In 2010, the gift tax lifetime exemption rose from $1 million to $5 million. For many of us, that exemption means that we will likely never have to pay gift tax. But there is no guarantee that the exemption will remain that high, and even if no gift tax is due, many transfers require the filing of a gift tax return. This article describes transfers that can be made without using your lifetime exemption and without having to file gift tax returns.
The gift tax generally applies to transfers in which the donor transfers value without receiving full value in return. Some transfers, although classified as taxable gifts and requiring a gift tax return, do not result in gift tax being due—for example, transfers that do not exceed the lifetime exclusion amount (currently $5 million) and most transfers to a spouse.
Specific types of gifts are excluded from the definition of taxable gifts. These gifts, regardless of the recipient, do not use any of the donor’s exclusion, do not result in gift tax, and, if they are the only gifts made in any calendar year, do not require the filing of a gift tax return. These exclusions allow us not to worry about gift tax on routine small gifts and can be valuable estate planning tools.
Imagine a couple with a potentially taxable estate who has three children and five grandchildren. Without the imposition of any gift tax and without filing any gift tax returns, they can: (1) give away $208,000 each year by making annual exclusion gifts to their children and grandchildren (more if they make gifts to their children’s spouses); (2) pay the tuition for all five grandchildren if they attend private elementary or high schools; (3) pay the grandchildren’s college tuition; (4) pay the medical expenses of all family members; and (5) purchase health insurance for all family members. These steps are simple and, when done consistently over time, can substantially reduce our imaginary couple’s taxable estates. These transfers are described below.
The first of the excluded transfers is commonly referred to as the “annual exclusion gift.” Each individual is allowed to give to another individual gifts up to $13,000 a year completely tax-free. Thus, a married couple can give $26,000 annually. (This $13,000 figure is indexed for inflation, so it may increase for future years.) There is no limit on the number of individuals to whom these gifts can be made.
To qualify for the annual exclusion, a gift must be one of a “present interest.” In simple terms, this means that the person receiving the gift must be able to enjoy the gift immediately. A direct gift to an individual clearly meets this qualification, but sometimes a direct gift is not appropriate, either because of the donee’s age or because of other circumstances. Most gifts to trusts do not qualify as a present interest, but a trust will qualify if the beneficiary has the right, even for a limited time, to take the gift out of the trust. Trusts with such provisions are referred to as “Crummey trusts”—named after the case that first approved of this technique. A gift to a minor may be made to a custodial account set up under state law with the child being entitled to outright distribution of the account once the child reaches a certain age (usually 21 or 25). One should carefully consider whether it is wise to make annual gifts to a custodial account—if the gifts are made annually, with growth, the amount that the child is entitled to receive outright at the termination of the custodial account may be substantially more than is advisable for a young adult to control.
The second type of transfer that does not consist of taxable gifts (and is not part of the $13,000 annual exemption) is the payment of educational and health care expenses. To qualify, these payments must be made directly to the service providers. The educational expense exemption is limited to tuition and does not apply to payments for nontuition items, such as books, supplies, and room and board. Medical expenses that can be paid without gift tax include medical care of the type that is deductible for income tax purposes, transportation primarily to obtain medical care, and the purchase of health insurance.
The transfer tax system is complex, and substantial effort is often required to transfer assets without paying transfer taxes, whether gift or estate. The gifts described above are simple, require little planning, require no returns, and, if done consistently over time, can transfer a large amount of wealth without paying gift or estate tax.