Can’t I Just Give It Away?

Part 1: Types of Gifts

Throughout our lives, many of us desire to divest part of our estate to others.  There are variety of reasons for doing so including tax avoidance, protection against long term care costs, charitable inclination, and the mere desire to make family members and friends happy.  However, there are often certain perils in giving away assets including capital gains taxes, income taxes from deferred assets, gift taxes, loss of government benefits and economic issues facing a gift recipient.  A complicating factor in making gifts is that the laws affecting gifting and government benefits are inconsistent.  Thus, one must obtain prudent advice before making significant gifts.

One of the first principles to understand is how much can be given away during lifetime.  There are seven primary types of gifts: (1) annual exclusion gifts, (2) lifetime exemption gifts, (3) leveraged gifts of present interest, (4) leveraged gifts of a future interest, (5) gifts with a retained interest, (6) charitable gifts, and (7) gifts between spouses.  There are certain nuances in making many of these types of gifts.

The most popular gift, over the years, has been the annual exclusion gift.  Still commonly referred to as the “$10,000 gift”, it is actually a law that allows individuals to make gifts of $14,000 per person per year.  This type of gift can be given to as many different people as the donor wishes.  There are three exceptions or nuances to this rule.  First, a donor may fund a 529 plan up to five years at a time.  Thus, the donor can fund a plan with $70,000 in year one rather than spread it out over five years.  This allows a donor to not only relieve his or her estate of the principal given but all the income which would have been generated on that principal as well.  Second, payments for education may be made in any amount so long as they are made payable to the institution directly.  Third, payments for medical expenses are exempt so long as they are made to the medical provider and to the extent said expenses are not reimbursed by insurance.

The lifetime exemption gift is a provision which allows an individual may leave an additional $5,450,000, in the aggregate, to others during his or her lifetime.  These gifts arguably require the filing of a gift tax return on the 15^th of April in the following year in which they were made.  For example, if I made a single gift to my daughter of $64,000 to help her buy a home, $14,000 would be my annual exclusion gift and $50,000 would be reduced from my lifetime exemption.  So upon my death, I would only be able to leave $5,400,000 tax free.  However, I would not have to pay a gift tax now.

The third gift is what is called a leveraged gift of a present interest.  Historically, the most common gift of this type was a limited interest in a family limited partnership.  For example, if a father owned a farm, he or she would transfer the ownership of same into a partnership.  The father would become a general partner which would mean he would control the farm until he died if he wanted to do so.  He could transfer almost all of his economic interest in the farm to his children as limited partners.  Limited partnership would give the children an immediate interest as owners.  However, because they have no control over the business and cannot typically sell their interests while their father is alive, the government recognizes the argument that the value of the gift is not the same as a simple gift of cash with no strings attached.  As such, for example, if the father gave away, $600,000 of limited partnership interests to his children, the gift may be able to be discounted by 20%, or $120,000.  Thus, the countable part of the gift, for tax purposes, would only be $480,000.  The benefit of this gift is that the discounted portion escapes the donor’s estate gift tax free.  Similar gifts can be set up in limited liability companies and closely held corporations.

The fourth gift is what is called a leveraged gift of a future interest.   This gift is similar to the leveraged present interest gift in that it allows a discount to be taken on the value of actual gift made.  The typical structures used for these are Qualified Personal Residence Trusts (QPRTs), Grantor Retained Annuity Trusts, (GRATs), and Grantor Retained Uni Trusts (GRUTs).  For example, in a QPRT, a mother could give away her beach house to a trust.  By retaining the right to live there for a period of years after the gift, the value of the gift can be discounted as there is an economic value to that right and because the children do not receive the right of ownership until the future (i.e. the expiration of the period that the mother can live in the property).

The last three gifts are pretty straightforward.  A gift of a present interest in which a donor retains a right to the property occurs most typically in conveyances of real property in which a parent gives away a home to his or her children, but retains a life estate (i.e. the ability to live in the property until death).   Gifts between spouses are generally unlimited without gift tax consequences, thus being exempt from the annual exclusion and lifetime exemption rules.  Many gifts from charities are likewise exempt without limitation.

The next part of this article will explore other areas of gifting including capital gains and income tax ramifications.