"Gifting around Tax" in 2012


2012 Gifting Bonanza[1]
The increase of the gift exemption to $5 million and the decrease of the tax rate of 35% for 2011 and 2012 provide golden gifting opportunities.  For a couple, the gift exemption is $10 million.  This generous gifting window ends on January 1, 2013, when it is scheduled to go back to $1 million with a tax rate of 55%.  Although some are concerned that there may be a claw-back event for people giving above $1 million, many believe that this period is a great gifting opportunity.

Gifting now will reduce the income tax liability of the donor.  In addition, the gift to an irrevocable family trust will help the accumulation of wealth if the trust income keeps on being reinvested in the trust.  For instance, a $5 million gift would grow to $15 million by the time of the donor’s death.  The estate taxes saved could be $5.5 million (55% of the $10 million of the appreciation).  

It is important to remember that many states[2] do not have a gift tax whereas most states have an estate tax.  Gifting now will prevent future state estate taxes. 

This good-sized tax exemption creates an additional cushion for hard-to-value assets such as limited partnership interests or ownership interests in closely held businesses.

I.        Understanding Which Gifts Are Subject to Reporting vs. Payment of Gift Tax

A. Gifts Subject to Gift Tax

The gift tax applies to transfers by gift of property (including money) without expecting to receive something of at least equal value in return, unless excluded.

A “gift” is a completed transfer of property made for less than adequate and full consideration in money or money’s worth.  If any consideration is paid, then the gift is the difference between the value of the property transferred and the consideration furnished.[3]  Once the gift is made, a tax may be imposed.  The gift tax will apply whether the gift is in trust or otherwise, direct or indirect, and whether the transferred property is real, personal, tangible or intangible.  Generally, a transferor’s donative intent is not essential to establish whether or not a gift was made; rather the facts and circumstances of a particular transfer determine whether a gift was made. 

Because the gift tax applies only to completed transfers, it is important to determine whether a transfer is complete or incomplete.  The transfer is deemed complete when the donor has fully relinquished dominion and control over the property transferred.  Examples of uncompleted gifts: (1) the donor retained the power to revoke the gifts; (2) the donor retained the right to change beneficiaries; (3) the donor retained the power to change beneficial interests other than in accordance with a fiduciary power governed by an ascertainable standard. 

A completed gift could be the following situation:  The donor transfers property to himself/herself as trustee, receives income from the trust but retains no power over the property except in a fiduciary capacity, and retains no power of appointment over the property to direct to whom the property should go at the donor’s death.  However, the Internal Revenue Service (IRS) requests that such complete transfers of property be included in the donor’s estate for estate tax purposes. 

Therefore, taxable gifts consist of the total transfers or aggregate gifts made during the calendar year minus allowable exclusions and deductions.  The current year’s tax is then reduced by the donor’s available “Applicable Credit Amount” to arrive at the actually payable tax. 

The donor is primarily liable for the payment and filing of the gift tax return.  However, if the donor does not pay the tax, the donee may become personally liable for the tax due and any interest accrued thereon.  A gift tax return is due on April 15 of the year following the calendar year in which the gift is made.  The donor’s executor or personal representative is responsible for filing the gift tax return, which is due on the earlier of the due date of the estate tax return, including extensions, or April 15 of the year following the year in which the gift is made. 

Gifts made by either spouse to a third party will be treated as if made one-half by each spouse if the donor elects the gift-splitting.  The following rules need to be followed:

                 ü  Both spouses need to consent to split the gift

ü  The spouses need to be married to each other at the time of the gifts and do not remarry during the remainder of the calendar year period

ü  Both spouses were U.S. citizens or residents at the time of the gift

The increase in the gift tax exemption from $1 million to $5 million creates a great opportunity for income shifting.  A wealthy taxpayer can transfer up to $5 million in assets to family members who are in lower income tax brackets than the donor. 

B. Gifts Excluded from Gift Tax

The IRS accepts that people pay medical bills and tuition fees for other people without qualifying these payments as gifts.  There is no cap on the amount transferred.  In order to benefit from this status, the donor has to directly pay the bills or fees to the qualified institution or care provider. 

            a.) Tuition Fees

The exemption is limited to the payment of tuition fees; it does not include books, supplies or dormitory expenses.  A qualifying educational institution is defined as one that: (1) maintains a regular faculty and curriculum; and (2) has a regularly enrolled student body at the place where its educational activities are carried out.

