June 8, 2022
Making Gifts to Individuals
As we work with clients to fulfill their goals and objectives, one of the most common strategies that we discuss is gifting. Making gifts to achieve goals and objectives, which are often generational in nature, requires a great amount of analysis and detailed execution to attain the desired outcome. Gifting strategies vary widely depending on the purpose (enhance lifestyle or reduce future estate tax), the type (present or future interest), the value (above or below the annual exclusion and lifetime exemption), the form (majority or minority interest), and the source (liquid or illiquid). In addition, the considerations often diverge when making gifts to individuals and making gifts to charitable organizations. This article focuses on making personal gifts to individuals.
In Michigan, three elements are necessary to constitute a valid gift: (1) the donor (person making the gift) must intend to gratuitously pass title/ownership of the property to the donee (recipient); (2) actual or constructive delivery of the property must be made; and (3) the donee must accept the gift.
The Internal Revenue Service defines a gift as “any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.” In other words, a gift is a transfer of money or assets (including intangible interests) to another person, and nothing of comparable value is given in return. A gift may be either a taxable or a non-taxable gift depending on how much is given, who it is given to, and how the gift is used.
In general, any gift made to an individual is a taxable gift. Meaning that the gift should be reported on IRS Form 709 to reduce your lifetime gift tax exemption or pay any gift taxes due. However, there are a few exceptions to this rule. Generally, the following gifts are not taxable or reportable gifts.
Gifts that are not more than the annual gift tax exclusion for the calendar year to any one individual ($16,000 for 2022)
Tuition or medical expenses you pay directly for someone
Gifts to your spouse
Gifts to a political organization for its use
In addition to the annual gift tax exclusion, every individual has a lifetime gift tax exemption. In 2022, that amount is $12,060,000 and is adjusted annually. Married couples enjoy an exemption of twice that amount because the lifetime exemption is available to each individual. Any gifts that exceed the lifetime exemption are taxable and reportable on IRS Form 709, Gift (and Generation-Skipping Transfer) Tax Return, unless a specific exclusion applies. Any single gift or cumulative gifts that exceed the lifetime gift tax exemption is taxed at the current Federal Gift Tax rate of 40%. It is important to note that in 2026 the lifetime gift tax exemption is scheduled to reset back to $5,000,000 (adjusted for inflation), unless Congress makes changes between now and 2026. This current period of a relatively high lifetime gift tax exemption creates a significant planning opportunity for high net worth individuals who want to reduce taxes upon their death.
Annual exclusion gifts are the most common type of giving. As already mentioned, each person is allowed to give up to $16,000 per calendar year to as many individuals as they would like, and the gift is exempt from gift tax. A married couple can combine their annual exclusion amount and give up to $32,000 to any one person in a calendar year.
Example: In a calendar year, wife wants to give her 4 nieces and her neighbor the maximum annual exclusion ($16,000 x 5 = $80,000 total giving). Husband wants to give wife’s 4 nieces and his 5 nephews the maximum annual exclusion ($16,000 x 9 = $144,000 total giving). Husband and wife have just given away $224,000 ($80,000 + $144,000) in a calendar year gift-tax free because each individual gift did not exceed the annual gift tax exclusion of $16,000.
Beyond the personal satisfaction of making these gifts, husband and wife also realize the benefit of removing $224,000 (and any future appreciation) from their taxable estate for Federal Estate Tax purposes upon death. For those individuals who have taxable estates, annual exclusion gifting is a powerful tool used to reduce future federal estate taxes.
The amount of tuition and medical expenses (as defined by the IRS) that you make directly on behalf of someone else is treated as a non-taxable gift and is unlimited. However, an important detail is that when you are paying tuition or medical expenses for another person, you need to pay those expenses directly to the educational institution or the medical provider. You cannot give your 20-year non-dependent daughter $24,000 for deposit to her checking account with the understanding that she will use the money to pay her tuition bill and have the gift qualify as an exception. In order to qualify for the unlimited non-taxable gift exemption for tuition, you must write the check directly to the educational institution. The same applies for direct payments of medical expenses.
If you do make a gift that does not qualify for one of the IRS taxable gift exceptions, the gift is reportable on IRS Form 709 tax return and any taxes due are from the person who actually made the gift, not the person who received it. The person receiving the gift does not report the gift as income or as any other taxable event in the year of receipt. Items you may need to include with your Form 709 return include a copy of a qualified appraisal, a copy of relevant documents with regard to the gift, and documentation of any unusual items shown on the return like partially-gifted assets such as 50% interest in real estate. Gifts reportable on Form 709 are required to be reported at fair market value, meaning the price at which the property or asset would change hands between a willing buyer and a willing seller (i.e., an appraisal for real estate or a business interest).
We often advise clients on how to most efficiently carry out the transfer of a business interest to their heirs with the goal of effective succession planning and/or reducing gift and estate taxes upon death. The rules available for valuation discounts can be immensely beneficial when gifting these types of assets. In its simplest form, when reporting the market value of a gift of a business interest on Form 709, the value of the gift can sometimes be discounted for items like lack of marketability, lack of control, minority share and future interest discounts. These discounts can range from 10% to 45%, meaning you are able to give away an asset that has a market value of $1,000,000 that potentially could be discounted for a taxable gift value of $550,000, resulting in using less of your available lifetime gift tax exemption than you would if the gift had to be reported at full market value. While a tax savings on 45% of the value of an asset seems like an easy outcome to shoot for, enormous care should be taken when contemplating using valuation discounts, as all valuation discounts must be substantiated by a qualified appraiser. If the IRS disallows the discount, significant underpayment of taxes and penalties could be due. It is also noteworthy to observe that there is currently serious discussion in Congress surrounding proposed legislation that would disallow all valuation discounts.
There are also a handful of irrevocable trusts that can take advantage of the current rules and regulations relating to gifts to individuals that can help reduce taxes upon death. We have discussed many of these in detail in previous Perspectives articles, and each of them warrants its own time and attention because of the complexity of the strategies. For the purpose of this article let it be sufficient to name a few of those irrevocable trusts and allow you to reference our website (www.greenleaftrust.com) for details from previous articles: Spousal Lifetime Access Trust (SLAT), Qualified Personal Residence Trust (QPRT), and Grantor Retained Annuity Trust (GRAT).
Although making gifts to individuals is a common occurrence by the clients we advise, it is an action that requires much thought and understanding of the rules associated with those gifts to assure your goals are met and all available strategies are considered. You will want to review your giving goals annually to ensure that laws have not changed and that the reason for the gifts are still relevant in the context of your estate plan. Take the time to talk with your Greenleaf Trust team before you make a gift (to an individual or charity) to ensure your gift is well thought out and properly implemented.