Will Uncle Sam Take a Bite Out of Your Gift?
by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
November 23, 2011

Dear Carrie,

If I gift my entire $1,300,000 to my grandson, does he have to pay income taxes on the gift?

—A Reader

Dear Reader, 

Questions regarding the tax treatment for gifts seem to come up time and again. I think that's because people often confuse the regulations regarding gift and estate taxes with income taxes. The easy answer to your question is no, the recipient never has to pay income taxes on a gift or inheritance, no matter the amount. However there are a few things that a giver needs to be aware of—whether that gift happens now or in the future.

Know what you can give tax-free
When it comes to estate and gift taxes, there are two primary numbers you need to be aware of. The first is your lifetime applicable exclusion amount, which is the amount you can give away tax-free, either during your lifetime or as part of your estate. Currently this exemption is $5 million. Above that amount, the highest estate tax rate is currently 35 percent.

The other number you need to know is the annual exclusion, which is the amount you can give away every year to any number of individuals–not only without a gift tax, but also without even having to report it on your tax return. Currently this amount is $13,000 each year (or $26,000 as a married couple "splitting" gifts). It's only when you give more than $13,000 to any one individual in a year that the applicable exclusion amount comes into play.

Given this, a $1,300,000 gift to your grandson is within the limit. You could give the entire amount to him now without owing tax. Or if you intend to leave your estate to your grandson, you're also currently in the clear. (Realize, though, that your state may impose a separate inheritance tax.)
A caveat is that these numbers could very well change after 2012. If they revert back to the previous exemption of $1 million, for example, you may well owe gift or estate taxes.

Factor in capital gains taxes
Even though your grandson won't owe income taxes on your gift, he may have a capital gains tax bill should he decide to sell the assets. So as you consider making such a sizeable gift, it's important to realize that your grandson's cost basis will be different if the asset is a gift as opposed to an inheritance.

In a nutshell, a gift retains the donor's cost basis. For example, if today you gave your grandson stock valued at $100 a share that you bought for $25 a share, he would assume your cost basis of $25 for capital gains tax purposes. That means he would pay capital gains taxes on $75 a share should he decide to sell.

The cost basis of an inheritance, however, is the value of the asset on the date of death (or possibly six months later), which can be a real plus for the recipient. So if your grandson instead inherits the stock, his cost basis would be "stepped up" to the value of the shares at the date of your death. He'd pay capital gains taxes only on any increase in value from the time he inherited it (in this example, anything over $100 a share).

Don't short-change yourself
Of course, your decision about when to give the money to your grandson isn't necessarily based only on taxes. There's a lot of joy in giving a gift during your lifetime and sharing the pleasure and opportunity it can bring. But since you say you want to give him your "entire" $1,300,000, I caution you to take care of your own security first. Make certain you have enough assets to cover your own needs, both present and future.

I don't know your age or your grandson's, but as an alternative to giving the entire amount, you might consider gifting him a portion now and willing the remainder to him. For instance, you could give him $13,000 a year for the rest of your life. That would be entirely gift-tax free and you wouldn't have to worry about exclusions or exemptions. If in the meantime your estate grows, so much the better for both of you.

Talk to your financial advisor
I think it would be well worth talking to a financial or tax advisor as well as to an estate planning attorney. These experts can help you put all this in perspective as well as help you understand your potential tax liability on either a federal or state level. Your generosity is a wonderful thing but be sure to exercise it in a way that benefits you both. Whether you decide to give your grandson the money now or later, he's very lucky to have such a loving grandfather.


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