It’s that time of the year again…tax time! Like it or not, when tax season rolls around it is time for most Americans to add “do taxes” to the “to do” list. Chances are you have already started gathering the documents that you or your accountant will need to complete your income tax return. Or, if you are ahead of the game, your income tax return is already filed and your refund (if you are lucky) is in your pocket.
But, as much as we take it for granted that our personal income tax returns are due on April 15th, income tax isn’t the only tax due that day. A gift tax return will also be due on April 15 if you made a gift during the tax year to any person (other than your spouse) in excess of $14,000. $14,000 is the annual exclusion amount for 2013 and 2014. A gift tax return is also due if you made a gift in any amount to a trust that is not a “present interest” and therefore does not qualify for the annual exclusion.
The annual exclusion is the amount that each individual taxpayer can transfer in any year to an individual donee without having to report the transfer to the IRS. The annual exclusion amount is doubled for married couples, regardless of which spouse gave the gift, so that a married couple can give $28,000 to any one donee per year. However, the annual exclusion is not available for transfers to trusts unless the beneficiaries of the trust have the present right to withdraw the amount of the transfer for a specified period of time, and the beneficiary has been notified that he or she has such right (these rights are often referred to as Crummey withdrawal rights).
You may be thinking, “I don’t make gifts that large to anyone, so I don’t have to worry about gift taxes.” For many people that is true, but before settling on that conclusion, think about the types of transfers you made last year. The scope of what is considered a gift for gift tax reporting purposes is much broader than just giving cash to someone or purchasing a big-ticket item, such as a car, for them. The general rule, according to the IRS, is that “the gift tax applies to any transfer by gift of real or personal property, whether tangible or intangible, that you made directly or indirectly, in trust, or by any other means.” This means that if you forgive a debt, make an interest-free or below-market loan, or pay an above-market wage to a family member, you may have made a taxable gift that needs to be reported on a gift tax return. Generally, any transfer, sale, or exchange not made in the ordinary course of business, where the value of the consideration received by the transferor is less than the actual value of the property or services transferred, is subject to gift tax.
To the surprise of many, even payments made for the support of an adult child or a significant other who is not a spouse may be taxable gifts if the transferor does not have a legal obligation to support the person to whom (or for whose benefit) the transfer is made. In most states, a parent no longer has a legal obligation to support a child after the child reaches age 18. This means that expenses paid for an adult child (or any other person, for that matter) that exceed $14,000 may need to be reported on a gift tax return. In particular, large payments by parents for extravagant living arrangements, clothing, vacations, etc. for their children may raise red flags for the IRS. Outright transfers to a U.S. citizen spouse are exempt from gift tax thanks to the unlimited marital deduction. Gifts to a non-U.S. citizen spouse are taxable to the extent they exceed $143,000.
So, you might be thinking, “I pay my adult child’s college tuition; surely that’s not a gift!” And you would be right. There are certain expenses that can be paid on behalf of a child (or any individual) which are not considered gifts. Payments made directly to a qualifying education institution for tuition and amounts paid directly to providers of medical care (as that term is defined by the IRS) for another person are not taxable. If cash is first transferred to the individual to pay tuition or medical costs, the transfer will be subject to gift tax; direct payment is key. Transfers to political organizations are also not subject to gift tax, and gifts to charity are eligible for the gift tax charitable deduction.
Do you need to file a gift tax return?
A lifetime gift and estate tax exemption (equal to $5,340,000 in 2014) eliminates the gift tax on lifetime gifts up to that amount. However, even if you have not used up your lifetime exemption against gift and estate tax, you may still be required to file a gift tax return. This is important because gift tax returns are how the IRS (and you, and eventually your executors) keep track of how much of your exemption you have used during life, and how much is available at your death to apply against the value of your estate.
Generally, if you made gifts in excess of $14,000 to anyone other than your U.S. citizen spouse, or in excess of $143,000 to a non-citizen spouse, or if you made gifts in any amount to a trust in which the beneficiaries do not have withdrawal rights, you will need to file a gift tax return.
There may also be situations in which it is a good idea to file a gift tax return even though you are not required to. If you make “adequate disclosure” of the gift, the statute of limitations begins to run from the date of filing of the return, which means that, in most situations, the IRS has only three years to contest the reported value of the gift. Determining the final value of a gift can be important because it provides certainty for purposes of planning your future gifting program and for memorializing the basis of the property at the time of transfer for purposes of determining income tax basis. A gift tax return may also be necessary to allocate generation-skipping transfer tax exemption to gifts to individuals who are two or more generations below you, or to gifts to trusts for such individuals.
Failing to file a gift tax return for years when potentially taxable gifts are made may not immediately raise red flags at the IRS, but can cause headaches for your executors and heirs and can attract IRS scrutiny after your death. The IRS can impose back taxes, interest, and, in some situations, even penalties for gifts made any time during a taxpayer’s life, if those gifts were not adequately disclosed to the IRS. This could mean your estate ends up paying a larger estate tax bill than expected, and that your heirs end up with fewer assets than you intended.