Pitcairn Update, June 2015
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Spring and summer are typically filled with celebrations of life’s milestones, graduations, and weddings to name just a few. These and other life events are all occasions when we may wish to bestow meaningful gifts on those we care about.
We have all experienced the simple pleasures of giving and receiving gifts. The potential benefits of gift-giving go far beyond this, however. Thoughtful gifting strategies can help families transfer wealth from one generation to another, soften the burden of education expenses, and give younger generations a taste of the responsibilities that come with substantial wealth.
Gift-giving can be as straightforward as a generous check or as complex as an intentionally defective grantor trust, but however we may structure our gifts, it’s important that we don’t get tangled up in tax regulations. As we pass through the prime gift-giving season, we thought you might benefit from a refresher on federal tax rules. You will still need to consult with your tax advisor and review the rules in your own state, but this summary will give you some idea of the available options and limits of gift-giving.
Outright Gifts (Non-charitable)
In general, a completed gift requires both donative intent and actual delivery of the item being gifted. Not only must you intend to transfer the item to another person, but you must also actually do it. For example, if you put a note on the back of your painting that you have given it to your child, but you actually keep it on the wall in your own house, this may not result in a completed gift because there is some question of whether it has been delivered out of your control.
When making an outright gift, there are dollar limits on the value, beyond which gift taxes would likely apply. Each year, each donor may give any individual up to $14,000, an amount adjusted annually for inflation. Known as the “gift tax annual exclusion,” this rule allows a married couple to give up to $28,000 to each recipient without incurring gift tax. The couple may fund the entire amount from one spouse’s account.
Asset types that fall under this rule include cash, securities, and tangible items, as well as loan forgiveness and entity and real estate interests. Furthermore, simply adding someone’s name as co-owner of a bank account, real property deed, or other asset creates a gift subject to gift tax rules. In such cases, determining the gift’s value for tax purposes depends on whether and how much the recipient contributed to the jointly owned asset. (Note that the recipient’s rights after the donor’s death depend on the legal title selected for the account.)
In a situation where a recipient is given a future right to receive an asset, such as a gift held in trust, the gift usually will not qualify for the gift tax annual exclusion. However, certain limited rights of withdrawal with notice to the beneficiary (called a Crummey notice after an old tax law case) will permit use of the annual exclusion to fund certain kinds of trusts.
Gifts of Educational & Medical Expense Payments
Direct payments of a recipient’s medical or educational expenses are also excluded from gift taxes, subject to some restrictions.
For educational expenses to be excluded from gift taxes, the donor must make payments directly to the school, not to the student and not to the student’s family as a middleman. Additionally, the gift tax exclusion applies only to tuition, not room, board, or other fees. For grandparents with a high school graduate heading off to college in the fall, you might consider paying college tuition directly. That way you still have the ability to give your grandchild the full exclusion amount – $14,000 not subject to gift taxes.
For those whose children or grandchildren are still years away from college, 529 Plans are another gifting opportunity. Donors may contribute up to five years of their $14,000 annual exclusion amount all in year one, with additional tax return filings required. Be aware that each state has its own 529 Plan with its own set of rules, investment options, and potential state income tax deductions for that state’s residents. It is important to compare all options before signing on the dotted line. Follow-up is needed to verify that the designated student actually uses the funds for school, though any excess amounts may be reassigned to another beneficiary.
Similarly, medical expenses must also be paid directly by the donor to the medical service provider in order to qualify for the gift tax exclusion. Determining these expenses can be tricky because of health insurance; donors should pay only the amount net of any insurance reimbursement. Payment of medical insurance premiums also qualifies for the gift tax exclusion.
Gifts in Trust
Using trusts as vehicles for gift-giving is certainly more complicated than making outright gifts, but can be effective wealth transfer vehicles in many circumstances. When using a trust, it is even more important to consult with experts in trust structures and tax issues. Here are two examples of trust techniques frequently used for gifts.
