Often times we field your questions surrounding gifting & gift taxes.  This series of articles will help you to understand the different types of gifting you can do.  In addition it will help you to understand the tax consequences of giving during your lifetime. Let’s begin with: What is a Gift? A gift is something given voluntarily without payment in return. The federal gift tax is an excise tax imposed on an individual for the lifetime transfer of property by gift. The transfer may be direct or indirect, and is measured by the value of the property passing from the donor. The property may be real or personal, tangible or intangible. Statutory exceptions apply to certain transfers of intangible property by nonresident aliens and to transfers to political organizations. The gift tax is imposed on the donor, although in some cases, the donee pays the tax. 301.2 When a beneficial interest in property is transferred for less than full and adequate consideration in money or money’s worth, a taxable gift occurs. Thus, a taxable gift can occur by creating a trust, forgiving a debt, assigning a judgment, or assigning the benefits of a life insurance policy, as well as by a direct transfer of cash or other property. However, the gift tax does not apply to transfers for full and adequate consideration or to ordinary business transactions. Full and Adequate Consideration  Generally, a transfer is not subject to the gift tax if the transferor receives full and adequate consideration in exchange for the property transferred. Consideration includes amounts received in money or money’s worth and both tangible and intangible property. Consideration not reducible to a monetary value, such as love and affection or a promise to marry, is disregarded. Discharge of Legal Obligation to Support. Transfers made to discharge the transferor’s legal obligation of support are deemed to be made in exchange for full and adequate consideration and are not taxable gifts. Therefore, a parent’s payment of a minor child’s food and shelter is not a gift. Property Transferred Exceeds Consideration Received. When the value of the property transferred exceeds the consideration received, the amount in excess of the consideration is subject to the gift tax. However, when a sale, exchange, or other transfer of property is made at arm’s length and in the ordinary course of business, the transaction is a transfer for adequate consideration. Example: Sales for less than fair value are gifts. Joe Murray bought 1,000 shares of ACME Corp. common stock in 1976 for $10,000. In 2007, when the stock was worth $100,000, Joe sold the stock to his son, Mark, for $10,000. The sale of the stock to Mark at a price below its fair market value is a gift of $90,000, which is the excess of the stock’s value over the consideration received by Joe.  Ensuring All Gifts Are Identified  Small Gifts Are Gifts. Most clients know that direct transfers of cash or property are subject to the gift tax. However, many may not recognize that birthday, wedding, and holiday gifts must be considered when determining a client’s total gifts for the year. In the authors’ opinion, the payment of expenses associated with events such as a child’s wedding or bar mitzvah are not considered gifts. However, if the funds are directly paid to the child with the intention of being used for such an event, the authors believe there has been a completed transfer subject to gift tax since the child is under no legal obligation to spend the funds on the event. Practitioners should develop procedures for identifying all the gifts made by their clients during the year to ensure they do not inadvertently exceed their annual exclusion. Example: Identifying gifts. On December 28, 2007, Homer Smith, a widower, directly paid Ashley, his adult daughter, $12,000 for all the expenses of her wedding reception. During 2007, Homer also paid $3,000 for Ashley’s vacation in the Bahamas and gave her $500 cash for her birthday. Homer has made taxable gifts to Ashley of $15,500 which he must report on a gift tax return.  Example: Creation of joint bank account. Al created a joint bank account for himself and his adult son, Bill, on July 1, 2007. As of December 31, 2007, Bill had not exercised his power to withdraw funds from the joint account. On March 1, 2008, Bill submitted a withdrawal slip and withdrew the entire balance in the account. When a joint owner actually withdraws more than his or her contribution to the joint bank account, a gift is deemed to have occurred. Thus, no gift occurred in 2007 because Bill made no withdrawals from the account. Al’s initial deposit is not a gift. However, assuming Bill made no contributions to the account, the withdrawal on March 1, 2008 is a gift. The transfer was made without consideration and Bill received a beneficial interest in the funds at the time of withdrawal. Once a gift is made, owners of jointly held property share in the income derived from the property based on their ownership percentages. Gain or loss from the sale of the property is also shared. Making Gifts during Your lifetime   If you give away property while you live, that removes the value of that property from you taxable estate.  