United States: Lifetime Gifts

Originally published September 2004

Warm feelings of affection may prompt one to make monetary gifts to loved ones. But those feelings can rapidly chill if the donor unexpectedly finds out that taxes are due on the gift. Donors who are considering making gifts in order to transfer wealth and shift income to the next generation also need to factor in the impact of any applicable gift taxes.

U.S. citizens and other individuals who are residents of the United States are subject to the federal gift tax. Unlike other states, such as New York and Florida, Connecticut has a separate state gift tax. The Connecticut gift tax applies to (i) gifts by Connecticut residents of intangibles, such as money and securities, and (ii) all gifts of tangible personal property (e.g., art, jewelry, antiques) and real estate located in Connecticut.

Non-Taxable Gifts. Not all types of gifts are taxable. Gifts to most charities and to most political parties or PACs are exempt from the federal and the Connecticut gift tax, as are payments for qualified medical and educational expenses. In order to qualify for the exception for medical expenses, payment must be made directly to the health care provider, and neither the donor nor the beneficiary can be reimbursed for the expense by medical insurance. To qualify for the exception for educational expenses, payment must be made directly to a tax-exempt educational institution and must be for tuition only. The educational expenses exception does not apply to payments made for room and board or for other ancillary costs of education. Donors wishing to prepay for a broader array of educational expenses may Counsellors at Law want to consider investing in a qualified tuition program (QTP). See further discussion of QTPs below.

The Annual Exclusion. Both federal and Connecticut law exempt from gift tax the first $11,000 of value of a present interest gift to any individual. There is no limit on the number of individuals to whom you can give gifts, but only one $11,000 exclusion per year per recipient is allowed. Married couples can split gifts, which means that a married couple can make non-taxable gifts of up to $22,000 per year per recipient; each such gift is treated as made one-half by each spouse, regardless of which spouse actually made the gift. (In order to elect gift splitting, however, the couple must file a gift tax return.)

Gifts of a Present Interest. To qualify for the $11,000 annual exclusion, gifts must be of a present interest, not of a future interest. This means that the recipient of the gift must have a current right to use the money or property that is transferred. Thus, unless the beneficiary has an immediate right of withdrawal, most transfers to a trust will be gifts of future interests to the beneficiaries, and, as such, will be subject to gift taxes.

The Applicable Credit. Under federal law, each person is allowed a credit that can be used against either the gift tax on lifetime taxable gifts or the estate tax on transfers made at death. To the extent that you use the credit during your life, there will be a reduction of the amount of the credit that is available to offset any estate tax at your death. As of 2004, the credit will shelter from tax lifetime gifts with a cumulative value of up to $1 million. Notably, the credit for gift tax purposes is capped at $1 million, even though the credit for estate tax purposes can shelter up to $1.5 million (as of 2004) from estate tax. The applicable credit for gift tax purposes is scheduled to remain at $1 million through 2009; for estate tax purposes, the credit is scheduled to rise to $2 million in 2006 and to $3.5 million in 2009. Current law provides for substantial changes to the gift tax in 2010, the year the federal estate tax is scheduled to be repealed, followed by reinstatement in 2011 of the estate and gift tax rules as in effect in 2001. A discussion of those changes is beyond the scope of this Advisory.

Special Rules for Connecticut taxable gifts. Unlike the federal system, Connecticut does not give each donor a gift tax credit. However, as part of a proposed phase-out of the Connecticut gift tax, as of 2004 the first $25,000 of what would otherwise be a donor's total taxable gifts for a given year for Connecticut gift tax purposes is exempt from gift tax. If the donor exceeds the exempt amount, however, the entire value of the taxable gifts (including the exempt amount) is subject to tax. The Connecticut exemption is scheduled to increase in $25,000 increments in each of 2006 through 2008. Thereafter, the exemption is scheduled to be $950,000 for 2009 and $1 million for 2010 and thereafter.

Rates. The federal gift tax rate is the same as the federal estate tax rate, i.e., a progressive tax starting at 18% and rising to 48% (as of 2004). The Connecticut gift tax rate is also progressive, but the maximum rate is 6%.

Making gifts to minors can pose special challenges. While you can make an outright gift of cash or property to a minor, for obvious reasons that is not always a sensible thing to do. All states permit some form of custodial accounts for minors, which can often be the most economical way of giving gifts to minors while still keeping some adult oversight. Other families choose to set aside funds for minors in trust. Either way, the gift tax, income tax and generation-skipping transfer tax consequences of such gifts should be considered.

Some form of the Uniform Transfers to Minors Act (UTMA) has been enacted by all of the states. These Acts provide a mechanism for establishing bank or brokerage accounts that are beneficially owned by a minor, but under the control of a custodian until the minor attains age 21 (or, in some states, age 18). Transfers to these accounts are treated as completed gifts of present interests for gift tax purposes, and so qualify for the $11,000 gift tax annual exclusion.

