Family Weath Transfer – The Power Of Gifts

Definitions Of What Constitutes A Gift

According to IRS guidelines, for US taxpayers a gift is defined as, “(a)..transfer of property by one individual to another while receiving nothing, or less than full value, in return”. Note that “property” is used to describe something that you legally own. The type of property could vary. Most commonly, gifts will be of cash, stocks and real estate, but could be other things- tangible and otherwise (e.g collectable items or intellectual property rights). In principal a gift is made when something of ascertainable value is given, or the enforceable right to receive something of value is not exercised (which presents some interesting planning opportunities…). In theory if you give somebody something that has zero value, a gift is not being made. As you can imagine, in certain gifting situations valuation methods become important given that gifts can be taxable.

How Are Gifts Taxed?

The US gift tax system is structurally similar to that of many other developed countries. At the time of writing, the annual tax-free gift allowance is 16,000 USD per person. That means that Mrs. Client can give 16,000 USD to as many different people as she wants during the year. If Mrs. Client has 100 friends that she likes, she can gift away 1,600,000 USD every single year. If she has 1,000 friends, that’s 16,000,000 USD. You get the picture. She wouldn’t even have to file IRS Form-709 which covers gifts as long as the gifts are 16,000 USD or less. Sticking with our example of gifting to 100 friends, that would enable her to remove 1,600,000 USD from her estate every single year. If she were to die (and was an estate tax payer) then that money would have otherwise been subject to estate tax before being distributed to her heirs. Estate tax rates are marginal and max out at 40% so estate tax planning is a must for those whose net worth exceeds the estate tax credit.

In the US the gift-tax allowance and the estate-tax allowance (or ‘credit’) are linked, and sometimes referred to as the ‘Unified Credit’. As of the time of writing the unified credit stands at 12,060,000 USD per person. You can spend this credit on gifts during life, or estate transfers (bequests) in death. To stop people from gifting away an unlimited amount of assets during their lifetime to avoid estate taxes, gifts above the annual exempted amount are subtracted from your unified credit. When you die, the value all of the taxable gifts that you made during life will be added together and subtracted from your unified credit and the remainder will be applied to any estate tax liabilities. People often think that gifts above the annual exempted amount are taxable in that year. That is not the case, however they must be recorded in Form 109. Gifts to non-US person spouses are treated slightly differently, so international families must be mindful of their reporting requirements. More on that later.

Due to the potential impact of estate tax, in later stages of life people move from accumulation to decumulation if it is clear that they will be ‘estate tax payers’ (people whose estate value exceeds the unified credit). Gifting is a ‘wealth transfer’ strategy that enables clients to transfer wealth to their beneficiaries, minimise estate taxes, and miaximise the amount received by the donee.

Reduce Taxes In Life

Tax filers who choose the “itemized deduction” method are able to receive an income tax deduction for gifts to charity throughout the year with no limit on the gift size. This is welcome tax relief for those higher-rate income tax payers who are charitably inclined. The amount of tax deductible is determined by two main factors: the type of property being gifted and the type of organisation receiving the gift. Calculating the value of the gift is necessary to arrive at the deductible amount, and herein the concept of “basis” presents itself- more on that later too.

Reduce Taxes In Death

US estate tax goes to the coffers of the taxman. If your estate owes it when you die, the estate pays the tax and then assets are distributed. If the estate tax payable does not exceed your remaining unified credit, the assets pass unmolested to their intended beneficiaries. If you intend to leave property to your heirs via your estate when you die, gifting during life is a powerful technique. Gifting during life costs less than gifting during death. Inter-Vivos (in life) gifts are tax exclusive. Estate bequeathals are tax inclusive. Simply put, it takes more money to give the same dollar amount to your beneficiary after tax. For example:

Intended amount to be received in life = 100,000 USD
Required gift amount = 100,000 USD

Intended amount to be received in death = 100,000 USD
Required pre-tax estate amount = 166,666 USD (100,000 / 40% tax)

Donor Vs. Donee Liabilities And Cross-border Gifts

Many families span the globe and financial transactions between them occur “cross border“. Sometimes the tax systems and rules are complementary and sometimes they are at odds with each other. Sometimes this complicates, and sometimes it turns an opportunity into a risk. Let’s use America and Japan as an example of two developed countries with very different tax systems. In the US the donor is responsible for paying the tax on the gift given. In Japan the donee is responsible for paying the tax on the gift received. So what does this mean for imaginary clients David and Mariko Smith? If both people were sole US tax residents at the time of the gift there would be no taxes payable for a 15,000 USD gift from David to Mariko. In the same scenario, if Mariko is a Japan tax resident at the time of the gift, she would have a tax liability for the amount in excess of the annual exempted amount for Japan, which at the time of writing is 1,100,000 JPY (8,310 USD). Japanese gift tax rates are marginal, and max out at 55% for amounts in excess of 45,000,000 JPY. This is in stark contrast to the US system where the exempted ‘gift’ or transfer amount between US taxpayer spouses is unlimited. Think then, what would happen if a US national transferred 50,000,000 USD worth of stock to his Japanese taxpayer wife? It get’s worse though, as non-US taxpayer spouses do not benefit from the unlimited transfer allowance…

