The Three Ways to Make Tax-Free Gifts

Congress is considering slashing the lifetime exemption for estate and gift taxes, perhaps cutting it in half or even more. Because of that, estate planners are telling clients to consider giving away assets before the end of 2021 to remove from the estate some assets that might be subject to the federal estate tax after this year.

The tax code has three ways to make tax-free gifts. Using each of these methods as they fit your estate and family situation maximizes the after-tax wealth available to your family.

The first tax-free giving method is the annual gift tax exclusion. In 2021, the exclusion limit is $15,000 per recipient. The annual limit is indexed for inflation, so it increases periodically. You can give up to $15,000 worth of money and property to any individual during the year without any estate or gift tax consequences. You can give in one transaction or a series of transactions.

Gifts that quality for the annual exclusion won’t count against your lifetime estate and gift tax exclusion. The recipient won’t owe any federal taxes on the gift or gifts. You can make these gifts to as many people as you want during the year, with a separate $15,000 tax-free limit on the gifts to each person. A recipient doesn’t need to have any family or other relationship with you.

If you have three children, you can give each of them $15,000, allowing you to remove $45,000 tax-free from your estate. In a married couple, each spouse has a separate $15,000 limit per recipient, or they can make joint gifts of up to $30,000 per recipient. The main restriction on using the annual exclusion is that only gifts of “present interests” qualify for the exclusion. Basically, this means any gifts with strings attached or limits don’t qualify for the tax-free annual exclusion. You have to give full legal title to the property.

An exception is what’s known as the Crummey trust power, named after the court case that first recognized it. A Crummey power allows a trust beneficiary to withdraw a gift from a trust within a certain period after the gift is made. The period usually is at least 30 days.

If Max Profits transfers $15,000 to a trust which his son, Hi, is a beneficiary, the Crummey power allows Hi to cause a distribution of the $15,000 to him if he makes the request within 30 days of the gift. If Hi doesn’t request a distribution, the money stays in the trust and is managed and distributed under the terms of the trust. The Crummey provision allows parents to use the annual gift tax exclusion without giving immature or irresponsible heirs immediate control over the money.

Some in Congress want to eliminate the Crummey provision. Education and medical gifts are the second method of tax-free giving. There’s no limit on the amount of tax-free gifts that can be made for qualified education or medical purposes. To be tax-free, education gifts must pay for direct tuition costs and not for items such as books, supplies, board, lodging, or other fees. The gifts must be made directly to an education institution, not as reimbursements to the student or parents.

The gifts can be made on behalf of any individual, regardless of his or her relationship to you, and for any level of education. Medical gifts also must be made directly to the medical care provider.

Payments for any items that would qualify as deductible itemized medical expenses on an individual income tax return qualify for tax-free medical gifts. Once the annual exclusion and tax-free medical and education gifts are exhausted, you can make additional tax-free gifts using the lifetime estate and gift tax exemption.

The lifetime exemption amount in 2021 is $11.7 million. In a married couple, each spouse has a separate $11.7 million exemption. Any gifts you make during life that exceed the annual exclusion and don’t qualify as tax-free medical and education gifts count against your lifetime exemption.

The lifetime exemption really is set up as a tax cred- it. Gifts that don’t qualify as tax-free under either of the first two methods are taxable gifts. You file a gift tax return and use part of your lifetime credit to eliminate the gift tax.

The credit amount is set to effectively allow up to $11.7 million of lifetime gifts without owing gift taxes. To the extent your lifetime exemption isn’t used by lifetime gifts, the remainder is used to reduce estate taxes. Suppose Max Profits has a $20 million estate and isn’t married.

Over the years, he gave $5 million in lifetime gifts to his son, Hi. Max dies near the end of 2021. His lifetime exemption is down to $6.7 million, because the $5 million in taxable lifetime gifts used part of the lifetime exemption. That means $13.3 million of Max’s estate is subject to federal estate taxes unless he has deductions or other credits to reduce the tax.

As you’re aware, there are proposals in Congress to reduce the lifetime estate and gift tax exemption. Even if none of these proposals is enacted, the current exemption amount is scheduled to be cut in half after 2025 when the 2017 tax law expires.

Because of the likelihood that the lifetime estate and gift tax exemption will be reduced, many estate planners encourage people to consider making gifts in 2021 to use at least some of the current exemption amount while it still is available.

Most estate planners expect that the lifetime exemption that applies in a year a gift is made will determine whether or not it is tax free. Taxes on the estate shouldn’t be increased if the lifetime exemption is lower when the estate is processed than when you made the gifts. Let’s go back to Max Profits and his $20 million estate. He already has made $5 million in lifetime gifts.

Let’s say he makes another $5 million in gifts by the end of 2021. Suppose the lifetime exemption is reduced to $5 million, effective in 2022. If Max dies in 2022, Max’s $10 million estate would be fully taxable, because his lifetime gifts exceeded $5 million.

He has no lifetime estate and gift tax exemption left. Though his lifetime gifts were $10 million, the “extra” $5 million won’t be brought back into his taxable estate and increase it to $15 million, because the exemption amount was higher at the time the gifts were made and they were tax free. There are some in Congress who want to “claw back” taxes on gifts made at the higher exemption amount if the exemption is lower when the estate is processed.

But that idea doesn’t seem to have a high probability of becoming law or being constitutional. There are other ways to reduce tax- es on gifts. These include structuring gifts so they qualify for valuation discounts and using different types of trusts, such as grantor annuity trusts.

There also are proposals in Congress to limit or repeal these strategies. Individuals whose estates exceed the current exemption level also should consider using these strategies while they still are available to reduce estate and gift taxes.