First instituted by the Revenue Act of 1924, gift taxes are incurred when there is a voluntary transfer (i.e., gift) of cash or other property from one individual to another that is less than fair market value.
The Internal Revenue Service (IRS) defines fair market value as, “… the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Each individual is allowed to donate up to 13,000 dollars in cash or property per donor annually without facing a tax, a practice commonly referred to as the annual exclusion.
The gift tax process can be complex, so it’s a good idea to consult a tax professional such as a estate planning lawyer, a CPA or an EA to ensure your gift-giving is efficient. They can keep you up-to-date on estate planning laws, point out tax loopholes in the system, and clear up common misconceptions. Many people aren’t aware that the annual exclusion amount is indexed for inflation (it usually increases $1,000 every few years), that the exclusion is applicable to both husband and wife, or that a gift tax credit allows an individual to make lifetime gifts (about the annual exclusion) totaling one million dollars without incurring gift tax.
In addition, some gifts are not subject to any taxation, including property transfers in a divorce settlement, donations to a provider of educational or medical services, and outright gift refusals. Others are fully deductible from transfer taxes, including gifts from a donor to a spouse, and accredited charitable contributions.
It is important to understand the legal and financial ramifications of gift taxes because you could end up costing yourself, your estate and your beneficiaries thousands of dollars, whether you unintentionally shortchange your gift, or your estate gets audited and assessed penalties for insufficient tax payments. In addition, gift giving reduces the size of your taxable estate before your death. According to Pacific Life, the maximum gift tax rates actually dropped by a percentage point from 2006-2009 (from 46 to 45 percent). Rates are projected to plummet further in 2010 (35 percent) before shooting up to 55 percent in 2011.
Life insurance can be used to avoid paying unnecessary gift taxes, according to Ed Robinson, an attorney and a member of the Estate Planning Department at Hurwitz & Fine, P.C. in Buffalo, N.Y.
“A common way to deal with the estate tax is to have a life insurance policy that is owned by a third party – an irrevocable trust,” said Robinson. “The death benefit will not be included in my estate upon my death … because the trust owns the policy, it won’t be paying any estate taxes. And death benefits aren’t considered income, so no income taxes will be paid on it. The beneficiaries of the life insurance policy would receive those benefits without estate tax or income tax… it’s a nice, tax-free plan to benefit my beneficiaries.”