Covering Your Bases so You Don’t Give a Gift That Keeps on Taking . . . Taxes, That Is

Q: I own some stock that has risen dramatically over the years, and now I would like to give some of it to a family member and some to a charity. However, I am unsure of the tax consequences of each of these gifts. Will you explain the issues involved here? Also, how are the gifts valued--my cost of the stock or its value when given away? If the latter, what is the operable date? Finally, what are the tax consequences when the stock is sold by the recipient?

--A.M.S.

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A: As an individual taxpayer, you are permitted to give another individual up to $10,000 per year ($20,000 if you are acting with a spouse) without triggering any gift tax issues. If you exceed that limit, you will have to file a gift tax form with your income tax return to notify the Internal Revenue Service of the excess, which will be deducted from an individual’s lifetime $600,000 gift and estate tax exemption. If you decide to exceed the $10,000 individual limit, there are potential tax consequences for you as the donor; however, there are no consequences for the recipient, no matter what the size of the gift.

There is no limit on the amount you may give away to a recognized charity.

The value of your gift is established as of the date you sign over control of the stock to the recipient. This may or not be the date the recipient actually receives notification of the transaction, but it is the date on which you relinquish control over the shares.

If you are making a gift to a charity, it is this amount that you may declare as a tax-deductible charitable contribution. If you are making the gift to another taxpayer, this is simply the value of your beneficence.

What happens when the recipient chooses to sell the stock? If the recipient is a charity, it simply sells and applies the proceeds toward its ongoing operations. Because it is a tax-exempt organization, any profit goes untaxed.

If the recipient is an individual taxpayer, the taxable gain from the gift of appreciated stock is based on the purchase price of the stock when you, the donor, bought it. So if you paid $10 a share for 100 shares of stock and gave it to your nephew when it was worth $20 per share, and he sells it when it is worth $30 a share, there is a taxable gain of $2,000 ($20 per share) because he assumes your tax basis in the stock. (However, if you were to bequeath the shares upon your death to this same nephew, his tax basis in the stock is its value as of your date of death, not your original tax basis.)

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Q: What if I exceed the $10,000 annual gift limit and fail to file a gift tax form with my income tax return? How stringently is this policed by the government?

--H.F.S.

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A: Basically, our entire method of taxation is based on the honor system. You can play it straight or you can cheat. If you choose the latter course, you run the risk of getting caught.

The risk of getting caught fairly closely tracks the amount of money on the line and the IRS’ opportunity to put its clamps on you. So it should come as no surprise that the IRS takes the question of gifts pretty seriously if your total estate exceeds the tax exemption threshold of $600,000 (set to rise to $1 million by 2006). After all, your estate tax return is the last crack the IRS has at you. According to some estimates, the IRS audits about 40% of the returns from estates on which taxes are owed.

Let’s say you routinely exceed the $10,000 individual gift limit each year and do not file a gift tax return that, in effect, reduces the amount of the estate exempt from taxes. And let’s say that when you die, your estate is worth more than that exemption. If your estate’s return is audited, the IRS is legally able to go back as far as it wants to check up on your gifts to determine whether you have used any of the exemption.

Practically speaking, the likelihood of an extensive search probably isn’t great for the average return, or even the average audit. But if the agent has reason to suspect that anything is amiss, watch out.

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Q: My wife and I own some stocks that are registered in her name only because it was easier to handle it that way. The stocks were purchased with money that is considered community property, not her separate funds. What happens if I should die before she does? Will the shares be stepped up in value as of the date of death, as is the case with other community property assets?

--W.C.D.

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A: Assuming that the surviving spouse can prove that the stock, or any other asset, was purchased with community property funds, the asset is entitled to be revalued as of the deceased’s date of death. In California, the presumption is that assets of spouses are purchased with community property funds, so it’s generally more important for spouses to prove that assets they hold separately were indeed purchased with their own separate funds.

To be sure that the assets are treated to the step-up in value, you and your wife should attach an addendum to your will noting that the stock or any other assets you hold individually were purchased with community property funds.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest.

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