Effectively using the annual gift tax exclusion.

• Author: Scroggin, John J.
• Position: Part 2

Part I of this two-part article examined the significant long-term benefits of the annual exclusion. Part II focuses on other issues and available planning opportunities, and addresses how the legislation to eliminate the estate and gift tax may affect the strategies discussed.

Part I of this two-part article, in the June 2001 issue, focused on the general planning issues surrounding the annual exclusion. Part II, below, focuses on some of the more detailed planning issues in using the exclusion.

Powers of Attorney

As Americans live longer, incapacity is becoming a growing issue. Guardianship is an expensive and time-consuming process that can often be replaced by a well-drafted power of attorney.(32) The IRS takes the position that an annual exclusion gift cannot be made unless a power of attorney or state law specifically allows such gifts.(33)

Planning

It almost always make sense to grant a powerholder authority to make annual exclusion gifts. The power could be restricted to provide that gifts cannot reduce the estate below the expected applicable unified credit (i.e., the tax benefit of an annual exclusion gift ceases if there is no taxable estate). Because an estate's value is a moving target, a power of attorney should require the power holder to make reasonable estimates of the estate's value. The grantor may also want to place other conditions on gifting (e.g., limiting gifts to children or restricting gifts to tuition and medical costs).

Some states provide that a power of attorney automatically terminates on the incapacity of the document's creator. To ensure that the power is enforceable (i.e., durable) after incapacity, it should contain specific language that it survives the creator's disability.

In many cases, a client is uncomfortable about giving another the ability to act on his behalf before incapacity occurs. In such case, a power of attorney may be "springing" (i.e., becoming operative only on the client's incapacity). The manner in which incapacity is determined should be defined in the document (e.g., via a letter from the client's primary physician).

To assure that a conflict does not develop between the power holder and a potential adverse guardian (e.g., a second spouse), the document should provide that the power holder should be the guardian (if one is appointed). To ensure that the death of the named power holder does not force the grantor's family into guardianship, the document should name one or more successor power holders.

It is generally better to appoint only one power holder at a time. If multiple power holders are appointed, confusion (e.g., must all power holders agree or is a majority sufficient? Can one power holder act without the others' approval?) and conflict may result (e.g., a child wants to make annual exclusion gifts to reduce a parent's taxable estate, but the current (third) spouse wants to retain assets in the estate to fund a marital qualified terminal interest property (QTIP) trust at death).

Court Orders

Many states' laws permit guardians to adopt an estate plan (with court approval) for an incapacitated resident.(34) However, in TAM 9731003,(35) the IRS ruled that, although a court ordered annual exclusion gifts to the family of an incapacitated taxpayer, the gifted assets remained in the decedent's estate. The court noted that, under applicable state law, the gifts could have been rescinded by the taxpayer had she recovered capacity (even though she had Alzheimer's disease).

Planning

The ruling points out the need to execute broad powers of attorney. Because of the substantial estate tax savings to be derived from annual exclusion gifts, a power of attorney should specifically authorize and set conditions for making gifts. A power of attorney granting "all authority" (or similar language) does not appear to be sufficient under the present IRS position.(36)

The GST Tax

The generation-skipping transfer (GST) tax provides for an annual exclusion that applies only to direct skips.(37) In addition to the GST annual exclusion, each taxpayer can make up to $1,060,000 (in 2001) in GSTs (during life and/or at death) without the imposition of a 55% GST tax under Sec. 2631(a).(38) Most direct annual exclusion gifts are also exempt from the GST tax, under Sec. 2642(c). Thus, if gifts are made pursuant to the annual exclusion, the $1,060,000 exemption is not depleted. The same rule applies to tuition and medical expense payments allowed by Sec. 2503(e).

However, gifts in trust do not qualify for the GST annual exclusion, unless the trust has only a single beneficiary, whose estate will include the trust assets at his death under Sec. 2642(c)(2) (should he die before the trust terminates). In many cases, clients are less concerned about depletion of the GST exemption than with ensuring that the benefits of having multiple Crummey, beneficiaries are maintained. Thus, gifts to Crummey trusts usually constitute taxable GSTs, even if the $10,000 gift tax annual exclusion applies; such transfers will reduce the GST exemption. If a married couple agrees to gift-splitting, they are treated as though each made half of the gift for GST tax purposes, under Sec. 2652(a)(2).

The application of the GST exemption is determined either on a timely fried gift tax return or on the fair market value (FMV) of the property at the time of the allocation, and can yield harsh inadvertent consequences.

Example: G places $1,000,000 in trust, with income to X, his child, for a number of years. If X is alive at the end of the period, he takes the remaining trust assets. If X is deceased, the assets pass automatically to G's grandchild. The assets are worth $5,000,000 when X dies and are passed to the grandchild. If the GST exemption is not elected on a timely filed gift tax return, a GST tax of $2,200,000 (55% x $4,000,000) can be imposed.

This result has particular application to irrevocable life insurance, under which the value of the life insurance proceeds will usually vastly exceed the value of the trust contributions (i.e., the insurance premiums).

Gifts to Minors

Many clients provide annual exclusion gifts to custodial accounts for minors, but fail to consider the long-term effect. For example, assume a client and spouse put $20,000 annually in a custodial account for a minor; the account grows at an eight percent annual rate. Under state law, the child may have control of the account at age 18 or 21; the account balance could easily exceed $750,000.Will the child be able to make the proper decisions as to those funds? Will the funds be used as the donor foresees (e.g., to fund a college education) or merely allow the donee to thwart those plans (e.g., to join a band)?

The gifting of assets to minors is a principal planning issue. A number of alternatives are available: (1) outright gift to a minor; (2) gift to a minor's guardian; (3) gift under a Uniform Transfers to Minors Act (Act); (4) gift to a Sec. 2503>) trust; (5) gift to a Sec. 2503(b) trust; and (6) gift to a...