Bill: "Every year I pay income tax. And when I pass away my estate will owe tax. But I was absolutely stunned today to hear that I might even have to pay a gift tax! Do you mean that if I give this land to my children, there is yet another tax?"
CPA Carol: "Yes, Bill, there could be a gift tax. You can make small gifts like birthday gifts without tax. But if you give a large property to your children during your lifetime, there could be a gift tax. And it may be as much as 40% of the value."
Why Did Congress Pass a Gift Tax?
Following the passage of the estate tax, Congress realized that a gift tax is also necessary. If there were no gift tax, creative CPAs and estate attorneys would urge their clients to make deathbed gifts. Rather than waiting until they pass away and paying estate tax, if there were no gift tax the transfer tax could be entirely avoided by making deathbed gifts.
As a result, Congress determined that it needed to pass a gift tax to make the estate tax effective. Now, even if a person makes gifts on his or her deathbed the tax will be payable on the transfer to children.
How Does Gift Tax Work?
A person who makes gifts to children, grandchildren or other heirs will be taxed on the fair market value of the gift. The first part of the gift is allocated to the annual exclusion. But if the gift is more than that amount, then the cumulative gifts over the donor's lifetime are added up and compared with the lifetime gift exemption. If your total gifts (over annual exclusions) during your lifetime exceed the gift exemption, then you must pay gift tax.
What is the Annual Exclusion?
When the gift tax was first created, Congress understood that parents give birthday gifts and other small gifts to children, grandchildren and other heirs. As a result, Congress decided that there would need to be an exclusion for these smaller gifts. The exclusion was $3,000 for many years, then $10,000 and now has increased in value to $17,000. It is adjusted up for inflation about every three years by another $1,000.
How Many Annual Exclusions Can I Use?
First, the annual exclusion must be a present interest gift. This means that the child or other recipient must be able to use the property or spend the money.
Each person is permitted one gift exclusion per recipient per year. For example, a mother could give her daughter $17,000 under the gift exclusion in 2023. A mother and father could give a son and daughter-in-law $68,000, because there are two donors times two recipients times the $17,000 exclusion.
A grandmother and grandfather with ten grandchildren could make quite large gifts. If each gives $17,000 to the ten grandchildren, then the total gifts under the exclusion amounts would be $340,000 in one year. Assume that they made that same gift every year for ten years, for a total of $3.4 million. If the grandchildren retain and invest the gifts, at the end of ten years the appreciated value could be over $4 million – and all with zero gift tax and no use of their lifetime gift exemption.
How Much is the Lifetime Exemption?
Donors will typically first use their available annual exclusions. However, large gifts such as the ranch that Bill contemplates giving to his children may involve use of the gift exemption. The exemption is $12.92 million per person in 2023. After making use of the $17,000 annual exclusion, Bill and his wife, Helen, can each then give $12.92 million in value ($25.84 million total) to children using their lifetime gift exemption.
While there is no tax cost now for using the exemption, it does affect the estate. In future years, there will be a reduced estate exemption. If Bill uses $1 million of his gift exemption, that reduces the future available estate exemption by $1 million.
Are There Gift Deductions?
Yes, there are potential gift deductions for marital gifts, charitable gifts and gifts for medical expenses and tuition.
There is an unlimited gift exclusion for transfers to a spouse. The gifts could be outright or could be in a qualified terminable interest property (QTIP) trust. This is a special marital deduction trust. The spouse receives all the income from the trust and the trust principal can be invaded only for the benefit of the spouse.
A second deduction is for gifts to charity. The donor receives an income tax deduction, but there is also a gift tax deduction so the donor does not have to pay any gift tax on the transfer to charity. Once again, this deduction is unlimited.
A transfer to charity also may be a qualified split-interest transfer. A donor may create a charitable remainder unitrust, charitable remainder annuity trust or pooled income fund gift. The charitable deduction value qualifies for both the income and the gift tax deduction.
Parents and grandparents on occasion will pay the medical bills of a child or grandchild. These gifts are not subject to the gift tax provided the payment is made directly to the medical institution.
Finally, if a parent or grandparent makes tuition payments for a student, those amounts are also not subject to the gift tax.