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Gift Taxation - An Overview

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The federal and state governments, including Vermont, have adopted various systems for taxing the transfer of wealth.  Under these systems, transfers which occur during life and at death are subject to taxation.  The estate and gift transfer tax systems are "unified," which means that gifts made during life can affect the amount of tax due upon death (see The Federal Gift Tax System, below).

Generally, gift taxes are imposed on the value of the assets transferred.  Like income taxes, the transfer taxes are graduated, so larger gifts are subject to a higher, overall transfer tax rate. 

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Gift Tax Exclusions

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Before discussing the federal gift tax system, it is important to understand three major exceptions to this tax.  First, under current law, you are permitted to give up to $15,000 to any person in any year without being subject to gift taxation.  You can make these “annual exclusion” gifts to as many individuals as you wish.  For example, if you have three children, you can gift each of them $15,000 per year without incurring any gift taxes (and without diminishing your unified credit, discussed below).  The exclusion is not limited to children or family members.  The $15,000 exclusion is indexed for inflation, and may increase in future years.

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Spouses can each utilize their annual exclusions.  In the above example, a married couple could gift their three children $30,000 each per year without adverse gift tax consequences - a total of $90,000 per year.  Better yet, if the transfer is from one spouse only, the spouses can elect to treat the gift as being made in equal shares by each of them (this is called “gift splitting”). 

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As simple as it sounds, some types of gifts can triggered a number of complex rules which may affect the availability of the annual exclusion.  A major limitation is the “present interest”  requirement.  If you limit the use, possession or enjoyment of a gift to a future date, then the gift will not be a gift of a present interest, and therefore will not qualify for the annual exclusion.  A common example is property placed in trust for a minor, where the intention is to have gifts to the trust accumulate for the minor’s future benefit.  Without further planning (see Crummey Trusts), such gifts would not qualify for the exclusion, possibly resulting in adverse gift tax consequences.

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A second exclusion from the gift tax is for tuition payments made directly to a college or university attended by the donee.  These types of transfers are not part of the $15,000 annual exclusion (you can make both).  The payment is limited to tuition and the payment must be made directly to the institution rather than to the donee. 

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A third exclusion is from gift taxation is for payments made directly to a health care provider for a donee's medical care.

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The Federal Gift Tax System

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The federal gift tax system is designed to impose a tax on all transfers made during life.  The tax is imposed on “taxable gifts,” which excludes gifts qualifying for the annual and other gift tax exclusions (see Gift Tax Exclusions).  All taxable gifts made during life (including the gift(s) for the current year) are added together to arrive at total taxable gifts.  From total taxable gifts, deductions are permitted for transfers to a spouse and/or transfers to charity (see Charitable Gifts, below).  The gift tax is calculated on this total amount, using a graduated tax schedule which starts at a rate of 18% and rises to a rate of 40%. 

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Once the gift tax is calculated, certain credits are allowed.  First, a credit is allowed for the tax imposed on gifts made in prior years - the purpose being to tax only the current gift, and to apply the appropriate tax bracket to that gift.  Next, each individual is allowed a unified credit.  Currently, the unified credit is $4,505,800 (2019) (which effectively means that no gift tax is paid on total gifts of $11,400,000 or less).  The credit is reduced by any credit used to shelter prior gifts. A credit is also allowed for foreign death taxes. 

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Simple?  No, but the key to gift taxation is to understand that you can give up to $11,400,000 during life without paying gift tax, plus you can gift $15,000 per year to any individual without incurring tax or using your unified credit. 

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The Vermont Gift Tax System

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Vermont's gift tax statute was repealed in 1979.  No Vermont gift tax is imposed on gifts, regardless of size.

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Under recent legislation, gifts made within 2 years of a decedent's death are added back to the estate for calculating the Vermont estate tax (see Estate Tax).

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Charitable Gifts

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Gifts made to charity result in an offsetting gift tax deduction, which means that gifts to a charity are made free of gift tax.  Gifts to charities can be outright, or can be made by utilizing a charitable trust (see the Charitable Trusts webpage). 

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Keep in mind that a deduction is allowed only for gifts made to a "charity" -- a term which has a very specific meaning under the Internal Revenue Code.  Some organizations which are not-for-profit may not qualify as a charity for gift tax purposes.  If gift taxes are a concern, you should check the status of any organization prior to making a donation. 

