Effectively Using the Annual Gift Tax Exclusion (Part I)

Estates, Trusts & Gifts

Estate taxes can be minimized by planning with the annual gift tax exclusion. Through the use of numerous examples, this two-part article demonstrates how proper use of the annual exclusion can, over time, move millions of dollars out of the estates of wealthy clients.

John J. Scroggin, J.D., LL.M.
Scroggin & Associates
Roswell, GA

Executive Summary

When combined with other planning techniques, use of the annual exclusion can provide substantial long-term tax savings.

A tax adviser must address the real and perceived fear that there will be insufficient funds to provide long-term care.

Because the IRS attacks Crummey rights, practitioners should ensure compliance with the existing rules.

The annual gift tax exclusion may be one of the most effective, but least used techniques available to estate planners, perhaps because $10,000 per donee seems such a small benefit. However, when combined with other planning techniques, its use can provide substantial long-term tax savings. This two-part article will explore in detail many of the planning opportunities available.

Example 1: G, a wealthy client, has three married children, each of whom has one child. G is unwilling to make gifts to in-laws. Shown below is the cumulative amount of $10,000 annual exclusion gifts to six descendants G could make over 30 years. After that time, the gifts total $1.8 million,¹ creating a transfer tax savings of $990,000 if G is in the 55% estate tax bracket. If G included in-laws, the total gifts would grow by 50% (i.e., to $2.7 million in 30 years).

However, this approach ignores another important aspect of the annual exclusion: moving assets out of a taxable estate on a discounted basis.

Example 2: The facts are the same as in Example 1, except that the gifts were of interests in a family limited partnership (FLP) that held real estate; further, a 35% valuation discount applies. Shown below is the net effect of this increased benefit to the same annual exclusion gifts of $60,000 over 30 years. Column 1 reflects the gifts' unadjusted value; column 2 shows the cumulative gifts after a 35% discount. Using this relatively simple device, almost $1 million more in assets are moved out of the taxable estate in 30 years, saving over $530,000 more in estate taxes for G in the 55% bracket.

Although almost $3 million is moved out of the taxable estate, there is an additional benefit from the effective use of the annual exclusion: it moves future value out of the taxable estate, stemming from appreciation in the value of the gifted assets and/or income generated by those assets.

Example 3: The facts are the same as in Example 2, except that the gifted assets appreciate 5% annually over 30 years.

Thus, significant benefit can be obtained from moving even small amounts of assets out of a taxable estate. In this case, $60,000 in annual gifts moved more than $6.15 million out of G's taxable estate in 30 years.

Annual Exclusion

The gift tax annual exclusion rules are fairly straightforward. Sec. 2503(b)(1) permits taxpayers to make annual gifts of up to $10,000 per donee, with no limit on the number of donees.² The gift must be of a "present interest in property," defined by Regs. Sec. 25.2503-3(b) as the "unrestricted right to immediate use, possession or enjoyment of property or the income from the property."

According to Sec. 2503(b)(2), the $10,000 annual exclusion is adjusted for inflation after 1998, but only in $1,000 increments (i.e., there must be at least a 10% increase for a change to occur). As of 2001, there have been no adjustments. Gifts covered by the annual exclusion do not reduce the donor's unified tax credit.

Maximizing Donee Exclusions

Most clients use the annual exclusion to make gifts to children and grandchildren. However, few clients have equal-sized family groups. Clients are often concerned that providing $10,000 in annual exclusion gifts to their children with larger families will result in a disproportionate benefit.

Example 4: Y, who is married and in the 55% estate tax bracket, has three married adult children, S, D and T. S and his spouse have two children; D's and T's families each have six children. Y is concerned that S's family will be negatively affected by annual gifts, because D's and T's families are larger. Y would like to maximize annual exclusion gifts, but also wants the three family groups to benefit comparably; Y thus asks about limiting the annual exclusion to $40,000 per family group (i.e., the maximum annual exclusion of the smallest family).

