Are Your Gifts Taxable? The Tax Result of Making California Gifts

Posted by Keith A. Davidson on December 28, 2011

I recently had the pleasure of speaking with Kate Ashford, a freelance journalist who occasionally writes “The Help Desk” column for CNNMoney online.  Her question was a common one: how are gifts taxed?  There is a lot of confusion on how gifts are taxed, and to whom they are taxed.  Here’s a few tips to sort out taxes relating to gifts:

What type of tax are you talking about?

There are different types of taxes that could potentially apply to gifts, namely, income tax and gift tax. 

Income Taxation of Gifts.

As a general rule, gifts you receive from others are not included in your income tax.  In other words, any amount received by you as a gift is completely tax-free (same rule applies to inheritances too).  Of course, this assumes that the amount received is actually a bona-fide gift.  You can’t try to fool the IRS by passing off a large bonus from your work as a gift.  But if you honestly receive a gift from a family member, for example, then there’s no income tax to you.  It doesn’t matter if its $1.00 or $1,000,000, it’s a tax-free gift to the recipient.

Don’t confuse gifts with things such as gambling winnings, lottery prizes, game-show loot, or receiving the HGTV Dream Home (if you are so lucky)—all of those cash and prizes are subject to income tax when, or rather if, you receive them.

Gift Tax.

Gifts are subject, however, to our Gift and Estate Tax rules, which obligates the grantor (that is the person GIVING the gift) to pay tax on all gifts made.  Read that again: the person making the gift is obligated to pay the tax—not the person receiving it.  Sounds ridiculous?  Maybe.  But that’s our gift tax system; if you’re going to be generous by giving a gift, then you may have to give an extra gift to Uncle Sam.

To begin with, you should also think that all gifts are taxable.  There are a few exceptions, but if you don’t fit within one of the exceptions, then prepare to be generous to the IRS.

The Exceptions to Gift Tax.

Annual Gift Tax Exclusion.  Every person has the right to gift up to $13,000, per person, per year.  These annual exclusion gifts do not have to be reported to the IRS.  The “per person, per year” requirement means that a single person can make multiple gifts to different people each year.  So a grandfather could gift up to $13,000 to each of his children, and each of his grandchildren and not have to report the gifts, provided that no one person received more than $13,000 in a given year.

Many people remember the annual exclusion gifts as being the annual $10,000 gifts.  That is the prior gift tax exclusion amount before they were indexed for inflation.  The annual gift amount is now $13,000.

Marital Deduction.  Spouses can gift each other an unlimited amount of gifts and pay no gift tax whatsoever.  The only requirement is that the couple must be legally married.  Sounds simple, but it can be tricky at times. 

For example, California does NOT recognize common-law marriage, unless such marriage is established in another State that does recognize common-law marriage (such as Texas).  Also, California does not recognize same-sex marriage (remember Proposition 8?).  California does allow same-sex partners to register and thereby receive many of the same benefits and obligations as married couples, but not the status of legal marriage. 

Gift Tax Exclusion.  Under our current Estate and Gift Tax laws, every individual is allowed an exclusion from gift and estate tax equal to $5,000,000.  This means that you can give up to $5,000,000 away and not have to pay a gift tax on that transfer.  However, any amount of exclusion you use during your lifetime by making gifts, reduces what you have left for your estate.  So if you gift $2,000,000 during your lifetime, you pay no gift tax, but your Estate Tax exclusion is reduced from $5,000,000 to $3,000,000 to account for the $2,000,000 of exclusion you used while alive.

Gifts in any single year to a single person that exceed $13,000 must be reported to the IRS using a Gift Tax Return (Form 709) even though no tax will be due on the return.  This reporting requirement allows the IRS to track gifts made over your lifetime to determine when, and if, you exceed you tax-free limit.

Charitable Gifts.  As you would expect, gifts made to charity, in any amount, are free of gift tax.  Luckily the IRS is not so callous as to require a generous donor to pay tax on gifts to charity. 