The donor can select anyone to serve as custodian of the account, but, for estate and income tax purposes, it is generally better if the donor is not the custodian because this may cause the account to be treated as the donor's. If a parent wishes to make a gift to a child, he or she should not serve as the custodian. A grandparent may choose to name his or her child as custodian for a grandchild's account. The custodian is expected to manage the account in a fiduciary capacity, but, subject to that standard, can use the assets in the account for the child's education or support or for other purposes the custodian deems to be in the child's interest.

Custodial accounts are easy to open and do not require much administration. One drawback to the accounts, however, is that the child is given absolute control over the account when he or she attains age 21 (18 in some states). Many children are able to appropriately handle funds at that age, but many are not. Particularly if there is a large amount of money involved, it may be better to set up a trust for the child's benefit which can be managed by a trustee until the child is older.

Trusts can be individually designed to address virtually any situation. Trusts can provide for fixed income and principal distributions at certain times or when the beneficiary attains certain ages, or can leave all such matters to the full discretion of the trustee. One possibility is to establish a trust as a vehicle to save for a child's education, but to include provisions in the trust agreement to the effect that if the trust funds are not needed for educational expenses, they can be used to pay for wedding expenses or for the purchase of a home. Children with special needs can also be accommodated, either through lifetime trusts or through special "supplemental needs" trusts that are intended to supplement, but not replace, any governmental assistance a disabled child might be entitled to receive.

Trusts offer the greatest flexibility in terms of design, but also require on-going administration. Also, unless structured correctly, gifts made in trust will not totally qualify for the gift tax annual exclusion, resulting in the need to file a gift tax return. Two popular techniques for avoiding this gift tax problem are through the use of trusts with powers of withdrawal or which meet the requirements of Internal Revenue Code §2503(c).

Trusts with withdrawal powers. To avoid a gift in trust being characterized as a gift of a future interest to a beneficiary, the beneficiary can be given a limited power to withdraw the amount of the gift from the trust. Typically, such a power of withdrawal (sometimes called a "Crummey power" after a court case involving trust withdrawal powers) will lapse if it is not exercised within a stated period of time (e.g., 30 days). Under current tax law, if the beneficiary has a current (even if temporary) right to withdraw the amount of the gift, the beneficiary is deemed to have a present interest in the gift, and so up to $11,000 of the gift will qualify for the gift tax annual exclusion. Except for the period of time a withdrawal power is in effect, the trust can limit the beneficiary's access to the trust assets until a given age is attained or for life. This type of trust allows gifts to be made for a minor without the minor gaining control over the assets when he or she attains the age of majority.

Code §2503(c) Trusts. Code §2503(c) creates an exception from the usual future interest rules that apply to trusts for certain irrevocable trusts that are solely for the benefit of a minor. A gift to a Code §2503(c) trust is treated as a gift of a present interest, and so transfers of up to $11,000 per year (or $22,000 per year, if made by a married couple splitting gifts) can be made to the trust with no gift tax consequences. However, like gifts under the UTMA, a Code §2503(c) trust must permit the child to have full control of the trust property when he or she attains age 21. One reason for using such a trust, rather than a UTMA account, is to have professional trustee management of the account or to hold unusual assets. Another reason is that it is possible to extend a Code §2503(c) trust for a period of time after the beneficiary attains age 21, provided the beneficiary is given a withdrawal power at age 21. Thus, for example, a donor could create a Code §2503(c) trust which allowed the beneficiary an unfettered right to withdraw trust assets for a relatively short period of time (e.g., 30 days) after the beneficiary attains age 21. To the extent the beneficiary does not exercise the withdrawal right, the assets remain in trust until some later date specified in the trust instrument (e.g., age 30). This hybrid form of trust is sometimes called a "window trust."

In addition to gift taxes, donors need to consider the income tax consequences that may flow from a gift and, in some cases, the generation-skipping transfer tax consequences.

Although a full discussion of the Kiddie Tax is beyond the scope of this Advisory, donors should realize that if a child under the age of 14 has investment income over $1,600 per year (as of 2004), the amount over $1,600 will be taxed at the parents' highest marginal income tax rate. Thus, parents making gifts of substantial value to a child are unlikely to reap any noticeable reduction in their income tax liabilities until the child attains at least age 14. Also, grandparents should take into consideration this income tax rule when making gifts to grandchildren. If gifts are made to a child in trust, however, there may be an opportunity to modestly reduce a family's overall income tax burden by retaining some taxable income in the trust (i.e., up to the maximum of the 15% income tax bracket for trusts, presently, $1,900) and having the trust pay the applicable income tax.

