Armanino Blog

Gifting Exclusions, Part 1: When Is a Gift Not a Gift?

by John Karls
January 30, 2017

The desire to give – to share what we have with others – is a fundamental human impulse. By employing some simple wealth transfer techniques, individuals can minimize the tax consequences of their generosity and optimize their gift strategies.

Gifts can impact estate tax liabilities
The U.S. estate tax system imposes a tax on individuals whose net worth at death exceeds a floor amount, which for 2017 is $5,490,000.  In addition, the law imposes gift tax reporting requirements.  Generally, amounts gifted to individuals during one’s lifetime reduce the amount of wealth one can shelter from the estate tax at death.  If lifetime transfers exceed the floor amount, the law imposes a tax on amounts gifted in excess of the floor.

Thus, for wealthy individuals seeking to make lifetime gifts, any type of economic transfer that is excluded from gift tax reporting is valuable. The three most commonly utilized exclusions (meaning economic gifts that are not treated as gifts for purposes of the gift or estate tax systems) are:

  • Payments of tuition directly to the educational organization
  • Payments of medical expenses directly to the provider
  • Annual exclusion gifts

Each of these exclusions applies to transfers to any individual, not just family members.  In practice, however, most such transfers occur between family members. In addition, each of these exclusions also applies for purposes of the generation-skipping tax, which is a second level of tax aimed at transfers that “skip” generations.

In this article, we discuss the exclusions for tuition and medical expenses. In Part 2, we’ll provide a case study on gift tax arithmetic and the use of annual exclusion gifts.

Payments of tuition directly to the educational organization
“Tuition” means tuition only.  There is no exclusion for payments for books, supplies, fees, room and board, or living expenses. Payments to a Section 529 college savings plan also do not qualify for this exclusion.

“Directly” means directly.  There is no exclusion if the donor gives the cash to the donee, who then pays for the tuition, or if the donor reimburses the donee, who has already made the payment.

“Educational organization” is an organization with the primary function of providing formal instruction.  It has a faculty, a curriculum, and a regularly enrolled student body.  IRS regulations say that the term includes primary, secondary, preparatory, and high schools, as well as colleges and universities.  An IRS pronouncement lays out how certain structured nursery or pre-school programs may also qualify.

Payments of medical expenses directly to the provider
Health insurance premiums are considered medical expenses for this purpose, along with co-pays and amounts billed by health care providers. As with the tuition exclusion, “directly” means directly (see above). 

If a donor pays a medical expense that is subsequently reimbursed by insurance to the donee, the portion that is reimbursed to the donee is not eligible for exclusion and will be treated as a gift.

Using these two exclusions
Anyone can make use of these exclusions, but they seem particularly well suited to wealthy grandparents paying expenses for the benefit of their grandchildren. The idea of a grandparent funding tuition for a grandchild’s education is particularly satisfying for many people. Another scenario would be for an aunt or uncle who has achieved wealth to make such payments on behalf of nieces and nephews.

Logistically, tuition payments are often simple to manage, since they usually occur only once or twice a year. Medical expenses are typically more frequent and occur at random intervals during the year, so it can be difficult to coordinate having the donor be the payor. Health insurance payments are more predictable and easier for the donor to pay (if the insurance is not employer-provided).

Note that there is no dollar maximum or limitation associated with these two exclusions!

Simple techniques can yield big benefits
In conclusion, effective wealth transfer techniques do not have to be hyper-complicated.  Many wealthy individuals and families take advantage of simple techniques like these exclusions to optimize their gifting strategies.

January 30, 2017

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John Karls - Partner, Tax - Dallas TX | Armanino
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