By SHEETAL MEHTA FISHER With the holidays upon us and the spirit of giving in the air, the time has come for year end tax planning. An often forgotten and underused tax savings strategy is the annual gift tax exclusion. Not only do lifetime gifts reduce the size of the estate at the death of the donor (and thus potentially reduce the amount of estate tax), but they often are more practical to loved ones who currently need funds for a down payment on a new home, for tuition, or to start a new business. Donors who make gifts at the end of the year have the added advantage of an opportunity to review their financial situation for the year and assess their ability to make gifts. What is the gift tax? The gift tax applies to the transfer of any property (including money). A completed gift occurs where a transfer is made and the person transferring does not expect to receive something of at least equal value in return. An example of this occurs when a parent makes an interest-free or reduced interest loan. Although the general rule is that any gift is a taxable gift, there are many exceptions to the rule. What is the “annual exclusion” and to whom does it apply? The IRS allows any individual to make a gift to any other individual free of the gift tax each year up to a certain amount; that amount is the “annual exclusion”, which is indexed for inflation. The annual exclusion for 2005 is $11,000 and is expected to increase to $12,000 in 2006. The annual exclusion is especially useful, because it does not apply to the $1 million lifetime gift tax exemption. There are no carryover provisions for the annual exclusion. An unused exclusion from 2005 may not be used in a future year. Completion time The donor should be sure to complete the gift in the year that the donor wishes to apply the exclusion. Gifts made by check are generally considered completed the date the donor gives the check to the recipient, however, to avoid confusion, it is advisable to encourage the recipient to deposit the check in the same year. The annual exclusion is not limited to family members. It applies on a per donor and per recipient basis. Thus, parents may jointly give $22,000 to each child, each grandchild and any other person, tax free in 2005. A couple with two children and four grandchildren, who use the exclusion to its fullest, may reduce their estate by $132,000 this year alone. Not only have they removed $132,000 from their estate, but the future interest and income on the $132,000 has also been removed from the estate tax free. Further tax savings are achieved on income producing gifts, such as rental properties and dividend paying stocks, where the donee is in a lower income-tax bracket. The annual exclusion and young children. Donors often fear that an $11,000 gift to a young child will be improperly expended. However, a gift to a custodial account under the Uniform Transfers to Minors Act qualifies for the annual exclusion. To avoid the possibility of the gift being included in the donor’s taxable estate, the donor should not be named a custodian on the account. The donor should be aware that the child will have a right to receive these funds at the age established when the account is opened. Other exclusions What other gifts are excluded from gift tax? Tuition and medical expenses that are paid on behalf of another individual are excluded from the gift tax and do not apply towards either the annual exclusion or the lifetime exemption. However these gifts are only excluded when paid to the educational and medical institutions directly. Contributions made to “529 plans” do not qualify for this exclusion, but qualify for the annual exclusion. Donors who make contributions in excess of the annual exclusion in a given year to a 529 plan, may elect to treat the gift as if it were made pro rata over five years. By way of example, a $55,000 contribution made to a 529 plan in 2005 may be treated as five $11,000 gifts made for each of years 2005 through 2009. Additionally, gifts to spouses, qualified charities and political organizations are excluded from gift tax. What if a gift in excess of the annual exclusion is made? A Form 709, U.S. Gift Tax (and Generation-Sipping Transfer) Return must be filed for all non-exempt gifts in excess of the annual exclusion. The return is due April 15th of the following year, which can be extended when the income tax return due date is extended. Even if the $1 million lifetime gift exemption has not been reached and no taxes are due, the return must still be filed so that the IRS may keep a running tab on the remaining lifetime exemption. Sheetal Mehta Fisher is with the law firm of Lewitt Hackman Shapiro Marshall & Harlan in Encino. She specializes in Estate Planning and Corporate Law.