Take-Away: As you counsel clients on their end-of-year gifting opportunities it is important to keep in mind some of the more sophisticated techniques when making those gifts and some deduction limitations.

Background: A taxpayer can make annual exclusion gifts of present interests of up to $14,000 per donee this year; this amount is scheduled to increase to $15,000 per donee in 2018. The lifetime transfer tax exemption amount that shelters estate, gift and GST taxes is  $4.9 million per taxpayer in 2017, which is schedule to increase by about $110,000 in 2018. The current Senate Bill on tax reform would double this exemption amount, but it would retain all three taxes- gift, estate, and GST. In addition to the annual exclusion gifts, a taxpayer can make a direct gift on behalf of an individual to pay for medical expenses, or tuition, of an unlimited amount; a popular misconception is that these direct gifts do ‘count against’ the annual exclusion gifting opportunity, which is not the case, as they are ‘in addition to’ annual exclusion gifts.

Strategies: Some techniques can be used when making gifts that need to be considered when counselling a client. Some of these strategies are included in the Tax Code, while others are the result of favorable court decisions.

  • Use a Qualified Charitable Distribution: Taxpayers over the age 70.5 can direct that up to $100,000 can be distributed from their IRA directly to a publically supported charity. While the gift does not permit a charitable income tax deduction, the gifted amount is applied against the taxpayer’s required minimum distribution for the calendar year. Donor advised funds are not eligible for this qualified distribution. Since the qualified charitable distribution is not treated as part of the donor’s taxable income for the year, it is possible to escape higher marginal income tax brackets, or the phase out of some deductions, and possibly also avoid the 3.8% net investment income surtax which is tied to the taxpayer’s higher reported income for the calendar year. Expect this opportunity to be more frequently used in the coming years when fewer taxpayers will itemize their income deductions due to the elimination of many current income tax deductions and the doubling of the standard deduction amount, where charitable deductions will be far less impactful to a taxpayer’s income tax liability. IRC 408(d)(8).
  • Use a Net Gift: A large gift that carries with it a gift tax liability can  shift that liability to the donee of the gift. If a client has fully used their lifetime transfer tax exemption and is faced with paying a gift tax on the intended gift, that gift tax liability can be shifted to the donee, the result of which is a smaller ‘net’ taxable gift to the donee. The donee receives the gift, but it is subject to the obligation to pay the federal gift tax, which means that a smaller ‘net’ amount remains in the hands of the donee, which in turn reduces the amount of the gift tax that is owed. Since there is a gift tax liability that will have to be paid, it is best to use easily liquidated assets as the subject of the gift, assuming that the donee will have to sell part of the gifted assets in order to generate the funds to pay the gift tax. Note: the IRS grudgingly accepts net gifts.
  • Use a Net, Net Gift: Under the current estate tax laws, if a gift tax is actually paid and the donor dies within three years of the gift, the value of the gift tax paid is added back to the donor’s taxable estate when the federal estate tax is calculated. In short, it is a phantom asset that comes back into the donor’s taxable estate. If the donor survives the three years after the gift, the value of the gift tax is not added back to the donor’s taxable estate. If the donee agrees to pay the gift tax under a ‘net gift’ and the donee also agrees to pay any additional estate tax that is caused by the inclusion of the gift tax amount in the donor’s taxable estate if death occurs within three years of the gift, that is an additional contingent liability that the donee assumes, which further reduces the size of the gift that is subject to the gift tax. Even if the donor survives the three years and this risk of including the value of the gift tax disappears, it can still be used to reduce the net value of the original gift to the donee. Again, this would be a useful strategy to pursue if the donor has ‘maxed out’ his/her lifetime exemption amount and yet wants to continue to transfer wealth to others. Note: the IRS does not like net, net gifts.