The donor can also enter into a contract with the institution to pay future tuition.  The IRS has ruled that a grandmother would qualify for the exclusion under § 2503(e) for the payment in advance of the tuition of her grandchildren.  The IRS requires that the payments could not be refunded and would be forfeited if the grandchildren ceased to attend the school.

            b.) Medical Expenses

Medical care is defined to include expenses incurred for the diagnosis, cure, mitigation, treatment or prevention of disease, or for transportation for such medical care, and applies only to payments that have not been reimbursed by the donee’s insurance.  In addition, the person who pays medical expenses for a third person may report the payment as a deduction on his/her own income tax returns.  If the yearly medical expenses exceed 7.5% of the Adjusted Gross Income (AGI), then this deduction can be reported.  This is very important when a family member pays a nursing home.  Health care premiums and long-term care insurance are deductible medical expenses. 

The person who pays tuition fees for a spouse or a dependent may also be eligible for an income tax deduction by filing Form 8917 with the federal income tax return. 

            c.) Gifts to Political Organizations

            Gifts to a political organization – defined in section 527(e)(1) – for the use of the organization are not taxable.  However, the organization’s primary purpose cannot be political; otherwise gifts would be taxable.  See 26 U.S.C. §527(e)(1), which states as follows:

(e) Other definitions

For purposes of this section—

(1) Political organization

The term “political organization” means a party, committee, association, fund, or other organization (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.

“Exempt function” is defined under 26 U.S.C. § 501(c)(4) as follows:

Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.

Stephanie Strong, in her recent article published by The New York Times[4], reported that the I.R.S. was enforcing the provisions mentioned above, and that the agency had contacted several big donors for political campaigns for a review of their contributions.  The I.R.S. was reportedly verifying whether their contributions to nonprofit advocacy groups were actually tax exempt.  Donald B. Tobin, a legal expert on campaign finance, expressed his opinion that a lot of people are misusing (c)(4) groups as a means of getting around campaign finance regulations.

            d.) Using the Annual Exclusion

For gifts of present interest only, a donor may exclude the first $10,000 of gifts, adjusted to inflation, made to each donee during any calendar year.  Currently the annual exclusion amount is $13,000.  As a result, the first $13,000 of gifts made to each donee during the year is subtracted from the total gifts made during the calendar year in determining the amount of taxable gifts.  If the donor is married, the annual exclusion may be aggregated per couple and increased to $26,000.

In addition, a donor can contribute a lump sum of $65,000 ($130,000 for married donors) to a 529 College Savings Plan.  The IRS allows a donor to book his/her upcoming 5 years of annual exclusions for the beneficiary of the 529 College Savings Plan.  The beneficiary will be able to take immediate advantage of the potential growth of the 529 Plan’s investments.  If the donor were to die within this 5-year period, a portion of the gift may be includable in the gross estate of the donor.  

            e.) Annual Exclusion for Non-Citizen Spouse

As we will discuss in more detail below, a U.S. citizen spouse has an unlimited transfer deduction.  A non-U.S. citizen is not allowed this deduction.  In addition, the presumption that joint property with right of survivorship held between spouses is owned 50% by each, does not apply either.  Upon the death of the first spouse, the IRS will presume that the joint property was owned 100% by the decedent.  The alien spouse will have to prove his/her ownership interest in the property by tracing the origins of the funding. 

The IRS, under Section 2523(i), allows an annual exclusion of $100,000, adjusted to inflation.  The annual exclusion is in the amount of $134,000 for 2011.  This is a good estate planning tool when at least one spouse is an alien and the other spouse has a higher income.  By making an annual gift, the couple can rebalance their assets. 

            f.) Deductions for Transfer to Spouse

There is an unlimited marital deduction[5] for transfers to a U.S. citizen spouse.  This unlimited marital deduction is recognized for transfers of joint property, but where a life estate or a terminable interest in property is created the deduction is generally not allowed.  There is an exception to this rule.  When the life estate is coupled with a power of appointment in the donee spouse, a marital deduction will be allowed if the following five (5) conditions are met:

·        The donee spouse is entitled for his/her lifetime to all of the income generated by the property;

·        The income is paid to the donee spouse at least annually;

·        The donee spouse has the power to appoint the interest to himself/herself or his/her estate;

·        The donee spouse’s power to appoint rests solely in the donee spouse; and

·        The entire interest is not subject to a power in any other person to appoint any part to any person other than the donee spouse.

