Reducing Estate Tax by Making Gift

NOTE: The federal gift and estate tax is currently slated to be eliminated for 2010 (one year only). Whether the phase-out will be extended to 2011 and beyond is still a hot political question (many pundits believe permanent elimination of the estate tax is an impossibility in this era of record deficits) . For details, read The Estate Tax is Dead.

Unless you expect to pass in 2010 only; you probably want to take steps to reduce possible estate tax liability at your death. One way to avoid estate tax is to give away property during your life. This provides you with more than just tax savings; you also get to see the recipients enjoy your gifts.

Currently, you can make $11,000 gifts of cash or other property each year, to an unlimited number of beneficiaries completely tax-free. To ensure these tax savings, you need remember only that no individual recipient can receive more than $11,000 in a calendar year ($22,000 if from a married couple). If you left the same gifts at your death and they were subject to estate tax, the recipients would see their gifts shrink by at least 39%.

The $11,000 annual tax exemption rule (called the "annual exclusion") is pretty straightforward. For instance, if you give $25,000 to someone, $11,000 of it is exempt from gift tax. The remaining $14,000 is not. A few more examples:

The exclusion amount is indexed for inflation; it rises, in $1,000 increments, as the cost of living does.

Couples: Double Your Exclusion

Couples can combine their annual exclusions, meaning that they can give away $22,000 worth of property tax-free, per year, per recipient. In fact, even if only one spouse makes a gift, it's considered to have been made by both spouses if they both consent. (IRC ξ 2513.) If you and your spouse give to another couple, you can transfer up to $44,000 tax-free each year.

Example

Hansel and Gretel, a couple in their late 70s, want to give their son and his wife money for a down payment on a house. They also see this as an opportunity to shrink the estate tax bill that their son -- who will inherit everything -- will eventually have to pay.

Both Hansel and Gretel take advantage of their $11,000 exemptions to give a total of $22,000 to their son and another $22,000 to his wife. As soon as the first of the year rolls around, they can give away another $44,000 if they're still feeling generous.

Gifts to Your Spouse

All gifts you make to your spouse are tax-free, as long as he or she is a U.S. citizen. If your spouse isn't a citizen, the limit on tax-free gifts is currently $112,000 per year. (Internal Revenue Code 2523(a).

There's seldom a reason to make large gifts to your spouse. If you each own about the same amount of property, you could worsen your tax situation by saddling your spouse with an estate that's so large it will be taxed at his or her death.

Using the annual exclusion repeatedly over a number of years can greatly reduce the size of your estate -- and your ultimate estate tax bill. Let's say you give $7,000 each to your two children, three years in a row; the $42,000 is not subject to gift tax. Nor would it be subject to any eventual estate tax when you die. If you give $10,000 per year to one person for five years, you've given away $50,000 tax-free. (If you gave the same $50,000 to the same person in one year, you would get only one $11,000 exemption; $39,000 would be subject to tax.)

Timing Your Gifts

To make the most of the annual exemption, keep in mind that it is based on a calendar year. If you miss a year, you can't go back and claim that year's exemption amount. But if you spread a large gift over two or more years, you may escape gift tax complications. For instance, if you give your daughter $20,000 on December 17, $9,000 of it is taxable. You'll have to file a gift tax return (by April 15 of the next year), and you'll use up $9,000 of the total amount you can give away or leave free from estate tax. But if you give your daughter $10,000 in December and wait to hand over the other $10,000 until January 1, both gifts are tax-free.

Giving Away Non-Cash Property

Not only gifts of cash can be spread over several years. You can give away some stocks now, some next year. You can even give real estate in pieces -- physical pieces, if that's possible, or pieces (percentages) of ownership.

Example

George and his wife Barbara want to give their vacation cabin to their son George W. The cabin has a fair market value of $75,000, but their equity is only $40,000 because there is still $35,000 left on the mortgage. In November, George and Barbara sign a deed transferring the cabin to Barbara and George W. as joint tenants, meaning that Barbara and her son, George W., each own a 1/2 interest in the property. (George gave George Jr. his $20,000 share of the equity in the cabin.) George Jr.'s gift from his parents is tax-free, because together they can give him up to $22,000 tax-free each calendar year.

The next calendar year, Barbara gives her half-share, worth $20,000, to her son, George W. Even though only Barbara makes the gift, the IRS considers it, for tax purposes, to have come from both spouses. George W. now owns 100% of the vacation cabin.

Giving children valuable property before they are adults raises the important question of who will manage the property for the child. If you give a large gift to a child under 18, an adult must be responsible for the money.

Fortunately, it's easy to arrange for an adult to manage the property, by setting up either:

The second way, a custodianship, is easier: You simply name an adult to serve as "custodian" of the money.

Custodianships

Custodianships are authorized under a law called the Uniform Transfers to Minors Act (UTMA), or the Uniform Gifts to Minors Act, one of which has been adopted by every state. All you need to do is appoint a custodian, in writing, and give the property to that person, instead of to the child directly. To learn more about naming a property manager, see Leaving Property to Young Children.

The custodian must manage and use the money for the benefit of the child. When the child reaches adulthood (defined as age 21 in most states), he or she gets whatever's left.

To qualify for the annual exclusion from gift tax, a gift to a minor must satisfy these conditions:

The recipient must receive the property outright by age 21. This means that if you set up a custodianship for your child, it must end when the recipient turns 21. That said, the property and its income may of course be spent by, or for the benefit of, a recipient who isn't 21 yet. Similarly, if you create a trust for the child, the trust document must state that the property will be turned over to the recipient by his or her 21st birthday. (But you may also give the recipient the right to extend the trust.)
If the recipient dies before age 21, the remaining property must go to the recipient's estate or to someone the recipient named -- for example, in a will. (IRC 2503(c).

Example 1

Bill gives a thoroughbred horse worth $30,000 to his daughter Chelsea, age 16, who loves horses. Bill makes the gift under his state's UTMA, which requires the horse to be legally turned over to Chelsea when she becomes 21 -- which is fine with Bill. Bill names Chelsea's mother, Hillary, as custodian for the gift. They all know that this is only technical, since Chelsea will be, and wants to be, responsible for the horse.

The first $11,000 of Bill's gift is free of gift tax. He is assessed gift tax on the remaining $19,000.

Example 2

Jane wants to be certain that her grandchildren Ann, 12, and Ben., 10, will have money for college. Jane wants to make the gift now, so that her grandchildren will know their educational future is secure.

To qualify for the annual gift tax exclusion, the money must be turned over to the kids when they reach 21. Jane names their father as custodian for a $10,000 gift to each child, and specifies that the custodianships end at age 21.

She transfers some more money to a trust for each grandchild, to last until the grandchild is 30. She names their father as trustee. Jane realizes that by doing this, she will not obtain the annual gift tax exclusion for any money she gives to the trust, because neither child will receive the money outright by age 21. But her concern about giving a 21-year-old a big bundle of money overrides any consideration of tax savings.

(If Jane were in good health and her grandchildren were a little older, she might just wait until they enter college, and pay their tuition directly; that's also a tax-free gift.)

An ambitious program of gift-giving is not for everyone. If parting with assets makes you feel vulnerable, fearful that you will someday be without money you need, don't do it. Or you may decide that your children or grandchildren are not ready yet to appreciate your generosity. But helping a 21-year-old get an education, or the head of a new family buy a house, can give you great satisfaction.

One reason that planned gift-giving has gained in popularity is that people live so much longer than they used to. If you wait until you die to transfer your wealth, the recipients -- for most people, their children -- may be nearing old age themselves. Your financial help will probably be more useful when they are younger.