As discussed in the Firm’s previous newsletter, Congress passed legislation in December, 2010, (the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010”) that significantly impacts current federal tax law. One of the new law’s most important features is a provision that grants an increase in what is known as the “lifetime gift tax exemption” from $1,000,000 to $5,000,000 per person, and up to $10,000,000 per married couple. This $5,000,000 per person gift tax exemption presents historically unprecedented opportunities to make tax-free transfers of wealth, though the window of opportunity is limited: by its terms, the new federal law will “sunset” on December 31, 2012, and the lifetime gift tax exemption is likely to be substantially reduced at that time.
Many of the Firm’s clients and friends may hesitate to take advantage of the unique gift-giving opportunity now available due to confusion, or lack of knowledge, of underlying gift tax law concepts. This Article is intended to provide a basic understanding of state and federal gift tax rules so you may be better equipped to determine whether gift-giving makes sense for you and your family. If you would like to further explore gift-giving opportunities, please contact Thomas Pillari, David C. Wiersma, John D. Frankel, Thomas E. Stuckart III, or Timothy J. Pillari in the Firm’s Probate & Estate Planning Department.
What Is a “Taxable” Gift?
Only certain gifts are deemed “taxable” for federal tax purposes. Gifts of up to $13,000 per donor, per year, per donee are excluded from federal gift taxation, provided that the transfer is of a present interest, not a future interest. That is, the gift must enable the donee to have present possession of our dominion over the transferred asset. (An example of a gift of a future interest is the transfer of an asset to a trust that only provides for future distributions to a trust beneficiary.) If a gift of a future interest is made, the $13,000 annual exclusion does not apply, and the entire amount of the gift is “taxable.” A donor can make annual tax-free gifts of $13,000 or less to an unlimited number of donees.
Certain “qualified transfers” of any dollar amount are also exempt from federal gift taxation. Qualified transfers include the payment of tuition to an educational organization (provided the payment is made directly to the educational organization) and payments of medical expenses on another’s behalf. In addition, gifts to or for the benefit of a tax-exempt charitable organization are not taxable. Likewise, present interest gifts to one’s spouse are not taxable (provided one’s spouse is a U.S. citizen; special rules apply for gifts to spouses that are not U.S. citizens).
A concept known as “gift-splitting” enables married couples to increase the amount of the $13,000 annual exclusion. If a married donor gives a gift in excess of $13,000, the donor and his or her spouse can elect to “split” responsibility for the gift (provided that the spouses elect to split all gifts made during the calendar year), such that half of the gift is deemed to come from one spouse, and half from the other spouse. This enables each spouse to use some or all of his or her $13,000 per donee annual exclusion, resulting in a total possible annual exclusion of $26,000 per donee. In order to split responsibility for a gift, a federal gift tax return (on IRS Form 709) should be filed by April 15 in the year following the year the gift was made. Married couples should consider this “gift-splitting” opportunity for any gifts in excess of the $13,000 per donor, per donee annual exclusion.
Any gift (or set of gifts in one calendar year) to a donee that is not a “qualified transfer,” a charitable bequest, or a gift to one’s spouse and that exceeds the annual exclusion is a “taxable” gift and must be reported to the federal government by filing a federal gift tax return. The amount of the gift that is taxable is the total amount of the gift, less the annual exclusion amount. For example, if Joe Smith were to give a $30,000 gift to his daughter Mary, $17,000 of the gift would be taxable. If Joe is married and elects to split responsibility for the gift with his wife Jill, $4,000 of the gift would be taxable, and each would have responsibility for $2,000 of the taxable portion of the gift.
There is no gift tax under Ohio law. However, as discussed in more detail below, certain gifts in excess of $10,000 made within three years of one’s death may be taxed as part of one’s estate, for Ohio estate tax purposes.
What Gift Tax Must Be Paid On Account of Taxable Gifts?
No tax is paid on account of any taxable gift until one’s lifetime gift tax exemption is exceeded. As noted in the Introduction to this Article, the current lifetime gift tax exemption, per person, is at the historically unprecedented level of $5,000,000. If gift-splitting is utilized, a married couple’s total lifetime exemption is as high as $10,000,000. A 35% gift tax must be paid on all gifts that exceed one’s lifetime gift tax exemption. Gift tax liability rests with the donor of a gift, not the donee, unless modified by agreement between the donor and donee.
