Any good estate planner will tell you that there's no time like the present to consider a program of gifts to loved ones as part of an over all estate plan. Before embarking on a program of gift giving, it pays to know some of the basic rules of federal gift taxation. A few states also have gift taxes, but we're going to ignore state gift tax implications for the purpose of this article.
One of the most important and basic gift tax strategies is to make gifts that take advantage of the "annual exclusion" amount. Gift tax rules permit the donor of a gift to give up to $11,000 (in cash, property or some combination of the two) to as many people as the donor wishes. There is no requirement that the donee of the gift be related in any way to the donor. If you have $11,000,000 and 1,000 close friends you can give each of them $11,000 completely free of gift taxes.
Notice the rule applies to gifts of both cash and/or property. If Mom gives each of her three kids $11,000 in cash and then gives each of them Christmas and birthday presents worth $1,000, she has made a taxable gift (more on taxable gifts later) of $1,000 per child. Many experienced estate planners recommend that donors make regular gifts of $10,000 to $10,500 to allow the donor to continue to make their regular special occasion gifts without having to worry about gift tax implications. Finally, husbands and wives can join together to give $22,000 per year per donee.
In order to qualify for the $11,000 annual exclusion, the donor must give a gift of a "present interest." That means the donee must have at least some rights to use the gift today. That right may include the right to receive income from a trust. A gift into a Uniform Gifts (or Transfers) to Minors Act account qualifies as a gift of a present interest. So do gifts into special trusts for minors provided they terminate when the child turns 21.
Two other gift tax exclusions are available. If the donor pays directly either the tuition or medical expenses of the donee, there is an unlimited exclusion for the gift. The tuition payment must go directly to the school and the donee may be either a full or part-time student. The exclusion is not available for expenses other than tuition. The medical expenses must be paid directly to the health care provider, not reimbursed to the donee. To qualify, the medical expense must be deductible for income tax purposes regardless of the percentage of income limitations. Note, there is no requirement of any family relationship between the donor and donee for either the tuition or medical expense exclusion.
If the gift exceeds the $11,000 per year, per donee, limit or does not qualify for either of the unlimited tuition or medical expense exclusions, the donor has made a taxable gift. Taxable gifts, in effect, "use up" some or all of the lifetime transfer exemption equivalent ($1 million for 2005) applicable to the gift/estate taxes. If taxable gifts over one's lifetime exceed this amount then the donor must actually write a check (rather than use up the exemption equivalent) to pay the gift taxes.
One basic strategy involves developing a habit of making annual gifts of $11,000 ($22,000 for a married couple) to each individual the donor(s) would like to benefit. The annual gift tax exclusion is too good a deal to pass up. If you miss a year, you will not be able to make it up in the future. Use it or lose it is the motto here, so use it if you have the opportunity.
While donors may give anything they like to their donees, it is generally best to give something that will grow in value between the date of gift and mortality. Although not guaranteed, given a long enough time horizon, virtually any investment could show a positive return. However, the only item that is positively going to go up between the date of gift and the date of death is life insurance (or the cash used to pay premiums on life insurance). That's one of the reasons (liquidity is another) to look at life insurance as an ideal gift giving vehicle.
However, even if the donor is uninsurable, making annual gifts still makes sense. Let's say the donors have four children and six grandchildren to whom they would like to make gifts. Further assume that the donors have a $3 million dollar estate. The donors can join together to give gifts totaling $220,000 each year ((2 x $11,000) x (4 + 6)). If the kids and grandkids can be persuaded to invest rather than spend their gifts (use a trust if other persuasive techniques won't work) and they earn an 8% hypothetical return, after 10 years the donors will have transferred wealth worth almost $3.2 million without any negative estate or gift tax implications. (This is a hypothetical example and is not indicative of any security's performance. Investing involves risk and you may incur a profit or a loss.)
Rather than cash, some donors should consider giving away an asset with growth potential, for example, common stocks. For capital gain purposes, the basis of the donor in the stock will become the basis of the donee. If the donor has a very low basis, he/she is sometimes loath to make a gift of the asset because the donee might have to pay a capital gains tax. They think it makes more sense to hold onto the stock and receive the "step up" in basis at death.
These donors should keep two things in mind. First, the capital gains tax is a voluntary tax-- you only pay it when you sell an appreciated asset. The estate tax is involuntary--it's due 9 months after death essentially no matter what. Second, the maximum long term capital gains tax rates (ignoring the possible implications of those imponderable phase-outs of personal exemptions and itemized deductions) is 15%. The lowest estate tax bracket is effectively 35%. The capital gains tax rate applies only to the gain. The estate tax rate applies to the entire asset.
Should everyone be making annual gifts? No, for some there are compelling reasons not to. Potential donors who need everything they have to maintain their lifestyles are not very good potential candidates. Neither are those who will not have a taxable estate (i.e. their net worth is less than $1,500,000 for 2005). Often the foregoing will describe the same people. However, those with excess assets and a taxable estate are prime candidates to consider implementing a disciplined, systematic gift giving program.
Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, you can contact me, an attorney or tax advisor as appropriate.