This article offers an overview of the estate and gift taxes imposed in the United States. Estate taxes may be imposed on the money (“estate”) a person leaves to heirs. Gift tax concerns the amount of money a person can “gift” (used as a verb in this context) to another person without tax consequences, as well as the tax consequences when that amount is exceeded. The handling of estates is discussed with gift taxes because transfers while a person is living (i.e., gifts) can influence estate taxes.
The estate-tax laws changed markedly as of 1 Jan 2010, and further change is expected. Here’s a brief summary that unfortunately may be outdated by the time you read it. The recipient of a gift made by a U.S. citizen has nothing to worry about, no matter the size of the transfer, because gifts are not taxable income. No estate tax at all was imposed in 2010 because that tax was repealed for 2010. Contrast this with 2009, when an estate of less than US$3,500,000 was not taxed, depending on prior gifts; then in 2011 the law restored a limit of US$1,000,000. A person who gifts less than $13,000 to any one individual in 2011 also has nothing to worry about (unchanged from 2010). If a person gifts more than $13,000 to an individual in 2011, that’s considered a “lifetime gift” and the regulations discussed in the rest of this article must be followed carefully. Note that gifts are never deductible from a gift giver’s gross income. And finally, charitable gifts to tax-exempt organizations have no tax consequences.
The first basic concept in estate and gift regulations is the annual exclusion. This is the amount of money a person can gift annually without affecting the unified credit (defined next). The annual exclusion limit is indexed to inflation and will change over time. In 2011 any US taxpayer can gift up to $13,000 to a single person (increased over the years from 10,000 in 2002 and 12,000 in 2008). Gifts that fall under the annual exclusion do not affect the gift giver’s lifetime unified credit. The annual exclusion rules mean that the total amount that a person can effectively transfer to another individual without triggering taxes is very large.
The second basic concept in estate and gift regulations is the unified credit. Roughly speaking, this determines the amount of wealth a person can transfer without incurring various tax obligations. The term “unified credit” is used because the credit is the “unified gift/estate tax credit.” Please note this is a tax credit, not a gift/transfer limit. And despite the name “unified”, there are two different limits for the two types of transfers. This is the limit which changed drastically in 2010, and further changes are expected. In tax year 2009, the unified credit for gift tax purposes was $345,800, and the unified credit for estate tax purposes was $1,455,800. That gift tax credit basically allowed a person to make lifetime gifts (gifts above the annual exclusion) totaling $1 million without incurring gift tax. The gift tax credit is frozen by current law. The 2009 estate tax credit allows an estate to reach $3.5 million without incurring estate tax. As of 2010, the estate tax exclusion is unlimited; the gift tax limit remains at $1 million. In 2011 the estate tax exclusion is scheduled to return with a limit of $1 million.
To recap, the annual exclusion allows a person to make gifts to as many different people in a year as she or he likes with no tax consequences. Only gifts within each calendar year count towards that year’s annual exclusion. If the gift is by personal check, then the deposit date at the recipient’s bank and the check-clearing date at the giver’s bank may be important. Ideally both will be in the same calendar year so no explanations are needed to the IRS. This may present a challenge for gifts that happen around end-of-the-year holidays! A gift giver can dodge this issue by using a certified check.
Gifts in a marriage are a special case. U.S. citizens who are married (i.e., citizen spouses) can give each other gifts of any amount without gift tax filings. This is called the “unlimited marital deduction.” However there is a catch for transfers to non-citizen spouses. A U.S. citizen can only gift his or her non-U.S. citizen spouse (i.e., alien spouse) up to $134,000 in tax year 2011 without tax consequences. This number is indexed for inflation.
Another special case of gifts and marriage is gifts by a couple to another individual. A married couple can gift anyone $26,000 in 2011 without gift tax consequences, but unless the husband gives half and the wife gives the other half (e.g., they both write a check), they should file a Form 709 with the IRS and elect to use gift splitting. Gift splitting means a husband and wife can elect to treat a gift given by one of them as if half were given by each of them. The implications are simple: If one spouse gives $26,000 to someone during the year, and gift splitting is not elected, the IRS can treat that as a gift by just the one spouse, even if the funds are drawn from a joint account. The IRS Form 709 can be filed for notifying the IRS that gift splitting is elected. (The instructions for the form are on the form itself.) This is a bit silly in many cases, since in community property states, community property is automatically considered split equally between each spouse, but that requires the IRS to somehow know it came from community property funds and not from non-community funds. So they require you to prove it, basically.
