By Attorney Paul T. Czepiga, JD, CPA

I have many clients, including grandparents, who each year make gifts to their children or grandchildren. Unbeknownst to many, both the IRS and the State of Connecticut impose a gift tax on the donor of the gift. The federal gift tax rates range from 37% to 55% and the State of Connecticut imposes a tax of between 2% and 6%. In both cases, the amount of the tax depends on the size of the gift. There is, however, an exception that exempts most gifts from tax. If a gift to a particular person does not exceed $10,000, then it is not taxable. In other words, a grandparent can give to each grandchild up to $10,000 per grandchild per year and be fully protected from a gift tax. The Connecticut gift tax is being phased out over the next several years. In addition to the $10,000 per person annual exclusion, in 2001 you can make gifts over $10,000 to multiple recipients in any year so long as the aggregate excess amount does not exceed $25,000. For example, if grandfather gifts $22,500 to each of his two grandchildren, he will not have to pay a Connecticut gift tax because there is a $10,000 annual exclusion for each gift and the excess is $25,000. Some people take advantage of the annual exclusion amount each year to reduce their estates for either federal estate tax purposes or as part of a plan to make themselves eligible for Medicaid benefits.

The nice thing about gifts, if you are on the receiving end, is that they are not income. If Bill Gates should be so inclined to give me $10,000,000, he will have to pay a whopper of a gift tax, but I do not report income from the receipt of the gift. Once I take the $10,000,000.00 and invest it for dividends and interest, those dividends and interest are taxable, but that is a problem I would welcome anytime.

The drawback about gifts is that when someone gives me something, I take as my tax cost whatever the tax cost was of the person who gave it to me. For example, assume grandfather gives me the hunting cabin he bought in 1935 for $10,000, but that is now worth $250,000. Should I ever sell that cabin in the future, I will have to pay capital gains tax on the $240,000 gain. If, however, grandfather had kept the cabin until he died and left it to me in his Will, then I would take as my tax cost whatever the fair market value of the cabin was at the time of his death. If I decided to sell the cabin shortly after grandfather's death, I would likely have little or no capital gain and, therefore, no tax to pay upon the sale. When selecting what assets are appropriate to give away, therefore, your tax cost should be taken into account and usually the more recently acquired assets (those with the smallest potential capital gain) are selected for the gift. A gift of cash, however, does not result in any capital gain issues and is always a welcome gift!

A common way for grandparents to make gifts during their lifetime to grandchildren is to establish a bank account for the grandchild under the Uniform Transfers to Minors Act (formerly known as the Uniform Gifts to Minors Act). Such accounts are generally known as "custodial accounts." This is a simple and inexpensive way to establish the equivalent of a trust for the grandchild without the need for a lawyer. Grandparent would simply go to a bank (or brokerage house) and create an account bearing a designation "UTMA" and designate the "custodian" of the account. The custodian is like a trustee. The Uniform Transfer to Minors Act consists of several statutes adopted by the legislature that together set forth what a custodian can and cannot do with the funds and, essentially, comprise a trust. In general, the funds in the account may be used by the custodian (who is usually the grandparent or a parent of the child) only for the child's welfare and benefit and, when the child reaches age 21 (not eighteen!), the account terminates and all that remains is distributed to the grandchild. If you do create a UTMA account, however, and the child is entering college, 35% of the account balance is deemed available to the child for financial aid eligibility purposes.

Under a UTMA arrangement the money is the child's. If the custodian uses the money for any purpose other than to benefit the child, you, as the person who deposited the money, may sue the custodian to restore the misapplied funds. In 1996, for example, there was a Connecticut Superior Court decision in which a father was sued for misappropriating, as custodian, funds in a custodial account for his son, and the court ordered him to restore $65,000 to his son's custodial account. Although the case did not say, the inference is that the account was created by someone other than the father, the father likely ran into personal financial troubles and used the custodial account for his personal needs, and the person (likely a grandparent) who established the account discovered the depletion and sued the father.

In sum, gift giving is a good idea if you can afford to do without the money. It can reduce your estate tax exposure and enhance your Medicaid eligibility. If you make gifts in 2001 to multiple recipients, remember to take into account the $10,000 per person annual exclusion, and so long as any aggregate excess amount does not exceed $25,000, you will not incur any transfer tax costs. If the gift is to a young child, a custodial account under the Uniform Transfers to Minors Act is a simple method to accomplish your goal.