Wise Estate Planning Ways to Make Family Gifts

We’re entering the traditional gift-giving season. The tax rules still are important. Too many people believe that with the estate tax exemption set at $5 million per person, they don’t need to worry about shrewd, tax-wise ways to give wealth. (The exemption is indexed for inflation; it is $5.25 million in 2013.) They couldn’t be more wrong and their Estate Planning could suffer.

Of course, Congress always can change the law, and your wealth could grow faster than expected and create a taxable estate. More importantly, paying attention to the income tax effects of gifts is critical. Giving the wrong way can cost your family a bundle in unnecessary taxes. Here’s another point to keep in mind. Even when your gifts aren’t taxable, you still are responsible for filing a gift tax return in many cases. See the box on page 2 for details.

Following the best giving strategies is important whether you’re in a position to give away $5 million or an amount with substantially fewer zeroes.

The basics.

Your lifetime gift tax exemption is the same amount as your lifetime estate tax exemption, $5 million indexed for inflation or $5.25 million in 2013. But each dollar of the lifetime gift tax exemption that you use reduces your estate tax exemption.

Not all gifts are potentially taxable or use the lifetime exemption. The most important exemption for many people is the annual gift tax exclusion. This also is indexed for inflation. In 2013 you can give up to $14,000 of cash or property per recipient and not have it count toward the lifetime exemption. A married couple can give up to $28,000 in joint gifts in 2013. You have a separate annual exemption for each person to whom you give. A married couple with three children can jointly give each of the kids $28,000 in 2013, or a total of $84,000, tax free and without reducing their lifetime exemptions. This exclusion starts fresh each year, though you can’t carry forward unused amounts from previous years.

There also are opportunities to give unlimited tax-free gifts when you help someone with medical and education expenses. To qualify, you must pay the provider of the services directly. The medical expenses must meet the definition of deductible medical expenses. Qualified education expenses are direct tuition only. Not qualified are room, board, books, fees, and other expenses. You can find the detailed qualifications in the instructions to Form 709 available free at www.irs.gov

Gifts that exceed the annual exclusion amount to a person begin to reduce the lifetime exemption. Only after the lifetime exemption is exhausted are gifts taxable.

Estate Planning Strategy #1

Give early. The traditional gift-giving season is around the end of the year. That’s partly because it is the holiday season and partly because it is the end of the calendar year and people are wrapping up their finances for the year.

I’m not discouraging you from making year-end gifts this year, but consider doing next year’s giving earlier in the year. One advantage of early gifts is that any of the appreciation for the year is out of your estate. Also, by giving assets before they appreciate for the year, you are increasing the amount of property and future wealth you give tax-free. Suppose a mutual fund is priced at $20 per share on Jan. 15 and $25 on Dec. 31. With a $14,000 annual gift tax exclusion you can give a loved one 700 shares on Jan. 15 but only 560 on Dec. 31. When you compound the future appreciation of those shares over years, you moved a lot of future value out of your estate by giving early in the year.

Gifts early in the year also remove from your income tax return any income generated by the investment during the year. The whole family benefits when you use this strategy to shift income to a lower-tax-bracket family member.

An alternative is to make gifts of investment property during a market downturn instead of by the calendar. You probably think about making portfolio changes when the market moves, trying to buy low and sell high. Also consider making gifts after prices drop. You can give away far more shares of property when the price is down, so market panics are a good time to make gifts.

Estate Planning Strategy #2

Give more. Most people want to give only the annual exclusion amount. But if you own appreciating assets, it makes sense to give more of them now to the extent you can live without them. Remember the lifetime estate and gift tax exemption is indexed only for the Consumer Price Index. If your assets are appreciating faster than that and your estate value is at or close to the lifetime exempt amount, you’re losing ground. Eventually your estate will be more valuable than the exemption and the annual exclusion won’t be enough to keep significant wealth from being taxed.

In those cases, it makes sense to use the exempt amount with gifts. Put appreciating assets in the hands of loved ones early. You don’t have to give them direct control. Assets can be removed from your estate using trusts, limited partnerships, and other vehicles.

Estate Planning Strategy #3

Give property you expect to appreciate. Too many people make cash gifts with their annual exclusion. When your goals are to establish a legacy, provide for loved ones, and reduce estate and gift taxes over the long-term, there’s a better approach.

Give property you expect to appreciate over time. By giving the property now, you are removing all the future value from your estate tax free. You are transferring that future value to your loved ones. The appreciation and future value are what will provide financial security for them.

