Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
We've had a number of questions concerning the basic gift tax rules and, based on the questions, there are a lot of misconceptions. In this article we'll deal with the basics about giving gifts to relatives, friends, etc. As always, things can get much more complicated and, if you're making a large gift or trying a unique approach, you should get professional advice.
The discussion below involves only the current rules. Over the years there have been a number of changes in the gift and estate tax rules that makes some of the discussion inapplicable to older gifts. You should also be aware that there is a considerable impetus to eliminate the estate tax. You should remain flexible in any planning.
For federal purposes the gift and estate taxes are unified. In other words, you can't save on estate taxes by giving your fortune away before you die. Once you're above the exemption amount (discussed below) $1 of gifts reduce your estate tax exemption by $1. The exemption amount is currently $$5,340,000 ($5,430,000 in 2015; adjusted for inflation) for a single individual. An individual can use his spouse's unused exemption amount, effectively doubling that for a couple. In the discussions below we'll use a $5 million exemption in the examples to keep things simple. For example, Fred is single but has a favorite nephew. Fred's net worth is $6 million. He gives $5 million to his nephew free of the gift tax. But two years later he dies with a $1 million estate. He's used up his exemption so the estate pays tax at 40% on the $1 million. The tax result is the same as if he had given the entire $6 million to his nephew on his death. (Ignoring the annual gift exclusion, etc.)
Well, clearly it's more complicated. Even calculating the tax can be complicated for a number of reasons. There are a number of differences between making gifts and leaving assets in your will. We'll deal with the most frequently encountered below. Keep in mind that a number of states have gift and estate taxes. Some of them are structured the same way, some are not. In some cases the exemption is lower than the federal and the rates are high enough that the tax consequences cannot be ignored.
You can't claim a deduction on your income tax return for gifts to your children, relatives, etc. On the other hand, the recipient is not generally liable for income taxes on the amounts received.
The most frequent question we hear is "I know I can give away $10,000 (or $12,000) a year without paying a gift tax". The law has contained an annual exemption amount for many years. The way it works is simple. Let's say you give $9,000 to your favorite niece in 2015. The $9,000 does not affect your $5 million estate tax exemption.
The second point here is that the annual exclusion was $10,000 some time ago, but the amount has changed and it's indexed annually for inflation (though rounded to $1,000 so it can remain static for several years). For 2014 and 2015 the exclusion is $14,000.
The $14,000 exemption is an annual one and applies to each donee. Thus, Sue can give $14,000 tax free to each of her 10 children (each year), or $140,000, without impacting her estate exemption. Over a 10-year period she could give away $1.4 million. Her husband, Fred, could do likewise, giving an additional $14,000 annually to each child.
What if Sue controls all the money? She takes care of all the family finances and all the bank accounts are solely in her name. Sue and Fred could elect to "split" any gifts. Thus, Sue writes a check for $28,000, but Sue and Fred are each deemed to give $14,000 if the election is made. The election is made on a gift tax return (Form 709). Thus, even if you don't go over the $14,000 threshold, if you elect to split a gift, you'll need to file a gift tax return. If it's just as easy for Fred to ask Sue to deposit $14,000 in his personal checking account, both could write $14,000 checks and avoid filing a return.
The exclusion applies to each donee and expires at the end of each year. Once the year is over, you've lost a chance to reduce your estate tax by $14,000. That's why year-end gifts can be important.
Usually we think of making gifts to our children, or close relatives. But the gift tax isn't limited to that. Your college friend from 20 years ago has a talented child that could go on to become a professional musician but needs funds to live on. A gift here is the same as one to your children, at least from a gift tax standpoint.
The exclusion applies to an unlimited number of donees. But there's a prohibition against reciprocal gifts. For example, Ken and Keith are brothers and each have two children. Ken can give $14,000 to each of his two children and $14,000 to each of Keith's two children. But if Keith reciprocates, the exclusion can be denied. On the other hand, Sue and Sharon are sisters and both doctors. Sue is a neurosurgeon who makes over $800,000 a year. Sharon is a tropical medicine specialists who volunteers in Africa. Sue gives $14,000 annually to Sharon's daughter, but Sharon does not reciprocate. The exclusion applies.
No gift taxes apply to gifts to political organizations.
Keep in mind that a gift is a transfer where no consideration is received. Because your business was short-staffed your secretary worked long hours during the year so you gave her a check for $10,000 in late December. That would probably be considered a bonus and fully taxable. On the other hand, your secretary and wife have been friends for years. Your wife became ill and your secretary, without being asked, took her to the doctors, stayed with her after an operation, etc. and you gave her $10,000. That could be considered a gift. The facts are important here. Get professional advice.
Gifts of cash or property to your spouse are not considered gifts for gift tax purposes. Put another way, there's an unlimited exclusion. For example, you inherit a small office building worth $750,000 from your parents. The attorney titles it in your name. The following year you get married and retitle the property in both your names. There are no gift tax consequences. However, if your spouse is not a U.S. citizen and the total gifts exceed $145,000 (for 2014; $147,000 for 2015), you need to file a gift tax return.
There are some gifts (certain terminable interests) to a spouse that require the filing of a return.
