusion to $3 Million and raising the top estate tax rate from 40% to 45%. She would also disconnect the gift and estate tax exclusions and limit the lifetime gift exclusion to $1 Million.

Special Tuition/Medical Exclusion – In addition to the current $14,000 annual exclusion, a donor may make gifts that are totally excluded from the gift tax in the following circumstances:

  • Payments made directly to an educational institution for tuition. This includes college and private primary education. It does not include books or room and board.
  • Payments made directly to any person or entity providing medical care for the donee.

In both cases, it is critical that the payments be made directly to the educational institution or health care provider. Reimbursement paid to the donee will not qualify. The tuition/medical exclusion is often overlooked, but these expenses can be quite significant. Parents and grandparents interested in estate reduction should strongly consider these gifts.

Gift Splitting — A husband and wife can each make annual exclusion gifts, thereby increasing the exclusion from the current $14,000 to $28,000 per year per couple. However, only one of the spouses may be in a financial position to make the gifts. Spouses may elect on the gift tax return to treat a gift made by one spouse as being made by both spouses. Gift splitting can be used for annual exclusion gifts, lifetime exclusion gifts, and gifts above the lifetime exclusions.

Example — Gift Splitting —John and Jane are married and have two children. In a year when the annual exclusion limit is $14,000, they would like to exclude $56,000 ($14,000 x 2 donors x 2 donees) in gifts. Jane received a large inheritance some years back; John has only a modest estate. Jane gives the children $28,000 each. Then the couple elects to gift split so that the $28,000 gift is treated as given one-half by Jane and one-half by John (or $14,000 each). The gifts all qualify for the annual exclusion. Even if both spouses have sufficient resources to make gifts, gift splitting is useful when the husband and wife have different estate planning goals.

For residents of community property states, if community property is given, gift splitting is not necessary. Regardless of who holds the property’s title, or who “makes” the gift, the property is owned one-half by each and is therefore given one-half by each.

Gifts of Property — Gifts of property have some of their own circumstances to consider. For instance, where gifts are made of appreciated property such as stocks or real estate, although the donor’s gift is considered at the fair market value (FMV) for purposes of valuing the gift, the beneficiary of the gift assumes the donor’s basis. As a result, the beneficiary of the gift is assuming any taxable gain the donor would have had if he or she had sold the property instead of gifting it and will have to include as income that gain when and if the gifted property is later sold.

Although the FMV of traded stocks is readily available, the same is not true of most other types of property, in which case a qualified appraisal will be needed to determine the value as of the date of the gift.

Finally, keep in mind that a beneficiary inherits property at its FMV at the date of the decedent’s death as opposed to assuming the decedent’s basis, as happens in the case of a gift.

If you are contemplating gifting money or property to an individual, it may be appropriate to consult this office in advance to minimize the impact on estate taxes and help with any gift tax filings that may be required.

Gifting Money or Property Can Have Serious Tax Consequences

Gift and inheritance taxes were created long ago to prevent an individual’s assets from being passed on to future generations free of tax. Congress has frequently tinkered with these taxes, and currently the gift and inheritance taxes are unified with a top tax rate of 40%. However, the law does provide the following two exclusions from the tax:

Lifetime exclusion – For 2015, $5.43 million per person is excluded from gift and inheritance tax. This amount is annually adjusted for inflation and applies separately to each spouse of a married couple. Where one of the couple dies and does not use the entire exclusion amount, the unused portion of the exclusion can be passed on to the surviving spouse by filing an estate tax return for the decedent, even if one is otherwise not required.

Annual exclusion – The exclusion amount is periodically adjusted for inflation. For 2015 the annual gift exclusion is $14,000 per recipient. Thus, an individual can give up to $14,000 to as many recipients as he or she would like without creating a requirement to file a gift tax return. The $14,000 applies to each individual giver, so each spouse of a married couple can give $14,000, for a total per couple of $28,000 to any one person.

If a person gives more than $14,000 for the year to any single individual, then a gift tax return is required, and the excess of the gifts over $14,000 reduces the lifetime exclusion. Once the annual limit and the lifetime limit have been exceeded, the excess becomes taxable.

Gifts can take the form of cash or property. When property is given, the dollar value placed on the gift for gift tax purposes is the property’s fair market value (FMV) at the time of the gift. However, the gift recipient assumes the giver’s tax basis in the property, which means that if the giver’s property had built-in gains, the recipient becomes responsible for those gains when the recipient subsequently disposes of the property in a taxable event.

