"It’s the thought that counts."

All of us learned these lessons when we were children. Expressions such as these teach us that a gift is a gift, and should not be closely examined. We are grateful to those who give to us without seeking anything in return. And we appreciate the generosity of others; even where the gift received is not exactly what we were hoping for.

Of course, the giver of the gift has choices to make. Should it be cash or gift certificate, or maybe a special item? How large of a gift should it be, and how much can I afford to give? Should I make it a surprise? How should I wrap it? Should I give it all as one gift, or spread it out in multiple gifts?

In trying to make the right decisions, the giver should also become familiar with the tax laws relating to gifts.

The donee (receiver), on the other hand, incurs no Gift Tax.

Generally, the donee does not even need to report the gifts received. However, gifts received from nonresident alien individuals or foreign estates must be reported by the donee – for informational purposes only - using Federal Form 3520, when the value exceeds $100,000 (only $12,097 if received from a foreign corporation or foreign partnership). Actually, in light of the ever-growing global economy, there is a greater likelihood than in past years for some of us to receive reportable gifts from international business associates.

THE GIFT TAX RETURN REQUIREMENT
Most people who give gifts do not have to file the Gift Tax return (Form 709). Unlike income tax returns, Gift Tax returns are not filed jointly. Each individual who is required to file must have his or her own return. This is true even if the gifts came from jointly held funds. In that case, the gifts are considered made equally by each of the joint owners.

The general rule is that you do not have to file a Gift Tax return unless you made gifts during the year that are valued at more than the "annual exclusion" (presently $11,000, but increasing to $12,000 in 2006) to any one donee, other than your spouse.

In order to take maximum advantage of the annual exclusion, a married couple will often make gifts from joint funds of up to $22,000 to their single child. And married children may receive up to $44,000. This can be accomplished if the parents give a joint gift to their child and the child’s spouse in joint name. (Obviously, with the annual exclusion going to $12,000, beginning in 2006, these amounts will change to $24,000 and $48,000 respectively.) In these cases, no Gift Tax returns would be required, as the total gifts for the year to these donees did not exceed the annual exclusions.

It may be a good strategy to spread a gift over two years, particularly when you were intending to give it at the end of the year anyway. If you gave part in December and another part in January, you could avail yourself of two years’ exclusions on the same gift. This cannot work in all situations, but should be considered where feasible.

Example 1:

In December 2005 John wants to give Bob, his son, as much cash as he can without having to file a Gift Tax return. John’s wife, Barbara agrees. Bob is married to Susan and they have no children. John and Barbara decide to give joint gifts to Bob and Susan on December 25. John and Barbara can give up to $44,000 without having to file. (John and Barbara each have an annual exclusion of $11,000 for each donor. $11,000 x 2 x 2 = $44,000.)

Example 2:

The facts are the same as in Example 1, except that they are willing to give more if they can make the gift in two installments – first, on December 25, and second, on January 1. John and Barbara can give up to $92,000 without having to file. (John and Barbara each have an annual exclusion of $11,000 for each donor in 2005, and $12,000 for each donor in 2006. $11,000 2 x 2 = $44,000, which is the total to give on December 25, 2005; $12,000 x 2 x 2 = $48,000, which is the total to give on January 1, 2006. In this manner, John and Barbara can give a total of $92,000 in one week.)

Example 3:

The facts are the same as in Example 1, except that Bob and Susan have three children. If John and Barbara want to include their grandchildren in the gifts, then they can give up to $110,000 in December without having to file. (John and Barbara each have an annual exclusion of $11,000 for each donor. $11,000 x 2 x 5 = $110,000.)

There are some exceptions to the general filing requirements
Since the annual exclusion applies only to gifts of present interests, then gifts of future interests are reportable, regardless of the value. A future interest is one in which the donee will not have full rights to the use, possession and enjoyment of the cash or property given until sometime in the future.

Similarly, whereas gifts to spouses are generally not reportable regardless of the amount, a donor must report gifts of certain "terminable interests" made to a spouse. A donor also must report all gifts made in excess of $117,000 ($120,000 in 2006) in a year to a spouse who is a non-US citizen.

