Congress and the Wilson administration established the original federal estate tax in 1916. However, the lack of an annual gift tax limitation provided a large unintended loophole for individuals to distribute inheritances prior to their death and avoid the estate tax. The federal annual gift tax exclusion was first enacted in 1924, repealed in 1926, reenacted in 1932 and has remained in force since that time. Congress and the Reagan administration unified the lifetime and annual gift exclusions in 1981.
The 2015 Lifetime Estate Tax Exclusion
The lifetime estate tax exclusion passed in 2011 set the maximum exclusion at $5 million per individual. The individual exclusion was set at $5.43 million in 2015 because the amount resets annually and is indexed to inflation. Based on the 2015 exclusion, couples can transfer $10.86 million while they are living or after they pass away before the current 40 percent estate tax becomes applicable.
To explain by way of an example, let’s use the case of a married couple who have assets totaling $12.86 million. Together the couple may distribute $10.86 million tax- throughout their lifetime or at the time of their deaths using their combined exclusions. The $2 million in assets above the combined exclusions is subject to a 40 percent estate tax and triggers a tax liability of $800,000 at the time of their deaths.
The 2015 Annual Gift Tax Exclusion
Under the annual gift tax exclusion, individuals may distribute as much as $14,000 per person to any number of gift recipients per calendar year without impacting their lifetime estate tax exclusion. Married couples together may give as much as $28,000 per person to an unlimited number of gift recipients within each year. Every gift reduces the taxable value of an individual’s estate by $14,000 or the corresponding amount of the gift if less.
The amount may not seem like a great deal of money. However, aggregated over time, it will add up and should be used if there is a long-term strategy to provide inheritances to an extended list of individuals. The annual gift tax exclusion might also be used to fund an irrevocable trust incrementally for the benefit of someone else. This annual gift tax exclusion can also be used to give tax- gifts of shares in a family limited partnership.
Direct Payment of Educational and Medical Expenses
There are two additional annual gift tax exclusions that allow for direct payment of education and medical expenses without limitation. Individuals may give an educational gift to students for tuition expenses without using any of their annual $14,000 per person exclusion, and without impacting their unified lifetime exclusion. Books, fees, and living expenses do not fall under this exclusion; however, it is possible to utilize the $14,000 per person annual gift tax exclusion to provide for these expenses. It is important to note individuals must remit payment directly to the educational institution and funds cannot be given to the student.
An exclusion also exists for direct payment of medical expenses. This exclusion is executed in a process similar to paying for educational expenses, in that, health care providers must be paid directly. It is also possible to purchase health care insurance within this exclusion.
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