3 Key Gift-Giving Strategies to Consider [And Exceptions]

For most people, gift-giving season has come and gone. But for shrewd estate planners, the time to give is just beginning.

Family gift giving is part of most estate plans. Gifts primarily are made to minimize estate and gift taxes by removing property from an estate. Estate and gift taxes are based on the value of assets. Removing an asset from an estate now ensures the value of both the property and all its future appreciation are out of the estate.

Gifts also allow the giver to see how the gifts enrich the lives of others. Many people prefer seeing their gifts used instead of imaging how beneficiaries of their estates will benefit from them. Beneficiaries also can plan better, since they do not have to wonder when, if ever, they will receive additional wealth.

Unfortunately, most people do not maximize the power of giving. They give at the wrong time, or give the wrong assets. Or they overlook some effective giving strategies that can multiply the benefits of gifts.

Here are some key strategies to consider in 2006.

Give before spring. Making gifts early in the year provides several benefits. Obviously, it ensures that the gifts are made and out of the estate. Also, any income generated by the property during the year is off the donor’s tax return and in the hands of the donee. In addition, the year’s appreciation is not included in the gifts or the estate, increasing the amount that can be given tax free during the year and over a lifetime.

For example, Max Profits owns shares of Hussman Strategic Growth. At $5.00 per share, in January Max can give each of his children about 2,400 shares free of gift taxes. Suppose Max waits until December to make the gifts and HSGFX returns 10% by then. Then, Max can give each child less than 2,200 shares gift tax free. When giving appreciating assets, more property can be given tax free the earlier the gifts are made.

Give generously. Many estate plans call for giving each beneficiary only the annual gift-tax free amount each year, which is $12,000 in 2006. Each person can give each beneficiary up to $12,000 gift tax free during the year. For the same reasons that it makes sense to give early in the year, it makes sense to give more than the annual gift tax amount. The more property you give now, the lower the tax cost and the less that is left in your estate to be taxed.

Gifts that exceed the annual exempt amount are not automatically taxed. Each person has a lifetime gift tax exemption of $1 million. Only gifts above the annual exempt amount apply against the lifetime exemption. Each married couple can give away up to $2 million tax free during their lifetimes ? in addition to the annual exempt gifts.

Of course, you do not want to give away money or property to the point that your standard of living is reduced. But if you know where you want the property eventually to go and do not need it to maintain your lifestyle, from a tax standpoint it makes sense to give up to the lifetime exemption now instead of holding the property.

For the very wealthy, it can make sense to make gifts that exceed the lifetime exemption and pay taxes on the excess amount. If the assets are appreciating, it is cheaper to pay gift taxes now instead of having the estate pay even higher taxes later. This is particularly true if the estate is primarily a business or real estate that you do not want sold in pieces to pay estate taxes.

For estates in the $3 million to $10 million the decision is more difficult. It appears that Congress is unlikely to permanently repeal the estate tax. But a possibility is to permanently raise the estate exemption amount to $3 million or more. It would not be good to make gifts exceeding $1 million this year only to have Congress permanently exempt from estate taxes a higher amount. Therefore, people with estates of $3 million to $15 million should suspend plans to make gifts exceeding $1 million until Congress settles the issue.

Give cash last. Many people make their annual gifts with cash or checks. As you might have gleaned from the previous discussions, it makes more sense from a tax standpoint to give property that is likely to appreciate. Get that appreciation out of your estate.

Even if you know the donee plans to convert the gift to cash and spend it, a gift of appreciated property can be the right move. If the donee will pay a lower tax rate on the gains than you will, give property. Let the donee sell the property, pay the taxes, and spend the after-tax amount. The family’s after-tax wealth is increased.

There are a couple of exceptions to this rule.

One exception is the Kiddie Tax. Children under age 14 have their parents’ top tax rate imposed on income and gains above a certain amount ($1,700 in 2006). But children age 14 and older usually face a 5% or 10% long-term capital gains tax and a 15% ordinary tax rate.

The other exception is for property that has appreciated significantly. The beneficiary of a gift takes the same tax basis the donor had. So, the giver’s lifetime appreciation will be taxed when the donee sells. But someone who inherits property increases the basis of the property to its fair market value. No taxes are paid on the lifetime appreciation of the original owner. For valuable property with significant appreciation, keeping the property in the estate can be the better move.

Do not give investments or business property that has declined in value. A donee takes as the tax basis the lower of the donor’s tax basis and the fair market value. If property has declined in value, the donee’s basis is the current fair market value. No one deducts the loss that was incurred during the donor’s ownership. A better move is to sell the property, deduct the loss on your tax return, and give the sale proceeds.

Make direct payments. The tax-free gift amount can be increased in some circumstances if gifts are made directly to third parties instead of to the person benefiting from the gifts.

Education gifts are tax free for an unlimited amount if made directly to an education institution for direct tuition costs. This exception does not apply to gifts that pay for other education expenses, such as books, supplies, board, lodging, or other fees. Your $12,000 annual exclusion can be used to pay for those items, and then you can pay the tuition directly to the education institution.

Medical expenses also are tax free gifts in any amount. Qualifying payments are those made for any medical expense that meets the definition of a deductible itemized medical expense. Again, the payments must be made directly to the medical care provider.

Scheduled changes in the estate tax complicate these decisions, as I mentioned earlier. If the estate tax is permanently repealed, or repealed for most people, there is no tax benefit to making substantial lifetime gifts. There are the non-tax benefits mentioned above. On the other hand, if the estate and gift tax reverts to its 2001 version as would be the case without congressional action before 2011, making large gifts between now and then would turn out to be a smart move.

My advice is for most people to take a middle road. Do not give purely for estate tax reasons or to the extent that it changes your lifestyle. Make annual gifts that will benefit your loved ones without causing you to cut back.

If you own substantial assets, it often is best to begin shifting those to the next generation even if there are no tax savings. They need to learn how to handle the assets ? whether you own a business, real estate, or investments. In addition, it looks like complete repeal of the estate tax is not likely. Instead, estates below a set amount will be exempt, while larger estates will begin paying estate taxes but perhaps at a maximum 35% rate. The exempt amount is being negotiated, and the amounts discussed begin at $3 million.

If people do not make estate planning gifts now because the tax law is uncertain, they will look smart if full repeal occurs. But valuable time and opportunities would be lost if repeal never happens. As with our investments, keep a margin of safety in your estate planning. Keep a giving program in place and make tax-wise gifts. But don’t overdo the giving.

Some people are reluctant to make gifts, because their children or grandchildren might not handle the property responsibly or might develop poor values. In next month’s visit, we will review ways to give that let you retain some control, save assets from divorces, or encourage good habits.