Therefore, a terminable interest in trust will be eligible for a marital deduction if it is a “qualified terminable interest” and satisfies all of the requirements set forth under IRC § 2523(f)(2) for “QTIP” treatment. 

A non-U.S. citizen spouse may have the bequest qualifying for the marital deduction if the bequest is held in a Qualified Domestic Trust (QDOT).  This trust postpones the payment of the tax due until the first spouse dies, whereas under the unlimited marital deduction the assets are transferred into the surviving spouse’s estate and the tax is calculated on the surviving spouse’s estate.  Basically, the QDOT needs to have a U.S. trustee and when distributions of principal are made, estate tax needs to be paid. 

            g.) Deductions for Transfers to Charity

A charitable deduction is allowed for all transfers to or for the use of the public or any corporation exclusively established for religious, charitable, scientific, literary or educational purposes.  The income tax charitable deduction[6] is parallel to the estate and gift tax charitable deductions.[7]  However, the estate and gift tax charitable deductions for property passing outright to charity are unlimited and do not vary with the identity of the charity, so long as the charity is qualified, and are available for foreign charities. 

Some donors are making a charitable gift through a “split interest.”  A split interest gift is a gift made in part to a charity and in part to a non-charitable beneficiary.  For instance, a property is transferred in trust to pay income to an individual for life with the remainder interest going to charity.  No charitable deduction is allowed for a split interest gift unless the charity’s interest is in the form of a:

ü  Charitable remainder annuity trust[8]

ü  Charitable reminder unitrust[9]

ü  Pooled income fund[10]

ü  Charitable lead trust (in the form of either an annuity or unitrust)[11]

Section 725 of the Act provides tax-free distributions from individual retirement plans for charitable purposes.  The termination date of IRC Section 408(d)(8) extended through December 31, 2011, is retroactive to January 1, 2010.  For instance, a donor aged 70 ½ or over may make charitable donations up to $100,000 directly from Individual Retirement Accounts (IRAs) to charity.  Donations made in January 2011 may be counted as having been made in 2010.

C. Taxable Gifts

1.         All gifts [not excluded from gift tax] which exceed a person’s Unified Credit or “Applicable Exclusion Amount.”

2.         The Applicable Exclusion Amount under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” or “2010 Tax Act” for gifts made in 2011 and 2012 is $5 million per person.  The $5 million Applicable Exclusion Amount is reached by both transfers triggering gift tax inter vivos and transfers subject to federal estate tax.

3. Uncertainty for 2013 Gifts: Uncertainty of Gift Rules Returns Similar to 2010 for Tax Planning.

                                             i.            The 2010 Tax Act “sunsets” on December 31, 2012.  Effective January 1, 2013, the law reverts to the Economic Growth and Tax Relief Reconciliation Act or “2001 Tax Act.”

                                           ii.            The applicable exclusion under the 2001 Tax Act is $1 million. In 2013 the gift and estate tax will have separate annual exclusions: $3.5 million for estate tax and $1 million for gift tax.

                                          iii.            “Coupling” means a gift tax dollar paid to the state offsets federal gift tax liability.

a.       Decoupled means a tax credit is not applied for payment of state gift taxes.

b.      Only two states have a gift tax in 2011 – only Tennessee and Connecticut impose gift taxes.

c.       Gifts are subject to Generation-Skipping Transfer Tax or GST.

1.      The GST tax is applied to gifts or direct skips occurring at your death to skip persons.

2.      The GST tax is calculated on the value of the gift, after subtraction of any allocated GST exemption, at the maximum estate tax rate for the year involved.

3.      Each individual has a GST exemption equal to the applicable exclusion amount for the year involved. For 2011 the GST applicable exclusion is $3.5 million.

4.      A direct skip is a transfer made during your life or occurring at your death that is:

a.       Subject to the gift or estate tax

b.      Of an interest in property, and

c.       Made to a skip person.

                                                                                                                                                         i. A skip person is generally a person who is assigned to a generation that is two or more generations below the generation assignment of the donor.

                                                                                                                                                       ii. For instance, your grandchild will generally be a skip person to you or your spouse.

d.      The GST tax is computed on the amount of the gift or bequest transferred to a skip person, after subtraction of any GST exemption allocated to the gift or bequest at the maximum gift and estate tax rates.

