Gift Tax Basics

The gift tax exists in order to prevent people from having an easy way to avoid or bypass the federal estate tax .  If people could easily make unlimited gifts to their heirs, few taxpayers would ever be subject to the estate tax -- which can consume up to 50% of an estate in excess of $1 million.  

The law does permit an unlimited amount of gifts (or bequests) to a spouse without any gift tax or estate tax. But gifts to children or others are subject to a gift tax if the value of the gifts exceeds the available exemptions.

There is an exemption (for 2004) of $1 million of assets from the federal estate and gift tax. It's a "unified" exemption from the tax -- which means that it applies to the accumulated total of gifts and to the total of an estate. Technically it's a tax credit that eliminates the estate or gift tax on the first $1 million of an estate.

For example, if you have an estate of $3 million and have made $500,000 of gifts during your lifetime, your estate will only be eligible to use the remaining $500,000 of exemption from the estate tax. Or -- if you made gifts of $1.5 million during your lifetime, the first million would be free of any gift tax and the next $500,000 would be subject to the gift tax. Your estate would not be able to use any exemption because it was previously used to avoid taxes on gifts. 

The gift tax rates are currently the same as the estate tax rates but the lifetime exemption for 2004 is not the same.  However,  a subtle and often overlooked difference results in less tax on gifts than on the same amount left in an estate.  This is because the gift tax is based on the net amount of the gift, excluding the tax. The estate tax is based on the pre-tax value of the estate. For example, if $1 million were left in an estate and were subject to an average tax rate of 45%, the tax would be $450,000 and the heirs would get $550,000. By contrast, the gift on the same $550,000 might be only $247,500 (or somewhat less). To make a gift of the entire million, the gift tax might be about $690,000 with a gift tax of about $310,000.

In addition to the unified exempt amount, the gift tax permits taxpayers to make annual gifts of a "present interest" in the amount of $11,000 per taxpayer and per recipient. For a married couple, gifts can be "split" -- meaning that twice the exempt amount can be gifted without tax. Thus a couple can gift up to $22,000 per year to each child, grandchild or other heir. With ten heirs, up to $220,000 could be gifted each year.

However, the annual $11,000 gift tax exemption, the gifts must be of a "present interest".  This basically means that the recipient o the gift must have ownership and enjoyment of the gift and any income that it produces.  Generally, gifts in trust for future distribution to a donee are not gifts of a present interest -- except for the 2503-C Minor's Trust .  Gifts of cash are the ultimate in terms a "present interest". 

Generally, gifts of securities such as stocks, bonds, mutual fund shares, an interest in land, or other assets are also a gift of a present interest.  Gifts of appreciated assets to a child or grandchild also results in the transfer of the tax on any unrealized gain.  If the donee is in a 15% or lower tax bracket,  there could be some tax savings in terms of the capital gains taxes that must be paid on the sale of the property. 

In most cases, gifts of stock in a family owned corporation or a family limited partnership are treated as gifts of a present interest. However, if the donor retains all control over a corporation or partnership and the donee never derives any income or other benefit from the property, there is a chance the IRS may dispute whether the gift is of a present interest.

A popular estate and gift tax planning technique being used currently is to put financial assets into a family owned limited partnership (LP) or limited liability company (LLC).  The parents then make gifts of an ownership interest as limited partners or as members of the LLC.  Due to restrictions on the free transferability of such security interests, they are not worth as much to a buyer as an equal share of the underlying assets in the LP or LLC. For example, if a LP has financial assets of $1 million, a 40% share of the LP might only be worth $250,000 to an unrelated buyer.  Thus a gift of a 40% interest in the LP to a son or daughter would be valued at $250,000 instead of $400,000. The IRS has been trying for years to find a way to stop this practice but thus far with very limited success.

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Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/  

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