Gift-splitting election:
If a married couple has not made all gifts from joint funds, they may elect to treat the gifts given from the separate funds of one as if they had been made jointly ("gift-splitting"), but in order to do so, both spouses must file Gift Tax returns.

Accordingly, Gift Tax returns are required in any the following circumstances:

• Gifts of present interests exceed $11,000 ($12,000, beginning 2006) in value to any single donee other than a spouse;
• Gifts of future interests, regardless of amount;
• Gifts to a spouse who is not a U.S. citizen in excess of $117,000 ($120,000 in 2006);
• Gifts to a spouse of certain terminable interests; or
• Gifts that a married donor elects to "split" with his or her spouse.

WHICH GIFTS MUST BE REPORTED
A gift is a gratuitous transfer of money or property from a donor to a donee. A gift is not considered "complete" (and, therefore, not reportable) until the donor relinquishes dominion and control over the item given. In effect, it must be irreversible.

Most completed gifts are counted for purposes of the Gift Tax, but not all. There are two very important exceptions to remember:

• Qualifying Tuition – Amounts paid directly to a qualifying educational organization as tuition will not be treated as gifts subject to the Gift Tax rules.

  Notes:
  Amounts must be paid directly to the organization and, therefore, cannot be given to the student as a "reimbursement." If you intend to use this exception, you should arrange to have the tuition bills sent directly to you.

  A qualifying educational organization is one that is described in Internal Revenue Code Section 170(b)(1)(A)(ii). That section refers to "an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on." Consequently, a correspondence school or private tutoring arrangement will not qualify.

  Only tuition is excluded. Payments to a Section 529 account (or similar arrangement) for education savings will not qualify. (However, see the five-year spread election mentioned earlier.) Nor will room and board, or books and supplies.
  
  

• Medical Care – Amounts paid directly to a medical care provider as payment for that medical care would also not be subject to the Gift Tax rules.

  Notes:
  Amounts must be paid directly to the provider and, therefore, cannot be given to the patient as a "reimbursement." Using the same logic as above, the payer should arrange to receive the medical care bills.

  Qualifying medical expenses include: Payments for the "diagnosis, cure, mitigation, treatment or prevention of disease or ailment, or for the purpose affecting any structure or function of the body" qualify (Internal Revenue Code Section 213(d)(1)(A)). These would include medical, dental, psychological and other care, as well as prescription drugs. Also qualifying are transportation costs and long-term care. Even insurance premiums paid for medical, dental and certain long-term care will qualify.

Furthermore, it is not necessary for the recipient of the tuition and/or medical benefits to be your dependent (or even a relative). However, you should take care not to cause someone else to lose a dependent unintentionally. These expenses do enter into the calculation of "support" for the dependent exemption test. By giving too much, you could find that you have provided more than half the support for the donee. If that happens, then the person who was hoping to take the dependent exemption will lose it.

Other gifts will have to be reported if they exceed the specified threshold amounts for each of the donees. This means listing on Federal Form 709 for each reportable gift to each reportable donee:

• The donee’s name and address, and the relationship to the donor;
• A description of the gift (e.g., "Cash", "200 shares of XYZ Corp.", "Real Estate – 100 Luxury Drive");
• If the gift is of marketable securities, you must list the CUSIP number;
• If the gift is an interest in a closely-held entity, you must show the entity’s Employer Identification Number ("Tax ID");
• The donor’s adjusted basis (the tax basis used for purposes of calculating gain or loss immediately before the gift);
• The date of the gift. (Multiple gifts should be shown as separate gifts); and
• The value on the date the gift was made.

THE GIFT TAX CALCULATIONS AND THE EFFECTS ON THE TAXABLE ESTATE OF THE DONOR
Just because the donor has gifts that are reportable on Form 709 does not mean that there is a tax to pay immediately.

The "Unified Credit" is the credit that each person uses to offset the tax on both lifetime transfers (gifts) and transfers upon death (the estate). This credit is in addition to the annual exclusions for gifts. Once gifts exceed the annual exclusions, and are therefore "taxable gifts," the donor begins to use the Unified Credit before Gift Tax is actually paid.

