The Internal Revenue Code includes a provision that imposes a gift tax on the gratuitous transfers you make, such as cash gifts. The gift tax rules dictate how much money you can give away each tax year without incurring a gift tax liability. However, since the underlying purpose of the gift tax is to prevent wealthy taxpayers from transferring their assets tax-free, there is ample opportunity for the average taxpayer to avoid paying it.
Gift Tax Structure
The gift tax rules require the payment of tax on all gifts of cash and property you make during each tax year. However, just like the income tax, there are various exceptions that allow you to reduce the amount you must include in your “taxable gifts” for the year. These include an exemption from the tax for all gifts you make to a spouse, the medical and educational liabilities of other individuals that you make direct payment for, all charitable gifts and most importantly, gifts that don’t exceed the annual exclusion.
Annual Exclusion Giving
The annual exclusion is what keeps most taxpayers from having to pay tax on every gift they make. The exclusion amount represents the maximum value of gifts you can provide to each recipient in a single tax year without incurring any tax liabilities or reporting obligations. As of the time of publication the annual exclusion is equal to $13,000. This means that regardless of whether you make one gift of $13,000 or choose to provide every friend and family member with a check for $13,000, you will not owe the IRS gift tax. However, if even one of those gifts exceeds $13,000, you will have an obligation to file a gift tax return on Form 709 to report the taxable portion of your gifts.
Form 709 Reporting
When preparing Form 709, the IRS requires you to report your taxable gifts and calculate the tax on them. However, you can use your unified credit to eliminate the resulting tax liability. The credit allows you to eliminate up to $1 million of taxable gifts during your lifetime. As you use the credit over the years, you must reduce the balance you have available for future gifts. For example, if your unified credit balance is $1 million and you report your first taxable gift of $5,000 because of an $18,000 gift you make in 2011, you can use the credit to eliminate your liability, but you now have $995,000 left to use in future tax years.
Alternative Cash Gifts
As part of effective gift tax planning, you should consider taking advantage of the education and medical payment exception if you exhaust the annual exclusion for a recipient because of the cash gifts you make during the year. To illustrate, suppose you provide your grandchild with a $13,000 check but would like to give him more than that during the same year. Instead of reporting the excess on Form 709 and using your unified credit, you can make direct payments to his school for his tuition expenses or to a medical provider if he has outstanding medical bills.