Tax-Free Gifts
The following is adapted from an article by attorney Adam H. Crow of the Rose Law Firm, a Professional Association (used by permission). Mr. Crow can be reached at 501-377-0423.
Individuals who make gifts often take advantage of the "annual exclusion" from the federal gift tax or the related exclusion for the payment of certain education and medical expenses. This article summarizes some of the main issues involved with such tax-free gifts.
The federal gift/estate tax exemption for 2014 is $5,340,000. An individual can make gifts in an amount equal to his exemption without paying federal gift tax. Any gifts in excess of the exemption are subject to a 40% gift tax.
The use of the exemption during life reduces the amount of assets that a donor can transfer free of estate tax at death. For that reason, tax-free gifts that do not utilize a donor's exemption continue to be important.
Annual Exclusion Gifts.
The annual exclusion amount for 2014 is $14,000 per recipient. Married donors can each make a $14,000 gift to a recipient. Alternatively, one spouse can make a $28,000 gift to someone and elect on a gift tax return to split gifts with the other spouse.
There is no limit on the number of persons to whom you make annual exclusion gifts. Therefore, married couples who wished to gift to five family members could make $140,000 of such gifts in 2014 without using any estate/gift tax exemption.
Some common methods of making annual exclusion and other tax-free gifts are:
- Outright Gifts. Outright gifts are popular due to simplicity. They work well when the gift consists of cash or publicly-traded stock and the recipient is an adult. Using a trust or other entity might be preferred if the recipient is a minor or if the gift is a fractional ownership in real estate or an interest in a closely held business.
- Custodial Accounts.
Gifts made to a custodial account for a minor can be managed by a custodian until the minor reaches the age of 18 or 21, depending on applicable law.
The custodian appointed by the donor is in control of the account and determines when and why distributions are made to the minor. However, the minor obtains total control over the assets upon reaching the age of 18 or 21.
The donor should not serve as custodian if estate tax savings are important. Doing so could cause the assets of the account to be included in the donor's estate for estate tax purposes.
- 529 Plans.
Many families use 529 Plans to save for college, since earnings from assets held in them are not subject to income tax and distributions are not taxable if used for qualifying educational expenses.
A donor can transfer funds to a 529 Plan equal to five times the annual exclusion amount ($70,000 in 2014) and elect on a gift tax return to treat that single transfer as annual exclusion gifts made over a five year period. - Irrevocable Trusts.
A donor may decide for various reasons to use an irrevocable trust.
Common reasons are to receive a significant gift or multiple years of annual exclusion gifts, to receive gifts expected to appreciate in value, to provide management beyond the beneficiary's 18th or 21st birthday, or to provide creditor or spousal protection.When established, the donor determines when the trust assets will be distributed to or for the benefit of the beneficiary. The trustee can be given discretion over distributions, or the trust can direct that distributions be made at a certain time or upon certain events.
The trust remains in existence until an event specified in the trust, which often is when the beneficiary reaches a certain age. In some cases the trust remains in existence for the beneficiary's lifetime.
A beneficiary of an irrevocable trust is often given a temporary withdrawal right over gifts to the trust to qualify those gifts for the annual exclusion.
- Exclusion for Education and Medical Expenses.
Tuition paid on behalf of an individual to certain qualified educational organizations is exempt from the federal gift tax. Only tuition qualifies and it must be paid directly to the educational organization.
A qualified educational organization can include a primary, secondary, preparatory and high school, and also includes colleges and universities.
Amounts paid on behalf of someone directly to the provider of certain medical care are also exempt from gift tax. The exemption does not apply to reimbursements of amounts previously paid by an individual and nor to amounts reimbursed by insurance.
- Generation-Skipping Transfer Tax.
Donors making gifts that are generation-skipping transfers (GST) should determine whether the GST tax will apply. Generally, GSTs are those made to or for the benefit of grandchildren or other recipients that are more than one generation younger than the transferor.
It is possible for gifts to qualify for the gift tax annual exclusion but not qualify for the GST tax annual exclusion.
Each strategy above has advantages and disadvantages, and the right approach depends on which factors are most important to the donor.
