Frequently Asked Tax Questions --December 22, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday December 22, 1996

 

Year-End Tax Planning

ROBERT L. SOMMERS

Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

This World Wide Web Server is the creation and property of Robert L. Sommers , attorney-at-law. Copyright 1995-7 Robert L. Sommers, all rights reserved.


Sunday, December 22, 1996 (part 1 of 2) 

Year-End Tax Planning

It's the holiday season, an appropriate time to gather around the fire, reminisce and discuss financial planning. Here's a primer on year-end gifting, guaranteed to make every child's holiday a little merrier:

Maximum Your Annual Gift Tax Exclusion

You may gift up to $10,000 per year in cash or property per beneficiary without incurring a gift tax. Husband and wives may gift up to $20,000/year per beneficiary. A gift of cash or property may be placed in a properly drafted trust so that the beneficiaries will not have ownership of the asset no sooner than majority.

This holiday season, consider giving an undivided interest in an asset, such as real property, rather than cash. The benefits are two-fold: first, you will not deplete your cash reserve and, second, the gift of property might qualify for a "fractional-interest" discount, if the donee (recipient) ends up with less than a majority interest in the asset.


Using the Fractional-Interest Discount Rules

The fractional-interest discount rules are as follows: Suppose you are married and own real estate worth $200,000. If you and your spouse gift $20,000 of the property, the beneficiary receives a 10% interest in the property. However, assuming the fractional interest is subject to a 30% discount, then the $20,000 interest becomes worth $14,000, which is less than the spouses' $20,000 annual gift tax-free limit. A discount is permitted since the fractional-interest holder cannot readily sell this asset since there is no "market" for only this interest and he also does not control the property.

Thus, with a 30% discount, you and your spouse may effectively transfer much more, in fact, up to $28,500 of property per year, and remain under the $20,000 gift tax limit ($28,500 discounted by 30% is $19,950). Note: 30% is a typical discount percentage used, but there is no uniform standard discount. You'll need an appraisal to justify the discount percentage applied to your particular asset.


Tax Benefits to the Donee

Using this technique, one can gift a much larger percentage of property than the equivalent amount of cash. Also, one can greatly leverage the annual gift tax exemption to reduce the donor's estate for estate tax purposes while shifting the asset's future appreciation to the donee.

For example, compare the difference between a gift of cash of $20,000, which earns 5% interest, and a gift of $28,500 of property valued at $200,000 (which is within the $20,000 annual gift tax limit, assuming a 30% discount). At the end of 10 years (using a simple interest calculation) the beneficiary's stake in the property would be worth $42,750, but the bank account would have only $30,000.

The interest earned on the cash would be subject to ordinary income taxes (currently a maximum federal tax rate of 39.6%), but the property's appreciation is not subject to tax until the asset is sold, and then is subject to capital gains taxes (currently a maximum federal tax rate of 28%). In addition, the property may be part of a tax-free Section 1031 exchange which would defer taxation until the property is later sold.


Selecting the Proper Asset

Your basis establishes your tax investment in an asset; it is used to measure your subsequent gain or loss. In most cases, your basis is the price you paid for an item. Assets received by gift, however, receive a "carry-over basis": The recipient's basis is the same as the donor's. For example: Suppose you bought 100 shares of IBM at $10 per share and that stock is now worth $100/share. If you gift the stock to your son, his carry-over basis is $10/share; if he sells the stock, he'd have a $90/share capital gain. Therefore, when gifting property, if possible, choose an asset which has not greatly appreciated or has declined but you think will appreciate later in value.


Shift Income to Your Children

There is a tax break that almost every family can successfully utilize: A child's unearned income (interest, dividends, rents or royalties) to $650 is not taxed, and income from $650 to $1,300 is taxed at a 15% tax bracket. Therefore, a gift transfer to a child of $10,000 which earns 6.5% annually will not be taxed. A transfer of $20,000 earning 6.5% annually ($1,300 in income) will produce just a $97.65 tax (15% of $650) to the child. If the same income were taxed to a parent in the 31% tax bracket, the tax would be $403.

Parents who own their own businesses are permitted to hire a child and the income (which is considered earned income) is taxed to the child. Also, other earned income by a child, such as a paper route, will be taxed to the child.

If a child is under age 14, then unearned income over $1,300 is taxed at the parent's tax bracket; children over age 14 are taxed at their bracket which is usually 15%. Carefully drafted educational trusts and other financial arrangements for children over age 14 can take advantage of the child's lower tax bracket, as well as protect those funds from the parent's potential creditors.


Making Gifts in Trust

Making a gift transfer to your children, in trust, is a widely-used tax planning technique. In general, if you retain the right to receive the trust property (a reversionary right) or the discretion to alter, amend or revoke the trust, or have certain powers to distribute the income or principal of the trust, you will be considered the owner of the trust and liable for its taxes. Designating your spouse as trustee will not alter your tax liabilities.

Fortunately, you may sufficiently limit your trustee powers to shift back the taxes to either the beneficiaries or the trust. As a tax-exempt trustee, you may retain the power to distribute trust principal, if the distribution is (1) limited to education, support, maintenance or health of a beneficiary; for the beneficiary's reasonable support and comfort; to enable the beneficiary to maintain his or her accustomed standard of living; or to meet an emergency; or (2) charged against that beneficiary's share, thereby reducing that beneficiary's future distributions by the amount of the present distribution.

You may be the tax-exempt trustee of an irrevocable trust for your children (or other family beneficiaries) without being considered the owner of the trust, provided you accept very limited powers for distributing the trust's principal and no discretion to distribute current income.


Gifting an LLC Interest

Another technique to gift fractional-interest property while retaining control over the asset is to form a limited liability company ("LLC"), place the asset in the LLC, then gift a portion of the "economic" interest in the LLC to the beneficiary. Ownership of an economic interest does not entitle the beneficiary to participate in management of the LLC.

A beneficiary's right to manage, control or participate in the operations of an LLC can be further restricted by making the donor the exclusive manager. Therefore, a gift of a minority LLC interest can shift the economic ownership to your children without seriously impinging upon your right to control the asset.

Go to Part 2 of this article




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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**