But beware, the charity must be recognized as a valid charity by the IRS under Internal Revenue Code Section 501(c)(3).  Always ask to see proof of a charity’s determination letter before making any large gifts to charity, and then confirm the charity’s status with the IRS because sometimes charitable status can be revoked by the IRS.

Tax Law Changes.

Tax laws these days are very fickle things.  The current set of laws for Estate and Gift Tax are set to expire at the end of 2012, meaning that a whole new set of rules will be put in place.  We have no way of knowing if the rules will be better or worse than what we have now.  So you have to keep an eye out for future developments.

The bottom line: no good dead goes unpunished.  Giving ‘till it hurts really can hurt if you don’t plan out your gifting ahead of time.

The Childish Balancing Act-How to Plan for Children in Your Trust.

Posted by Keith A. Davidson on April 08, 2011

Children are a big part of Trust planning, and a big part of Trust litigation (lawsuits) when the planning falls apart (or is not done properly to begin with).  There are many factors that affect planning for children, including age, marital status, health, legal or creditor issues, and level of responsibility (or rather perceived level of responsibility by the parent).

Age Issues:

Age is easy to plan for in that a child’s trust can be created to hold assets until a certain age.  Choosing the “certain age” is a highly personal question to answer.  As a starting point, a child must be a legal adult to receive assets, which is at age 18 in California.  And most people agree that ages 19, 20, and even 21 are too young for a child to receive anything substantial.  In fact, research has shown that the Prefrontal Cortex-the part of the brain that controls reasoning and impulses-does not fully mature until age 25.  So a scientific argument can be made that age 25 is a good minimum age to work with, but does it apply to every case?  Sure, why not.  If nothing else, age 25 is a good starting point.  What about an age other than 25, like 30, 35, or 40?  That’s where personal preference comes into the mix.  Of course, it’s not an all or nothing proposition because a Trust could allow a portion of the assets to be distributed at age 25 (say ½ or 1/3), and then use other ages for the remaining distributions.  You can be as creative as you like in setting the “certain age” for distributions.

Marital and Creditor Protection Issues:

Age is only one part of the equation because keeping assets in trust for a child also impacts marital property issues and creditor protection.  By placing a child’s assets in trust it can (i) protect those assets from creditors, and (ii) help the assets retain their character as the child’s separate property (this applies in California, which is a community property state, but inherited assets are, by definition, separate property).  So as long as the assets are in trust, they have some protection in case of creditors or divorce.  This may be helpful if the child is in a high-risk profession, such as a doctor, lawyer, stuntman, dare devil, motor cross, etc.  But the protection only lasts for as long as the Trust is in existence.  If the trust provides for distribution at a certain age, such as 25, then the creditor protection ends at age 25.  The trust could continue for the child’s entire lifetime if this is a concern.  But you have to balance the inconveniences of the trust with the protection being provided. 

Health Issues:

Children with health issues can face substantial costs for medical care in the future.  A child’s trust can be created so that the child will qualify for government assistance, but have trust assets available for extraordinary expenses that add to the child’s comfort.  Known as “protective”, “Medicaid”, or “Special Needs” trusts, these devices can be helpful for children in need.  In this case, the trust would remain in existence for the child’s lifetime, so the age question is no longer a concern.

Level of responsibility:

This is the real issue parents grapple with in determining a proper age for distribution.  How responsible are your children?  Perhaps the more important question is: how do you perceive your child’s level of responsibility? 

Before I had children I had a hard time understanding why continuing trusts for children were such a big deal—let the children have their cake, I thought.  Not anymore.  As the father of two boys I now understand just how perplexing the question of responsibility can be.  I also know that every child is different and my perception of each of my children may vary from their actual level of responsibility.  And it is my perception of responsibility that matters because that is what will drive my decisions in planning for my children.

