Client's Guide to Gifts and Gift Trusts

1. How can I reduce my estate taxes by making lifetime gifts?

Making lifetime gifts of assets that would otherwise be subject to federal estate taxes to your children and grandchildren can dramatically reduce or even eliminate estate taxes. You can avoid the estate tax that may deprive your beneficiaries of as much as 55% of their inheritances by using these features of the federal estate and gift tax laws:

a.    The $12,000 Annual Exclusion.  Each individual can give up to $12,000 per year per recipient (beginning in 2006) without gift tax consequences and without filing a gift tax return. The number of possible recipients is unlimited. This means that a typical couple with two children can give up to $48,000 per year to their children under this exclusion. An older couple with two married children and four grandchildren can give up to $192,000 per year in this fashion if the children's spouses are included. The unused portion of your annual exclusion in any one year is lost forever; it cannot be carried forward into the next year. To qualify for the annual exclusion, a gift must be a gift of a "present interest", which is discussed in Section 4. The $12,000 amount is indexed to inflation and will increase in future years.

b.     The Unlimited Exclusion for Educational and Medical Expenses. In addition to and entirely separate from the $12,000 annual exclusion, there is an unlimited gift tax exclusion for payment of another person's educational or medical expenses. To qualify for this exclusion, the payment must be made directly to the service provider (the hospital, doctor, or educational institution). Reimbursing a person for expenses already paid does not qualify for this exclusion. The exclusion for payment of educational expenses is limited to tuition only, and does not include books, supplies, dormitory fees, etc. This is a perfect way for grandparents to make a valuable, tax-free gift to their grandchildren. Medical expenses can include payment of medical insurance premiums, but do not include expenses that are not deductible for income tax purposes (such as elective surgery for purely cosmetic reasons).

c.     The Applicable Exclusion Amount (formerly the "Unified Credit"). Each person has an estate and gift tax exemption  (called the "applicable exclusion amount" under current tax law) that allows up to $1,000,000 worth of assets to be transferred during his or her lifetime or $2,000,000 at death. The portion of your applicable exclusion amount not used during your lifetime would be used at death. Gifts using your applicable exclusion amount can be made in addition to gifts using your $12,000 annual exclusions and the exclusion for educational and medical expenses. Many clients do not use their applicable exclusion amount during their lifetime, but early use of the applicable exclusion amount has numerous advantages. First, increases in value of gifted property and the income earned on the property will not be subject to gift or estate taxes. Second, if Congress ever decides to reduce the applicable exclusion amount then any reduction will probably be "grandfathered" so it doesn't apply to gifts made before the law changed. 

d.     Gift-Splitting Between Spouses.  When a gift is made by a married person to a third party, the spouse of the donor may allow the gift to be treated as if it was made one-half by each spouse. This gift-splitting is effective for both use of the annual exclusion and the applicable exclusion amount. For example, assume that Wife owns a $20,000 vacant lot that she wants to give to Child. Without gift-splitting, this would exceed her $12,000 annual exclusion and $8,000 of her applicable exclusion amount would be used. If Wife and Husband elect to split the gift, then the gift is treated as having come one-half from Husband even though Wife is the sole owner of the property. The gift would be within the couple's combined annual exclusions, and Wife's applicable exclusion amount would not be used.

To qualify for gift-splitting, the couple must be married at the time of the gift, and must file a timely gift tax return (IRS Form 709) signed by both spouses consenting to the gift-splitting. The election will apply to all gifts made by either spouse while the couple is married during the year for which the return is filed. Gift-splitting is not available for property passing at death.

e.     Post-Gift Appreciation Is Not Taxed.  When you make a lifetime gift, it is valued as of the date of the gift for gift tax purposes. Estate tax on property left upon death is generally figured on date of death value. This means that any post-gift increase in the value of the property has been transferred free of estate and gift taxes. As an extreme example, we know of people who given stock in a company they helped found to their children during the company's early years when the stock was worth very little. A few years later, the company went public. The stock price skyrocketed, and made the children millionaires while still in their teens. Through their foresight, the parents were able to transfer this stock to their children at little or no estate or gift tax cost and saved hundreds of thousands of dollars in potential estate taxes.

