Gift and Estate Tax Primer

Article Highlights:

• Exclusions from Gift and Estate Taxes
• Annual Gift Tax Exclusion
• Gifts for Medical Expenses and Tuition
• Lifetime Exclusion from Gift and Estate Taxes
• Spousal Exclusion Portability
• Qualified Tuition Programs
• Basis of Gifts

The tax code places limits on the amounts that individuals can gift to others (as money or property) without paying taxes. This is meant to keep an individual from using gifts to avoid the estate tax that is imposed upon the assets owned by the individual at their death. This can be a significant issue for family-operated businesses when the business owner dies; such businesses often must be sold to pay the resulting estate taxes. This is, in large part, why high-net-worth individuals invest in estate planning.

Exclusions – Current tax law provides both an annual gift tax exclusion and a lifetime exclusion from the gift and estate taxes. Because the two taxes are linked, gifts that exceed the annual gift tax exclusion reduce the amount that the giver can later exclude for estate tax purposes. The term exclusion means that the amount specified by law is exempt from the gift or estate tax.

Annual Gift Tax Exclusion – This inflation-adjusted exclusion is $18,000 for 2024 (up from $17,000 for 2023). Thus, an individual can give $18,000 each to an unlimited number of other individuals (not necessarily relatives) without any tax ramifications. When a gift exceeds the $18,000 limit, the individual must file a Form 709 Gift Tax Return. However, unlimited amounts may be transferred between spouses without the need to file such a return – unless the spouse is not a U.S. citizen. Gifts to noncitizen spouses are eligible for an annual gift tax exclusion of up to $185,000 in 2024 (up from $175,000 in 2023).

Example: Jack has four adult children. In 2024, he can give each child $18,000 ($72,000 total) without reducing his lifetime exclusion or having to file a gift tax return. Jack’s spouse can also give $18,000 to each child without reducing either spouse’s lifetime exclusion. If each child is married, then Jack and his wife can each also give $18,000 to each of the children’s spouses (raising the total to $72,000 given to each couple) without reducing their lifetime gift and estate tax exclusions. The gift recipients (termed “donees”) are not required to report the gifts as taxable income and do not even have to declare that they received the gifts on their income tax returns.

If any individual gift exceeds the annual gift tax exclusion, the giver must file a Form 709 Gift Tax Return. However, the giver pays no tax until the total amount of gifts more than the annual exclusion exceeds the amount of the lifetime exclusion. The government uses Form 709 to keep track of how much of the lifetime exclusion an individual has used prior to that person’s death. If the individual exceeds the lifetime exclusion, then the excess is taxed; the current rate is 40%.

All gifts to the same person during a calendar year count toward the annual exclusion. Thus, in the example above, if Jack gave one of his children a check for $18,000 on January 1, any other gifts that Jack makes to that child during the year, including birthday or Christmas gifts, would mean that Jack would have to file a Form 709.

Gifts for Medical Expenses and Tuition – An often-overlooked provision of the tax code allows for nontaxable gifts in addition to the annual gift tax exclusion; these gifts must pay for medical or education expenses. Such gifts can be significant; they include.

• tuition payments made directly to an educational institution (whether a college or a private primary or secondary school) on the donee’s behalf – but not payments for books or room and board – and
  
  
• payments made directly to any person or entity who provides medical care for the donee.

In both cases, it is critical that the payments be made directly to the educational institution or health care provider. Reimbursements to the donee do not qualify.

Lifetime Exclusion from Gift and Estate Taxes – The gift and estate taxes have been the subject of considerable political bickering over the past few years. Some want to abolish this tax, but there has not been sufficient support in Congress to do that; instead, the lifetime exclusion amount was nearly doubled as of 2018 and has been increased annually due to an inflation-adjustment requirement in the law. In 2024, the lifetime exclusion is $13.61 million per person. By comparison, in 2017 (prior to the tax reform that increased the exemption), the lifetime exclusion was $5.49 million. The lifetime estate tax exclusion and the gift tax exclusion have not always been linked; for example, in 2006, the estate tax exclusion was $2 million, and the gift tax exclusion was $1 million. The tax rates for amounts beyond the exclusion limit have varied from a high of 46% in 2006 to a low of 0% in 2010. The 0% rate only lasted for one year before jumping to 35% for a couple of years and then settling at the current rate of 40%.

This history is important because the exclusions can change significantly at Congress’s whim – particularly based on the party that holds the majority. In fact, absent Congressional action, the exclusion amount is scheduled to return to the 2017 amount, adjusted for inflation, in 2026, estimated to be just over $6 million per person.

Spousal Exclusion Portability – When one member of a married couple passes away, the surviving member receives an unlimited estate tax deduction; thus, no estate tax is levied in this case. However, as a result, the value of the surviving spouse’s estate doubles, and there is no benefit from the deceased spouse’s lifetime unified tax exclusion. For this reason, the tax code permits the executor of the deceased spouse’s estate (often, the surviving spouse) to transfer any of the deceased person’s unused exclusion to the surviving spouse. Unfortunately, this requires filing a Form 706 Estate Tax Return for the deceased spouse, even if such a return would not otherwise be required. This form is complicated and expensive to prepare, as it requires an inventory with valuations of all the decedent’s assets. As a result, many executors of relatively small estates skip this step. As discussed earlier, the lifetime exclusion can change at the whim of Congress, so failing to take advantage of this exclusion’s portability could have significant tax ramifications.

Qualified Tuition Programs – Any discussion of the gift and estate taxes needs to include a mention of qualified tuition programs (commonly referred to as Sec 529 plans, after the tax code section that authorizes them). These plans are funded with nondeductible contributions, but they provide tax-free accumulation if the funds are used for a child’s postsecondary education (as well as, in many states, up to $10,000 of primary or secondary tuition per year). Contributions to these plans, like any other gift, are subject to the annual gift tax exclusion. Of course, these plans offer tax-free accumulation when distributions are made for eligible education expenses, so it is best to contribute funds as soon as possible.

Under a special provision of the tax code, in a given year, an individual can contribute up to 5 times the annual gift tax exclusion amount to a qualified tuition account and can then treat the contribution as having been made ratably over a five-year period that starts in the calendar year of the contribution. However, the donor then cannot make any further contributions during that five-year period.

Basis of Gifts – Basis is the term for the value (usually cost) of an asset; it is used to determine the profit when an asset is sold. The basis of a gift is the same for the donee as it was for the donor, but this amount is not used for gift tax purposes; instead, the fair market value as of the date the gift is made is used.

Example: In 2024, Pete gifts shares of stock to his daughter. Pete purchased the shares for $6,000 (his basis), and they were worth $25,000 in fair market value when he gifted them to his daughter. Their value at the time of the gift is used to determine whether the gift exceeds the annual gift tax exclusion. Because the gift’s value ($25,000) is greater than the $18,000 exclusion, Pete will have to file a Form709 Gift Tax Return to report the gift; he also must reduce his lifetime exclusion by $7,000 ($25,000–$18,000). His daughter’s basis is equal to the asset’s original value ($6,000); when she sells the shares, her taxable gain will be the difference between the sale price and $6,000. Thus, Pete has effectively transferred the tax on the stock’s appreciated value to his daughter.

If Pete’s daughter instead inherited the shares upon Pete’s death, her basis would be the fair market value of the stock at that time (let’s say it is $28,000) and if she sold the shares for $28,000, she would have no taxable gain.

This is only an overview of the tax law regarding gifts and estates; please call this office for further details or to get advice for your specific situation.

 

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