So take a good look at your individual situation and ask yourself, what do you think is best for your family?  There are many variables and options to choose from to help your children.  But your opinion is the only one that counts when creating your own trust. 

The Asset Puzzle - Why Your California Will May Not Matter.

Posted by Keith A. Davidson on April 01, 2011

The manner in which assets are titled govern how those assets pass at death.  And this can override a disposition contained in a Will or Trust. All the effort people take to prepare a Will or Trust can be wasted if assets are not titled properly.  This is what I call the asset puzzle.

The first part of the puzzle is knowing the possible pieces (i.e., the way in which assets can transfer at death).  There are differing ways in which assets pass at death and it can be downright confusing.

For exapmle, life insurance passes by beneficiary designation. Whoever is named as the beneficiary on the form in the files of the life insurance company takes at death. It does not matter what the decedent's Will or Trust state, the beneficiary designation controls. Therefore, even though a Will may be created that leaves assets equally to the decedent's children, if only one child is listed as a beneficiary of a life insurance policy, then that one child takes the life insurance proceeds and the other children get none.

Same applies to assets titled in joint tenancy. Bank accounts, brokerage accounts, real property and cars all have the ability to be held jointly with another person or persons. When one joint owner dies, the other joint owners receive the property automatically without the need for probate. But this also means that the assets pass without regard to a Will or Trust. All too often I see children unintentionally excluded because they are not included as a joint tenants on the assets.

For some reason people think that if they have a joint tenancy over their assets one of two things will occur. Either (1) the child who takes that asset will share with the other children (even though there is no legal obligation to do so), or (2) the Will or Trust will override the joint tenancy or beneficiary designation (which is false, the beneficiary or joint tenancy overrides the Will or Trust).

This is where planning comes into the picture. Planning is NOT the act of simply having a Will or Trust.  A Will or Trust is a required part of planning, but that is just the beginning. The most crucial part of planning is looking at all the assets in the estate and changing title to those assets to conform to the plan.  This means filing a new deed so the house is in the Trust, for example.  Changing the title on bank or brokerage accounts, ensuring any beneficiary designations go to either the Trust or the proper individuals.  In other words, looking at the entire, big picture and taking all necessary action.  That’s truly the definition of planning.

By the way, it's lack of planning that keeps lawyers fully employed because that is when litigation and probate ensue. And we lawyers make far more money on probate and litigation then we do on planning. So while people look at me skeptically when I plead with them to have an estate plan, I really should be pleading NOT to create a plan. So support your local lawyers, neglect your planning!

Trust Checkup -- The Decay of An Estate Plan

Posted by Keith A. Davidson on March 07, 2011

If you are one of those forward thinking people who incurred the time, effort, and expense of creating an estate plan that includes a California Trust (living Trust or revocable Trust--they're the same thing), have you ever looked at it since its creation?  Did you know that your estate plan can become less valuable and your Trust can become less Trust-worthy over time? 

Like anything else, life brings changes.  Changes in tax law, changes in California Trust law, changes in assets owned, changes in debts outstanding, and a whole host of family changes (birth, deaths, marriages, etc.).  Most of these changes can have a substantial, and often negative, effect on your estate plan.  While doing an estate plan is great, checking up on that plan to ensure everything is still going smoothly is key.

For example, whenever I create an estate plan that includes a Trust, my firm will assist the client in transferring assets to the Trust.  Such as preparing a Deed to transfer real property in the name of the Trust.  Yet, as life goes on, the client may sell the house that we transferred into the Trust and buy a new one, but forget to title the new property in the Trust's name--a huge mistake.  A Trust can only control assets titled in the name of the Trust.  A Trust with no assets is no longer a valid Trust (in the legal field we call Trust assets "res" (latin for thing) or Trust corpus and a Trust cannot exist without res or corpus).

Or worse yet, a client refinances his or her home and the finance company pulls the property out of the Trust (this is common practice because lenders are wary of lending to Trusts).  Once the refinance is complete, the house is never put back into the Trust--another big mistake.