Let’s take a look at the different types of gifts you may want to make. Using the federal gift tax Exclusion   You can make gifts worth up to $12,000 per person per calendar year free of gift tax for 2008.  A couple can give $24,000 tax free to any person.  Tax –exempt gift giving can remove large amounts of money from an estate.  A gift-giving program can be particularly advantageous for wealthy folks who have several children, grandchildren, or other people they’d like to help.   You can also make tax-free gifts of any amount for:   ?      Payments made for someone’s educational or medical costs, and ?      Contributions to tax-exempt charities.  If you’re quite prosperous, you      may want to look into what’s called a “charitable remainder trust.”   EXAMPLE: Julie gives each of her five children $12,000 in 2008.  All of these gifts are tax exempt.   Both members of a couple have separate $12,000 exemptions, so they can give a combined total of $24,000 per beneficiary per year tax free.   EXAMPLE: In 2007, Elliot and Gina give $24,000 to their daughter, $24,000 more to their daughter’s husband and $24,000 to each of their daughter’s three children.  All these gifts are tax exempt.   As this example shows, over time, wealthy people can give away large amounts of money tax-free.  Elliot and Gina give away $120,000 in one year.  Multiply that sum by, say, five years, and you get an idea of just how much can be removed from a wealthy estate by an extensive gift giving program.   The $12,000 gift tax exemption is indexed yearly to the cost of living.  As the cost of living rises (assuming it does, which seems a safe bet) the gift tax exemption will also rise, in increment of $1,000 rounded down to lower thousand.  In other words, cost of living increases must cumulatively raise the current exemption by more that $1,000 before the gift tax exemption is raised to $13,000.    The Marital Exemption   All gifts between spouses are exempt from gift tax, no matter how much the gift property is worth.  This rule is part of the marital deduction.   The marital deduction does not apply to gifts from a citizen spouse to a non citizen spouse.   The rule here is that gifts worth up to $125,000, per year can be make to a non citizen spouse, tax free.  Thus, a citizen spouse with an estate worth $2.3 million can be sure that his or her estate won’t owe tax if he dies before 2014 if the citizen spouse give his non citizen spouse $125, 000 in each of three years; the remaining estate is under the estate tax threshold.   Gifts for Medical Bills or School Tuition   If you pay someone else’s medical bills or school tuition, your gift is tax exempt.  This exemption has a couple of twists, however.  First, you must pay the money directly to the provider of the medical service or to the school.  If you give the money to an ill person or the student, who then pays the bill, the gift is not tax exempt.  Nor can you reimburse someone who has already paid a medical or tuition bill and receive the tax exemption.  Finally, you cannot get the exemption for payment covering a student’s other education expenses, such as room and board.    Gift of Interest in a Family Business   Gifts of minority interests in a family business can, in the right circumstances, reduce estate taxes.  This is because a minority interest can be valued, for gift tax purposes, at less than the value it would have if it were part of the majority interest.    EXAMPLE: Angela gives her daughter, Lucia, 10% of Angela’s interest in her furniture company.  At the time of the gift, the company is worth $1 million.  The value put on Lucia’s 10% share in not $100,000 but something significantly less, in the $60,000-$80,000 range, because of minority business discounts.   Gift of Life Insurance   From an estate tax standpoint, it can be very desirable to give away life insurance during your life.  If you own your life insurance policy at your death, the proceeds (death payment) are included in you taxable estate.  If the policy has a large death benefit-say, hundreds of thousands of dollars- including that sum in your taxable estate can result in substantial federal estate taxes.  But the proceeds will not be subject to tax if someone else owns the policy when you die.    ! CAUTION   Don’t wait to make a gift of life insurance.  Under IRS regulations, a gift of life insurance must be made at least three years before your death.  The potential tax savings from making a gift of life insurance are so large that the IRS will not allow and “deathbed” gifts.  Defining “last minute” to mean at least three years does seem a tad excessive, but it’s better to be safe than sorry.   Gifts of life insurance are subject to gift tax.  The worth of the gifts is, basically, the current value of the policy.  This will always be far less than the amount the policy will pay at your death.  If the present value is under $12,000, no gift tax will be assessed.   There are two ways you can transfer ownership of the life insurance policy.  First, you can simply give the policy to another person or persons.  Your life insurance company should have as assignment form you can use to accomplish this.  