Same-sex couples who are legally married in a state that recognizes such unions qualify for the unlimited exclusion, even if they move to a state that does not recognize such marriages.
Medical, Tuition Exclusion
Amounts you pay for qualified medical or tuition expenses are excluded from gift taxes, no matter what the amount. There are two requirements. First, the expense must be qualified. For medical expenses, they must meet the requirements for a deduction. Thus, amounts paid for cosmetic surgery generally don't qualify. In the case of education expenses, the payment must be made to a qualifying domestic or foreign educational organization for tuition. College tuition qualifies, horseback riding lessons don't. The second requirement is that the amount must be paid directly to the provider--doctor, hospital, etc. for medical expenses; college, school, etc. for education. You can't cut a check to your daughter so she can pay for her tuition.
While contributions to 529 plans are subject to the $14,000 exclusion, you can make a lump-sum payment and treat it as made ratable over a 5-year period. For example, you can write a check to the plan for $70,000 and treat it as made $14,000 annually for 5 years.
If you don't make any gifts that exceed $14,000, you generally don't have to file a return. A gift can be cash, marketable securities or property. For marketable securities you'll have to list how you calculated the value. For other property you'll need a qualified appraisal. Giving your son that classic Camaro? You'll need more than a handwritten note from the guy down the street who rebuilds old cars in his spare time. Depending on the property an appraisal might be costly. And the appraisal must be attached to the return. For that, and several other reasons, you might want to just give cash. But there can be advantages to property. See below.
Failure to file a return or to disclose all required information will keep the statute of limitations open. If a valuation question is involved, convincing the IRS of the value you claimed could be difficult years down the road. In addition, there are penalties for willful failure to file and substantial understatement (e.g., undervaluing the property subject to an appraisal).
Loan vs. Gift--Documentation
Is it a loan or a gift? There can be very different tax implications. A loan has to be repaid, a gift doesn't. If you intend a loan make sure you document it by drafting a formal promissory note. It needn't be unduly complex, but it should state the names of the parties, the amount, an interest rate equal to at least the Applicable Federal Rate, and a fixed maturity date. Repayment should not be dependent on some factor such as the profits of a business. It helps to have a repayment schedule and collateral. And you should adhere to the terms of the note. (Talk to your tax adviser or attorney.)
If either the donor or donee has a business, documentation of the loan or gift and repayments is important. Canceled checks on both sides of the transaction should be retained. Why? If audited, the IRS could claim the receipt of funds by one party was additional income. For example, Fred gifts his son $10,000 to help out his business. On audit the IRS could claim the $10,000 was additional income unless the son can prove otherwise. The same could be true of a loan, but there could be a challenge going both ways.
Gifts to Minors
A gift to a minor is considered a present interest and qualifies for the $14,000 exclusion if all of the following conditions are met:
Basis in Property Received
There's a big difference in the recipient's basis in the property if the transfer is a gift versus an inheritance. A donee's basis in the property is the same as the donor's basis for gain, but the lesser of the donor's basis or the fair market value of the property at the time of the gift for loss. If an individual inherits property, the basis is the fair market value at the date of death of the transferor for gain or loss.
Example 1--Fred bought Madison Tech Inc. at $1 a share in 1994. His total investment was $10,000. The stock is now worth $2 million. Fred has substantial assets and gives his entire holdings to his daughter, Sue, who sells the stock the next day for $2 million. She has to report a long-term capital gain of $1,990,000.
Example 2--The facts are the same as in Example 1, but Fred wills the stock to his daughter. On his death the stock is valued at $2 million. She sells it the next day for $2 million and reports no gain.The differences in basis will make a big difference in what assets should be gifted or left in your estate and the timing of any transfer. For example, Fred inherited a lake house from his parents that has been in the family for years. The house is not only valuable monetarily ($500,000), it has sentimental value. Fred's basis is $150,000. Fred's been single for years and will have a taxable estate. Fred's two children, Sue and Sharon, both enjoy the property as do their children. Sue and Sharon have always been on good terms and want to keep the property. Because of the lake's location and a low turnover of properties, prices have been climbing at more than 12% per year. Fred's in good health. It's not unreasonable to assume that the property could double in value before he passes. Gifting the property now would keep at least $500,000 (the additional increase in value) out of his estate. Moreover, the stepped-up basis on an inherited property doesn't mean much here because the beneficiaries have no intent to sell the property.
If you own a business or have income-producing assets such as rental properties, etc., talk to your tax advisor concerning your options.
The more complicated your assets, the more planning opportunities and the more complex those opportunities become. While there are steps you can take if your family assets consist only of a personal residence, vacation home, and $10 million in marketable securities, your options increase if your assets consist of one or more active businesses, rental properties, farm or timber land, etc. Planning here involves tradeoffs and analysis of both the estate tax and income tax implications of any action.
Other planning options include a family limited partnership, other methods of gifting property at a discount because of minority interests or other restrictions, basis in business ownership (S corporation, partnerships, LLCs, etc.), passive activity losses associated with business ownership, special trusts including charitable trusts, and the generation-skipping transfer tax.
Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/08/14