Cash is very likely to be spent, not invested. Giving appreciating assets might discourage some loved ones from selling them and spending the proceeds. As I said earlier, you can give through trusts, partnerships, and other vehicles to reduce the chance donees will sell the assets.

Estate Planning Strategy #4

Retain property with big gains. Most of the time you don’t want to give property in which you’ve earned big gains. When you give appreciated property, the recipient’s tax basis is the same basis you had in the property. The recipient will owe capital gains taxes on all the appreciation that occurred during your lifetime when he or she sells it, because capital gains are paid on the price received for property minus its tax basis.

When the recipient is in the 0% capital gains tax bracket, the gift of appreciated property can be a good idea. Otherwise, it is better to hold the asset for your estate. The person who inherits it can increase the basis to the current fair market value. All the appreciation during your lifetime won’t be subject to capital gains taxes.

Ideally, you want to give property you expect to appreciate but that hasn’t appreciated substantially in your hands.

Estate Planning Strategy #5

Keep loss property. It’s almost always a mistake to give property that’s declined below its tax basis. The donee’s basis in the property would be the lower of the current value and your basis in it. So, when you give loss property, the donee’s basis will be the current fair market value and no one will deduct the loss that occurred while you held it.

It’s better for you to sell the property, deduct the loss on your tax return, and give the cash proceeds. Or find other property to give.

Estate Planning Strategy #6

Consider income taxes. Fewer estates are subject to the estate tax, and income taxes are a bigger expense to many people. That’s why you should consider income taxes and capital gains taxes in your giving strategies. Consider giving to loved ones assets that generate ordinary income that you don’t need to maintain your standard of living, if those loved ones are in lower tax brackets. Reducing the income taxes that are extracted from you now will leave more wealth available to your loved ones.

When you make gifts to minors, pay attention to the Kiddie Tax. It was tightened a few years ago, so in more cases investment income earned by minors will be taxed at their parents’ highest tax rate. Generally, the Kiddie Tax kicks in when a child’s investment income exceeds $1,900 for the year and the child was under age 19 (or under 24 if a full-time college student). It doesn’t matter if the parents claim the child as a dependent. You can find details about the Kiddie Tax in IRS Publications 17 and 929 and in the instructions to Form 8615 available free at www.irs.gov.

Maximize trust gifts.

A gift to a trust qualifies for the annual exemption if the gift is direct and immediate. To meet these requirements, the trust should have a Crummey clause, which gives the beneficiary the right to withdraw the gift from the trust. A beneficiary must be aware of the withdrawal right. The right to withdraw can expire after a period of time, such as 60 days. If the gift is not withdrawn in the time period, it stays in the trust and is subject to its limits. Of course, if a beneficiary does withdraw a gift from a trust, there is no obligation to make future gifts.

A gift to a trust with a valid Crummey clause qualifies for the annual gift tax exclusion. It removes the property from your estate, but it does not give the beneficiary unfettered control of and access to the wealth. Once the right to withdraw the gift expires, the property is subject to the terms of the trust. You can use trusts to remove property from your estate, provide income to beneficiaries, but impose some restrictions and professional management on the property.

Estate Planning Strategy #7

Add contingent beneficiaries. The annual gift tax exemption amount can be contributed for each beneficiary of a trust. If there are three beneficiaries, $42,000 can be contributed tax free when the trust has a Crummey clause. Contingent beneficiaries also increase the tax free gifts when the trust is properly drafted. For example, your children can be the main beneficiaries of the trust and the grandchildren contingent beneficiaries. You can make gifts that qualify for the annual exclusion for each of the grandchildren. Your estate planning advisor should know how the trust must be written for contingent beneficiaries to increase the annual exempt amount.

Estate Planning Strategy #8

Make discounted gifts. A discounted gift is one in which the value of the property for tax purposes is less than the current value of the property. The value is discounted because there are some restrictions or defects that reduce the value to the beneficiary.

For example, you can transfer real estate or shares of a business to a limited partnership and give your children limited partnership interests. The value of the limited partnership interests will be less than a pro rate share of the property in the LP, because there isn’t a ready market for the ownership interests and the limited partners are minority owners with restricted influence and control over management. Discounted values often are 20% or more, depending on the details of the arrangement.

Discounted gifts can be made through some trusts, limited partnerships, corporations, and other vehicles. Work with your estate planning advisor to devise the best strategy for you.

RW November 2013.