Variation 1--The family exclusion can be maximized at $200,000 ($10,000 to each of 20 family members) instead of $120,000 ($40,000 to each family). If Y and spouse agree to gift split,³ the total annual exclusion doubles to $400,000. Y can use the unified credit, either during life or via his will, to make additional gifts to S's family. Although lifetime use reduces the available unified credit at death, large annual exclusion gifts increase the overall tax-free dispositions to heirs and can more quickly move an appreciating asset out of a taxable estate.

Variation 2--Y can create a lifetime trust with all descendants as beneficiaries. At least $200,000 should be contributed, using annual exclusions and Crummey⁴ withdrawal rights. The trust is divided into three equal trust shares (one for each family), although the Crummey powers among the family groups will differ. A discretionary "spray power" would allow the co-trustees to make income or principal distributions to family members as needed. A special power of appointment would allow the children (S, D, T) to reconfigure the trust for grandchildren at any time before their deaths.⁵ At the death of each child, the trust share can be distributed to grandchildren or held in trust for their benefit. The growth in the contributed assets will not be subject to estate taxes at either the parent's or a child's death. Capital gain investments will avoid or reduce income taxes to the trust and/or beneficiaries.

Variation 3--What if D has no children? To the extent annual exclusion gifts (at a potentially discounted value) are made directly to D and spouse, the assets may eventually pass to unrelated parties (e.g., D's surviving spouse's niece). Instead, the assets can be held for the benefit of D and spouse in trust for their joint lives, triggering three principal benefits. First, the assets are retained within the Y family line. At the death of the second to die of D and spouse, the trust share pours over to other Y family members' trust shares. Second, even if D and spouse intended to pass their assets to D's family, such passage could result in the imposition of Federal or state estate tax. Holding the assets in trust can avoid such tax. Finally, if a spendthrift trust is created,⁶ the trust assets are protected from D and spouse's creditors. Moreover, the trust might provide that if the spouse divorces D, the spouse's trust benefits terminate.

Variation 4--If gift-splitting is not elected, the trust in 3 above could name Y's spouse as an additional trust beneficiary. During the spouse's life, the trust income and principal could be used for the spouse's benefit, allowing Y an indirect benefit. The spouse can be a co-trustee with the power to remove any other trustee. The spouse could be given a special power of appointment to reconfigure the trust, allowing changes in the trust's disposition to account for future tax, legal or family changes. If such an approach is used, Y may want to add a provision that a divorce automatically revokes any rights the spouse has in the trust and requires the spouse to resign as a trustee. Moreover, under Rev. Rul. 95-58,⁷Y can retain the right to remove the spouse or any one else as co-trustee.⁸

Benefiting the Entire Family

The tax adviser should view the annual exclusion available to the larger family groups (i.e., D's and T's) as a benefit to all family members. For example, in Variation 1, maximizing the annual exclusion increased the annual tax-free gifts to family members by $160,000,⁹ saving Y $88,000 in estate taxes for each year of gifts. If $400,000 is gifted for each of 10 years, using a 35% valuation discount and a 5% annual growth in contributed assets, an additional $2.7 million is moved out of Y's taxable estate, saving over $1.5 million in estate taxes and benefiting all of Y's heirs.

Other Beneficiaries

Donors can be other than parents and grandparents.

Example 5: Married brothers A and B inherited significant assets from their parents. A has three married children and five grandchildren; B has six descendants. Each brother has a significant estate. They have decided that it is in the family's best interest not to have their respective children share common ownership of the various family assets (i.e., they do not want their children to have common ownership with each other). A and B should decide which properties will be conveyed to their respective families and create FLPs to hold their property interests. Each brother can be a general partner of the partnership owning the properties held by his family group. A and B will gift FLP interests (with applicable minority and lack of marketability discounts) to each other's family members.¹⁰Assuming A and B are in the top transfer tax bracket, each gift would save up to $6,000 ($10,000 x 60%).

Fear of Insufficient Funds

Elderly clients are often concerned that they may later need assets they gift today. A tax adviser must address the real and perceived fear that there are insufficient funds to provide long-term care. Such a client should purchase a long-term care policy; alternatively, the client's donees (children) could use the first dollars of any annual exclusion gifts to pay the premiums of a long-term care policy on the donor.

