What is the Gift Tax? How Does it Work?

If you are planning on transferring assets to someone (or are interested in significantly reducing your taxable estate) you should know what the gift tax is.

Definition of a Gift

To really understand the tax, let’s get clear on what a gift is. Basically, when you transfer something of value to someone else without being paid, you have made a gift. When you are on the receiving end of that equation, you received a gift. Happy day.

The Tax Treatment of Gifts

First the simple part. If you receive a gift you can relax. You won’t have to pay any tax on that transfer. You don’t even have to report the transaction. End of story. Of course you must remember that in order for this to be a gift, you cannot have provided any value in exchange.

If you actually did give someone else a product or service in exchange for what you received, it is indeed a taxable event. And any “gift” your employer gives you is not a gift but taxable income. Sorry. Don’t play around trying to disguise compensation as a gift. It’s a huge IRS audit flag and some day soon the Treasury agents will come knocking on your door. Bad tone.

What about the person who gave the gift?

The person who gave the gift may or may have to report the gift and/or pay a tax on the gift. The good news is that if you play your cards right, you probably won’t have to worry about that tax. That’s because there is a whole list of exclusions that allow you to make gifts without worrying about reporting or paying taxes. What are those exclusions? Here they are according to Wikipedia:

• Annual Gift – you can gift up to $13,000 per year to anyone without worrying about a thing. No tax. No reporting. That $13,000 is the “annual exclusion amount” and can change if Congress so chooses. The annual exclusion is a powerful tool. It means that if you are married, you and your spouse can gift $26,000 per year to any individual. It doesn’t have to be a relative either. You can gift this amount to anyone you like. Nice.
• Charity – You can make charitable contributions without triggering a gift tax or the reporting requirement.
• Spouse – when you transfer assets to your spouse, it isn’t considered a gift.
• Payments made to political organizations.
• Payments made for the benefit of another person for tuition or medical expenses as long as the payments are made directly to the respective institution.

If you want to make gifts above these exemption amounts, you can do so tax-free up to $5,000,000 over your lifetime (in 2012). That happens to be the same amount you can have in your estate when you die without paying any estate tax.

But if make a gift to one person which is greater than the annual exclusion amount you’ll have to file a gift tax return and you’ll have a few choices to make. You can either pay the gift tax or use that gift amount as a credit against the $5,012,000 lifetime estate tax exclusion. Let me illustrate this by way of example.

Let’s say you just won $1,000,000 in the lottery. You feel so good about it you pay off your brother’s credit card debt of $40,000. You make two checks to him – one for $13,000 and the other for $27,000. (This way the IRS is crystal clear on your intent and only $27,000 counts against your lifetime credit. If you only make out one check, the entire $40,000 will count against your credit.) If we assume that the estate tax exclusion remains at $5,012,000 when you die, you’ll be able to pass $4,985,000 estate tax free.

You can see that the gift tax is pretty straight forward but there are a few nuances to be mindful of. I’ve seen people get tripped up by failing to make use of the annual exclusion effectively and then needlessly have to file a gift tax return.

Are you making use of the annual exclusion? Have you made gifts that exceed this amount? Did you remember to file the gift tax return?