Valuation Calculations And The Concept Of “Basis”

According to the IRS, “Basis is generally the amount of your capital investment in property for tax purposes. Use your basis to figure depreciation, amortization, depletion, casualty losses, and any gain or loss on the sale, exchange, or other disposition of the property. In most situations, the basis of an asset is its cost to you.”. If your beneficiary receives an asset from you via your estate their basis is ‘stepped up’ meaning that upon disposal in the future when they sell the property their ‘acquisition cost’ or “basis” is seen to equal the value of the asset, its fair market value (FMV) at the date of death of the decedent (the person who died). This means that any accumulated gains in the property are ‘realized’ but not ‘recognized’ for the purpose of tax. In other words, the property transfers to you at its current value and no taxes are payable at that time.

Non-cash gifts given and received during the lifetime of the donor are subject to the dual-basis rule. Simply put, this rule limits the ability of the donor and donee to defer or avoid paying taxes on any historic, unrealized appreciation in property.

Recordkeeping Is Good Housekeeping

Although gifts below the annual exempted amount do not usually require the donor to file form 709, there are many situations in which a 709 must be filed:

• When you gift more than 15,000 USD to somebody that is not your US Taxpayer spouse
• Certain gifts, called “future interests”, are not subject to the $15,000 annual exclusion and you must file Form 709 even if the gift was under $15,000
• Spouses may not file a joint gift tax return. Each individual is responsible for his or her own Form 709 if due
• When you make a “split gift” with your spouse (more on this later)
• When you make a gift of “community property” (property owned equally by yourself and your US Taxpayer spouse in a community property state), it is considered made one-half by each spouse. For example, a gift of $100,000 of community property is considered a gift of $50,000 made by each spouse, and each spouse must file a gift tax return
• Each spouse must file a gift tax return when they make a gift of property held by them as “joint tenants” or “tenants by the entirety”.
• If a trust, estate, partnership, or corporation makes a gift, if you are one of the individual beneficiaries, partners, or stockholders you are considered the donor and may be liable for the gift and “Generation Skipping” taxes (more on this later)
• If you receive a gift but the donor does not pay the tax, you will be liable for the tax
• If you make a gift and die before filing a return, your estate executor must file the return

Even if you are not obligated to file a return, it can sometimes be a good idea to file one anyway. When making lifetime gifts basis considerations come into effect. To ensure a speedy and positive resolution in the future if the IRS contests or questions any of your stated valuations when your 706 estate tax return is filed by your executor, having good records, and a history of (sometimes unnecessary) 709 filings is helpful.

Gifts To Non-US Taxpayer Spouses

If your spouse is not a US person you do not have an unlimited transfer exemption. For a non US person spouse your annual gift allowance is limited to 164,000 USD. Any amount above this will eat into your universal credit. This is one planning technique that is discounted or nullified when a non US person is involved. The other foreign spouse pitfalls relate to trusts; the backbone of US domestic tax, asset protection and generation planning.

Gifts From “Foreign” Nationals and Foreign Corporations

At this point you might be expecting the worst, but it’s ok. The amount that a US taxpayer can receive from a “foreign person” is unlimited. A foreign person includes a nonresident alien individual or foreign corporation, partnership or estate, as well as a domestic trust that is treated as owned by a foreign person. Distributions from a foreign trust are reportable on Part III of Form 3520.

There are two gotcha’s that you should be aware of though, as they will require you to make a filing:

1. For gifts or bequests from a nonresident alien or foreign estate, you are required to report the receipt of such gifts or bequests if the aggregate amount received from that nonresident alien or foreign estate exceeds $100,000 during the taxable year. If the gifts or bequests exceed $100,000, you must separately identify each gift in excess of $5,000.
2. For gifts from foreign corporations or foreign partnerships, you are required to report the receipt of such purported gifts if the aggregate amount received from all entities exceeds $16,815 for 2021 (adjusted annually for inflation). You must separately identify each gift and the identity of the donor. Note that the IRS may recharacterize purported gifts from foreign corporations or foreign partnerships.