If the interest being transferred is a business interest, perhaps the donor could receive deferred compensation to pay income after retirement; the payments would end at death. In effect, the donor is making gifts in return for an ensured future income stream from the business. The business should obtain a long-term care policy as a fringe benefit for the donor. If the policy is tax-qualified, the premiums the business pays are deductible.¹¹

Purposeful Gifting

Sometimes a client is unwilling to make gifts because the potential donee has not "properly" used the money in the past or the client wants to delay the donee's (e.g., an 18-year-old spendthrift's) access to the gift's benefits.

Parents can make annual exclusion gifts to minors who qualify for a Roth IRA and are in lower tax brackets, but do not have the funds to make contributions. For example, a client can match a child's summer job earnings to fund a Roth IRA. The parent will control the funds as guardian. Obviously, the parent will lose direct control over such funds when the child reaches majority.

A married client may be hesitant to make gifts to certain spendthrift family members. The client can instead make gifts of FLP interests (when the FLP owns family assets); the spouse and/or the donor can be general partners controlling the underlying assets. Alternatively, the donor can make gifts to a Crummey trust.

Sometimes a donor wants to retain indirect benefits from a gift or create a tiered structure of benefits from a trust.

Example 6: J is substantially older than his wife L; their long-term marriage is stable. J has 15 descendants from a prior marriage. He seeks to reduce estate taxes, but does not want to benefit his descendants to L's detriment. J can create a lifetime trust, with L and his descendants as vested beneficiaries. J will contribute at least $200,000 to the trust using the annual exclusion (i.e., 16 donees with Crummey powers + $40,000 of his unified credit). Gift-splitting is not elected, because L is a trust beneficiary. J names L primary trust beneficiary for her life; when she dies, benefits accrue to all of the Crummey power holders. Effectively, J used $160,000 in annual exclusion gifts to remove assets from his taxable estate without reducing the couple's lifestyle or depleting his unified credit. Obviously, when L dies, this indirect benefit ceases, because a reversionary right in L would pull the gifted assets back into her estate, under Sec. 2033.

Deathbed Gifts

"Deathbed" annual exclusion gifts are a significant planning tool. However, in Rev. Rul. 96-56,¹² the IRS ruled that if a donor dies before a gift check clears his account, the gift amount is not removed from the estate; the Tax Court agreed in Est. of Newman.¹³However, a charitable deathbed check does not have to clear the decedent's account before death.¹⁴

Example 7: M is in the 55% estate tax bracket and is terminally ill. She has four married children, 20 grandchildren and 4 great-grandchildren. Maximizing annual exclusions could move $320,000 out of her taxable estate each year, saving the family up to $176,000 annually ($320,000 x 55%). Gifting is preferable even if the gifted assets have a zero basis (that will carry over to the family), because the capital gain rate is lower than M's estate tax rate.

Example 8: V, a terminally ill client with no children, has a taxable estate. Her will provides for 10 special bequests of $10,000 each to friends, with the balance going to nieces and nephews; any estate tax is to be paid from the residuary estate. V should eliminate those bequests from her will and instead make gifts during life. Such an approach could save her nieces and nephews $37,000 – $60,000 in estate taxes.¹⁵

Trustees of living trusts need to be specifically authorized to make gifts of the donor's property. Powers of attorney should have similar provisions.

Crummey Powers

The $10,000 annual exclusion applies only to a gift of a present interest; the donee must be given present use and enjoyment of the property. A gift to a trust is a future interest, because the beneficiary's access to unfettered control of the gifted asset is delayed. A "Crummey right"¹⁶ is a trust provision that converts a contribution from a future interest to a present interest, by giving trust beneficiaries a right to withdraw trust contributions for a limited period (generally, 30 days). Crummey powers are often used to fund annual premiums to irrevocable life insurance trusts. Planning issues with Crummey powers include:

If the annual exclusion changes due to inflation or a law change, specific dollar withdrawal rights can create problems. Document language should instead refer to "the annual exclusion amount permitted by IRC Section 2503(b)."
To avoid having a beneficiary treated as an additional trust grantor under the Sec. 2514(e) "five and five" rule, the withdrawal right should be set at the greater of $5,000 or five percent of the trust principal, but not more than the annual exclusion amount. Using a straight $10,000 withdrawal right will violate the five-and-five power when the trust holds less than $200,000 (i.e., five percent of the trust will be less than $10,000). In such case, the beneficiary whose right has lapsed is deemed to be a grantor, creating potential tax problems.¹⁷
To simplify the notice process, any beneficiary who is also a trustee should have the first right of withdrawal and automatically be deemed to have notice of withdrawal rights on any trust contribution. This eliminates the need to provide actual notice to beneficiaries if the potential withdrawal rights to trustee/beneficiaries exceed any contributions (e.g., insurance premium costs).
The document should provide that a minor's withdrawal right can be exercised by a parent or legal guardian, and that a parent is automatically given the right to act on a minor's behalf.
Withdrawal rights should be provided only to vested beneficiaries.¹⁸
It should be provided that the withdrawal right is superior to all other trustee powers and authority, to avoid the argument that the withdrawal right is contingent on the powers of others involved with the trust.
If the donor's spouse or son- or daughter-in-law is to be a trust beneficiary, it should be provided that such person's rights automatically terminate on divorce or legal separation.
The IRS and the courts have, in many cases, held that the gift of nonincome-producing assets (e.g., a closely held business that does not pay dividends) is either a future interest that does not qualify for the annual exclusion or an asset that cannot be valued.¹⁹ Such assets should not be used to fund a Crummey right.

The IRS often attacks Crummey rights. Thus, practitioners should ensure compliance with existing rules, including:

Giving actual notice by certified mail and keeping copies of return receipts.
Maintaining sufficient assets to fund all beneficiaries' withdrawal rights, until the end of any withdrawal period.
Making contributions before December 1 each year and not making life insurance premium payments until after withdrawal periods have lapsed.²⁰
Having the grantor make trust contributions to the trust, with the trust then making any life insurance premium payments.
Having the trust contributions differ from the cost of annual life insurance premiums to avoid the IRS argument that the trust is the grantor's alter ego (e.g., trust contributions can be rounded to the nearest hundred dollars).
Having no "side" agreements that beneficiaries will not exercise their rights or waive their rights in advance.

In Letter Ruling 9804047,²¹ the IRS showed how not to construct a Crummey withdrawal right. A husband created a trust and gave his wife the right to withdraw 10% each year. The withdrawal right violated the Sec. 2514(e) five-and-five rule²²; for each year the spouse failed to withdraw, she was treated as having made a taxable gift to the trust. Such gift was not eligible for the annual exclusion, because Crummey rights had not been granted to the trust's remainder interest holders, the couple's children. Thus, if a withdrawal right is granted, it should be limited to the greater of five percent of the value of the trust's assets or $5,000, to ensure that any lapse does not result in adverse tax consequences to the beneficiary.

Tuition and Medical Gifts

In addition to the annual exclusion, under Sec. 2503(e)(2), amounts paid on behalf of an individual for education, training or medical care are not subject to gift tax. Thus, parents and grandparents²³ should consider making tax-free gifts of tuition and medical costs for family members without using the unified credit or annual exclusions.

The payments should be made directly to the qualifying medical or educational provider.²⁴ The tuition exception does not apply to amounts paid for room, board, books or supplies. The exclusion for medical expenses is not permitted for amounts reimbursed by insurance.

There are two related income tax issues. First, unless the donee is the donor's dependent, the donor will not be entitled to an income tax deduction for payment of medical expenses. (Payments qualify for the gift tax exclusion without regard to the parties' relationship.) Second, the gift could be taxable income to a parent with the obligation to provide that support.

Grandparent's Tuition Prepayment

In Letter Ruling (TAM) 9941013,²⁵the IRS ruled that a grandmother's advance payment of her grandchildren's tuition at a private secondary school was excluded from gift tax under Sec. 2503(e). This ruling offers an opportunity for clients (especially those who may die before tuition comes due) to reduce their taxable estates.