The Gift Tax Unified Credit, which is actually a credit against the calculated Gift Tax, equates to a present exemption to offset up to $1,000,000 of taxable gifts. Each year the unused portion of the Unified Credit is carried forward - until the death of the donor.

Upon death, the donor’s estate will offset the taxable estate value by the Estate Tax Unified Credit, which represents an exemption of $1,500,000. (Although the Estate Tax Unified Credit will increase to $2,000,000 for 2006 through 2008 and $3,500,000 for 2009, the Gift Tax Unified Credit is scheduled to remain at $1,000,000.) The estate must add to its taxable value the excess of lifetime gifts over the annual exclusions in effect when the gifts were given. In essence, the Gift Tax Unified Credit that was used during the decedent’s life reduces the Estate Tax Unified Credit available to the estate’s executor.

The tax rates used for taxable gifts and estates are shown below in Table A. You would use the total value of gifts given in excess of the annual exclusions to compute the tentative Gift Tax. The Unified Credit, as explained above, reduces this tax.

The question I’ve heard often is "When do I have to pay the tax on this income?" The simple answer is, "Never." Receiving a gift where no goods or services are required in return is not a taxable event. (Of course, if a "gift" were really disguised compensation, then the receipt of it would cause a tax. Therefore, gifts from an employer to an employee are taxable as compensation income.)

Gifts are not subject to income tax on the donor.
Even if the market value of the gift exceeds the donor’s cost, there is no tax gain that must be recognized by the donor.

If gifts exceed the annual exclusions, you do not always pay Gift Tax.
The Unified Credit is a very valuable tool to offset "immediate" taxes (Gift Tax) and save for "future" taxes (Estate Tax). As already illustrated, even after using the annual exclusions, no Gift Taxes are paid unless you have also exceeded your $1,000,000 Gift Tax Unified Credit.

It does not always pay to be secretive about gifts. Filing the Gift Tax return may be a good idea.
At the first sound of the need for a "Gift Tax" return, many people get scared. Perhaps it is because they expect to pay tax. Perhaps they just don’t like sharing such personal information with the government. Both are understandable.

However, the filing of the Gift Tax return may provide a necessary explanation of how the gifted items got there.

Suppose you received a gift of $50,000 in cash from your parents in 2004, which you promptly deposited into your bank account. Your accountant encouraged you to have your parents file a Gift Tax return by the April 15, 2005 due date. If you ever get a letter from IRS informing you that your 2004 tax return is being examined, you will not have to worry about explaining where this (untaxed) money came from. You would merely produce a copy of your parents’ Form 709.

In addition, an estate’s executor must report prior taxable gifts on the Estate Tax return, whether all the Gift Tax returns had been filed or not. And whereas filing the return would have started the statute of limitations – where the IRS could not challenge the value of any properly documented gift after three years – not filing will leave the statute of limitations open indefinitely.

The "tax basis" (sometimes also referred to as "cost basis" or "adjusted basis") represents the amount that is subtracted from the net selling price to determine the tax gain or loss on the sale or exchange of property. The donor’s tax basis is generally determined from the original cost (less adjustments such as depreciation, depletion, etc.). But the donee is getting it for free. So is the donee’s basis for the gifted property ZERO?

THE GENERAL RULE
When the value on the date of the gift is either equal to or greater than the donor’s tax basis, then the donee’s tax basis will be the same as the donor’s. Of course, if only a partial interest is given in the gifted property (e.g., a 50% interest to each of two children), then the donor’s basis is shared proportionately by the donees.

Example 4:

Mary gave her daughter Caroline $15,000 in cash and 6,000 shares of XYZ Corporation, a publicly traded company, on April 15, 2005. Mary bought the XYZ stock for a total cost of $9,000 in 1985. On April 15, 2005, XYZ was selling for $10 per share. Mary’s gift can be summarized as follows:   Tax Basis   Value   Cash $15,000 $15,000 XYZ stock 9,000 60,000 Totals $24,000 $75,000 Neither Mary nor Caroline needs to report any gain on the $51,000 appreciation in the value of the XYZ stock for income tax purposes. Caroline’s basis on the stock received will equal Mary’s basis immediately before the gift ($9,000). If Caroline later sells the stock – whether at a gain or loss - she will use $9,000 as her tax basis.