If you nature of the gift(s) received falls under either of the two above categories then you must file Form 3520 by the 15th day of the 4th month following the end of the U.S. person’s tax year. Easy enough, if you are aware the rule exists, but there are stiff penalties if you don’t and fail to make the filing.

Generation Skipping Transfer Tax (GSTT)

Reporting Requirements, Penalties, Deadlines And The IRS-709 Form

Sometimes abbreviated to GSTT or GST for short, Generation Skipping Transfer Tax ensures that Uncle Sam doesn’t have to wait for generations to get his piece of your pie as would be the case if you transferred all of your wealth to your great grandchildren who aren’t even able to eat solid foods yet. The good news is that there is a GST credit available. To confuse things, the GST allowance also happens to be 12,060,000 USD but is separate from the gift and estate tax allowance (the unified credit). Any transfers made, whether in life as gifts, or in death via your estate or certain trusts that go to a “skip person”  will be subtracted from your GST allowance. A skip person would be any of the following:

A lineal descendant, at least two generations below the transferor

A non-relative, at least 37½ years younger than the transferor

A trust, if all beneficiary interests in the trust are held by skip persons

It is important to note that any gift over the standard exempted amount will also be deducted from your unified credit. Gifts above 15,000 USD to skip person will thus deplete two different types of credit; the unified credit, and the GST credit. There is no annual exemption for generation skipping transfer tax and the tax rate applied to generation skipping transfers once you have used up your GST credit is a flat 40%. Failure to plan around this could see your assets subject to both estate and generation skipping tax. Gifts to skip persons need to be declared using Form 709.

One For You. And One For You. And One For You.

There is no limit to the number of annual gifts that you can make and gifts under the threshold are not taxable. To be clear, you can only gift to one individual once in that year. You cannot simply give multiple gifts of 16,000 USD to the same person throughout the year. There is however scope to gift more than the annual exemption amount to a single family if there are multiple members. For example, gifting 16,000 USD to your son, Mr. Husband, another 16,000 USD to Mrs. Wife, and 16,000 USD to each of their children Son A and Son B. This would remove 64,000 USD from the donors estate every year and create zero tax liabilities for the giver or the receiver(s).

“Split Gifts” With Your US-Taxpayer Spouse

If you file taxes jointly with your spouse (MFJ) you can ‘split’  gifts. This enables you to make gifts of 200% of the annual tax free allowance because 50% of the gift is seen to have come from each spouse, resulting in an annual tax free gift allowance of 32,000 USD. Despite the individual gift amount falling below the reporting threshold, split gifts must be reported on Form 709. There are some gotcha rules for multi-national families that may undermine this technique and suitability should be assessed before gifting.

Gifts And Family Loan Forbearance

Family members often provide loans to one another. Particularly to younger family members. If a mother gives 1,000,000 USD to her daughter, that is 984,000 USD above the annual tax free allowance so the mother would use 984,000 USD of her unified credit in that year. If she lends her daughter 1,000,000 USD there is no gift, and she is not required to use any of her unified credit. This does not mean that the daughter does not have to pay the loan back. The loan must be bona fide–  it must be a real loan, there must be a written contract and there must be loan terms. If that agreement does not have the requisite parts to make it a loan, it will be treated as a gift of 1,000,000 USD. Understanding this, many would be tempted to set the rate of interest as a nominal or zero number- after all, you probably do not want the money back from your child. This is not an option. The rate of interest on the loan must be similar to the rate of a comparable loan made between unrelated parties- the market rate. A below market rate of interest would be treated as an annual gift to the amount of the difference between the interest rate being charged and the applicable federal rate (AFR).

Now that mother has established her loan agreement with her daughter, her daughter must now make repayments as per the agreement. But what if she doesn’t? Because mother is not going to foreclose on the loan, or exercise her right to receive that repayment from her daughter (forbearance) this is treated as a gift for tax purposes. The mother has gifted to her daughter a free pass on the loan repayment of X daughters, which means that X dollars get to stay in her daughters pocket. The benefit to her daughter is readily quantifiable. That is a gift.

But what if this is part of the plan. As the mother can gift 16,000 USD to her daughter every year, if the daughter’s loan repayments throughout the year total less than 16,000 USD the mother can forgive the loan repayments for that year, and the daughter does not have to give back any money to her mother. The result is that the daughter can potentially receive an amount of money from her mother that is significantly larger than the tax free gift allowance and use, or invest that money for her benefit today without any tax obligations. This is a simplified explanation of a strategy that requires the loan agreement to be structured correctly so as not to be deemed abusive. When structured properly, family loan forbearance strategies can be very powerful.