If a person gives away more than the annual exclusion to another person (not a charity) in a tax year, that is a lifetime gift. After making such a gift, the gift giver is responsible for filing a Form 709 declaring that gift and keeping a running, lifetime total of the lifetime exclusion used. As long as the exclusion is below the maximum, no gift tax is due. Once the exclusion reaches the maximum, the donor calculates the tax due with Form 709 and attaches a check (payable to the United States Treasury). So in a nutshell, computation of gift tax is quite easy: just fill out the 709. If there is some remaining lifetime gift tax exclusion remaining, then there is no tax due. If there is no exclusion remaining, there is tax due. Note that there is no way to pay gift tax and somehow “preserve” some amount of lifetime exclusion; the system simply does not work that way.
Next, the exclusion amounts. As of 2010 the exclusion amount is unlimited. Just to be complete, here is the information from 2009 because many people believe Congress will restore those numbers during 2010. Your mileage may vary of course! In 2009, the first $1 million of gifts and the first $3.5 million of estates were exempt from estate and gift tax. At first glance you might think that when someone who made no taxable transfers during life dies, you total up the estate, subtract off any deductions, and then subtract $3,500,000 and compute the tax on whatever (if anything) is left. But that naive impression is wrong. The way it actually worked is that you subtracted off any deductions, computed the tax on that amount, and then applied the unified credit of $1,455,800 against the computed tax bill.
Of course the result was identical for most estates; the first $3.5 million of the estate was not taxed. But look what happened to the first dollar past the limit. If the tax really was done the naive way, the taxable estate would be $1, and the tax assessed would be based the bottom of the estate tax-bracket structure. But what actually happens is that the tax must be computed on an estate of $3,500,001, which leaves that estate in the middle of the bracket structure. Then the unified tax credit is subtracted. So the marginal rate is much higher under the way things actually work than it would be under the “naive” way.
Another exception to these rules is the treatment of gifts made within three years of a person’s death. Generally, gifts made within three years on one’s death must be included in the gross estate for tax purposes. These gifts are said to be “lapsed back” into the estate, and can thereby affect the amount of tax due on the estate.
A gift (used as a noun) in this article means a gift of present value. A gift of present value is an unrestricted gift the receiver can use immediately (if an adult, or immediately upon becoming an adult). Alternately, a trust could be set up for a child so that the money in trust is payable to the child only on the child’s 25th birthday provided the child has graduated from college and has no felony convictions. A gift with these sorts of restrictions is considered a future interest, not of a present interest (present value). In this situation, a 709 form would have to be filed starting at the first gift dollar.
Note that if securities or other non-cash instrument is given, the fair market value of the securities as of the gift date is used to determine whether the gift tax rules apply.
Ok, time for an example: If an individual makes a gift of present value of $43,000 in a year, the 30,000 above the current annual exclusion limit reduces the amount of estate excluded from estate tax to the current limit less the 30,000.
Now another example: What happens in 2011 if a married couple (we’ll call them Smith) gifts $52,000 to another married couple (let’s call them Doe). This is perfectly ok and has no tax consequences provided things are done properly. Let’s examine some of the possibilities. If a single check is drawn on Mr. Smith’s account and deposited into Mrs. Doe’s account, the very conservative amongst the tax folk will point out that the gift was from Mr. Smith and not Mr. and Mrs. Smith and further, even if the check was to both Doe’s, it was deposited into only one of the Doe’s accounts, so it could be a gift of 52,000 from one person to another! Since the gift splitting rule is out there, the moderately conservative tax experts would have separate checks written to Mr. Doe and Mrs. Doe. The ultra conservative would have four checks written of exactly the annual exclusion limit each. The use of four checks avoids the gift splitting election as well as the worry about whose account it is deposited in. (Since a spouse can gift unlimited amounts to the other spouse, it really should not matter.)
The Economic Growth and Tax Relief Reconciliation Act of 2001 made dramatic changes to the estate tax laws. In fact, that act repealed the estate tax — but with many caveats. The estate tax exclusion numbers are as follows: $2 million for 2007 and 2008, then $3.5 million in 2009. And in 2010, the estate tax is gone. But (don’t you just love Congress), in 2011 the estate tax comes back with a lifetime exclusion of $1 million. This is how Congress balances its books. It’s anyone’s guess what will actually happen by 2011. Note that the gift tax was not repealed; the lifetime exclusion remains stuck at $1 million after 2011. The annual gift tax exclusion amount is indexed to inflation, so it is difficult to predict how this value will change in future years. Finally, note that the Heroes Earnings Assistance and Relief Tax Act of 2008 (H.R. 6081) made some changes that affect gifts made by expatriates, and those provisions are not discussed here.
To recap one important issue that people often ask about, the blessed recipient of a gift never owes or pays any tax. Stated a bit differently, receipt of a gift is not a taxable event. Of course if someone gives you securities, and you immediately sell them, the sale is a taxable event. See the article elsewhere in the FAQ about calculating cost basis for help with computing the number used when reporting the sale to the IRS.
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Contributed-By: Rich Carreiro, Art Kamlet, John Fisher, Chris Lott