Even Gifts Have Tax Strings to Them
Annual gift giving to children and grandchildren is one of the main strategies people can use to lower estate taxes that range to 40% when an estate exceeds $5,430,000 (as many have read, something may "give" in Washington in 2016 - stay tuned). In 2015, a husband and wife can now each make gifts of up to $14,000 annually in money or other property to as many beneficiaries as they like without incurring any gift tax liability. Furthermore, a husband and wife can give away $10,860,000 tax-free in 2015 (reduced by any prior lifetime gifts over their annual exclusions). Unfortunately, many people make inadvertent errors that defeat the benefit they hope to derive. Common mistakes we at Abo and Company LLC and Abo Cipolla Financial Forensics have seen include:
Making gifts of future interests in property when the intent is to obtain the annual gift tax exclusion.
Not considering their state's estate and/or inheritance tax hit (currently only a $675,000 exclusion in New Jersey).
Gifting highly appreciated property just before death, thus eliminating the benefit of the step-up in basis on inherited property.
Failing to make payments for tuition or medical expenses directly to the medical institution or educational provider and instead giving the funds to a child or grandchild.
Gifting mortgaged property with a mortgage balance that exceeds the adjusted basis of the property.
Not knowing that the annual exclusion is unaffected by transfers for medical, dental and tuition expenses.
Not realizing that a special rule permits a donor to put 5 years of an annual exclusion (i.e. $70,000) into a section 529 college savings plan for a particular donee.
Transferring income-producing property to children effected by the Kiddie tax (can sometimes apply to students up through age 23).under 14 since the unearned income in excess of a threshold amount is taxed at the parent's marginal rate.
An Abo and Company bit of advice - since the rules are complicated, especially as they pertain to property, it is essential that professional tax and legal assistance be obtained before gifts are executed.
We don't want to get too technical but let's dig a little deeper since we now all can see from our comments above that people frequently make gifts of property during their lifetime to reduce their estate and lower estate taxes. A common error we, as planners, frequently encounter is that income tax effects are ignored. For example, as our bullet three above noted, when gifts are made of property that has significantly appreciated, the property retains the same basis in the hands of the donee (he/she who receives) as it had in the hands of the donor (he/she who gives), so that when it is eventually sold, there will be significant capital gains taxes. On the other hand, if it had been retained by the donor and inherited by the donee, the basis to the latter would be the value at the time of death. In effect, at the time of a subsequent sale, all of the appreciation that occurred during the decedent's life would be inherited tax-free. Thus, appreciated property should generally be gifted when the donee is not expected to sell it. This also might be the case with a valuable business interest. Other rules of thumb we've seen are to give appreciated property away only to a donee that is in a lower tax bracket than the donor. If a donor is in the same or a higher tax bracket, the property should be sold first, capital gains taxes paid and the proceeds given away by the donor.
The use of gifts and their proper implementation to lower overall taxes is just one more illustration of how a client is best served by a planner who values a multi-disciplined approach to multi-faceted needs. Conversely, disservice is done when a client or planner does not appreciate the interdependence apparent in Abo and Company's "three legged stool" - tax planning, estate planning and financial planning.
When it comes to estate and Inheritance taxes on the state level, individual states have their own rules, exemptions and rates which may or may not parallel the federal estate tax rules. Thus, the structure of any estate plan (designed to minimize overall taxes to maximize inheritance dollars to named beneficiaries) should ALWAYS take into account the applicable state inheritance and estate tax laws as well.
Many states, including New Jersey and Pennsylvania, have variable estate and inheritance tax rates depending on the amount received and the relationship of the heir to the decedent.
For example, in New Jersey, there is the Transfer Inheritance Tax. No tax (0%) is imposed on those included and designated as Class A Beneficiaries (father, mother, grandparents, descendants, spouses, civil union partners, or domestic partners). Class C beneficiaries (brother or sister of decedent, husband, wife, or widow(er) of a child of decedent), civil union partner or surviving civil union partner of a child of decedent are taxed at 11% to 16%, with the first $25,000 exempt. Class D beneficiaries (not otherwise classified) are taxed at 15%-16%. New Jersey also has an Estate Tax with an estate tax rate of 4.2% up to 16% on estates over $675,000 (note that any estate tax imposed is offset by any inheritance tax incurred).
In Pennsylvania, the Inheritance Tax rates are slightly different...0% on transfers to a surviving spouse or to a parent from a child aged 21 or younger; 4.5% on transfers to direct descendants and lineal heirs; 12% on transfers to siblings; and 15% on transfers to other heirs.
In New York, the Estate Tax is computed based on the New York taxable estate of a resident or nonresident (as defined in the statute) with tax rates ranging from 3.06% to 16%.
Also, each state has varying minimum exemption amounts that may or may not be equal to the federal inheritance tax exemptions. New York, for example, has an exemption amount for decedents dying April 1, 2014 - March 31, 2015 of $2,062,500, increasing each year until it maxes out at the federal exemption rate in 2019 projected to be $5,900,000. So the estate of a resident dying through the balance of 2015 in New York with a taxable estate of $5,430,000 would owe nothing to the IRS but would owe New York State approximately $442,000. If the decedent was a Pennsylvania resident, Pennsylvania would receive up to $814,500 (depending on the class of beneficiary). Assuming the same decedent was a New Jersey Resident, they would place in Governor Christie's coffers up to $868,800 (depending on the class of beneficiary inheriting from the decedent).
Finally, since this article is about gifts, we would be remiss if we did not mention that, as a general rule, where a state like New Jersey does not have a gift tax, gifts made within three years of the death are construed as "gifts in contemplation of death" and added back to increase the taxable estate,
While gifting can be a powerful estate, tax and financial planning strategy, you should be careful to ensure that you will continue to have sufficient resources to meet your financial needs over time.