Gift taxes for most people are irrelevant. Any gift of $14,000 or less to an individual is not even reportable. Cumulatively, your lifetime gifts over the annual exclusion amount, added to your estate value, are potentially taxable only IF they add up to more than $5,250,000. Therefore, if you are a middle class or even upper middle class person, you will never have to pay gift taxes.
However, if you receive money from overseas, if you have over $100,000 in assets and you or your spouse is not an American citizen, if you potentially have more than significant assets (even if they are below the current thresholds which are subject to change), then you should read this to have a foundation of knowledge for planning, to avoid some easily avoided mistakes that could be expensive or that could result in your having to have more difficulty in your life, or potentially more bills to pay.
Also, there are special considerations for Muslims who may encounter this law in different ways from most other Americans. Two underlying assumptions I am making are that Muslim Americans are (1) more likely than other Americans to have contacts with and receive money from foreign individuals and corporations, and (2) slightly more likely to have spouses who have not been naturalized. Another assumption is that Muslim Americans by and large have a higher percentage of people who make enough money to have to pay gift and estate taxes, even if that percentage is still a small percentage of the total.
The purpose of this essay is to (1) briefly go over basic gift tax rules that are surprising or at least not intuitively obvious, (2) briefly go over some relatively simple pitfalls that are easily avoided, (3) briefly go over reporting requirements which some readers will likely intersect (there are special applications of the law involving international transactions and gifts to non-citizen spouses), (4) briefly go over potential strategies for Muslims who are wealthy and earning enough, potentially, to be forced to pay gift taxes.
The purpose of this essay is not to explore specific estate planning strategies like trusts and wills, but only to discuss the broad strategies suggested by the logical implications of the gift tax law.
1) The basics
The most important single fact about the gift and estate tax area of law is that it is subject to change without much notice. You should consider from the outset that while today you can give a relatively large amount without incurring any gift tax at all, a stroke of the pen by an as-yet unelected congress could make the gift tax apply to a far greater proportion of Americans, and could increase (or decrease) their gift and estate tax liability. Therefore it is worth acting prudently now with regard to preparing for gift taxes, especially if you are in a profession, such as medicine or business, where there is a relatively open-ended maximum amount of money you can make and you may be in a position at the time of your death to pass on significant wealth to your heirs.
The gift tax is not intuitively easy to understand, because most taxes are based on income, whereas this tax is the oppositeâ€”it is a tax potentially assessed against the donor. To illustrate, a young man with a large wealthy family could receive gifts of $14,000 per year from 10 or 15 relatives, totaling $140,000 to $210,000 per year, living on that money while never having to pay income taxes. If his father gave him $100,000 per year then his father (depending on his total gifts to all recipients) might eventually have to pay gift or estate taxes (when the total gifts and estate transfer in excess of $14,000 per year, and the accumulated total taxable gifts in excess of the total lifetime exclusion) but the son would not have to pay.
The rate of the maximum gift tax is currently 40%, the same as the estate tax. This is a volatile number which fluctuates even more than the other vital controls on the gift and estate taxes.
Gift and estate tax is a volatile area of the law because the area is politically chargedâ€”disputed territory which shifts back and forth between the hands of Democrats and Republicans, sometimes as a bargaining chip in broader strategic political disputes. The underlying principles (an annual exclusion amount, a lifetime exclusion amount, exclusions for tuition and medical expenses) are likely to remain in place, but the actual numbers vary sometimes dramatically and may vary dramatically and unpredictably in the futureâ€”even the â€œindexed for inflationâ€ changes are significant, especially over the long term, let alone sudden reversals in the law due to shifting political winds. The law was most recently rehashed in 2012, it was a compromise between the sides, and it currently looks as though enthusiasm from either side to violently shift this law has wanedâ€”but one congressional election or one hot political controversy could change all of that.
Reportable gifts should be reported on the IRS form 709, which is due on April 15th like your income tax return. Estate taxes should be reported on IRS Form 706, which is due generally 9 months after death (this varies). Forms 709 should be kept forever because they will be required in order to properly fill out Form 706, potentially decades after the Form 709 was originally filled out. It is almost certainly a necessity to hire a tax professional to file these forms for the taxpayerâ€”donors able to make gifts of this magnitude should also be able to afford attorneys or accountants to fill out the necessary paperwork. There is specialized software to fill out the 706 and 709, and knowledge of the relevant law and potential strategies is very important. Ordinary consumer income tax software may not be capable of handling this specialized area of taxation.
Sometimes reporting requirements are exercised against the recipient, but the tax itself applies to the donor. Donors must file the Form 709 to report gifts, for gifts in excess of $14,000 (this number is indexed for inflation and rises in increments of $1,000 periodically, on average every three yearsâ€”it rose most recently in 2013).
A married couple may combine their yearly exclusions, so a husband could make a check out to their son for $28,000, and file a Form 709 signed by his wife to claim their combined exclusion. Alternatively the wife and husband could each give their son a check for $14,000 to avoid the reporting requirement.
Noncash gifts valued over $14,000 must also be reported. In some cases it may be worthwhile to report non-cash gifts valued less than $14,000 on the Form 709 in order to explicitly have a formal appraisal and valuation of something to forestall later IRS challenge to the giftâ€™s valuation.
There are several types of gifts that are excluded from application of the gift tax: gifts under the yearly exclusion amount, gifts to citizen spouses, gifts to political organizations, payments of tuition, payments of medical expenses. A separate exclusion also applies to gifts to charities. Gifts to charities provide an income tax deduction, although the other gifts excluded from gift taxation do not necessarily provide income tax deductions.
