Generational Generosity
Would you rather transfer your wealth to the IRS or to your loved
ones? If you answered the IRS, then disregard this article.
On the other hand, if you answered your loved ones, then
read on. We will review some of the relevant tax rules for
lifetime gifting, then examine two common transfer methods (along
with a few of their potential pitfalls).
Gifting Fundamentals
Every taxpayer may transfer up to
$12,000 each year to an unlimited number of individuals. This is
known as the Annual Gift Exclusion (AGE). Through gift
splitting, spouses may give a total of $24,000 each year to an
unlimited number of individuals (even if only one spouse is the
sole source of the funds gifted). Such lifetime gifts made within
these dollar limitations do not trigger gift taxes when made, nor
do they reduce the combined Applicable Exemption Amount
available to protect lifetime transfers of wealth exceeding AGE
limits and postmortem transfers of wealth. Accordingly,
maximizing transfers within the limits of the AGE has been and
remains a prudent method to transfer wealth between generations.
[Exception: Qualified payments in any amount made directly
to an educational institution for tuition and directly to a
provider of medical care on behalf of any individual are fully
excluded from gift tax consideration and may be made without
dollar limitation.]
EGTRRA Exemption
Under the Economic Growth and Tax
Relief Reconciliation Act of 2001 (EGTRRA), taxpayers are able to
make total lifetime tax-exempt transfers of wealth totaling $1
million independent of the AGE limitations. For example, a widow
with five grandchildren could transfer a total of $1.06 million to
them free of gift taxes all in the same calendar year.
Additionally, this $1.06 million would be excluded from her estate
for determining any future estate tax liability, as would any
future appreciation on the gift. [Note: On the downside, however,
the grandchildren would receive their grandmother’s cost
basis in the gift, triggering potential capital gains taxation
on any appreciation above cost basis. Proper estate planning often
requires balancing your tax and non-tax objectives.]
Depending on the size of your overall
estate and your ability to make gifts without affecting your
lifestyle, maximizing your lifetime wealth transfers may be a
tax-savvy strategy given the uncertain future of the estate tax.
Nevertheless, once you have made the decision to be
inter-generationally generous, the next decision is how to make
the transfer. Two popular methods are outright gifts and custodial
accounts.
Outright Gifts
An outright gift with no strings
attached is the simplest method of making a lifetime wealth
transfer. You simply deliver the asset directly to the donee. Once
in the hands of the donee, however, your gift may be taken away
from them through a divorce, lawsuit or bankruptcy. More commonly,
your gift may be squandered, because you have no further
control over an outright gift once delivery is made. Fact: No one
appreciates the value of a dollar like the person who earned it
(and paid taxes on it). Fortunately, the law provides at least one
simple alternative to protect gifts, particularly when made for
the benefit of minors.
Custodial Accounts
Custodial accounts established under
the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to
Minors Act (UTMA) are very popular methods of making transfers to
loved ones who are minors. They are popular because they are
convenient and inexpensive to create. Almost all financial
institutions offer such arrangements.
Beware: The account becomes the unrestricted
asset of the beneficiary upon reaching age 18 or 21, depending on
applicable state law. In other words, it could be used for fast
cars and stereos, instead of books and tuition.
Summary
Inter-generational generosity makes
good sense for a variety of reasons. However, great care must be
given to the method of transfer to avoid the potential pitfalls of
these do-it-yourself methods.
Crummey Trusts
There are many non-tax benefits to making lifetime gifts to loved
ones, aside from the obvious tax benefits. For example, what
better way to preview the financial maturity of your loved ones
with an inheritance in the future than through a dress
rehearsal in the present … while you are still in the
audience?
Keeping Control
If you are like most people, you may
be reluctant to part with control over how your lifetime gifts
will be used once transferred. Unfortunately, when you retain
direct control over a gift, the value of the gift (and its
appreciation) may be included in your estate upon your death for
estate tax purposes. Worse yet, the gift may be taxable at the
time of transfer as a future interest gift, rather than
treated as a nontaxable present interest gift.
To qualify as a nontaxable present
interest gift, the donee must be able to exercise complete and
unrestricted control over the gift. Fortunately, there are
exceptions to this general rule, such as custodial accounts for
minors as described. Another exception is the Crummey Trust,
as created in the landmark case of Crummey v. Commissioner,
397 F2d 82 (9th Cir. 1968).
Although the Crummey case carved an
exception to the general rule regarding the present interest
requirement for nontaxable gifts, the path to safety is very
narrow. Therefore, it is essential for the success of your Crummey
Trust that you dot all of the legal i’s and cross all of
the procedural t’s. Truly, the devil is in the details
here. [Note: If a Crummey Trust is properly created, administered
and funded with life insurance, then 100 percent of the eventual
insurance proceeds will be excluded from the trustmaker’s
estate under current tax law.]
Crummey Requirements
First, you create an irrevocable trust
agreement (you cannot change its terms once signed by you)
containing all of the strings you wish to attach to the
future gifts to the trust.
Second, you make lifetime gifts to the
trustee on behalf of your trust beneficiary (or beneficiaries).
Third, the trustee must provide written
notice to the beneficiary (or their legal guardian, if the
beneficiary is a minor) each time you make such a gift, giving the
beneficiary a period of time (typically not less than 30 days) to
exercise their right to withdraw all or part of the gifted amount.
If the beneficiary does not exercise this
withdrawal right, then the gift lapses and the trustee
administers the gift for the beneficiary according to the strings
you attached. These strings may provide valuable protection for
your gifts from divorces, lawsuits, bankruptcies and squandering.
Conversely, if the beneficiary exercises this withdrawal right,
then you may have gained a valuable insight into their current
financial maturity level. In either case, you may wish to revise
your estate plan accordingly.
As on Broadway, a dress rehearsal today
may prevent bad acting tomorrow.
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