2.   How much estate tax can I save by initiating a lifetime gift program?

Following a gift program can save substantial estate taxes, even if you only use annual exclusion gifts. 

Assume that John and Jane Doe have two children and four grandchildren, and assets of $5 million. If John Doe dies in 2006 (when the estate tax applicable exclusion exemption amount will be $2,000,000 under current tax law) and Jane Doe dies in 2008 (when the estate tax applicable exclusion amount will still be $2,000,000), and assuming that John Doe's applicable exclusion amount has been preserved by use of a credit shelter trust in his Will or Living Trust, then estate taxes of approximately $460,000 will still be imposed upon Jane Doe's death in 2008, even with no appreciation in their assets! 

If John and Jane Doe make annual exclusion gifts of $12,000 per year to each of their children and grandchildren, they can each give up to $72,000 per year. Based on the above facts, these gifts will reduce the taxable estate of the surviving spouse by $504,000, reducing estate taxes from $675,000 to $467,100, thus saving $207,900!

3.   How can I be sure my children won't frivolously waste my gifts?

Despite the tax advantages of making lifetime gifts, many parents are apprehensive about making substantial gifts to their children.

They fear that the children will fritter away the money that the parents worked very hard to earn. They're afraid that if the children receive the money before they are mature, they will lose the drive and initiative to be successful in their own right.

These concerns can be addressed by structuring the gift properly. There are four common methods used to make gifts:

1.      The first is an outright gift, which gives the recipient complete control and leaves the gift vulnerable to the recipient's creditors.

If the recipient is at least 18 and has earned income, a gift can be made as a contribution to a traditional or Roth IRA in the recipient's name.  While the child would have the right to withdraw the contribution from the account, the resulting income tax penalties may discourage such action. 

2.      If the gift is to a minor child, a second way is to make the gift to a custodian of your choice under the Florida Uniform Transfer to Minors Act. Under this Act, the custodian controls the money or property until the child turns 21. At this point, the accumulated gifts must as a matter of Florida law be distributed outright to the child all at once. One advisor has called this law the "Uniform Sports Cars to 21-year-olds Act." Also, a gift to an UTMA account may require filing separate income tax returns for each child.

While it is possible to transfer assets to yourself as custodian for a child, please be aware that such assets will nevertheless be subject to estate taxes if you die while serving as custodian.   A third party should therefore be named as custodian to avoid estate tax inclusion.

3.      A third way to make gifts is to make contributions to a Section 529 Plan for your children's future education. Significant income tax benefits are achieved so long as the funds are used for qualified education expenses of the beneficiaries. 

4.      The fourth way is to establish a trust for the beneficiary (called a "Gift Trust') to hold the gift under the terms that you, as Grantor of the Trust, determine and set forth in the trust instrument. You can dictate how much the beneficiary receives, when it is received, and the purposes for which a distribution can be made. You can choose a trusted person or persons to be Trustee and can retain the right to replace the Trustee for any reason. You can also give the Trustee discretion to withhold distributions if the Trustee thinks it's in the beneficiary's best interest at the time. You can provide that the Trust assets could be used for college and graduate school expenses, a first home, or to start up a new business. You can even provide that the beneficiaries receive nothing until after your death. Because a Gift Trust contains spendthrift and anti-alienation clauses, any undistributed property in the Trust is generally immune from your children's creditors.

Clients often use family limited partnerships or family corporations whereby the client can control the entity and its assets, but can give partial ownership interests without control rights (e.g. limited partner interests in a limited partnership or non-voting stock in a corporation) to their children, grandchildren, or to Gift Trusts established for their children and grandchildren.

