GIFT TAX ANNUAL EXCLUSION AND UNIFIED CREDIT

We receive many inquiries about the federal gift tax annual exclusion. As I describe in this post, taxpayers can transfer substantial amounts to their children or other done/recipients free of gift taxes through the proper use of this exclusion.

Annual Gift Tax Exclusion.  The amount of the exclusion for 2016 is $14,000 and is subject to inflation adjustment each year.

The exclusion covers gifts an individual makes to each donee each year. Thus, a taxpayer with three children can transfer a total of $42,000 to them every year free of federal gift taxes. If the only gifts made during a particular year are those covered by the annual exclusion, there is no need to file a federal gift tax return. If annual gifts exceed $14,000 to a particular donee, the exclusion covers the first $14,000 and only the excess is taxable. However, even taxable gifts may result in no gift tax liability because of the unified credit against gift and estate taxes (discussed below). Gifts made by a donor during lifetime to his or her spouse are generally gift tax-free under separate marital deduction rules unless the amount of the gift exceeds $148,000.00 and the spouse is not a U.S. citizen.

Tuition and Health Care Expenses.  In addition, the gift tax does not apply to payments made by a donor directly to a qualifying educational organization as tuition for another individual or to a provider of medical care as payment for that medical care health care for another are treated as non-taxable transfers.

Gift-splitting by married taxpayers. If the donor of the gift is married, gifts to donees made by only one of the spouse’s during a year can be treated as split between the husband and wife. By utilizing the gift-splitting rules, up to $28,000 a year can be transferred to each donee by a married couple because their two annual exclusions are available. Thus, for example, a married couple with three married children can transfer a total of $168,000 each year to their children and the children's spouses ($28,000 for each of six donees).

To utilize gift-splitting, both spouses must consent to it. Consent should be indicated on the gift tax return (or returns) the spouses file. IRS prefers that both spouses indicate their consent on each return filed. (Because more than $14,000 is being transferred by a spouse, a gift tax return (or returns) will have to be filed, even if the $28,000 exclusion covers total gifts.

The “present interest” requirement. For a gift to qualify for the annual exclusion, it must be a gift of a “present interest.” That is, the donee's enjoyment of the gift can't be postponed into the future or burdened with any “strings”. For example, if you put cash into a trust and provide that donee A is to receive the income from it while he's alive and donee B is to receive the principal at A's death, B's interest is a “future interest.” Special valuation tables are consulted to determine the value of the separate interests you set up for each donee. The gift of the income interest qualifies for the annual exclusion because enjoyment of it is not deferred, so the first $14,000 of its total value will not be taxed. However, the gift of the other interest (called a “remainder” interest) is a taxable gift in its entirety.

Exception to present interest rule. If the donee of a gift is a minor and the terms of the trust provide that the income and property may be spent by or for the minor before he reaches age 21, and that any amount left is to go to the minor at age 21, then the annual exclusion is available (that is, the present interest rule will not apply). These arrangements (called Code Sec. 2503(c) trusts because of the section in the Internal Revenue Code that permits them) allow parents to set assets aside for future distribution to their children while taking advantage of the annual exclusion in the year the trust is set up.

“Unified” credit for taxable gifts. Even gifts that are not covered by the annual exclusion, and that are thus taxable, may not result in a tax liability. This is so because a tax credit wipes out the federal gift tax liability on the first taxable gifts that you make in your lifetime, up to $5,450,000 (for 2016). However, to the extent you use this credit against a gift tax liability, it reduces (or eliminates) the credit available for use against the federal estate tax at your death.