Editor: Todd Miller, CPA
With the looming threat of legislative change expected to drastically lower the estate and gift tax basic exclusion amount, the pressure to make large gifts before year end is causing a flurry of gifting.
It is important to consider some of the less-obvious gifts when you are advising clients who are intent on using up their full $11.7 million basic exclusion amount before the end of the year. Outside the more obvious outright transfers of money or property, some indirect gifts may cause your client to exceed the lifetime exclusion inadvertently when property (tangible or intangible) is transferred without full and adequate consideration under Regs. Sec. 25.2512-8.
One common example is providing support to an adult child. To first determine whether support to a child over the age of 18 is a gift, start by looking to the applicable state's law to determine whether it imposes a legal obligation to support the child. Each state defines its legal support obligation, and the duty to support must be a legally enforceable obligation under state law, not a purely moral obligation (see, e.g., Lester, 35 F. Supp. 535, 540 (Ct. Cl. 1940) ("A moral obligation is not a sufficient consideration to avoid the incidence of the [gift] tax."). In most states the age of majority is 18, and in others it is 19 or 21. Further, there appears to be no clear guideline on whether a parent is legally obligated to pay for a college education or to provide support if a child is merely unable to support himself or herself (and not mentally or physically disabled). Laws in each state vary, and, in some states, making a determination may boil down to a careful review of the facts and circumstances.
It is also important to recognize that the federal income tax requirements for the dependency deduction fall under different rules and that a parent does not automatically have a legal obligation to provide support under state law just because the child qualifies as a dependent. It is possible to claim the adult child as a dependent under the support and other tests and still make a taxable gift in the form of the support. A discussion of income tax consequences is beyond the scope of this item.
Often, the client assumes that if the child is in college, the client can continue to support the child without incurring any gift tax consequences. The payments could include providing a home or paying for room and board at the school dormitory, or paying for books and other college expenses such as tuition. The following example may help explain what is and is not a gift to a child in college:
Example: A's 18-year-old son E is in college, and she paid the following costs in 2021:
- Tuition of $25,000 directly to the college;
- Room and board of $15,000 paid to the college for dormitory fees and meals; and
- A monthly stipend to cover books and other incidental costs of $12,000 for the year.
E did not earn any wages or use any personal funds for his support. E's late father left a trust to provide for his health, education, maintenance, and support (HEMS), and the trust generated $30,000 of income in 2021. The trustee is allowed to make a distribution under the HEMS standard, but no distribution was made.
A lives in a state where the legal age of majority is 21. Even though E could have taken a distribution from the trust to provide for his support, A is legally obligated to provide the support. None of the payments A made for E's support are a gift, and because A provided for more than one-half of E's support (and E therefore did not provide more than one-half of his own support), she can claim him as a dependent for federal tax purposes.
If A lived in a state where the legal age of majority is instead 18, the payments made for room and board and the monthly stipend would be taxable gifts amounting to $27,000 (with an annual exclusion of $15,000 for 2021). However, the $25,000 direct payment of tuition would be excluded under Regs. Sec. 25.2503-6.
Whether or not the child is in college, providing full access to a home (that could otherwise be rented to an unrelated third party) without charging fair market rent could be an indirect gift under Regs. Sec. 25.2512-8 if the child is an adult under state law.
Another common example is the payment of life insurance premiums. Clients often forget to inform their CPAs when they create irrevocable life insurance trusts and contribute cash each year to the trust to pay life insurance premiums. A common reason they fail to inform their CPA is that they know the total contributed does not exceed the annual exclusion in total for all the beneficiaries. However, for the gift in trust to qualify as a present interest that qualifies for the annual gift tax exclusion, the trust should comply with IRS Letter Ruling 199912016 to allow for an immediate withdrawal right, and actual notice of this right must be given to the beneficiary (Crummey notice, from Crummey, 397 F.2d 82 (9th Cir. 1968)). And the client may fail to consider that this gift may use up the annual exclusion for other gifts made in a given year.
Another often-overlooked indirect gift is when a beneficiary of a trust requiring mandatory distributions of income fails to take the annual distribution. Sec. 2511 says, regarding transfers in general, "Subject to the limitations contained in this chapter, the tax imposed by section 2501 shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible." Therefore, when the beneficiary fails to withdraw income each year and allows the funds to become part of the corpus that will ultimately pass to the remaindermen, this is an indirect gift to the trust remainder beneficiaries. So be sure to ask if the required income distributions have been taken each year, to help your client avoid making an inadvertent gift.
Other commonly overlooked gifts are those made for holidays, birthdays, and vacations and for loans made at an interest rate below the required minimum applicable federal rate. While they may seem small and inconsequential, these gifts can add up and in total create a taxable gift when combined with other gifting.
Transfers that are not gifts
Clients can take advantage of several nongift opportunities to make a considerable impact when used as part of their overall wealth transfer planning. These include the following:
- Gifts that are not more than the annual exclusion for the calendar year (Sec. 2503(b), $15,000 for 2021);
- Outright donations to qualified charities;
- Transfers to a U.S. citizen spouse;
- Direct payments to medical providers for medical costs;
- Direct payments to qualifying educational institutions for tuition (grade school through higher education; Sec. 2503(e)); and
- Contributions to a political organization defined in Sec. 527(e)(1).
Countless other examples of indirect gifting are not covered in this discussion, so it is important to ensure your client understands the basic rules when engaging in wealth transfer planning. The fundamentals in Regs. Sec. 25.2512-8 covering transfers without full and adequate consideration should be carefully explained so that you and your clients can work together to optimize their wealth transfer strategies. Careful planning to help your clients make the best use of transfers that are not gifts can help preserve their lifetime exclusion in the most tax-efficient manner.
Todd Miller, CPA, is a tax partner at Maxwell Locke & Ritter in Austin, Texas.
For additional information about these items, contact Todd Miller at 352-727-4155 or firstname.lastname@example.org.
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