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A lifetime gift to charity may also result in an income tax deduction for all or a portion of the gift (see the Charitable Trusts webpage for a discussion of the income tax aspects of charitable giving). 

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Why Lifetime Transfers are Better Than Transfers at Death 

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Lifetime gifts have several advantages over gifts made at death.  First, any gift tax paid by the donor is not considered an additional gift to the donee.  For example, if you gifted $100,000 to an individual and were in a 35% gift tax bracket, you would owe $35,000 in gift tax.  The entire transfer would cost you $135,000.  In contrast, in order to leave the same individual $100,000 through your estate (assuming the same tax bracket), you would need $153,846 ($153,846 - ($153,846 x 35%) = $100,000).  The gift tax is exclusive, and can result in a substantial difference in the way in which a transfer is taxed.

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Second, by making a gift during life, you ensure that future appreciation will accrue in the hands of the donee rather than in your estate.  Therefore, if you have assets which are likely to appreciate, and to ultimately be subject to estate taxation, a lifetime gift would prevent the appreciation from becoming part of your estate tax problem.

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Third, you can enjoy watching the benefits of a lifetime gift -- something which is not possible with transfers at death.

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Why Lifetime Transfers are Worse Than Transfers at Death 

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The main reason not to make a transfer during life is the income tax consequence of a lifetime gift.  When assets are gifted during life, the donee's tax basis is equal to the donor's basis immediately before the gift.  In contrast, if the same asset is held until death, the donee's basis is equal to the fair market value of that asset at the donor's death.  If the asset has appreciated significantly, the donee of a lifetime gift may face a large gain for income tax purposes on disposition of the asset.  Therefore, the income tax aspects of any gift should be made prior to completing the gift.

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Another reason not to make a lifetime gift is loss of control. In order to make a gift for transfer tax purposes, the donor must relinquish "dominion and control" of the asset.  If the asset might be needed for the future care and benefit of the donor, it might be imprudent to make a lifetime gift, even if the asset would be ultimately subject to estate tax.

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Crummey Trusts

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As noted above, if you limit the use, possession or enjoyment of a gift to a future date, then the gift will not be a gift of a present interest, and therefore will not qualify for the annual exclusion.  A common example is property placed in trust for a minor, where the intention is to have gifts to the trust accumulate for the minor’s future benefit. 

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One way to circumvent this problem is through the use of a trust which gives the donee a limited power to withdraw the gift from the trust.  This power is known as a "Crummey" power -- after the name of a famous court case which upheld it use as an estate planning tool.

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Here's how it works:  the donor makes a gift to a trust for the benefit of a donee.  The trust provides that the donee may withdraw an amount equal to the amount of the gift (with some other limitations), but that the power to withdraw expires after a set period of time (i.e thirty days).  By giving the donee the power to benefit immediately from the gift, the annual gift tax exclusion is available.  When the period expires, the donee loses the ability to withdraw the gift, and the trust provisions take over. 

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Note that the area of planning for Crummey powers has become fairly complex - you should consult with an advisor prior to implementing a trust containing such powers.

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Generation Skipping Transfer Taxation

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As if the taxes discussed above are not enough, the federal system imposes yet another tax on transfers which "skip" a generation.  The theory of the generation skipping transfer tax (or "GST") is that if (for example) a grandparent transfers assets to a grandchild (known as a "skip person"), the gift tax that would have been imposed on the middle generation (i.e. the grandparent's child) is lost.  To recoup this tax, the GST is imposed on any transfer (not necessarily from grandparent to grandchild) which skips a generation.  The GST is imposed at the highest marginal gift tax rate (40% in 2019), and is in addition to the gift tax levied on the same transfer.  Where both taxes apply, the resulting gift tax can exceed 50%.

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Some relief is afforded under the GST rules.  First, each individual is permitted to transfer up to $11.4 million to "skip" persons without the imposition of the GST.  Therefore, the GST affects only larger gifts.  Second, during life, an individual can gift up to $15,000 per year/per skip person without incurring GST.

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To put it mildly, GST planning is very complicated.  There are many rules governing the use of trusts, the assignment of generational levels, the application of the $11.4 million exemption, etc. which make the GST one of the most difficult areas of tax law.

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If you have any questions regarding lifetime giving or any aspect of the estate planning process, please  contact Richard W. Kozlowski, Esq. at (802) 343-7419 or by e-mail.