Example: Earl gives his son, Jack, stock worth $14,000 that originally cost Earl $5,000. Later, Jack sells the stock for $16,000. Jack’s taxable gain from selling the stock will be $11,000 ($16,000 – $5,000).

However, if Jack had inherited the stock from his father, Jack’s basis would have been the FMV of the stock at the date of his father’s death instead of what Earl had paid for the stock. Assuming the FMV was $14,000 at the time of Earl’s death and Jack subsequently sold the stock for $16,000, he would only have a taxable gain of $2,000 ($16,000 – $14,000).

This example points to a mistake often made by elderly taxpayers. They will frequently sign over their assets, most commonly their home, to their heirs while they are still alive rather than waiting and allowing the heirs to inherit the property. By doing this, they create a large tax liability for the heirs since the basis of the gift is the giver’s basis, thus the heirs become responsible for the giver’s built-in gain rather than inheriting the property with the basis equal to the FMV at the time of the decedent’s death.

Example: Mary signs over her home worth $500,000 to her son, John. Mary originally paid $100,000 for the home. If John immediately sells the home for $500,000 after Mary’s passing, he will have a taxable gain of $400,000. However, if John had inherited the property after Mary’s passing, his basis would be the FMV at date of death, or $500,000, and if he sold it for $500,000, he would have no taxable gain at all.

Additional Exclusions For Gift Tax – In addition, certain medical and education expenses are also excludable over and above the $14,000 annual exclusion cap.

Tuition Expenses – Tuition expenses paid directly to the qualifying educational institution are permitted without gift tax consequences. For example, a grandparent who wants to help out a college-bound grandchild can pay the student’s tuition directly to the college. Even if the amount is over $14,000, no gift tax reporting is required, and the grandparent’s annual gift exclusion with respect to the child and his or her lifetime exclusion are not affected.

Medical Expenses – Medical expenses paid directly to the qualifying medical institution or individual providing the care or to the insurance company providing the medical coverage are also exempt from the gift tax and don’t affect the gift tax exclusions. The payments cannot go through the hands of the individual who incurred the medical expenses, but must go directly to the medical provider or insurance company.

As you can see, gifting can be complicated and requires advance planning to fully take advantage of tax benefits. Please call this office if you need assistance planning your gifts.

President’s Budget Proposal

The President’s Fiscal Year 2016 Budget Proposal was just released and includes a number of tax proposals that would increase the taxes on higher-income taxpayers and provide more tax breaks for low- to middle-income taxpayers. The following are some highlights of the budget proposal that would impact individuals and small businesses, but remember these are proposals only.

Business Provisions

  • Section 179 Expensing – Would make the Sec. 179 expense cap $500,000 for 2015 (it is currently at $25,000, down from $500,000 in 2014). Would raise the expense cap to $1 million in 2016 and make the $1 million permanent with inflation adjustment for future years.
  • Cash Basis Accounting – Would expand use of the cash method of accounting to small businesses with less than $25 million in average annual gross receipts, estimated to apply to 99% of all businesses.
  • Qualified Small Business Stock – Would permanently extend the 100% exclusion on capital gains from sales of tax-qualified small business stock held by individuals for more than five years, and would eliminate the inclusion of excluded gain from the Alternative Minimum Tax.
  • Start-Up & Organizational Expenses – Would increase and consolidate the deduction for start-up and organizational expenditures.
  • Small Employer Health Insurance Credit – Would expand the credit for small employers to provide health insurance to apply to up to 50 (rather than 25) full-time equivalent employees, with phaseout between 20 and 50 employees (rather than between 10 and 25).
  • Mandatory Employer IRA Payroll Deductions – Would require employers with 10 or more employees who don’t have a 401(k) plan to automatically enroll full-time and part-time employees in an optional IRA payroll deduction plan.