One gift tax exclusion is for payments of tuition MADE DIRECTLY to the educational institution on behalf of a beneficiary. Similarly, the gift tax is not applied against medical payments MADE DIRECTLY to healthcare facilities on behalf of a beneficiary. The pitfall in these two rules is that if a generous donor makes his or her gift to the beneficiary and then the beneficiary pays the tuition or the medical bill, then unfortunately that gift is subject to ordinary reporting and accounting, and conceivably tax.
Another important pitfall is the filing requirements and the necessity of holding on to past 709s. When your estate fills out the 706 at your death, it will be necessary to know all of the past 709â€™s from your lifetime. Therefore you and/or your estate planners must keep all of your 709s for your lifetime.
3) Reporting Requirements
A vital reporting requirement is for gifts from foreign entities. There is not necessarily a gift tax to be paid, and as before it is unlikely any gift tax will have to be paid except on very large gifts. Gifts from money or property may need to be reported on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.â€ This is an â€œinformation return,â€ however there are significant penalties for failure to file a required Form 3520. As before, payments for tuition and health care expenses paid directly to the university or health care facility do not trigger tax or reporting requirements. However, you must report (1) gifts or bequests valued at more than $100,000 from a foreign nonresident individual or foreign estate (gifts from related individuals are considered a single gift), or (2) gifts valued at more than $13,258 (adjusted annually for inflation) from foreign corporations or foreign partnerships (again, gifts from foreign persons related to the corporation or partnership are considered a single gift). You must aggregate gifts received from related parties.
The penalty for failing to file Form 3520, when it was required, is 5% of the amount of the foreign gift for each month for which the failure to report continues (not to exceed a total of 25%). This is potentially a huge loss of money for the taxpayer, who ordinarily would have had no responsibility at all to pay any tax.
This contrasts with the IRS penalties for incorrect gift and estate tax returns, which are proportional to the amount of late taxes (which therefore means there is no penalty for lateness provided you do not OWE tax) rather than to the amount of the gift. With foreign gifts, there can be a penalty up to 25% of the gift (which therefore means there can be a penalty when originally there would have been NO tax).
Another important pitfall to consider, for wealthy people, is the preservation of â€œportability.â€ A surviving spouse has the right to use the unused exclusion amount from the spouse. Currently the Unused Exemption Amount could be $5.25 million and that number will likely increase with time. Lifetime gifts subtracted from the lifetime exclusion amount will leave the unused and â€œportableâ€ exemption.
A wealthy family or a family that is potentially wealthy must be at pains to protect the portability of the lifetime exemption of the first spouse to die. To preserve it, the surviving spouse must file a timely Form 706 after the death of the first spouse. According to the official IRS instructions for Form 706, â€œA timely-filed and complete Form 706 is required to elect portabilityâ€ of the unused exemption.
Under Regulations section 20.2010-2T((a)(5), the executor of an estate of a nonresident decedent who was not a citizen of the United States at the time of death cannot make a portability election.
Another potential pitfall for Muslims with large estates is the limit on gifts to oneâ€™s spouse. Ordinarily a spouse can give all of his income to his wife without using either his yearly or his lifetime exemption, however in rare cases of estates over the lifetime exclusion amount the following rule would be relevantâ€”noncitizen spouses can take only $143,000 after the lifetime exemption free of gift taxes.
However there are strategies to legally avoid this problem, for example getting citizenship for both spouses or using a QDOT Trust. It is possible to set up a QDOT trust even after the first spouse has died, provided it must be complete and funded before the decedentâ€™s Form 706 is due.
The simplest strategy to approach gift taxes is to give the annual exclusion amount consistently to each person you wish to use as a beneficiary over the course of many years. If for example (using figures extrapolated based on a ballpark estimate of current limits) you are a doctor earning $400,000 at age 30 with three children and you set up a trust to benefit your children, donating yearly from yourself and from your spouse to the trust to the maximum annual exclusion amount, you will have protected by age 60 (without even engaging any reporting requirementsâ€”assuming you and your spouse give separate checks to each beneficiary) 30 X 3 X 2 X $14,000 or in other words $2,520,000. If your estate is a high value estate which will someday be worth more than the total lifetime exclusion amount, you will have saved 40% times 2,520,000 in gift taxes, or $1,008,000.
In addition to this, you could pay educational expenses and health care expenses directlyâ€”this could potentially be an immense amount of money, if again we extrapolate based on current numbers. If we assume education costs $50,000 per year in tuition, for four years, plus private schooling for four years of high school at $20,000 per year, plus post-graduate education of two years at $60,000 per year), this would be:
(4 years X $50,000) plus (4 years X $20,000) plus (2 years X $60,000) = $400,000 per child times 3 children = $1,200,000.
Honestly for an educated family, these educational standards are modest and almost certainly less expensive than what a child born today should expect to pay if we extrapolate todayâ€™s education costs into the future.
This is aside from health care expenses, which are more unpredictable, and which could potentially add up to far more.
So as you can see, it is possible to gift a sizeable chunk of your income before even engaging the reporting requirements, and this is before you consider gifts to other members of your family or to non-family members. And this is before charitable giving. And this is before any other more complicated planning to move the bulk of your estate.
There are many other more complicated strategies to avoid gift taxes, involving trusts. The above discussion was meant mainly to outline the gift tax law and the legal tax avoidance that is suggested by a logical look at the rules in the law.
In fact, the majority of tax planning concerns the use of trusts and wills and other planning documents, in support of transferring large amounts of property and money in such a way as to legally reduce taxationâ€”however as you can see a great deal of tax planning can occur in advance of such moves.
This essay should not be construed as legal advice. It is a general description of a complicated area of law. The reader should hire competent legal or accounting counsel in order to discuss and approach his or her own specific circumstances.