Generation-Skipping Transfer Tax. The generation-skipping transfer tax (GST tax) was enacted to curb dynastic trusts that might otherwise continue for generations without ever being subject to federal estate tax. For that reason, the GST tax rate is the same as the top federal estate tax rate (currently 48%; the rate is scheduled to drop to 47% for 2005, to 46% for 2006, and to 45% for 2007 through 2009). The GST tax may apply to any gift that passes to a skip person, which is defined as a person two or more generations below the donor, or, in non-family situations, a person more than 371/2 years younger than the donor. Special generation assignment rules apply where a person who would otherwise be a skip person has a deceased parent. In some instances such persons are moved up a generation for GST tax purposes, and so no GST tax is triggered.

Like the gift tax, as of 2004 outright gifts of up to $11,000 in value per recipient are exempt from the GST tax, as are payments of qualified educational and medical expenses. However, most gifts in trust, even if the beneficiary has a power of withdrawal, are subject to the GST tax if a trust beneficiary is a skip person. Like the federal estate tax, each person has a GST tax exemption that as of 2004 shelters up to $1,500,000 of gifts to skip persons from the GST tax. The exemption can be used for gifts made during life or at death, and, like the estate tax exemption, is scheduled to increase to $2 million in 2006 and to $3.5 million in 2009. The exemption covers the cumulative total of gifts to skip persons, regardless of the number of individual beneficiaries, but as the exemption amount increases, only new gifts can be covered by the additional exemption amount. In other words, if as of 2004 you have made generation- skipping transfers totaling $2 million, when the exemption amount increases in 2006 you cannot apply for a refund on the taxes you paid for the gifts made in prior years that were in excess of the exemption amount then in effect. However, as of 2006 you would be able to make an additional $500,000 in generation- skipping transfers without triggering a GST tax liability. (But beware of gift taxes, as the federal lifetime gift tax exemption is capped at $1 million and Connecticut may impose gift taxes on amounts in excess of $25,000.)

One particularly tax-efficient way of saving for higher education expenses is through "qualified tuition programs" ("QTPs"), also known as Section 529 Plans because they are authorized under Code §529. All 50 states have set up qualified tuition programs.

Although there are minor variations in the programs depending on the state sponsor, basically, the programs work like this: A donor, who need not be related to the intended beneficiary, contributes money to a Section 529 account created for a specific beneficiary. (The beneficiary can be anyone, even yourself.) Most programs offer a variety of investment options for the accounts, to suit the beneficiary's time frame and the donor's risk tolerance.

Earnings in the account are not subject to current federal income taxation. Earnings may be subject to state income tax, but many states only tax the earnings on outof- state programs. Amounts can be withdrawn from the account to pay for tuition, fees, books, supplies and equipment required at accredited public or private educational institutions. Additionally, a student enrolled at least halftime is eligible to use the distributions for reasonable costs of room and board. Withdrawals that are used for qualified expenses are not subject to federal income tax. Withdrawals that are not used for qualified expenses are subject to income tax on the earnings, plus an additional penalty tax of 10%. States may also tax nonqualified withdrawals.

A contribution to a Section 529 account is treated as a present interest gift for gift and GST tax purposes. A special rule, applicable only to Section 529 accounts, allows donors to use their annual exclusion for the given year and the next four succeeding years to jump-start the funding of an account. In other words, a donor may contribute $55,000 to a beneficiary's account in one year without triggering a gift tax. (Similarly, a married couple splitting gifts could contribute $110,000.) This option may be quite attractive for older donors or if a donor receives a windfall. However, because the use of the donor's annual exclusion is, in effect, carried forward, this type of funding restricts one's ability to make tax-free gifts to the beneficiary in the succeeding years.

Benefits of participating in a QTP include:

• Tax-free investing for college expenses.
• Accounts can be rolled over to another family member if the intended beneficiary does not attend college.
• Unused money remaining in the account because the intended beneficiary received a scholarship can be withdrawn with no penalty (except for the standard income tax on earnings).
• Anyone can open an account and contribute money. No income limits exist on participation.
• No age limit exists for the intended beneficiary.
• The donor maintains general control over the investments. The donor can roll-over the account to another state's plan or change the intended beneficiary. QTP Limitations:
• Section 529 is in effect until 2011. If it is not re-authorized, distributions will be taxed at the intended beneficiary's tax rate.
• The account will affect the beneficiary's eligibility for financial aid.
• A penalty tax of 10% is assessed on non-qualified use of the income (in addition to the regular income tax on earnings).
• The donor cannot control the specific investments of the account, but may direct which funds the account will be invested in.
• Only cash can be contributed to the account.
• Each beneficiary must have a separate account.
• The account cannot be used as collateral for a loan.

Section 529 accounts are not for everybody. But, in the right circumstances, they can provide a family with tax-free growth on a professionally managed account, with no adverse estate, gift or generation-skipping transfer tax consequences.