Lifetime gifting can be a powerful estate planning tool. Transferring property during your life, instead of at your death, has many advantages. Making lifetime gifts can be desirable for personal reasons (e.g., to help your children or other family members) or for financial reasons (e.g., saving taxes). No matter what your reasons for starting a gifting program, there are a few gifting traps you should be aware of.
1. The kiddie tax rules
Beware of the kiddie tax rules when transferring income-producing property to your children. Investment income over $1,800 (for 2008) will be taxed at your marginal income tax rate, not your child’s.
The kiddie tax rules apply to children who are: (1) under age 18, (2) age 18 with earned income that doesn’t exceed one-half of their support, and (3) ages 19 to 23 who are full-time students with earned income that doesn’t exceed one-half of their support.
2. Gifts of retained interests or powers
Be careful when making gifts of property in which you retain some financial interest (e.g., a life estate, right of reversion, or right of revocation) or powers (e.g., the power of appointment). This property may be includible in your estate for estate tax purposes.
For example, say you transfer ownership of your home to your son on the condition that you’re allowed to continue living in the home for the rest of your life. You have retained a financial interest in the home, and this interest may be includible in your estate for estate tax purposes.
3. Income taxation of gifts made to a trust
Some types of trusts are taxpaying entities, which are taxed at more compressed income tax rates than individual taxpayers. If you’ll be using such a trust, be sure to consider the consequences of paying income tax on trust income at higher income tax rates.
4. Delays in making a gift of life insurance
Do not delay making a gift of a life insurance policy on your life. A transfer of an insurance policy by gift within three years of death results in the proceeds being includible in your estate for estate tax purposes.
5. Delays in planning your estate to meet percentage tests
Do not delay removing certain nonbusiness assets to help your estate meet the percentage tests to qualify for Section 303 (redemption of stock), Section 2032A (special use valuation), or Section 6166 (installment payout of taxes) tax treatment. This technique will work only if the gift is made more than three years prior to your death.
6. Payments for tuition or medical care made to the donee
Payments you make for tuition or medical care on behalf of another are exempt from federal gift tax. However, to qualify, you must make the gifts directly to the educational or medical institution–do not make such payments to the donee.
7. Overlooking gift splitting
For 2008, you can give $12,000 per donee federal gift tax free under the annual gift tax exclusion. There is also a gift-splitting privilege for spouses who qualify that can double the exclusion.
8. “Reverse” gifting if death is imminent
Reverse gifting is a technique where a healthy individual transfers low-basis assets to a dying individual. If the decedent lives for more than one year from the date of the transfer, the basis gets stepped up to fair market value. However, the basis will not get stepped up if the decedent dies within a year of receiving the gift, and should this happen, you may end up needlessly paying gift tax and/or using up your $1 million gift tax applicable exclusion amount.
9. Overlooking the benefit of taxable lifetime gifts
Don’t assume that lifetime gifts and transfers made at death result in the same tax effect. Paying gift tax on taxable lifetime gifts can result in an overall tax savings because the tax you pay is also removed from your estate.
10. Selecting property that does not attain your tax-savings objectives
There are some types of property that you should avoid giving if you want to enjoy tax savings, such as property that has depreciated in value or is likely to depreciate.