Professional Services And Direct Payments (education, healthcare)

Many people are unaware that gifts of professional services are free from gift tax. If Mr. Smith, who is an attorney, gives his son 1,000,000 USD, then the amount above the annual tax free threshold will be deducted from his unified credit. If Mr. Smith, the attorney, represents his son in court during a lengthy trial after his son hit a pedestrian while driving his vehicle, for a total of 1,000 hours, with Mr. Smiths professional fees totaling 1,000 USD per hour, his sons non-payment of his father’s 1,000,000 USD outstanding fee does not constitute a gift from the father to the son and neither have a tax liability. Doctors, dentists, accountants, architects. Anything you can think of. Gifts of professional services are limitless and untaxed.

In a similar vein, payments made directly to qualifying medical and education providers are also not considered for gift tax. After successfully defending his son in court, Mr. Smith can then send 55,000 USD directly to the university to pay for his son’s first year at college, and can send 10,000 USD a month directly to his sons therapist to help him work through his issues surrounding the accident. If he felt so inclined, Mr. Smith could actually pay for the health and education for his entire family, for the duration of his life, and would never need to touch his unified credit.

Split Gifting Into 529 Education Plans

If you wish to help fund a 529 college savings plan, the $15,000 annual gift limit comes back into play. In this scenario, you’re allowed to combine five years’ worth of $15,000 gift tax exemptions into an initial $75,000 contribution to one student’s 529 account. Keep in mind that any additional gifts to that individual during the next five years will put you over the annual giving limit, so your lifetime exclusion will be reduced by those additional gift amounts. Also, if you die in the five years after you make the gift, a prorated amount of your gift is returned to your estate, but only for tax purposes. The entire amount of money you gave stays in the student’s 529 account.

The IRS lets you pre-fund somebody’s 529 college savings plan with up to 5 years of tax free gift contributions. That means, as of now, you could contribute 16,000 USD x 5 = 80,000 USD into a 529 plan for somebody else’s benefit, tax free. You would not be able to make any further gifts to that person for the following 5 years, but having that money front-loaded and invested could allow the money to compound and grow faster than trickling in 16,000 USD each year. Another thing to be aware of is that the pre-funding would have a tail. If you die within 5 years of making the gift, the gift would be prorated, with the remainder being returned to your estate for tax purposes. This does not mean the ‘student’ has to give the money back, and is a notional addition to your estate.

That’s already a great trick to have, but you can turbocharge that account growth by making a split gift with your spouse. Doing so would enable you to contribute a total of 160,000 USD in a single year, free from tax.

Gifting To Charities, Foundations And Other Charitable Organizations

There is no cap on donations to charity but to claim charitable deductions you must be an itemized filer. You can deduct between 20% – 50% of your adjusted gross income (AGI) for that year and any amount gifted that exceeds your AGI for that year can be carried over for up to 5 years. The size of the deduction depends on the type of property being gifted and to whom. Many people are unaware that an individual can establish their own charity (a non-profit 501c3 company) or foundation. Donations to one’s own charity or foundation are tax deductible. For tax purposes, gifts to charity are valued in a different way to non-charitable gifts, with the deductible value usually being less than the fair market value (FMV) at the time of making the gift. The deductible amount to a self-controlled private charitable enterprise will be a smaller percentage of the gifted property than it would be to a public one, but it enables families to control the charity, and its assets, and utilise the funds to benefit their chosen causes directly. Different types of qualifying organisation will be subject to different rules concerning reporting and minimum distributions but the range of options is sufficiently broad. Whether you intend to gift tens of thousands, or millions, there is an appropriate structure for your philanthropy. The IRS Interactive Tax Assistant (ITA) is a useful online tool that will answer tax questions in reference to your own circumstances and will help you understand the implications of your intended donations.

Donating in the current year may enable clients to offset income in future years where they would be subject to higher tax rates. Even for those who are not otherwise charitably inclined, when presented with two options by their advisor; 1. give the money to the taxman, or, 2. control, invest and grow that money, and give it to causes that you care about- clients immediately see the appeal.

Gifting often benefits both the donor and the donee. The donee receives something for nothing and the donor is able to reduce their income or estate tax (although technically we could also ascribe the benefit of reduced estate tax to the donee who is also a beneficiary of the estate). Consider using gifts to take advantage of tax planning’s simplest strategy.

• Minimal to zero filings
• Benefit an unlimited number of people
• Transfer wealth out of your estate
• Support the education and health of your loved ones
• Provide large capital sums for education (529) or investment (loans)
• Get tax relief for supporting causes that you care about