5.      Seldom do the earth, moon, and stars align.

a.       A married couple can gift their combined $10 million applicable exclusion and avoid a combination of the three taxes.

iv.  The 2010 Act sets gift rules for two years but leaves the future unknown:  is there opportunity in these murky waters?

1.      Absent congressional action, the tax law reverts to the Tax Act of 2001 on January 1, 2013.  If history is consistent in 2012 the Congress may or may not reach agreement on a new gift tax. If agreement is reached it may be similar in timing to the 2010 Tax Act which passed in December of 2010, leaving the entire tax year for 2010 difficult to plan.

2.      Remember that a tax law may be effective retroactively, which makes 2012 especially difficult to project the terms of a new law.

3.      Deficits pressure public policy to change revenue laws to exact greater taxes. This includes the gift tax.

4.      Thus significant opportunity exists in these two years to reduce the size of an estate by inter vivos gifting which reduces the amount subject to federal estate tax.

            4.         Split Gifts.  A couple can make a joint gift and use both of their annual exclusions and lifetime exemptions.  Usually, if the couple elects gift splitting, they both must file their own individual gift tax returns.  However, if only one spouse makes the gift and uses the exclusion of the other spouse, then the one spouse must file his/her own gift tax return, and his/her consenting spouse will sign on the consent line of the return. 

            5.         Joint Tenancy.  Please note that when a property in bought in joint names with right of survivorship while actually only one person contributed to the purchase, the purchaser has made a gift of 50% of the property to the other joint tenant.  It is the same for a joint account, however, the gift is made when the donee draws on the account for his or her own benefit.  The IRS defines this gift as “the amount that the donee took out without any obligation to repay you.”[12]  The situation with a U.S. savings bond is the same in that the gift is made when the donee cashes the bond without any obligation to pay the donor. 

            6.         Crummey NoticesThe annual exclusion is only available for gifts of a “present interest.”  An outright gift of a life insurance to a trust is a non-qualifying gift of future interest.  Because of the Crummey demand powers, the future interest can be re-qualified into a present interest.[13]  The trustee will give notice to the beneficiaries of the following rights:

ü  Notice of the right to make a withdrawal

ü  Notice of each gift to which the withdrawal relates

ü  When there are minors, notice to the guardian or the minor’s parent

The IRS considers the notice as a fundamental requirement that cannot be waived by the beneficiary.  It seems that an oral notice will probably suffice as long as the power holder actually is informed of his/her right.  However, a written notice is preferable, particularly if the IRS asks for proof of the notices. 

It is recommended that the notice provide the following:

ü  Inform the beneficiaries that the only expected gifts to the trust are the premium gifts

ü  Gives the beneficiaries a schedule of the dates on which premium gifts will be made to the trust

ü  Informs the beneficiaries of their demand rights

ü  Promises supplementary information only if there are gifts not made according to this schedule

The notice is not required to be sent to the beneficiary who is also the trustee. 

It is required that the demand period be long enough to give the beneficiary a meaningful interest in the property given to the trust.  The beneficiary must be given a realistic opportunity to actually withdraw the settlor’s contribution.  In Estate of Cristofani v. Commissioner[14] the Tax Court held that a 15-day withdrawal period was sufficient.

The common gift tax pitfall in Crummey powers is that the trustee forgets to send the notices or we don’t have records of the notices.  It seems that may not be a problem anymore.  In Estate of Turner v. Commissioner[15], the tax court held that the right to withdraw a share of the trust assets equal to the value of the contribution was sufficient.  In this case, the trust gave the beneficiaries the right to withdraw.  The settlor never made payments to the trust.  Instead the settlor directly paid the premiums on the policies to the insurer.  The IRS denied the annual exclusion for the direct payment of the insurance premiums.  The tax court stated that the fact that “some or even all of the beneficiaries may not have known they had the right to demand withdrawal” did not prevent the creation of a present interest.

There are three kinds of Crummey powers:  (1) five-or-five Crummey powers, (2) Crummey powers with testamentary control, and (3) hanging Crummey powers.

The most common way to eliminate the beneficiary’s gift tax problem is through limiting each demand power to a noncumulative annual right to withdraw the greater of $5,000 or 5 percent of the value of the trust funds.  Section 2514(e) specifically provides that the lapse or release of a general power of invasion is not a taxable gift except to the extent that it exceeds the greater of $5,000 or 5 percent of the trust funds from which it could have been satisfied.

