Jessica A. Lyons, Esq. and
Fred F. Mashian, Esq.
Gift tax continues to be one of the least understood and frequently overlooked areas of estate and tax planning. As the lifetime gift tax exemption has and continues to be increased gradually, with the latest increase to $11,700,000.00 per individual ($23,400,000.00 for married couples), many people–including financial advisors and accountants–became less vigilant with compliance, assuming gift taxes were only an issue for the extremely wealthy.
Ignoring the requirements or having no gift tax strategy at all can have major ramifications on any affluent person’s tax situation, especially in the event of an IRS audit. Worse yet, failure to comply with gift tax requirements can even trigger an audit.
People wrongly assume the IRS won’t find out about gifts if they aren’t reported. However, the IRS routinely searches public property as well as other public records, looking for transfers of property between relatives or transfers that were made without payment, which they can later compare to filed gift tax returns. The IRS also looks to the tax returns of children of the wealthy, and often successfully challenges how children in a second generation would have amassed substantial real estate or other assets in their early 20s, outside of gifting.
Just like any other tax return, a gift tax return has a three-year statute of limitations for an audit, effective the date the tax return is filed. However, if a gift tax return is never filed reporting a gift, then the statute never starts to run. It can be another five to ten years before the gift is discovered through an audit or otherwise, and then the taxpayer is looking at substantial penalties and interest.
Even if the IRS doesn’t catch these transfers during one’s lifetime, it can later audit the estate of the taxpayer, imposing heavy penalties and interest from the date the gift tax return should have been filed, thus defeating the entire purpose of one’s estate plan.
To help avoid these disasters, we’ve prepared a short primer on gift tax, with explanations of the most misunderstood areas.
Gift tax basics:
Currently the amount of money that one can give as a gift to an individual who is not their spouse, in any given year, without having to pay any gift tax is $15,000.
This $15,000 gift tax limit isn’t a cap. One can make individual $15,000 gifts to as many people as they want, and so can their spouse. One just cannot gift any single person more than $15,000 within one year, or $30,000 if gifting as a husband and wife.
If one does gift more than $15,000 to a person, they will need to file a gift tax return to disclose those gifts to the IRS. Depending on the fair market value of the gift, it is possible that they won’t have to pay any gift taxes, so long as they have not hit the lifetime gift tax exemption detailed above.
However, one still needs to file a gift tax return. One of the biggest misconceptions about gift tax is the assumption that no tax return needs to be filed because a gift isn’t taxable, due to the available exemption of the donor and/or his spouse.
Gift tax returns are filed using IRS Form 709 [U.S Gift Tax and Generation Skipping Tax Return] and—like individual tax returns—are due on April 15, for reporting activity from the previous year.
The good news is that if one has neglected to file gift tax returns for the past few years, there’s no penalty for late filing. One will want to file before the IRS catches the problem. Keep in mind that every Form 709 that is filed needs to be kept indefinitely. The heirs of the taxpayer will need them to calculate any estate tax owed after they pass away.
Other situations where a Form 709 gift tax return must be filed:
(i) Gift splitting by married couples.
Married couples can combine their individual annual exclusions of $15,000, which allows them to give $30,000 annually to any individual, whether related to them or not. That way, the recipient can receive a larger amount of money and the married couple won’t exceed their $15,000 limit. Even if one spouse is the sole source of the gift, this combining of exclusion limits is still allowed.
However, once a gift is split, the married couple is required to split all gifts for the remainder of the tax year, for any additional people who receive gifts.
(ii) College Savings Plans- 529 Accounts.
If one sets up a 529 Plan for a child or other individual, they are allowed to bundle 5 years of annual ($15,000/$30,000) gift exclusions into the first year. For example, an individual or married couple can transfer $75,000/$150,000 to a college savings plan in one lump sum but still be allowed to treat this transfer as though they had contributed $15,000/$30,000 each year for 5 years. To take advantage of this benefit, a Form 709 must be filed.
So what gifts are exempt from gift tax?
(i) Payment for a child’s or individual’s medical or educational expenses. Keep in mind the payment must be made directly to the healthcare provider or educational institution; the money can’t be given to the individual directly to make the payments.
(ii) Gifts to charities which are tax deductible.
(iii) Gifts to one’s spouse (either made directly to the spouse or to a trust that meets certain criteria.) Spouses can give each other unlimited gifts for their entire lifetime.
(iv) Gifts to a spouse who isn’t a U.S. citizen, that are below $159,000. Any amount above $159,000 must be reported on Form 709.
Situations where one should file a gift tax return even if it’s not required:
It’s usually a good idea to file a gift tax return when dealing with “hard to value” assets such as an interest in a privately-held business, because doing so limits the amount of time the IRS is allowed to challenge the value of one’s gifts to a period of three years.
For example, if one transferred business interests valued at $8 million over a period of time–using tax-free gifts to their spouse and the annual exclusions to their children–and the IRS later decides these interests were actually worth $20 million (thus exceeding the $11.7 million lifetime exemption), the IRS can assess gift taxes plus interest and penalties on the amount that exceeds the exclusion.
Similarly, when dealing with gifts of real estate, or business entities that hold real estate investments, it is wise to file a return. Real estate appraisals and business valuations can vary in value, and one will want to ensure that the IRS cannot counter those values years later, by filing the gift return, and starting the three-year statute of limitations.
A common gift tax mistake: confusing present interest with future interest
A gift of “present interest” is one that the recipient is free to use or spend and benefit from immediately—with no strings attached. It becomes a “future interest” gift if the recipient doesn’t have complete use of it until some future point in time. This is an important distinction.
If one makes a gift that can’t be immediately used by the individual in question (such as putting money into a trust for the individual’s future benefit which they cannot access now) they need to file a Form 709, even if the amount in question is less than $15,000.
That said, the gift could qualify for the present interest requirement if the gift recipient has a limited right to withdraw the money from the trust. While the amount of money one can gift to one’s spouse is unlimited, things get a bit more complicated when making a gift to a trust for a spouse’s benefit.
Three things are required to keep the gift to a trust non-taxable:
1) The spouse must be entitled to all the trust income;
2) The spouse must have a power of appointment over the trust’s assets. A power of appointment is a right given in the trust that allows the recipient to dictate that another person or entity receive the trust property; and
3) The spouse may not be subject to any other person’s power of appointment.
Another issue to be aware of: Generation-Skipping Transfer Taxes
The generation-skipping transfer (GST) tax is a tax assessed on transfers of property to a person or persons who are more than one generation removed from the transferor. These persons are known as skip persons. A transfer from a grandparent to their grandchild, either outright or in trust, is the most common example of a situation that triggers this tax.
Each individual has an annual and lifetime GST exemption that mirrors and is part of their gift and estate tax exemption. So, a total of $15,000 per year, up to $11,700,000 total can be transferred to a skip person without triggering taxes.
However, if one makes an outright gift to a skip person, or if their trust makes a distribution to a skip person, they should still file a gift tax return, even if the resulting tax due is $0.
Also, many trusts are designed to avoid estate taxes for the trustor’s children, and so it is important to keep in mind that a GST tax may ultimately be due after the death of those children, and the distribution of trust property to the subsequent generations.
We are here to help
Gift tax returns can be an important part of your overall estate plan strategy. They can also serve as a proactive measure to protect you and your family from audits or penalties in the future. You may wish to consult an experienced estate and tax planning attorney to ensure you are covered. Please don’t hesitate to contact us at the Law Offices of Fred F. Mashian, at (310) 274-7501 if you would like to discuss gift tax returns in more detail.
