Tax Implications of Gifting Money and Assets
Many articles have been written about the Gift Tax implications of estate planning gifts. For most individuals, a more important consideration should be the income tax implications of substantial gifts to family, to charities, or mixed gifts that benefit charities and family (or yourself). Gifts are not considered income, but there may be income tax implications of some gifts, which bears consideration.
GIFTS TO FAMILY
You may give any amount of cash to as many people as you wish without incurring income tax liability for yourself or imposing an income tax liability on the recipients. This is true for any bona fide gift, that is, an unfettered transfer of cash that does not involve any consideration in return. In contrast, a bonus payment to an employee would be taxable income, not a gift. Gifts of other types of property, however, may result in some tax surprises.
IRAs, Retirement Plans, Life Insurance
Properly filling out and signing the Beneficiary Designations for IRAs, Retirement Plans, and Life Insurance is a crucial part of any estate plan. The assets held in IRAs and Retirement Plans (except for Roth accounts) are subject to ordinary income taxes at the time they are distributed to the recipient, whether that recipient is you or anyone else of your choosing. If you name a spouse, child, or other person as your beneficiary, then that person will be required to take at least minimum distributions each year, with the remainder of the account continuing to accrue tax-deferred. The good news, however, is that naming individuals as Designated Beneficiaries of such plans allows the recipients to continue the tax deferral until they take distributions.
Extreme care must be exercised whenever using retirement plan assets as the source of charitable gifts. If a portion of any IRA or qualified account is left to charity, then all assets of such account, including the portion left to individuals, will be treated as if they were paid out within five years of the date of death. This can result in acceleration of taxable payouts, which can bump the recipients into a higher tax bracket and require more taxes to be paid sooner.
If you are contemplating using retirement funds as a source of charitable gifts, make sure to consult with your tax adviser first.
Life insurance is clean and simple when it comes to gifts and taxes. Simply name the beneficiaries of your choosing. They will receive the insurance proceeds shortly after filing a claim with the insurance company, and the proceeds will be tax-free.
Gifts via a Trust
Some people establish and fund revocable or irrevocable trusts for the benefit of family members. The trusts themselves often earn income from rents, dividends, and interest. Income-producing trusts must file income tax returns. If a trust has more income than expenses and makes distributions to beneficiaries, then the Trustee will send a schedule K-1 to each beneficiary, reporting the amount of net income that was distributed to each. The beneficiaries are required to include their share of net income on their own income tax returns.
Unlike cash, stocks, bonds, real property, and business interests have a basis for income tax purposes, which is generally the original cost of the property. When the property is sold, the owner incurs a capital gain or loss depending on whether the sale is for more or less than the basis. If the owner gives appreciated property away, the recipient takes the owner’s basis. When the recipient sells the property, the capital gain or loss is measured by the difference between the sale proceeds and the basis of the original owner.
Note that when the owner of property dies, the owner’s estate receives a “step-up” in basis. This means that the basis of the property in the estate is determined by the fair market value on the date of death. Consequently, there may be significant income tax implications in the choice between making lifetime gifts of appreciated property or letting it pass instead through the estate of the owner. Elder and infirm donors, in particular, should consult with their tax advisers before making significant gifts of publicly-traded stocks, closely-held business interests, farms, houses, or other non-cash property. Proper advice can mean the difference between incurring or avoiding a substantial amount of capital gains taxes.
Gifts to Public Charities, which are recognized as such by a letter from the IRS which they keep on file, have a different set of tax implications. Public Charities do not pay income tax. Therefore, gifts of appreciated property will not lead to an income tax liability by the charity when it sells the property. Consequently, when making relatively large gifts to charities, donors should consider giving away appreciated property rather than cash.
For example, someone with a stock portfolio accumulated over a number of years may have a few stocks with very high value and very low basis. An investment adviser may recommend paring down those investments in order to diversify, or balance, the portfolio. If the stock owner plans to make significant charitable gifts, the appreciated securities may be a better choice than cash to make such gifts. Instead of selling stocks and incurring capital gains taxes, the stock owner may donate some of these shares to a charity of the owner’s choice. The owner will be considered to have made a charitable gift equal to the fair market value of the stock on the date of the gift, without incurring any capital gain. The charity can immediately sell the stock and realize the full value of the gift without paying any tax. The owner will also preserve cash, which may be used for living expenses, given away to family members, or reinvested in other securities.
The tax lesson to be learned here is, for income tax purposes, appreciated securities often are a better choice than cash for gifts to charities, whereas cash is better than stocks for gifts to family.
Charitable Gift Planning
The tax-exempt nature of Public Charities also creates tax-saving opportunities with a little more sophisticated planning, as follows:
Many universities, hospitals, and other large charitable institutions have what they call Planned Giving Programs. These programs often include annuities, pooled income funds, charitable trusts, and other vehicles that provide cash benefits to donors while also benefiting the charity.
A charitable annuity is a contract arranged by a charitable institution to pay an annual or quarterly amount back to a donor in exchange for a gift. The gift may be in cash or other property. The amount paid back will be a percentage of the gift. For example, one donor had a stock portfolio that included a disproportionate amount invested in two individual stocks. The securities adviser recommended paring down those positions to diversify the portfolio, but doing so would have caused a large income tax because each of the stocks had a very low basis. Each one also generated relatively low dividends. This donor had made significant donations for years to a local hospital. That hospital had a Planned Giving Program that included charitable annuities. The hospital offered an annuity of 9% of the value of a gift. The stocks in question had been generating 0.9% combined dividends. Instead of selling the stocks, the donor gave them to the hospital in exchange for an annuity. The hospital received $1 million of stock, which it immediately liquidated. The hospital paid the donor $90,000 per year for the rest of her life. The donor lived another nine years so received a substantial portion of the gift back, and, because it was an annuity, a portion of each payment was treated as income, a portion as capital gain, and a large portion as tax-free return of capital. In addition, the donor received a charitable income tax deduction of almost half of the amount of the gift, which was spread out over the following five years. Serendipitously, the transfer was made two weeks before a stock market correction. The stocks that were given away would have lost 20 percent of their value had the donor done nothing.
Charitable annuities may also be issued in exchange for cash gifts, but the example above shows how much more beneficial a gift of stocks may be.
Pooled Income Funds
A pooled income fund provides benefits to a donor similar to those received from a charitable annuity. Instead of purchasing an annuity, the donor will make a gift to a stock fund owned by the charity. The gifts of many donors are pooled into a single fund, and each donor receives a share of the income paid out by the fund. The benefits are similar to a charitable annuity. Pooled income funds are useful for somewhat smaller gifts.
Charitable trusts are another tool for making charitable gifts while receiving some benefits for yourself or others. Unlike charitable annuities or pooled income funds, which are established by an individual charity, charitable trusts are established by the donor, and may be used to benefit several charities or may give the Trustee discretion to choose among many charities that serve a special purpose, such as funding medical research or providing food, shelter, or services for the poor. Charitable trusts may pay out to charities for a number of years, then pay the remainder to you or your designees, or they pay you or your designees a specified sum for a number of years with the remainder going to charities.
All charitable trusts must file an informational tax return showing the amounts paid to noncharitable recipients and the amounts paid to, or set aside for, charities. The noncharitable recipients will receive a report (similar to the one for a charitable annuity) that breaks down the payments into ordinary income, capital gains, and non-taxable return of principal. The recipients must report the income on their individual income tax returns.
For all types of charitable planned giving vehicles, the choice of what property to contribute is very important. Generally, property with relatively high fair market value and low basis will provide the best tax choice.
If you have any questions concerning charitable or non-charitable gift giving in your own estate plan, we can help.