However, this power restricts the donor’s annual exclusion to $5,000 per donee.  If the trust has a principal value of more than $100,000, the 5 percent alternative limitation would increase the demand limitation, but few life insurance trusts have such significant principal values.  Thus the $5,000 limitation is commonly applied, and it may not shelter from gift tax all of a grantor’s gifts to a life insurance trust.  To the extent that these gifts are not covered by the $5,000 demand powers, the grantor must file gift tax returns and expend his or her unified credit or pay a current gift tax. 

In addition, this power is required to be measured annually.  Since the demand power is only exercisable after the receipt of notice of the gift, it compels the donor to make gifts before December 1 in order to leave enough time for the power to lapse by the end of the year.  Furthermore, it seems that the power shall lapse and cannot be released.  A release could be viewed as a taxable event.

Finally, multiple demand powers held by the same beneficiary must be aggregated.

7.            Importance of an Appraisal.  It is important to remember that every gifted real estate property needs to have an appraisal.  The tax assessed value is not sufficient.  Any gift of a work of art needs to be appraised.  Finally, any gifts of an interest such as a partnership interest, an interest in an LLC or a business needs to be appraised.  The cost of an appraisal can be pretty high and takes time.  A lot of information needs to be provided to the appraiser.  You have to ensure that your client is willing and ready to provide such information and to pay for the appraisal. 

Discounts for an interest in a partnership, family limited partnership or other businesses are often the cause of an audit.  Therefore, caution should be taken on the level of discounts.  Special valuation rules for Grantor Retained Annuity Trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs) are also strictly reviewed by the IRS.    

On the other hand, the IRS usually does not challenge discounts applied to tenancy-in-common interests. 

            D. Generation Skipping Transfer Tax (GST Tax)

The first Generation-Skipping Transfer Tax was enacted by the 1976 Act.  This tax was created in order to prevent the avoidance of transfer taxes over a period of successive generations.  The tax was tremendously complex.  The 1986 Act repealed it and replaced it with a new transfer tax applicable to all generation-skipping transfers whether by way of a trust, trust equivalent, or direct transfer.  The Generation-Skipping Transfer (GST) Tax applied to estate tax and gift tax.  This tax was created for people dying after October 22, 1986. 

The GST tax rate for 2010 was still 0%.  The Tax Act provides the same increase of tax exemption and tax rate for years 2011 and 2012: $5 million exemption (adjusted to inflation) and 35% tax rate.  The exemption is scheduled to be reduced in 2013 to $1 million with a 55% tax rate.  However, unlike the unused estate tax exclusion, an unused GST exemption at the first spouse’s death is not transferrable to the surviving spouse. 

As a result of the increased exemption of the gift and GST tax, a gift can be made to a trust that could be structured to continue for multiple generations (“Dynasty Trust”).  The GST exemption to the gift can be allocated to the trust so that the trust would never be subject to a GST tax, even though it may extend for multiple generations.  

The tax is imposed only on the value of the interests in property that actually pass to certain transferees, who are referred to as “skip persons.”

1.)     Generation-Skipping Transfers

The GST tax brings new concepts such as “transferor” and “generation.”  Under I.R.C. Section 2652(a) the transferor is the donor or the decedent.  The generation is defined among the family lines.  There is the generation of the transferor which includes the transferor, the transferor’s spouse, and the transferor’s siblings.  The children are part of the next generation.  The grandchildren are part of the following generation.  If the transfer is made outside the family, generations are determined by ages.  A person who was born not more than 12½ years after the decedent is in the same generation of the decedent.  A person born more than 12½ years, but not more than 37½ years, after the decedent, is in the first generation younger than the decedent.  A similar rule applies for a new generation every 25 years.  Therefore, a skip person is a natural person who was born more than 37½ years after the decedent.

There are three types of generation-skipping transfers:

(1)   taxable terminations,

(2)   taxable distributions, and

(3)   direct skips.

A taxable termination occurs upon the termination of an interest in a trust.  After the termination event the skip person holds all interest in the trusts.  For instance, a father created a trust, giving income for the lifetime of his daughter and the remainder to his granddaughter. 

A taxable distribution exists when there is a distribution of principal or income from the trust to a skip person.  For instance, a mother created a trust providing payment of income and principal to her children and grandchildren.  What is collected by the grandchildren is subject to GST tax.

A direct skip is when property is transferred without compensation to a skip person.  Among family members, a skip person would be a grandchild.  For a non-family member, a skip person is a person of two or more generations below the transferor.

