2012: a good year for giving (Part IV).

March 8, 2012, by

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We have seen how rich Uncle Nils is likely to save estate taxes by taking advantage of the increased Federal gift tax exemption, and his State's (Washington's) failure to tax gifts at all. Those savings are projected at $200,000 on his $500,000 gift of cash and securities to a trust for relatives. He might have saved another $50,000 for his heirs by using a family investment partnership or LLC to make his gift.

Nils can create even more savings by qualifying his gift to the trust for the annual gift tax exclusion. Here's how that works. Under the law in effect in 2012, Nils has a $5 million lifetime exemption from gift tax. This means (assuming the law isn't changed before he uses it) that he may give up to $5 million to relatives before paying any Federal gift tax. In addition to the lifetime exemption there is an annual exclusion that allows him to give $13,000 per year per recipient before even using any of the lifetime exemption. The idea is that givers shouldn't have to report small gifts. But a bunch of relatively small gifts can amount to something significant, especially if repeated year after year. Particularly if the gifts accrue gain and income after they are made, there is a fairly miraculous effect similar to the miracle of compounding in the investment world.

In order to qualify for the annual exclusion, Nils's gifts must be of "present interests" in the assets given. That is, you really have to make a gift outright, and not in some form legally removed from the recipient, in order to get the exclusion. That would seem to be a problem for Nils's gift to trust. However, by case law a device has been developed for qualifying gifts to trusts. If the trust agreement gives trust beneficiaries a right, for a limited period of time, to withdraw their shares of the gift to trust (and so take them outright), the contribution to the trust will qualify for the annual exclusion. This limited ability to withdraw is called a "Crummey" power, after the case that found it acceptable.

So how much tax will this save on Nils's estate? There are eight beneficiaries of his trust: nephew Lars and his wife Kyra and their four descendants, and Lars's single sister and her son. Eight times the $13,000 gift tax exclusion means $104,000 of the $500,000 gift is entirely tax-free (does not use lifetime exemption). But wait, it gets better. Even though the gift is from Nils's separate property, his new wife Sylvia may share in the gift for reporting purposes, by also filing a gift tax return. So $208,000 goes into the trust without using lifetime exemption. At the current estate and gift tax rate of 35%, this creates a further tax saving, beyond those already described, of almost $75,000. If Nils had made the gift over two tax years, by contributing $250,000 in late 2011 and the same in early 2012, he would get two years' annual exclusions on it and double the savings again. BINGO!