Second, you can create an irrevocable life insurance trust, and transfer ownership to that entity.  You’d crate a trust if there’s no person to whom you want to assign the policy outright.    Transferring ownership of your policy to another person or a trust involves a trade-off:  Once the policy is transferred, you’ve lost all power over it, forever.  You cannot cancel it or change the beneficiary.  To make this point bluntly, suppose you transfer ownership of you policy to your spouse, and later get divorced.  You cannot cancel the policy or recover it from your now ex-spouse.  Nevertheless, in many situations, the trade-off is worth it –for example, when you transfer policy ownership to a child or children with whom you have a close and loving relationship.        Property Expected to Appreciate. When the objective of a lifetime transfer is to reduce the donor’s gross estate, property that is expected to appreciate is the best type of property to transfer. Likely candidates include closely held business interests, real estate, common stocks, life insurance (but life insurance only if the owner’s life expectancy is at least three years;), and collectibles. The obvious advantage of this strategy is to remove the future appreciation from the estate. Such property can be transferred at a relatively low gift tax value (when compared to the estate tax consequences if the appreciation is subject to estate tax). Property with Significant Appreciation. Conversely, property that has already appreciated significantly may not be the best candidate for a lifetime transfer, since (if not gifted) the basis will be stepped up to FMV at the owner’s death, allowing the appreciation to go untaxed (for income tax purposes). However, if a sale of the property is imminent, and the potential donee is in the 15% income tax bracket, a gift before the sale may result in a lower capital gain tax. Also, if the donee has a loss carryover that could be used to offset the gain on disposition, a gift of appreciated property before the sale may be appropriate.  Depreciated Property. A gift of depreciated property is not beneficial for tax purposes in most situations. The donee’s basis for recognizing a loss is the lower of the donor’s basis or FMV at the date of the gift. Thus, a realized loss associated with property that declined in value while owned by the donor may go unrecognized when the property is sold by the donee. A better approach would be for the donor to sell the property, recognize the loss for income tax purposes (assuming the property is business or investment property for which a loss deduction would be allowed), and give the proceeds to the donee. However, the sale should be made to an unrelated party to avoid the Section 267 related party loss limitations Personal Residences  Some donors may wish to make a lifetime gift of a personal residence, removing the property (and subsequent appreciation on it) from the donor’s estate, despite the fact that the donee will receive carryover basis on the property. Several transfer methods are available, but the best option for any given client will depend on that individual’s personal wealth transfer strategy and circumstances. Caution:   Clients must avoid the pitfalls of retaining rights to the possession or enjoyment of the property, or the property will still be includable in the estate.  Outright Gift. If a married couple transfers their residence to a child and his or her spouse, the amount of the gift can be offset by the $12,000 (for 2007) per donee annual exclusion. Thus, if the donor and spouse elect gift-splitting, or if the residence is community property, a gift to a child and his or her spouse will result in $48,000 of excluded value. The remainder of the gift can be offset by the donors’ remaining lifetime applicable gift tax exclusion ($1 million).  Sale for a Bargain Price. Alternatively, the taxpayers could sell the residence at a reduced price to the child and spouse, resulting in a gift of the difference between the FMV of the residence and the selling price. The annual gift tax exclusion amounts and remaining lifetime applicable exclusion will be available to offset the amount of the gift.  Consequences of Retained Use and Enjoyment. If the taxpayer retains for life the possession or enjoyment of the transferred residence, it will be included in his or her gross estate. Example: Transferred property with retained rights. Alex Jones purchased a condominium. In anticipation of incremental gifts of the property to his children, he executed an agreement that permitted him the exclusive right to use and occupy the property for as long as he desired. Subsequently, Alex transferred legal title in 100% of the property to his children through three deeds. Until his death, he occupied the residence and paid all of its monthly expenses, including utilities, insurance maintenance costs, taxes, and fees. The executor of his estate filed the estate tax return, excluding the value of the condo because of the transfers. The IRS asserted, and the Tax Court agreed, that the value of the condo was includable in the gross estate because Alex continued to use and occupy the residence and essentially treated the