4.   Do gifts to a Gift Trust qualify for the annual exclusion?

As previously mentioned, to qualify for the annual exclusion, a gift must be a gift of a "present interest," which simply means that the recipient must either receive or have the right to receive the gifted property at the time of the gift. This is not a problem for outright gifts or gifts under the Uniform Transfers to Minors Act, and the tax law specifically provides that contributions to Section 529 plans qualify, but can be a problem for gifts in trust. Gifts in trust do not qualify for the annual exclusion unless the trust either qualifies as a "Minor's Trust" under Internal Revenue Code Section 2503(c) or has certain temporary withdrawal powers called "Crummey" powers. To qualify as a "Minor's Trust," the beneficiary must receive or have the right to receive all of the property in the trust outright at age 21. This generally makes the Minors Trust unpopular for most clients.

A "Crummey" power gives the beneficiary a temporary right to withdraw the gift from the Trust. The beneficiary is given written notice of the gift to the Gift Trust and has a specified time, usually 45 or 60 days, to elect to withdraw the gift. If the beneficiary fails to exercise this right, then it lapses and the gift stays in the Trust irrevocably.

Gift Trusts using "Crummey" powers offer maximum flexibility. There is no specified age at which the beneficiary must receive the property except the age or ages that you select. A typical arrangement is to have the trust property distributed 1/3 at age 25,1/3 at age 30, and the rest at age 35, but you may leave the property in trust until the beneficiary reaches age 50 or even older if that is what you wish. You can give the Trustee discretion to change the ages as you wish. More and more clients are realizing the creditor protection and tax planning advantages of having assets held in trust and provide that each child's assets will remain in trust for his or her entire lifetime, with the child serving as sole Trustee at an age determined by the client. You can give the Trustee the power to invade the shares of less needy beneficiaries for the benefit of more needy beneficiaries. You can even have the trust be a generation skipping trust so that the property stays in trust for up to 360 years, to provide benefits to each succeeding generation while not being subject to estate taxes in their estates. 

5.   Who can be the initial Trustee of my Gift Trust?

A Grantor should usually not be the Trustee of a Gift Trust, but can retain the right to replace the Trustee at any time. A person who is also a beneficiary of the Trust (for example, a responsible eldest child) may serve as Trustee, if the Trust is specially drafted. If only one spouse is making gifts to the Trust, then the other spouse may serve as Trustee, although it is typically preferable to have a third party Trustee.

The Trustee can be a family friend or relative. A bank or trust company may also serve as Trustee. For a larger Trust, an individual and a bank or trust company could serve as co-Trustees, with the individual Trustee having the power to replace the bank or trust company.

6.   How much control can I maintain over my Gift Trust once it is established?

A Gift Trust is irrevocable. After it is established you cannot revoke the Trust or modify its terms. The key is to make sure the Trust document provides adequate flexibility. For example, the Trustee should be given the discretion to withhold distributions it deemed in the beneficiary's best interest, and should have discretion in other key areas.

Under IRS Revenue Ruling 95-58, you can now retain the power to replace the Trustee, so long as the replacement trustee you select is not "related" or "subordinate" to you. Most clients find that this ability gives them adequate control over the Trust.

Your Trust can also include the appointment of trusted independent persons as "Trust Protectors" who would have the authority to replace the Trustee and modify certain Trust provisions if necessary.

7.   How can using a Gift Trust allow me to transfer more to my children that I would be able to do so using an outright gift?

A Gift Trust can include a "grantor trust" power that would cause you to be considered as the owner of the trust for income tax purposes even though the property has been gifted and will not be included in your estate for estate and gift tax purposes. This means that, as Grantor, you would pay the income tax on the Trust's income on your personal Form 1040. This payment of the Trust's income tax is not considered an additional gift to the Trust under current law.