Capital Gains Tax, Estate Tax and Income Tax Consequences of Gift-Giving
If an appreciable asset (such as stock) is transferred to a donee by gift, the donee assumes the donor’s basis in the asset. This means that if a Joe Smith makes a gift of an asset to his daughter Mary that Joe bought for $1,000 but that is worth $30,000 at the time of the gift, Mary retains Joe’s $1,000 basis. Upon sale of the asset by Mary, Mary will be liable for capital gains tax (at a rate of 15%) on the difference between $1,000 and $30,000, plus any additional appreciation that occurs after the gift is made. This is a very important concept to keep in mind because if the same asset were inherited by the Mary from Joe after his death, Mary would receive a full “step-up” in basis to the value at Joe’s death. Thus, if the asset were worth $50,000 at Joe’s death, Mary’s basis would be $50,000, and she would only need to pay capital gains tax (upon sale of the asset) on the difference between $50,000 and the increased value of asset at the time of her sale of the asset.
Though there can be adverse capital gains tax costs that should be considered before making gifts, the estate tax savings often outweigh those costs. Upon one’s death, the value of a decedent’s lifetime taxable gifts at the time the gifts were made is added to the decedent’s gross estate, for federal estate tax purposes, rather than on the date of the decedent’s death. As an example, if Joe gives stock to Mary worth $30,000 at the time of the gift that is worth $50,000 at the time of Joe’s death, the value of the asset for estate tax purposes is the taxable portion of the gift at the time the gift was made (if Joe did not split responsibility for the gift with his spouse, $17,000). If Joe had retained the asset until his death, the full $50,000 value would be included in Joe’s gross estate. In giving the stock to Mary as a gift, the value of Joe’s estate is $33,000 less than it would have been had Joe retained ownership of the asset. If the value of a decedent’s gross estate exceeds the federal estate tax exemption (currently $5,000,000, but likely to decrease after December 31, 2012), the gift of a highly-appreciable asset can generate substantial estate tax savings (at a tax rate of 35%) for the beneficiaries of the decedent’s estate.
Under Ohio law, a decedent’s gross estate does not include the value of gifts made by the decedent (except as otherwise noted below). A decedent’s gross estate over $338,333 is subject to an Ohio estate tax of 6% of the value of the estate up to $500,000, and 7% of the value of an estate in excess of $500,000; thus, transferring assets by gift can generate significant Ohio estate tax savings. There is one important exception to the rule that gifts are not included in a decedent’s gross estate: gifts in excess of $10,000 per year, per donee given in the three years prior to a donor’s death are presumed to have been given “in contemplation of death,” and their value will be added back in to the decedent’s gross estate unless the representatives of the decedent’s estate can demonstrate that the gifts formed part of a regular pattern of gift-giving by the decedent. The $10,000 exclusion does not apply to gifts of future interests; thus, the entire amount of future interest gifts made within three years of one’s death are presumed to be given “in contemplation of death” and are added to a decedent’s gross estate.
The receipt of a gift, no matter how large, does not trigger income tax liability for a donee, and the donee of a gift does not need to report the gift on his or her state and federal personal income tax returns. Of course, an asset transferred by gift may generate income after receipt by the donee, in which case the donee would incur income tax liability and would need to report the income as he or she would with respect to any other asset he or she owns.
Evaluating Current Gift-Giving Opportunities
The current $5,000,000 per donor lifetime gift tax exemption presents a unique opportunity to transfer assets and generate significant tax savings. Those that hold highly-appreciable assets with a relatively low current value should consider transferring those assets now, by gift, to “lock-in” the value of the assets for federal estate tax purposes (and avoid Ohio estate tax on these assets altogether). This may be a particularly attractive opportunity for business owners that plan to transfer ownership of a growing family business to the younger generation. Through proper planning, business owners can act now to transfer ownership of shares to achieve gift and estate tax benefits while maintaining control of the business by retaining management and voting rights.
The current gift tax law also presents an excellent opportunity to transfer non-business assets. While many of our clients may by habit seek to avoid giving gifts in excess of the annual gift tax exclusion amount, there should be less hesitancy to do so (if gift-giving otherwise makes sense), since no tax is due for any “taxable” gifts until one’s $5,000,000 lifetime exemption is exceeded. As noted in the Introduction to this Article, we do not expect the lifetime exemption to remain at $5,000,000 per person after December 31, 2012, so now may be the best time to act if you are considering making gifts of assets.