Transferring real property back into a Trust is an easy thing to do--just requires a Deed--but failing to do it before the Trust creator (called the Settlor or Trustor) dies creates a huge problem that could result in substantial attorneys' fees and costs. 

This is just one example.  The same applies to family changes, tax law changes and Trust law changes.  So having your Trust and overall estate plan reviewed every two years or so is a very worthwhile activity.  It will keep your estate plan on course and ensure that your plan is implemented when the time arrives. 

Estate Taxes - Inadvertently Check the Wrong Box, Pay Over $120,000 in Penalties and Interest!

Posted by Keith A. Davidson on February 18, 2011

Shaun Maritn, in his blog entitled California Appellate Report (which I read regularly and enjoy), posts a recent Ninth Circuit Appellate Court decision penned by District Judge Timothy M. Burgess, sitting by designation with the Ninth Circuit Court of Appeals.

The case, entitled Baccei vs. United States, revolves around a request for extension of time to file an Estate Tax return and pay the dreaded Estate Tax (Form 4768).  Apparently, in Baccei, the taxpayer’s CPA filed his request for an extension of time to file a return and pay the tax.  Both the return and tax payment are due nine (9) months after the decedent’s death.  An extension of time to file an Estate Tax return six (6) months is almost always granted as a matter of course upon filing a request on Form 4768—easy.  An extension of time to pay the estimated Estate Tax is not so easily obtained.  The Government will wait for the paperwork, but not the money.  A sufficient explanation must be made before the IRS grants an extension of time to pay Estate Tax.

Unfortunately for Mr. Baccei, his CPA filled out Part II of Form 4768 requesting an extension of time to file, but did not complete Part III requesting an extension of time to pay.  As a result, the IRS imposed penalties and interest for late payment.  And since the tax came to over $1 million, the penalty was $58,954 and the interest came to $69,801, for a total hit of $128,755—all for not checking a box on Form 4768.

The taxpayer argued that he had substantially complied with the form by filing the form in the first place and completing the entire form other than Part III.  The taxpayer also argued it would be unfair to impose a penalty and that the taxpayer had “reasonable cause” to ask that the penalty and interest be abated given his reliance on the CPA to file the form properly.

The IRS disagreed with the taxpayer, the Federal District Court disagreed with the taxpayer and the Ninth Circuit Court of Appeals did the same.  Taxpayer loses for failure of his CPA to check a box on a tax form.  Shaun Martin in his blog post stated “this couldn’t be more right.”  I have to strongly disagree.  This couldn’t be more disturbing.  You don’t have to be a tax expert to know that tax forms are confusing!  Even the so-called “simplified” forms leave one puzzled at times.  And I speak from experience, having filed a good number of Estate Tax Returns and requests for extensions of time to file and pay in my career.

Luckily, I have never forgotten to request an extension of time to pay when one was required, but I can see how it could be done.  Quit easily in fact.  Primarily because payment is typically made at nine months and only the time to file is extended.  It’s true that the CPA should have filed the form correctly, but we all make mistakes (even the IRS).  What purpose is served by forcing a taxpayer to pay a hefty penalty when his CPA missed that portion of the form? 

Judge Burgess states that the unchecked box was essential to request an extension of time to pay even though the CPA’s cover letter to the IRS specifically stated that they were asking for an extension of time to pay.  While IRS forms should not be disregarded, failing to fill in all of the particulars should not lead to such a harsh and draconian penalty in every case—especially where a tax professional was retained on behalf of Mr. Baccei to file the form in the first place.  The Court reasoned that Mr. Baccei should have made certain the form was prepared correctly, but who would look over a form their CPA prepared?

The end result is that this particular decedent paid his share of Estate Tax and then some.  I don’t think the decedent would think this “couldn’t be more right.”  Apparently tax form technicalities can cost a decedent’s estate a bundle.  The lesson being that we must all submit perfectly completed tax form every time, no exceptions.  But does this "perfection" requirement equally apply to the IRS?  Hard to imagine it does.