By using this technique, you allow the property in the Trust to compound income-tax free which, over a number of years, could greatly increase the value of the property in the Trust (and out of your estate). For example, assume that $100,000 is contributed to a Gift Trust that is a grantor trust, and that it generates income equal to 10% of its assets per year which is taxed at a tax rate of 30%. If the Gift Trust paid the taxes on the Trust income, then at the end of 10 years, the Trust would have assets worth approximately $196,700. If the Grantor pays the taxes, then the Trust assets at the end of the same 10-year period would be almost $259,400, meaning that an additional $62,700 in assets would avoid being subject to estate tax, saving almost $34,500 in estate taxes assuming the 55% rate applies.

There are also potential income tax savings if your marginal income tax rate is less than the Trust's. Trust income tax rates are very compressed, reaching the top marginal rate of 35.0% at only $9,550 of income in 2004.

Of course, if you wish to use a grantor trust, a cash flow analysis should be performed to ensure that you have the cash to pay the taxes on the trust income. If the Trust is properly drafted, the grantor trust power can be released or terminated at any time, so that all future income would be taxed to the Trust rather than to you.

8.   How can using a Gift Trust save my family substantial income taxes, as well as estate taxes?

A problem with making outright lifetime gifts of assets that have appreciated in value or that can be expected to appreciate after the time of the gift is that you lose the "step-up" in income tax basis to date of death fair market value under Internal Revenue Code Section 1014 that currently applies to assets that you own at death.

Here's how the basis step-up works. Let's say that you bought $100,000 of XYZ stock in 1990. The stock is now worth $200,000, and you think it will go up to $500,000 during your lifetime. If you leave the stock to your children at death, then they have a "stepped-up" income tax basis equal to the fair market value as of the date of your death (i.e., $500,000). If they sell the stock for $500,000, they pay no capital gains tax, but there may be estate tax payable on the entire $500,000. However, if you give the stock to your children outright now, then then they will have a "carryover" income tax basis of only $100,000, and if they sell the stock for $500,000, then assuming a capital gains tax rate of 15%, they will have to pay capital gains taxes of $60,000 ($500,000 amount received - $100,000 basis = $400,000 capital gain x 15% tax rate = $60,000 tax). 

However, by making a lifetime gift of the stock to an Irrevocable Gift Trust that is a grantor trust, this problem can be avoided. This is because a commonly used "grantor trust" power is a power in the Gift Trust instrument that allows the Grantor to substitute trust assets with other assets of equal value. 

If you make the gift of XYZ stock to a Gift Trust with this grantor trust power, then you have the ability to replace this stock with cash or high-basis assets at any time during your lifetime, so long as the value of the replacement assets is equal to the fair market value of the XYZ stock at the time of the replacement. In this example, when the XYZ stock is worth $500,000, you could get it back from the Gift Trust by replacing it with $500,000 cash. Upon your death, you would own the XYZ stock, which would receive a stepped-up basis, while the $500,000 cash, which replaced the XYZ stock which had been transferred based on a $200,000 value, would pass estate tax-free to your children.  

Transactions between you and a grantor trust of which you are the grantor are ignored for income tax purposes and therefore do not trigger capital gains, under IRS Revenue Ruling 85-13.  The existence of "Crummey" withdrawal rights may make the Gift Trust not a grantor trust in part, and any proposed asset replacement should be carefully analyzed by the appropriate tax professionals at that time to avoid inadvertent capital gains tax recognition.

9.   After establishing a Gift Trust, will I have to make contributions every year?

No. You can stop making annual gifts into the Trust at anytime, and can restart at any time.  However, the annual exclusion is a "use it or lose it" proposition, and unused exclusion amounts do not carry forward into future years.

10.   How can I use a Gift Trust to make gifts that can benefit my children for their lifetimes and can then pass to my grandchildren or succeeding generations without being subject to estate tax in my children's estates?

