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Watch out for gift-splitting tax traps

This year, the inflation-adjusted annual gift tax exclusion remains at $13,000, up from $12,000 in 2008. Annual exclusion gifts can be a powerful estate planning tool, and they're doubly effective if you and your spouse elect to "split" gifts.

Before you get out your checkbook, though, it pays to review your gifting strategies with your estate planning advisor. Gift splitting is more complicated than you might think, and mistakes can be costly.

A little goes a long way

When you're planning an estate worth millions, $13,000 may seem relatively insignificant. But a well-designed program of annual exclusion gifts can generate substantial tax savings. The annual exclusion allows you to give up to $13,000 per year to an unlimited number of people tax free without tapping any of your $1 million lifetime gift tax exemption or $3.5 million estate tax exemption.

Let's say you have two children and six grandchildren. If you give all eight of them $13,000 per year for five years, you can transfer a total of $520,000 tax free. If you elect to split the gift with your spouse, that amount doubles to $1.04 million. (By splitting gifts, you can double your lifetime gift tax exemption, allowing you to make $2 million in tax-free gifts.)

When to split

Gift splitting allows you to maximize the amount you and your spouse can give tax free, regardless of whose assets are used to make the gift. For example, if you want to give your son $25,000 in stocks that are your separate property, your annual exclusion shelters $13 ,000 from gift tax, but the remaining $12,000 is taxable. If your spouse consents to gift splitting, the entire gift is tax free.

There are three basic requirements for splitting a gift:

1. You must be married at the time you make the gift.

2. You and your spouse must be U.S. citizens.

3. You must file a gift tax return in which your spouse consents to gift splitting.

Be aware that, if the amount of the gift exceeds the $26,000 combined annual exclusion, both you and your spouse must file gift tax returns. Also, you can't split gifts to your spouse or gifts over which one spouse has a power of appointment.

After you check the box on your gift tax return and your spouse signs the consent, it applies to all gifts either of you made during the year. So if you or your spouse plans to use exclusions separately for certain gifts, you should think twice before electing to split gifts.

Trust issues

Gift splitting couldn't be easier, but it's critical to understand the tax implications before you check the box. Making a gift that you incorrectly assume is splittable can lead to estate tax liability. And, the most dangerous tax traps involve gifts to trusts.

For example, let's suppose you establish a family trust that gives the trustee unlimited discretion to distribute income and principal among your spouse and children. The trust also provides that, when your spouse dies, the assets will be distributed to your kids.

In 2009, you make a $2 million gift to the trust from your separate property, and you and your spouse elect to split the gift. In 2010, you receive a $435,000 tax bill from the IRS. The reason for incurring the tax penalty? The gift wasn't splittable.

The $2 million gift benefits both your spouse and your children and, as previously noted, you can't split a gift to your spouse. Your children's portion of the gift can be split to the extent it's "ascertainable" at the time you make the gift and severable from your spouse's interest. But in this case your spouse and children may receive discretionary distributions from the trustee, so their interests in the trust aren't ascertainable.

The bottom line: The gift can't be split, so you can use only your own $1 million exemption. The remaining $1 million is subject to gift tax.

You can avoid this result, however, by designing the trust so the beneficiaries' interests are ascertainable. For example, you might provide your spouse with an annuity or limit distributions to an "ascertainable standard," such as health, education, maintenance or support.

Avoid splitting headaches

Splitting gifts is an easy way to increase the dollar amount you and your spouse can give as gifts, but watch out for the tax traps. To avoid unwelcome gift tax liabilities, be sure to consult your estate planning advisor before you check the box on your gift tax return.
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