- Crummey trusts for minors and others, including irrevocable life insurance trusts (ILITs): As we explained in our discussion of outright gifts, the annual gift tax exclusion applies to gifts in trust only if the gifts are subject to a right of withdrawal. A Crummey trust with a right of withdrawal provides greater flexibility in duration and beneficiary protection than §2503(c) trusts, which are discussed below.
- §2503(c) trusts for minors: Grandparents sometimes like to create a trust upon the birth of a grandchild, but don’t necessarily want to include the right of withdrawal required for Crummey trusts. §2503(c) trusts qualify for the gift tax annual exclusion if the trust assets must be spent for only the minor’s benefit, and if any amount remaining in the trust is distributed to the minor upon reaching age 21. If you prefer that the assets remain in trust beyond the minor’s 21st birthday, it may be possible to extend the trust beyond that time if certain notices are provided and the 21-year old chooses not to withdraw the funds.
Sometimes parents or grandparents want to make gifts larger than the $14,000 annual exclusion amount. In addition to that amount, every person has a Federal exemption amount ($5.43 million in 2015), which may be given during life by gift or upon death by will. Use of all or part of your lifetime exemption amount does require the filing of a gift tax return. If the gift is to, or for the benefit of, a grandchild, the generation skipping transfer (GST) tax exemption allocation rules must also be considered.
Occasionally, a gift donor may wish to transfer only a portion of an asset to a recipient, for example, gifting the future appreciation in an asset’s value while retaining either the right to enjoy the current income or another current right. There are a number of such techniques that may be appropriate, depending on your circumstances.
- Grantor Retained Annuity Trusts (GRATs) allow the donor to retain an annuity income interest for a term of years, while giving the remainder interest to the gift recipient. The amount subject to the gift tax is a complex calculation based on the donor’s retained interest, the term of the trust, and an interest factor that changes each month, but may be essentially “zeroed out” under current law. That means the future appreciation of an asset may be transferred with nominal gift tax impact.
- Qualified Personal Residence Trusts (QPRTs) enable the donor to transfer a principal or secondary personal residence, but retain the right to live in it for a term of years. The gift recipient receives the residence after the term ends.
- Grantor Retained Income Trusts (GRITs) are similar in concept to GRATs, but provide additional benefits. They are particularly useful for gifts to individuals who aren’t direct descendants of the donor (unmarried couples, aunts, uncles, etc.).
Charitable Split Interests
Sometimes a donor may wish to give not only to family or friends, but also a charitable organization. A charitable split interest trust, either a remainder trust or a lead trust, can be a tax efficient way to accomplish this. Either type may be structured as an annuity or unitrust. If grandchildren are the intended trust beneficiaries, however, there may also be consequences related to the GST tax exemption allocation.
- Charitable Remainder Trust (CRT) is one in which the grantor transfers assets to a trust and keeps the income from that asset for a term of years or for life. Alternatively, the grantor may gift the income to another person instead of keeping it for him or herself. After the term ends, the remainder interest passes to charity. The grantor immediately receives an income tax deduction for the charity’s calculated right to receive the remainder, depending on the length of the income term and the prevailing interest rates. The future appreciation in the value of the asset is also excluded from the grantor’s estate tax.
- Charitable Lead Trust (CLT) is the mirror image of a CRT. The grantor transfers assets to a trust, but gifts the income interest in the assets to a charity either for a term of years or for life. The grantor then gifts the remainder interest that is left after the term ends to children, grandchildren, or some other person. This is an interesting technique for families that have current charitable intent.
Intentionally Defective Grantor Trusts (IDGTs)
IDGTs are a complex form of gift tax planning. The donor creates a trust, but continues to pay all tax on the income generated by the trust’s assets even though the donor no longer owns the assets. This creates an ability to shift wealth to the next generation, both through the tax payment and through transactions between the donor and the trust.
We have all heard the saying that it is better to give than to receive. We can take that a step further and say, “It’s better to give with a purpose and a plan.” While spring and summer may bring an abundance of gift-giving occasions, it’s important to remember that gift-giving opportunities go beyond birthdays, graduations, and holidays. Mid-year is a perfect time to discuss gift planning with your relationship manager so you will have plenty of time to consider your options long before the year-end crunch begins.