Each person has an exemption from the federal "generation skipping transfer" (GST) tax, which is otherwise imposed on gifts or bequests to grandchildren and younger generations at a rate equal to the maximum estate tax rate in addition to any estate or gift tax imposed. The GST exemption is $2,000,000 in 2006, and is currently scheduled to increase in future years. If a Trust is established using all or a portion of this exemption, the assets in the Trust can be distributed for valid purposes such as health, education, and reasonable living expenses, or whatever purpose you determine, to your children, grandchildren, and succeeding generations. Any undistributed amounts will not be subject to either estate tax or generation skipping tax in their estates, no matter how many generations the Trust lasts. A Trust of this sort can last for 360 years or more under a new Florida law and can potentially save vast sums of estate taxes over many generations. A Dynasty Trust (also called a "Generation Skipping Trust") of this sort is something to be seriously considered as part of your estate plan, particularly if your children are wealthy enough to be concerned about their own estate taxes. While a Dynasty Trust can be set up either during life as an Irrevocable Gift Trust or Irrevocable Life Insurance Trust, or at death under the terms of your Living Trust, the GST exemption with respect to lifetime transfers to a Gift Trust or Life Insurance Trust applies to the fair market value of the gift as of the date of the contribution, so any increase in value after the gift will not use any further GST exemption. 

There is also a $11,000 annual exclusion from the GST tax. Gifts to grandchildren or great-grandchildren qualifying for this exclusion will not use any of your GST tax exemption. A specially drafted Gift Trust for grandchildren will qualify for the GST annual exclusion as well as the gift tax annual exclusion.

11.   How can using a Family Limited Partnership enable me to leverage my gifts?

A gift of a limited partnership interest may be valued for gift tax purposes as being worth significantly less than an outright gift of the same amount of underlying assets because of valuation discounts due to lack of marketability.  The availability and amount of the appropriate discount, if any, would need to be evaluated on a case-by-case basis and the services of a professional appraiser are strongly recommended.  If a 25% discount were found to apply, for example, you could theoretically gift $14,667 in partnership interests per donee per year (instead of only $11,000 in cash or other property), and still be within the annual exclusion.

12.   In what other ways can I leverage my gift program?

There are several kinds of specialized Gift Trusts and other transactions that can be used to leverage your gifts. These planning tools generally involve you receiving an income interest or a series of payments over a period of years or for your lifetime, or that of you and your spouse. The value of the transfer for gift tax purposes is reduced and can even be eliminated in some cases due to this retained interest. These tools include Qualified Personal Residence Trusts, Grantor Retained Annuity Trusts, Installment Sales to Grantor Trusts,  Private Annuities and Self-Canceling Installment Notes. If you would like more information about any of these, we can show you how they might work to save estate taxes in your estate.

13.   When is it not appropriate to make gifts?

Obviously, you should not give away property that you may need at some point in the future. To qualify for the tax advantages discussed here, a gift must be irrevocable. While it is possible that your children could return monies to you if the need arises, you should not put yourself in the situation of having to rely on your children's generosity.

Certain states (such as Alaska and Nevada) have enacted laws that allow you to make gifts to a specially drafted Irrevocable Gift Trust that permits an independent Trustee to have the ability to make distributions from the Trust back to you in the Trustee's discretion, while hopefully removing any undistributed trust assets from your taxable estate.  These special Gift Trusts can be used by Florida residents, so long as the applicable state statutes are followed. 

As a general rule, property which has a low "basis" for income tax purposes should not be gifted, unless the gift is to a Gift Trust that is a grantor trust, as discussed above.

14.   What is the cost of a Gift Trust?

The cost of a Gift Trust will vary based upon the complexity of its provisions and the planning involved. It will cost only a fraction of the estate taxes saved if the gift program is properly carried out.

15.   Who should prepare my Gift Trust?

We strongly recommend that an attorney who specializes in estate planning and taxation be retained to draft your Gift Trust. There are many important and complex issues that need to be addressed in order to properly structure gifts, gift trusts, and similar mechanisms.