 

Individual Provisions 

  • Child Care – Would allow a credit of up to $3,000 (50% credit for up to $6,000 of expenses per child) for each child under the age of 5 to enable gainful employment of the parent(s) or other qualified taxpayer. The regular credit for those ages 5 through 12 would also begin to phase out at $120,000 (instead of $15,000 under current law). Flexible spending accounts for child care would be eliminated.
  • Second Earner Tax Credit – Would provide a new tax credit up to $500 (5% of the first $10,000 of earnings for the lower-earning spouse) for joint filers with two wage earners. The credit would begin to phase out at income of $120,000 and would be fully phased out when family income reaches $210,000. It is estimated that this new credit would benefit 24 million joint filers.
  • Earned Income Tax Credit (EITC) – Would double the EITC for workers without a child and increase the credit applicability for childless workers with earnings up to 150% of the federal poverty level (currently about 125%). Would expand the applicability of the EITC to workers age 21 to 66 (currently 24 to 64).
  • Education Tax Benefits – The American Opportunity Tax Credit (AOTC) would be expanded to cover five years of post-secondary education, and the current $2,500 tax credit would be adjusted for inflation. The refundable portion of the AOTC would be increased to $1,500. Part-time students would be eligible for a $1,250 AOTC (up to $750 refundable). Duplicative and less effective provisions, including the Lifetime Learning Credit, the tuition and fees deduction, the student loan interest deduction (for new borrowers), and Coverdell accounts (for new contributions) would be repealed or allowed to expire. The credit would also be better coordinated with Pell Grants.
  • Top Capital Gains Rate – Would raise the top effective capital gains and qualified dividends tax rate to 28% (24.2% plus the 3.8% net investment income tax). For couples, the 28% rate would apply where income is more than $500,000 annually.
  • Itemized Deductions – Would limit to 28% the value of itemized deductions and other tax preferences for married taxpayers with incomes over $250,000 and individual taxpayers with income over $200,000. The limit would apply to all itemized deductions as well as other tax benefits, such as tax-exempt interest and tax exclusions for retirement contributions and employer-sponsored health insurance.
  • Limit Retirement Account Contributions – Would prohibit contributions to and accruals of additional benefits in tax-preferred retirement plans and IRAs once balances are about $3.4 million, which is about enough to provide an annual income of $210,000 in retirement.
  • Buffett Rule – Would implement the “Buffett Rule.” This rule, which is a carryover from prior year budget proposals, would require the wealthy to pay at least a 30% effective tax rate.

 

Gift & Inheritance Tax Provisions

  • Inheritances and Gifts – Would eliminate the current step-up in tax basis at death and require payment of capital gains tax on the increase in value of securities at the time they are inherited. Generally, a $100,000-per-person, portable-between-spouses exclusion would apply for inherited appreciated assets, along with exceptions for surviving spouses, small businesses, charities, and residences, among others. For couples, no tax would be due until the death of the second spouse. No tax would be due on inherited small, family-owned-and-operated businesses unless and until the business was sold, and any closely held business would have the option to pay tax on gains over 15 years. Couples would have an additional $500,000 exemption for personal residences ($250,000 per individual), with this exemption also automatically portable between spouses. Tangible personal property other than expensive art and similar collectibles – e.g., bequests or gifts of clothing, furniture, and small family heirlooms – would be tax-exempt.
  • Inheritance and Gift Tax – Would reinstate the prior, 2009, estate and gift tax rates with lower exclusions (generally at 45% at $3.5 million for estates and $1 million for gifts).

 

These are all proposals by the Obama administration and must be approved by Congress. The information is being passed along so you will have an idea of what might happen in the future.

Tax Smart Gifting

Frequently, taxpayers think that gifts of cash, securities or other assets they give to other individuals are tax deductible and, in turn, the gift recipient sometimes thinks income tax must be paid on the gift received. Nothing is 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 inheritance taxes.

Tax Gifting

As a result, what you give away prior to death will reduce the amount that can pass to your beneficiaries free of inheritance taxes after your death. For 2015, the lifetime exemption from inheritance tax is $5.43 million. The following amounts do not reduce the lifetime exemption:

  • $14,000 each to any number of recipients during every tax year. The amount is periodically adjusted for inflation, but the amount for 2015 remains at $14,000.
  • Directly pay medical expenses. This applies to amounts paid by one individual on behalf of another individual directly to a provider of medical care 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. Costs of room and board aren’t eligible as direct payments.

If the gift giver is married and both spouses are in agreement, gifts to recipients made during a year can be treated as split between the husband and wife, even if the cash or property gift was made by only one of them. 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 as much on to your heirs as possible while living, without reducing the lifetime exemption, you could pay directly your heirs’ medical expenses and higher education expenses in addition to annual gifts of cash or property of $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 them. 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 him or her to pay the medical expenses and claim the medical deduction on his or her tax return, or 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), and thereby avoid reducing the lifetime exemption. 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 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, an appreciated asset gifted to a charity not only gets 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.