  • Use a Defined Value Gift: While it is easy to give away cash and marketable securities, gifting real estate or interests in closely held businesses is another matter, since the IRS can always disagree with the value of the gift that is reported or it can challenge the size of the valuation discount used when reporting the value of the gifted interest. One way to address this ‘IRS audit risk’ is for the donor to enter into a defined value gift to the donee. Example: I own a closely held business and I want to transfer a part of that business to my child. Due to earlier gifts I now have $4.3 million in lifetime transfer tax exemption available to me. Rather gift my child 594 shares of stock in my closely held business, which an appraiser says is worth $4.3 million- a valuation that the IRS might object to and offer instead a much higher value on audit, asserting a gift tax deficiency-  instead of gifting  594 shares of stock to my child I gift to my child ‘that number of shares in GFB Incorporation that is equal to $4.3 million in value.’ In short, I give a defined value amount of my business to my child, not a specific number of shares in the business which may carry, on IRS audit, a larger value, possibly leading to a gift tax that is actually owed. This strategy was approved in a Tax Court decision Wandry a few years ago. Needless to say the IRS clearly does not like the concept of a defined value gift since even if it audits the subject of the gift, no more than the donor’s available gift tax exemption amount will be transferred, meaning no gift tax will paid regardless of how much the IRS disagrees with the value of the business interest transferred.  Thus, for assets that are hard to value or for which there could be strong differing opinions of value, it would be wise to use a defined value gift strategy.
  • Accelerate Charitable Giving into 2017: The Congress Joint Committee on Taxation projects that if the standard deduction is doubled under the pending tax reform legislation, the number of taxpayers who itemized their income tax deductions will fall from 40 million to 9 million.  For taxpayers who do not pay any mortgage interest, or whose property taxes are less than $10,000 a year, they will not get any income tax savings from the doubled standard deduction if they donate to charities each year. If there will be no income tax savings from charitable gifts in future years, it is a good bet that they will donate less to charities in those coming years. With this possible impact on the future of charitable giving, it is best to accelerate charitable giving into 2017 if at all possible. If a taxpayer is likely to itemize his/her income tax deductions in 2017, but is likely to not itemize their deductions in 2018 due to the passage of the pending tax reform legislation, consider the following:
  • DAF: Make gifts to a donor advised fund. That gift will create a charitable income tax deduction in 2017, but the end-recipient charity will not receive any distribution from the DAF until 2018 or later years, when the taxpayer is no longer itemizing deductions.
  • Pledges: If there is a multi-year pledge outstanding to a charity, see if the charity will give the taxpayer ‘credit’ for the accelerated payment of scheduled pledge amounts in future years into 2017.
  • Use Long Term Capital Gain Assets: Donate to the charity property which, if sold, would produce long-term capital gain. This permits an income tax deduction for the full fair market value of the subject property, or donate the appreciated property to a charitable remainder trust if the donor will need the cash-flow from the subject property for the donor’s lifetime.
  • Caution: Income Limitations:  If the donor wants to save income taxes this year by accelerating charitable giving into 2017, the donor needs to be cautioned that there are annual limits for his/her charitable gifts. The annual deduction limitation for charitable gifts of appreciated stock is 30% of the taxpayer’s adjusted gross income. (AGI) For gifts of cash, the limit is 50% of the taxpayer’s AGI. Example: Taxpayer has AGI in 2017 of $100,000. Taxpayer gifts $70,000 of appreciated securities to a charity. The maximum deduction will be $30,000, leaving $40,000 of the charitable deduction to be carried forward for the next 5 calendar years. If the gift to the charity had been of cash, then $50,000 (50% of the taxpayer’s AGI) could be deducted with a $20,000 charitable deduction carryforward into later years. IRC 170(b). But as noted, if the decision to accelerate charitable giving into 2017 is the recognition that carried forward charitable income tax deductions may not be very useful in future years due to the doubling of the standard deduction, then you have to ask how valuable will those charitable deduction carried-forwards for the next 5 years actually be if deductions are not itemized? If those carried-forward deductions are not going to be all that helpful, then the AGI deduction limits should  curb too aggressive charitable giving in 2017.