A COMMON ADDITION to the labels of many store-bought products is the word “improved.” Well, this time the “product” is annual gifts and improved is the perfect word.
Lifetime gifts — usually to younger family members — are one way to guarantee cutting the IRS’ share of your wealth. Remember, the gift tax and estate tax can go as high as 50% in 2002.
Following are the five questions about gift giving most frequently asked by attendees at my seminars on wealth transfer, business succession and estate planning, along with my answers:
1. How much can I give tax-free to one person? (Here comes the improved part.)
The first $11,000 (called the “annual exclusion”) of gifts made each year by the donor to each donee is gift tax-free. The $11,000 starting in 2002 (up from $10,000 last year) is a welcome number. A gift by one spouse can be treated for tax purposes as if it were made one-half by each spouse. This is called “gift-splitting” and doubles the annual exclusion to $22,000 for married couples.
For example, Ed gives $22,000 to his son Ted. Ed and his wife, Edna, elect gift splitting, which means that the gift is treated as if Ed and Edna each made a separate $11,000 gift to Ted. Both gifts are entitled to the $11,000 annual exclusion and are tax-free.
Are all gifts of $11,000 or less tax-free? No. To qualify for tax-free treatment, the gift must be a gift of a “present interest.” A “future interest” blows the annual exclusion.
For example, Jed has three children and every year he gives each child $11,000 in cash. These are gifts of a present interest (the kids can spend, save or squander the money now), and Jed is entitled to the annual exclusion.
Let’s look at a second example using the same facts except that the cash is put in a trust with instructions to the trustee to accumulate the income and give each child everything in the trust in five years (obviously, the future as opposed to now). This is a future interest. There is no annual exclusion. All the gifts are subject to gift tax.
2. Must I pay the gift tax in cash?
No. You can make up to $1 million in lifetime gifts. This would be all the gifts you make during your life, in excess of the $11,000 annual exclusion(s). These are added together and can be paid with a special credit created by law. For example, Edith could give her son Fred $1,011,000 in 2002 without owing any tax that requires a cash payment. If you are married, double the figures.
3. What can I give away?
Anything you own — the family business, bonds, real estate, an interest in a partnership, etc. The amount of the gift is based on the fair market value of the property on the date of the gift. Your cost, or how you acquired the property, is immaterial.
4. Can I deduct the gift?
No, no, no — in spite of what you may hear elsewhere. Nor is the gift income to the recipient.
Gift giving is a superb tax-planning tool. Use it. But to maximize your tax savings, it should be coordinated with an overall lifetime tax plan and a separate estate plan.
Get second opinion
This is a war story. It all started with a phone call.
We chatted for a while.
Then I asked Joe, age 62 and the owner of a successful family business (Success Co.) in Kansas, a simple question, “What are your goals?” Joe hit me with a torrent of words: “Have the business continue ... stay involved but on a part-time basis ... make sure that my son Sam eventually owns the business ... but make sure I stay in control ... take care of my wife, Mary, and treat my children equally, including my two daughters, Lana and Dana, when I pass on ... but keep them out of the business... and if possible, eliminate all estate taxes.”
Joe’s 36-year-old son, Sam, nodded his agreement. The three of us were having a typical transfer-of-ownership/estate tax planning consultation in my office. Joe and Sam had been working on a business succession/estate plan for four years. They had a plan but were not happy with it. They came to see me for a second opinion.
After looking at a stack of Joe’s old tax returns, financial statements and a number of other documents, I prepared a discussion agenda. This led to lots of questions, answers and discussion. Some problems and a few sore spots were exposed. The plain truth: Each member of the family had a separate agenda, unknown to any other family member. I took pages of notes. About three hours later, something interesting happened: Both Joe and Sam said that for the first time, they knew what they wanted to do and how they wanted to do it.
It happens all the time. A frank and open discussion, mixed with the choices available, gets most of the family, business and human (you know, the emotional stuff) problems out in the open, where they can be examined, discussed and solved. The result: A family-satisfying tax-saving plan. The decisions reached at this meeting will fit most of the business owner/readers (particularly those who have one or more kids in their business and one or more who are not) of this column.
Here’s a brief outline of some of the important decisions Joe and Sam made and the plan they implemented.
1. Success Co. (a C corporation) elected S corporation status. Then it was recapitalized to create two types of stock - voting and nonvoting. (This gives Joe the tool to retain control, yet transfer the corporation to Sam.)
2. Joe gifted all of the nonvoting stock, worth about $2.5 million, to a grantor retained annuity trust. For tax purposes, the gift portion of the GRAT was valued at $325,000. This arrangement gives Joe control — via the voting stock — for as long as he lives. The nonvoting stock will belong to Sam when the GRAT will terminate after 15 years.
3. During the 15-year term of the GRAT, Joe will receive $235,000 each year from the GRAT, which is not subject to payroll taxes. The GRAT gets the money from Success Co. as S corporation dividends. Joe will use a portion of this income to buy a $2.5 million life insurance policy (second-to-die) on Joe and Mary. The premium, $26,400 per year, will be paid for only 15 years and then the policy will self-carry (no more premiums). Actually, the policy was purchased by an irrevocable life insurance trust. When the second of Joe and Mary die, the ILIT will collect the $2.5 million free of any taxes, income and estate.
4. Joe and Mary gifted their residence to Lana and Dana via a qualified personal residence trust. The QPRT removes the residence from Joe and Mary’s estate, but Joe and Mary have the right to live in it.
5. During Joe’s life, he will continue to receive a small annual salary of about $18,000 (but to be increased for inflation) for services actually rendered (this will allow Joe to continue to receive his customary fringe benefits).
6. When Joe dies, all of his remaining voting stock will be bequeathed to Sam. Then Sam will own 100% of Success Co.
7. Joe’s and Mary’s other assets, including a $700,000 building leased to Success Co., will go to Lana and Dana along with the $2.5 million in the ILIT, which is written in such a way as to equalize the asset value left to each of the three children.
Although the above seven items do not give every nuance of Joe and Mary’s business succession/estate plan, the plan accomplishes every one of Joe’s objectives. Even his (and Mary’s) estate tax will be eliminated.
Irving Blackman is a partner at Blackman Kallick Bartelstein, e-mail at [email protected]