One of the effects of giving gifts that have appreciated in value, particularly those that go from parents to children, is that by operation of the general basis transfer rule, the eventual gain on the sale of the items could be taxed in a lower tax bracket. Ordinarily, the parents would pay capital gains taxes at 15% Federal, plus additional taxes for State and/or City. A child, however, is more likely to pay at 5% Federal, plus lower State/City rates.

THE SPECIAL LOSS RULE
When the value on the date of the gift is lower than the donor’s tax basis, then the donee’s tax basis will be the same as the donor’s for gain. However, the donee must use the (lower) market value for calculating loss.

Note: Under these rules, it is possible for the donee to later sell for a price between the donor’s basis and the date-of-gift market value and not have either taxable gain or loss!

Example 5:

The facts are the same as in Example 4, except that on April 15, 2005, XYZ was selling for $1 per share. Mary’s gift can be summarized as follows:   Tax Basis   Value   Cash $15,000 $15,000 XYZ stock 9,000 6,000 Totals $24,000 $21,000 Neither Mary nor Caroline can claim the loss on the $3,000 depreciation in the value of the XYZ stock. If Caroline later sells the stock at a gain she will use $9,000 as her tax basis. If she sells the stock at a loss, she must use only $6,000 as the tax basis, since the value at the date of the gift was less than Mary’s basis. However, if Caroline sells the stock for any amount between $6,000 and $9,000, she will have neither gain nor loss to report. Note: This Special Loss Rule does not apply to gifts between spouses. A donee who receives a gift from his or her spouse always uses the spouse’s basis for gains and losses.

THE GIFT TAX ADJUSTMENT TO TAX BASIS
If a Gift Tax is actually paid by the donor, it may be possible for the donee to increase tax basis.

If the values of all items given on the date of the gifts subject to tax were equal to or less than the donor’s basis, no adjustment can be made. However, when one or more of the gifts were appreciated in value (greater than the donor’s basis) on the date of the gift, the donee may increase tax basis by the portion of the gift tax paid that is attributable to the appreciation. In other words, the additional tax paid on the excess of value over the donor’s cost is an increase in the donee’s basis.

Example 6:

The facts are the same as in Example 4, except that on April 15, 2005, XYZ was selling for $2.50 per share. Mary’s gift can be summarized as follows:   Tax Basis   Value   Cash $15,000 $15,000 XYZ stock 9,000 6,000 Totals $24,000 $21,000 Since Mary had been giving generously for many years, she had already exceeded her Gift Tax Unified Credit and must pay a tax of $3,600 on her 2005 taxable gift of $19,000 ($30,000 - $11,000 exclusion). The appreciation on the XYZ stock represents $6,000 ($15,000 - $9,000). First, Mary must determine in what proportions the gifts of cash and stock contributed to her total taxable gifts. Since cash and stock were each valued at $15,000, then each contributed 50% to the total. Therefore, in applying the percentages to the $3,600 tax paid, $1,800 of the tax is attributable to cash, and $1,800 is attributable to the stock. Next, Mary must determine how much of the $1,800 tax that is attributable to the stock relates to the appreciation in value. Since the appreciation is $6,000, and the total gift of stock is $15,000, then 40% is due to the appreciation. Mary then multiplies (a) the $1,800 tax attributable to the stock by (b) the 40% appreciation factor, and arrives at $720. This is the portion of tax that applies to the appreciation of the XYZ stock. Caroline may increase her basis in XYZ by $720, from $9,000 to $9,720.

Once a gift is made, it is irreversible. Putting valuable assets under the control of an irresponsible child can be more trouble than the benefits one is seeking. Sometimes trusts or custodial accounts are good ways to manage funds for those who still need to benefit from our wisdom and experience. The details of those arrangements are beyond the scope of this article, but should be considered before large sums are transferred.

And it is the thought that counts. But it is the better thought that counts, and then recounts.