February 19, 2014
How can you make a gift?
A gift can take many forms. Each has advantages and limitations.
An outright gift is made directly to the donee (the recipient). Making an outright gift gives the donee unrestricted control of the property. Outright gifts may present problems in two situations:
- Gifts to minors: Outright gifts to minor children may not be a good idea, unless it is something that is meant to be enjoyed immediately, like a car. However, if it is a substantial gift, there is some risk that the child will spend the gift foolishly instead of spending it wisely or saving it. And since the child can't sell, lease, exchange, will, or otherwise deal with the property--minors can't enter into contracts by state law--the property will be tied up until the child attains the age of majority. Thus, it may be wasted.
Technical Note: Minority is determined by state law and, generally, the age of majority is 18.
Tip: You might want to consider making gifts to minors in the form of a guardianship under the Uniform Gifts/Transfers to Minors Act (UGMA or UTMA) or in trust (e.g., Section 2503(b) trust, Section 2503(c) trust, or Crummey trust).
Caution: Gifts made under the UGMA or UTMA may reduce the child's chances for financial aid when he or she attends college.
- Gifts to spendthrifts or those who are incapacitated may be unwise: A spendthrift is someone who spends money foolishly. An incapacitated person is someone who is either physically or mentally unable to make financial decisions. You may not want to put property in the direct and unrestricted control of either a spendthrift or an incapacitated person.
Tip: Gifts to spendthrifts or incapacitated persons should be made in trust.
Gifts in trust
Gifts in trust are more difficult to make than outright gifts. Gifts in trust require the preparation of a trust document and may involve trustee fees, tax preparation fees, accountant's fees, or attorney's fees. However, here are some advantages to using a trust:
- Flexibility of income distribution: You can control the distribution of the income and principal of the trust to the beneficiaries by giving the trustee sprinkling powers. Sprinkling powers give the trustee discretion over how to distribute the trust income and principal. This may be preferable if you don't want the donee to have the entire gift all at once but only as needed.
- Professional asset management: The property can be put into the hands of a trustee who is a professional asset manager, such as a bank. This may be desirable if you do not want to assume the duties of the trustee. Professional management will ensure that the property is not wasted but wisely invested.
- Creditor protection: A spendthrift trust is one that prohibits the beneficiary from transferring or assigning his or her interest in the trust to someone else. Putting property in a spendthrift trust keeps the property out of the hands of the beneficiary's creditors.
Tip: Some gifts to charity should be made in trust. Partial-interest gifts (property rights given to both charitable and noncharitable interests, such as a trust paying income to charity, with the remainder going to noncharitable beneficiaries) must be made in some form of charitable trust like a charitable lead trust, charitable remainder annuity trust, pooled income fund, or charitable remainder unitrust to qualify for the gift tax charitable deduction.
Forgiveness of a debt
You can make an indirect gift by forgiving a debt. This means that someone owes you money and you tell him or her they don't have to pay you back. You have, in effect, given him or her the money. Because of the annual gift tax exclusion, forgiveness of a debt can be an excellent way to make a large tax-free gift.
Example: Mr. A gives Ms. B $100,000 to start her own beauty salon. Ms. B signs an interest-bearing note that is payable on demand or at the end of three years. Within the three-year period, Mr. A forgives $10,000 each year on the loan. The $10,000 forgiveness of the loan is a gift, but no tax is due because it is fully excluded under the annual gift tax exclusion. At the end of three years, Ms. B makes a $20,000 payment on the note. The balance of the principal then due on the note is $50,000. During the next five years, Ms. B makes small payments on the note, and Mr. A forgives the remaining balance due on the loan in increments of $10,000 each year (all of which are fully deductible under the annual gift tax exclusion).
You must clearly establish a debtor-creditor relationship. Be sure to establish evidence that your intent is to make a loan--put it in writing, charge market rate interest, get security or collateral, make periodic demands, or let the borrower make some payment or demonstrate the ability to pay.
Interest-free or below-market loans
An interest-free or below-market rate loan is an indirect gift. The gift is the foregone interest. The foregone interest is the difference between the interest computed using the applicable federal rate and the interest computed using the stated rate.
Titling property in joint name
If you add a joint name to your property, you may be making a gift. For example, if you add your son's name to yours on the deed to your house as a 50 percent owner, you have made a gift of half your house.
When the gift occurs depends on the type of property. Generally, the gift occurs when the joint name is added. However, the gift may not occur right away for some types of property where the benefit is not received until later. For example, if you add your son's name to your checking account, there is no gift until your son withdraws funds.
Tip: Titling property jointly in the name of your spouse may be fully deductible under the unlimited marital deduction. Caution: By adding a joint name, you give up control and may expose the asset to the joint owner's creditors.
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