2.)     Married Couple Special Rule

A married couple may elect to treat generation-skipping transfers as being made one-half by each spouse.  The QTIP election used for estate tax purposes is separate and ignored for the GST tax.  The fiduciary may allocate part or all of the decedent’s GST exemption to the property.  Because each person is entitled to a GST exemption, indexed for inflation, the GST election on a QTIP trust allows using two times the GST exemption.  This is a reverse of the QTIP election.[16] 

3.)     Tax Allocation

The amount of tax imposed on any generation-skipping transfer is determined[17] by multiplying the “taxable amount” by the “applicable rate.” 

                        3.1.)  Taxable Amount 

The taxable amount varies depending on the transfer.  For a taxable distribution transfer, the taxable amount is the transfer received by the transferee, reduced by the expenses incurred in the determination, collection, or refund which Chapter 13 tax imposed.  For a taxable termination transfer, the taxable amount is the value of property received at the termination reduced by deductions similar to Section 2053.  For a direct skip transfer, the taxable amount is the amount received.  The taxable distribution transfer and the taxable termination transfer are tax-inclusive transfers while the direct skip transfer is a tax-exclusive transfer.  In a tax-inclusive transfer the tax is calculated on the amount of the transfer.  The transferee receives the net of the transfer, therefore less than the gross amount of the transfer.

For instance, if the transfer amount is $2 million and the tax rate is 45%, the transferee will receive $1,100,000 [$2 million – ($2 million x 45%)].  In a tax-exclusive transfer, the transferred amount is what the transferee will receive.  If the transferee receives $1.1 million, the tax to pay out of the gift is $495,000.  The cost of the gift is $1,595,000.  However, for inter vivos transfers to a direct skip, the IRS considers the transfer a tax-inclusive/tax-exclusive transfer.  In this situation, the payment of tax is considered to be an additional gift.  An additional $222,750 should be paid.  The total cost of the $1.1 million gift is $1,817,750.

                        3.2.) GST Exemption

In 2011 and 2012, the GST exemption is $5 million with a 35% tax rate.  The exemption is scheduled to be reduced to $1 million in January 1, 2013 with a 55% tax rate.  Because the exemption is indexed for inflation, the GST exemption presumably will be the 2013 amount of the GST exemption: $1,136,000.  There is currently no credit for state tax paid with respect to direct-skip, generation-skipping transfers. 

                        3.3.) Applicable Rate and Ratio

The applicable rate of tax[18] is defined as the maximum transfer tax rate then in effect multiplied by the inclusion ratio.

            Each transfer has an inclusion ratio of one if none of the transferor’s GST exemptions is allocated to the trust or transfer.  This exclusion ratio can be reduced by any GST exemption allocated.  For instance, John transfers $4 million to an irrevocable trust which provides that income is to be accumulated for 10 years.  At the end of the term, the accumulated income is to be distributed to John’s daughter, Mary, and the trust principal is to be paid to John’s granddaughter, Suzie.  John allocates $3.5 million of John’s GST exemption to the trust on a timely filed gift tax return. The applicable fraction with respect to the trust is 0.88 [$3.5 million/$4 million].  The inclusion ratio is 0.12 (1.00 - 0.88).  If the maximum federal estate tax rate is 45% at the time of the GST, the rate of tax applicable to the transfer will be 0.054.

                        3.4.) Transfers Subject to an Estate Tax Inclusion Period (ETIP)

If the transfer to a direct skip was received within less than 3 years from the date of death of the donor, the direct skip is treated as having been made at the end of the ETIP rather than at the time of the actual transfer.  Transfers to be reported on an estate tax return, Form 706, would be transfers where the ETIP ends because of the death of the donor.  For instance, the donor reserved a life estate on the gift of a real estate property.  When the close of the ETIP is due because of a different event than the death of the donor, then the transfers should be reported on the Gift Tax Return, Form 709.  

            3.5.) President’s 2012 Budget Proposals

The President’s 2012 budget proposal includes a 90-year limit on the GST inclusion ratio.  The proposed legislation states that on the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate.  The inclusion ratio would move to one.

E. Simplifying the Gift Tax Rules

a.       Generally, the following gifts are not taxable gifts:

                                                         i. Gifts, excluding gifts of future interests, that are not more than the annual exclusion for the calendar year

                                                       ii. Tuition or medical expenses you pay directly to a medical or educational institution for someone

                                                      iii. Gifts to your spouse

                                                     iv. Gifts to a political organization for its use, and

                                                       v. Gifts to charities.

b. File a gift tax return if any of the following apply:

                                                         i. Gifts to at least one person (other than spouse) exceed the annual exclusion for the year

                                                       ii. Gift-splitting by married couple.