residence as his own. Qualified Personal Residence Trust (QPRT). By transferring the residence through the use of a carefully drafted trust that meets the specific requirements, the taxpayer may avoid the consequences, continue to live in the residence for a period of time, and transfer the remainder interest in the property to the child. The value of the gift is the FMV of the residence less the value of the term interest retained by the donor. The technicalities of this arrangement must be strictly observed to achieve the desired result. Lifetime giving of property is one of the most powerful tools available to accomplish many of your estate planning goals and objectives. Nontax objectives, such as avoiding probate, protection from creditors, shifting administrative and management burdens, as well as the satisfaction and enjoyment derived from gratuitous transfers of property to loved ones, can be met through properly structured lifetime gifts. However, nontax disadvantages, including the loss of control over the transferred property, the fear of affecting the ambition and incentive of the donee, and the uncomfortable aspects of planning for one’s own death, often cause one to be reluctant to pursue a plan involving gratuitous lifetime transfers. Significant transfer and income tax savings can be generated from a properly structured lifetime giving program. Although saving tax is not always the primary motive for such a strategy, it may often be a significant factor. Gifts within Three Years of Death  The following concepts are critical to a lifetime giving program when the client is expected to die within three years of the gift: a. Make Maximum Use of Gifts That Are Excluded from the Gift Tax Base. These include the annual gift tax exclusion and the exclusions for medical and tuition costs. A program of annual exclusion gifts made early in each calendar year (preferably each January) leaves the donor in the best position of assuring that annual exclusion gifts are completed before death. An important and often overlooked planning tool is the payment of tuition and/or medical expenses for children, grandchildren, parents, grandparents, and other family members. b. Consider Spousal Transfers to Fully Use Both Spouses’ Applicable Credit Amounts. If the client is married, consider spousal transfers that will equalize the two estates if the surviving spouse is in a similar stage of life and the combined taxable estates exceed $4 million (for 2007). This will ensure that both estates make maximum use of the applicable credit amount. Generally, this can be accomplished by marital deduction gifts or gifts to third persons by the owner of the larger estate with the other spouse consenting to split the gifts. If the combined taxable estates exceed $2 million but are less than $4 million for 2007, the estates do not necessarily have to be equalized, but efficient use of the applicable credit amount will ensure that neither estate incurs any federal estate tax. However, if one spouse has substantially more of the assets, lifetime transfers to the other spouse should be considered because if the first to die does not use the applicable credit amount, this benefit is lost. c. Consider the Step-up in Basis Rules When Making Gifts of Property. The basis of property transferred during an individual’s lifetime “carries over” to a donee. On the other hand, property passing at death is “stepped up” to FMV in the hands of the heirs. Therefore, appreciated property is generally inappropriate for deathbed transfers when suitable alternatives are available because a lifetime transfer will cause the appreciation to be taxed (for income tax purposes) to the donee when the property is sold.   Warning:   The basis of appreciated property gifted from one individual (the donor) to another (the donee) within one year of the donee’s death will not be stepped up to FMV upon the donee’s death if the asset passes back to the original donor. This rule prevents the transfer of assets to a terminally ill person solely for a step-up in basis. d. Beware of Transfers of Life Insurance and Transfers of Certain Retained Interests or Powers within Three Years of Death.   (a)(2) causes the three-year inclusion rule to apply to transfers of life insurance on the decedent’s life and transfers or releases of certain retained powers or property interests. The retained powers and interests to which this rule applies include: (1) a retained right to income, possession, or enjoyment of the property, or the right to designate who receives the income, possession, or enjoyment; (2) a retained reversionary interest; and (3) a retained power to alter, amend, revoke, or terminate the beneficial enjoyment of the property. As a result of the three-year rule, a terminally ill individual is precluded from transferring a life insurance policy shortly before his death to avoid inclusion of the proceeds under IRC Sec. 2042. Similarly, a donor cannot transfer his life estate in certain property shortly before his death and avoid including the property interest under IRC Sec. 2036.   Practice Tip:   Should the donor live for three years after the transfer, IRC Sec. 2035(a)(2) will not apply.