Estate Tax Reduction Passes

Posted by Stewart R. Albertson on December 17, 2010

As a follow-up to yesterday’s blog post, the House of Representatives passed a package extending the Bush-era tax cuts for two more years and substantially revising the estate tax.

Writing for the Non Profit Times, Mark Hrywna reports that had Congress not acted, the estate tax would have returned to its 2001 rates beginning January 1, 2011--$1 million exemption amount with a flat tax of 55% for all amounts in excess of $1 million.

But now that Congress has passed President Obama’s negotiated package, the estate tax, for at least the next two years, is as follows: a $5 million exemption amount per individual (or $10 million per married couple), with a flat tax of 35% for all amounts in excess of $5 million for individuals (or $10 million for married couples).

For example, an individual dying in 2011 with a net estate of $6 million can pass $5 million tax-free to his/her heirs and beneficiaries. The remaining $1 million would be taxed at a flat rate of 35% or $350,000.

Married couples are allowed to combine the $5 million exemption (with the proper estate planning) allowing them to transfer $10 million tax-free to their heirs and beneficiaries. Thus, if a married couple both pass away in 2011, and their net estate is worth $12 million, then $10 million would pass tax-free to their heirs and beneficiaries. The remaining $2 million would be taxed at a flat rate of 35% or $700,000.

Much of this analysis is academic as Janet Novack, writing for Forbes, points out that fewer than 4,000 families will pay estate tax next year. But, Ms. Novack goes on to point out that individuals and couples who are not affected by the estate tax should still complete an estate plan. You can read Ms. Novack’s full article here.

How Does the Estate Tax Affect You After January 1, 2011?

Posted by Stewart R. Albertson on December 16, 2010

How does the estate tax affect you? Likely, it does not affect a majority of us in the last few days of 2010. But it may begin to impact more of us, beginning January 1, 2011, if Congress does not pass the current tax-cut extension package recently negotiated by President Obama and the Republicans.

Writing for the LA Times, Lisa Mascaro and Michael Muskal report that liberal Democrats in the House of Representatives are protesting the proposed estate tax provisions of President Obama’s negotiated package. Without any action by Congress, the estate tax will return to its 2001 rates beginning January 1, 2011. The 2001 rates have a flat tax up to 55% of any net estate value over $1 million. For example, under the 2001 estate tax rates, an individual’s net estate of $2 million would likely incur an estate tax of approximately $500,000.

Under President Obama’s negotiated plan, individuals would receive a $5 million exclusion amount that would pass tax-free to heirs and beneficiaries, or if married $10 million would pass tax-free. Any amount over $5 million per person would incur a flat tax of 35%. For example, under this plan an individual’s net estate of $6 million would likely incur an estate tax of approximately $350,000 (because the first $5 million is tax-free, and the remaining $1 million is taxed at a flat tax of 35%). Additionally, under the plan, if a married couple had a net estate of $12 million, then the first $10 million would pass tax-free, and the remaining $2 million would be subject to a flat tax of approximately $700,000 (assuming the married couple properly set up an estate plan to ensure both $5 million exclusion amounts could be used).

In contrast, under the House Democrats plan, individuals would receive a $3.5 million exclusion amount, and married couples a $7 million exclusion amount, and the any amount over those values would be subject to a flat tax of 45%. Using the same examples under the President’s and the Republican’s plan (referenced above) evidences the differing estate tax impact between the two plans: An individual with a net estate of $6 million would likely incur an estate tax of approximately $1.125 million under the House Democrats plan. A couple with a net estate of $12 million would likely incur an estate tax of approximately $2.250 million.

There is not much time to fix the estate tax before the Republicans take control of Congress on January 4, 2011. Hopefully a package will be passed before January 1, 2011 so individuals will know how they may be impacted by the estate tax.