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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