There are many reasons to give someone a gift but there are at least as many reasons why any sizeable gift should involve some tax planning for estate, income and gift tax purposes. Tax planning and wealth management go hand in hand. With proper planning you can transfer a significant amount of wealth either tax free or with considerable tax savings.

Reasons to Make Lifetime Gifts

Although some of the reasons to make a gift of an asset are quite rational, other gifts may be given for emotional reasons. And, while most gifts are intended to help the donee, some may be to help the donor with estate or income tax planning, or both.

Some of the reasons to make a lifetime gift of an asset are to:

• Help support ones parents,
• Help a family member purchase a house,
• Help a child with tuition for an advanced educational degree,
• Finance a family business,
• Teach a child about investments and money management,
• Transfer assets that might be too complex for the estate’s executor to manage,
• Help fund a family member’s retirement account,
• Reduce the size of an estate,
• Avoid both gift taxes and estate taxes on an asset’s future appreciation, and
• Transfer an income-producing asset to someone in a lower tax bracket.

Reasons Not to Make Lifetime Gifts

Even if a gift seems to make sense, you may not want to make it. Some of the reasons against making a lifetime transfer of an asset are:

• Loss of control over the transferred property,
• Being unable to trust that the recipient will use the gifted asset wisely and not misuse or deplete the asset,
• Worry that too much wealth might spoil the recipient,
• Refusal to consider one’s own life expectancy (the same reason why many people refuse to have their wills prepared),
• Insecurity about one’s own economic future even though it appears sound, and
• While saving on estate and income taxes, gift taxes may be assessed.

Gift Taxes

For gifts made in 2007 through 2009, the gift tax rate is 45 percent. In 2010, the gift tax rate is scheduled to be reduced still further to 35 percent, the highest applicable individual income tax rate. However, like the reduction in estate taxes, these lower rates are set to expire in 2011. Therefore, in 2011, unless changed, the gift tax rate will once again be 55percent for gifts over $3 million and there will be a five percent surtax on gifts over $10 million. (It is, of course, possible that the scheduled gift and estate tax changes will be rescinded by Congress before 2010. In fact, we may find the 2009 estate, gift and GST tax laws applicable to 2010 and future years. If this occurs, the gift tax rate would remain at 45 percent.)

If giving a lifetime interest in an asset, unless it is a gift of a future interest, there is an annual gift tax exclusion for each nonspousal donee. (For gifts to a spouse, there is an unlimited marital deduction.) Therefore, it is always important to differentiate between a present and future interest in property when making a gift. A Crummey trust, or a demand trust, is a technique often used. A Crummey trust gives the right of withdrawal of property from the trust and will qualify as a present interest even if the right of withdrawal is not exercised. In 2008, the annual gift tax exclusion is $12,000 per donee.

If the amount of the gift is more than the annual exclusion, the unified tax credit is then used to eliminate the tax. The gift tax exemption is currently $1 million, which used to be unified for both gift and estate tax purposes. However, using the $1 million credit, which is mandatory, for lifetime gifts, will reduce the credit amount available for future gifts and estate tax purposes. If no tax law changes are made, in 2011 we will revert to having a $1 million unified credit for gift and estate taxes.

There are no gift taxes on certain amounts paid for either school tuition or a health care provider for someone. However, qualifying payments must be paid directly to either the educational institution or health care provider.

Don’t forget the strategy of gift-splitting. Gift-splitting is when both spouses agree to treat one-half of a gift made by one spouse as being made by the other spouse for gift tax purposes. This results in two annual donee exclusions, two unified credit amounts, and two transfer tax rates structures.

One might also make a "net gift," where the gift tax is paid from the gift itself.  The gift’s value is reduced by the gift tax payable by the donee, which then reduces the total gift tax payable on the gift. Although this requires an interrelated computation, it can be easily calculated with good tax planning software.

Estate Taxes

Gifts have the added advantage that they are not usually included in one’s estate, thereby reducing its size for estate tax purposes.

Gifts made more than three years before one’s death are never included in your estate. Although gifts made within three years of the date of death are also generally not included, there are exceptions, such as certain gifts of life insurance proceeds or revocable transfers. Also, any gift tax paid within three years of death is includable in the estate regardless of whether the gift itself is included.

A word of caution: any gift of property given on one’s deathbed can be costly due to the donee’s loss of an otherwise stepped-up tax basis had the asset been inherited instead.

As I stated above, although the estate tax is scheduled to be eliminated for decedents in 2010, it is likely to be changed before that.

Income Taxes

A great way to save on income taxes is to gift income-producing property to a taxpayer who has a lower marginal income tax rate. Obviously, the earlier in the tax year you make the gift, the more effective this strategy will be. Be careful though if the gift is to your child under the age of 19 (under age 24 if a full-time student) as the kiddie tax may be triggered.

Gifting assets that have a high dollar basis is more effective than gifting assets with a low basis. The recipient of a low-basis inherited asset would receive a stepped-up basis at the date of death (a definite advantage if they later decide to sell it).

Whenever the tax basis of property is more than its fair market value, consider selling the property at a loss (which can be used to offset your income tax liability) and gifting the proceeds.

In Summary

There are all sorts of benefits from giving gifts. However, aside from achieving personal satisfaction, there are a number of possible tax benefits for the donor. For every gift given, you should consider the ramifications of gift taxes, income taxes and estate taxes.

Tax planning software is an important tool of successful wealth management. Estate and gift tax planning software, as well as income tax planning software, can allow you to see the tax effects of gifts beforehand.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.