Gifts to third persons (other than citizen spouse) of a future interest that he or she cannot actually possess, enjoy, or receive income from until sometime in the future.

                                                      iii. Gift to a citizen spouse of an interest in property that will be ended by some future event.

F. State and Gift tax systems unified.

Pay gift tax on gifts which exceed the annual applicable exclusion when added with any estate tax payable on an estate or GST.

II.  Failure to Gift Tax High Net Worth Taxpayers in 2011 and 2012

A. Couples can make, without incurring gift tax, five time more gifts than prior [2010] or future laws [2013] permit.  Also any gift tax is subject to a significantly lower rate than before.

B. “Super-Sizing” Gifts

1. For individuals, the gift-tax applicable exclusion for 2011 and 2012 jumps to $5 million from $1 million.

2. For couples, the jump is to $10 million from $2 million.

3. These gifts are tax free because of the enhanced annual exclusion “...meaning people can give away that much without paying a penny in taxes...5.4 million households had net worth of $2 million or more [last measured 2007 by Federal Reserve].”See generally January 29, 2011, Wall Street Journal Weekend Investor, "The $5 Million Tax Break".

4. Moreover, the tax rate on large gifts fell from 55% to 35%.

5. Prudent planning dictates undertaking a gifting strategy study for taxpayers that fit these profiles.

a. Net worth approaches or exceeds the estate tax exemption of $5 million for a single taxpayer and $10 million for couples.            

b. Net worth approaches or exceeds $1 million and $2 million for married couples, that has a high degree of risk tolerance.

i. One could speculate that Congress will reduce the gift tax to $1 million in 2013.

ii. Consideration factors of age, health, and intent of taxpayer and a. projected speed of appreciation of asset gifting are some of the guiding lights.

6. The taxpayer must be mindful that gifts are irrevocable and the donee cannot be lawfully compelled to return part or all of a gift.

a. Changed circumstances, such as living longer than the life expectancy of the taxpayer or incurring more medical expenses than planned for, militates the risk toleration of the taxpayer be carefully gauged.

b. Danger of good faith and loving acts, like gifting to children and grandchildren, can leave taxpayer destitute.

c. Refusal or inability of children or grandchildren donees to return gift could end up destroying family harmony – a goal loftier for most than tax avoidance.

7.  Other Risks

a. Future Law Lowering Applicable Exclusion

i. Congress could lower the gift tax applicable limit as well as the estate tax and GST exclusion.

ii. The new law would be applied in accordance with the law at the time of death, e.g., gift in 2012 and death in 2014.

iii. Retroactive application of reduced tax exclusion may lead to an unforeseeable planning result – greater taxes than if the gifts had not been made.

iv. A law effective in 2013 or later could apply to all past gifts, or the law might "claw back" gifts greater than the exemption at the time the donor dies.


b. Loss of step up

i. If donee plans to sell the gifted asset, the cost basis is the donor’s cost of purchase of the asset.

ii. A transfer of the same asset at death has its cost basis stepped up to the fair market value at time of death.

iii. The advantage of aggressive gifting in 2011 could lead to a lower net to the donee.

iv. For example, the writer has probated or administered many estates involving homes in Northern Virginia bought after World War II with a cost basis of $35,000.  Even in the down 2011 market, the home’s Fair Market Value typically exceeds $400,000. The step up is an important part of the gifting calculus.

III. Jeopardizing Medicaid Benefits

A. Much confusion for taxpayers between IRS gift rules and Medicaid rules

Much confusion exists for taxpayers between the IRS gift rules and Medicaid rules, coupled with the desire to move assets so they don’t all go to the nursing home. For example, many clients have told the writer their belief that “gifts excluded from gift tax don’t count towards the Medicaid Penalty.” This is incorrect.

B. Medicaid qualification

Medicaid qualification requires meeting a medical test and financial test. A single person that requires long term custodial care [meets medical test] must spend down all assets until $1,000. A couple’s financial test is more complicated. For purposes of the study of gifting mistakes, assume all the income of the institutional spouse goes to the nursing home, and the healthy spouse spends down until left with approximately $100,000 in nonexempt assets.