QSTPs

Gifts of prepaid tuition may also be made to a Sec. 529 qualified state tuition program (QSTP).²⁶ However, these gifts do not qualify for the Sec. 2503(e)(2)(A) tuition gift exclusion and will instead be covered by the annual exclusion or unified credit. The donor can elect to have the gift treated as made over a five-year period in certain circumstances, according to Sec. 529(c)(2)(B).

Basis Issues

In general under Sec. 1015(a), a donee takes the donor's carryover asset basis. However, the donee takes a fair market value (FMV) basis for loss purposes if the basis exceeds FMV on the date of the gift. Thus, the donor's appreciation in the asset will normally be taxed to the donee.

If a donee receives a low-basis asset, the gift's value is effectively reduced by the income or capital gain tax the donee will ultimately pay on the asset's sale. For example, if zero-basis stock worth $10,000 is transferred to a child, the gift's real value may only be $8,000 ($10,000 – 20% capital gain tax). The stock could instead be sold and the $10,000 cash given to the child. Not only is a higher value transferred out of the estate, but the payment of the capital gain tax effectively reduces the donor's estate. If the donor is concerned about losing future appreciation in the asset as a result of the sale, the donee could buy the same stock, using the cash gift.

At death, the basis in most of a decedent's assets steps up to FMV under Sec. 1014(a)(1). The determination of which assets should be gifted before death should include a review of basis. All other factors being equal (e.g., appreciation potential and income benefits), gifting of higher-basis assets is preferable, because lower-basis assets may step up to FMV at the donor's death.

Example 9: Z, a terminally ill client, could gift $10,000 in cash or zero-basis marketable stock. If cash funds the gift, on Z's death, the stock's basis step-up saves Z's family up to $2,000 in capital gain tax and any applicable state and local taxes.

However, if basis exceeds FMV on the gift date and the donee subsequently sells the asset for a gain, the donee uses the donor's basis in the property to compute the gain, under Regs. Sec. 1.1015-1(a)(1). If the donee sells the asset for a loss, the basis used is the FMV on the gift date. Thus, according to the example in Regs. Sec. 1.1015-1(a)(2), if the donee sells for a price between FMV and the donor's basis, neither loss nor gain is incurred.

Example 10: H has marketable stock with a $14,000 basis and a $10,000 FMV. If the stock is gifted to K, her child, who sells it for $10,000, the capital loss cannot be taken. Instead, H should sell the stock for $10,000, take a $4,000 capital loss, then gift $10,000 cash to K.

Under Sec. 1014, unlike a gift, the basis of an asset transferred at death is the asset's FMV, even if FMV is lower than date-of-death basis. Thus, it often makes sense to sell loss assets before death.

Gift-Splitting

Sec. 2513 permits a spouse to elect to be treated as the donor of a gift when the other spouse is the sole transferor.²⁷ For gift-splitting to apply, Regs. Sec. 25.2513-2(a) provides that the donor must file a gift tax return, on which the spouse consents to treat gifts as made one-half by each.²⁸ If elected, gift-splitting applies to all gifts made during the year; it cannot be made on a gift-by-gift basis. The spouses will have joint and several liability for any gift tax due.²⁹ If neither spouse has filed a gift tax return for the applicable year, generally the consent may be filed late, without any adverse effect.³⁰

Example 11: W, a widow, has three married children and five grandchildren, four of whom are married. W has now married F and has a sizable estate. W can make annual exclusion gifts of up to $150,000 to her family, saving estate taxes of $55,500 $90,000 per year.³¹ If F elects to split gifts, the tax savings double; further, F's estate is unaffected by W's gifts of $300,000 per year.

Example 12: B and J have each been married before; both are wealthy. B has five potential donees; J has nine. If they elect gift-splitting, each can double the other's nontaxable gifts, without any adverse effect on either's estate planning, while saving both families significant estate taxes.

Conclusion

This article has demonstrated the significant long-term benefits of the annual exclusion. Part II, in the July 2001 issue, will focus on other issues and planning opportunities available in using the exclusion.