C. Gifts and Medicaid

All gifts by Medicaid applicants will lead to a disqualification for Medicaid. The penalty period is computed by dividing the value of the gift into the average cost of nursing care in your community. Thus heartfelt gifts, including generous Christmas gifts, can leave the donor with funds to pay the nursing home and not eligible to receive Medicaid during the penalty period.

D. Dangers of gifting assets outright to children

1. There is a risk of not qualifying for Medicaid by failure to meet the financial test. Past gifts are treated as though still in custody of the Medicaid applicant in computing spend down.

2. Risks Emanating From Donee

a. Once the gift is in the donee’s asset, it may be subject to donee’s creditors, i.e., hitting a bus full of lawyers going to a Washington ABA meeting could lead to the loss of gifted assets.

b. Adult children may divorce, die, owe taxes, be sued, file bankruptcy or be spendthrifts, and the gifted assets may become dissipated.

3. One Solution - Family Protection Trust

            a. Estate Plan Design: irrevocable, grantor, income only trust reserving powers to change beneficiaries with lifetime power of appointment.

b. Assets owned by trust, not children, and not subject to children's creditors-only trust.

c. Grantor receives income so assets invested in insurance company annuities or bank CDs come back to parent; also used to pay taxes on real property in trust.

d. Home put into trust and trust maker retains right to occupy home for life.       

e.  Gift tax return timely filed, disclosing transfers to trust.

f. Assets remaining at death are legacy to beneficiaries of the trust, usually children.

g. Trustees are adult children with full discretionary powers to make distributions.

h. Grantors maintain a lifetime general power of appointment reserving the right to direct trust assets to third parties, often charities, at death.

i. Adult children are trustees and death beneficiaries.

j. Permits parents to live in home for rest of life and transfer residence to children with step up in cost basis. Compare to the loss of step up in an outright gift.

4. Trust Protection Solution

1. Avoids risk of dissipation of gifts by adult children creditors.

2. Takes home out of estate for Medicaid qualification if gift to trust occurs 5 years prior to application of Medicaid.

3. Not for everybody.

i. Requires taxpayer to understand complicated irrevocable grantor trust with power of appointment.

ii. Requires parents to agree to give up control of home prior to death.

IV.       Inaccurate Beneficiary Designations

A. Major danger missed by most.

            1. No copy or inability to locate copy of beneficiary designation leads to probate


2. Beneficiary designations do not take into account the owner’s consideration and skew the donor’s intent. For example, a living trust provides for equal shares to descendants per stirpes and $100,000 insurance policy designated beneficiary is spouse first and youngest child second for college tuition. Spouse predeceases policy owner, resulting in unequal distribution.


B. Avoid danger by updating all beneficiary designations when the estate plan is created and at each update. Writer recommends updating every three years and finds historical trend of clients is updating on a five-year basis.

C. Rules to Follow

            1. Always update beneficiary designations when updating estate plan.

2. Store beneficiary designations in a safe place where they can be located.

3. Ensure design of an estate plan to meet taxpayer’s goals that incorporates the impact of beneficiary-designated assets on the ultimate distribution.


[1] Presented by Richard Mayberry, Esquire, www.McLeanEstatePlan.com, (703) 714-1554 nationwide CLE webinar 12.14.11. Acknowledge assistance of Yahne Miorioni, Esquire, Of Counsel to Mayberry Law Firm,  in the writing. 

[2] Connecticut and Tennessee have a gift tax. 

[3] IRC §2512(b), Reg. § 25.2512.8

[4] “I.R.S. Moves to Tax Gifts to Groups Active in Politics” by Stephanie Strom, The New York Times, May 12, 2011.

[5] IRC § 2056 & 2523(a).

[6] IRC § 170(f)

[7][7] IRC §2055 & 2522

[8] See definition under IRC §(d)(1)

[9] See definition under IRC § 664(d)(2)

[10] See definition under IRC §(c)(5)

[11] See IRC § (f)(2), 2055(e)(2), 2522(c)(2)

[12] 2010 Instructions for Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, IRS.

[13] Crummey v. Commiss’r, 397 F2d 82 (9th Cir. 1968)

[14] Estate of Cristofani v. Comm’r, 97 TC 74 (1991)

[15] T.C. Memo. 2011-209 (Aug. 30, 2011)

[16] See I.R.C. Section 2652(a)(3).

[17] See I.R.C. § 2602.

[18] See I.R.C. § 264(1a).