Caution! State and Federal Tax Laws May Not Be Identical

Dear Friends,

This week’s column illustrates a very important point: It is dangerous to assume that state tax law follows the same rules as federal tax law! It always pays to check with a tax or financial advisor before making a financial move you’ll regret later.

Hello, Gail —

We live in Tennessee. I have an elderly aunt who also lives in this state. She’d like to make a gift to our family before the end of the year and not have to pay tax on this. What rules apply?

Thanks,

Paula

Dear Paula —

You’re smart to double-check. There are several areas where state law can deviate from federal law and this is one of them.

You don’t explain whether this gift from your aunt is being made to a 529 college savings plan or not, so for simplicity sake, let’s start by assuming your aunt just wants to make a gift to you and/or your husband.

As you may know, under federal law this year you can give as much as $11,000 to someone (in fact, as many individuals as you wish) without having to pay federal gift tax. A married couple can combine their annual gifting limits and give a joint gift of $22,000 to someone. (Next year the annual federal gifting limit is inflation-adjusted to $12,000.)

Importantly, federal law doesn’t care who the recipient of the gift is. Whether this is a relative or a perfect stranger the dollar limit is the same.

This is not the case under Tennessee law. According to Knoxville estate planning attorney Kevin Hardin, if a Tennessee resident wants to make a tax-free gift, the amount depends upon who is the beneficiary. You either fall into “Class A” or “Class B.”

Tennessee Gift Classifications

Class A Beneficiaries:

Spouse

Lineal Descendent (Child, Grandchild, Great-grandchild, etc.)

Lineal Ancestor (Parent, Grandparent, Great-grandparent, etc.)

Brother/Sister

Son/daughter-in-law

Stepchild

Class B Beneficiaries:

Everyone else

Tennessee residents can gift as much as $11,000 per year to as many “Class A” beneficiaries as they want. (Hardin says that like federal law, this limit increases to $12,000 next year.)

The problem is that “niece/nephew” comes under the heading of “everyone else,” i.e.“Class B.” Tax-free gifts to “Class B” beneficiaries cannot exceed $3,000/year. This amount is not scheduled to increase in 2006. Thus, your aunt could give you and your husband a total of $6,000 this year- $3,000 apiece — without incurring Tennessee gift tax.

Important exception! If your aunt has no children or grandchildren of her own, someone who is a niece or nephew moves up into “Class A” status and so do their direct descendents — children (great-niece/great-nephew), grandchildren, etc. However, according to Hardin, although you would qualify as a “Class A” beneficiary, your husband would not. In this case, this year your aunt could give you $11,000 and your husband $3,000, for a total gift of $14,000.

Because it’s near the end of the year, your aunt has the opportunity to gift significantly more to you without waiting 12 months. That’s because in January she eligible to give another $15,000 ($12,000 + $3,000) to you and your husband without incurring either federal or state gift tax. This would enable her to remove a total of $29,000 from her taxable estate in the space of a couple of weeks.

Tennessee also differs from the federal government in how it treats certain gifts made to a 529 college savings plan.

While the Web site of the “Tennessee Best” plan (http://www.tnbest.org/) states that “there is no annual limit to the amount you may contribute,” this only refers to the fact that Tennessee’s 529 plan allows you to give as much as you want until the account hits $235,000.

However, for gift tax purposes, Tennessee residents who make gifts into any 529 plan face the same limits that would apply if they simply gave the money outright to a beneficiary. In other words, the amount you can gift to a 529 plan (regardless of the sponsoring state) depends upon whether the beneficiary of the account falls into “Class A” or “Class B.”

Moreover, while Tennessee residents who “frontload” their 529 plan contributions by making five year’s worth of annual gifts in a single year ($55,000) do owe federal gift tax on this transaction, they will incur state gift tax on $44,000 (this year). That’s because Tennessee law does not permit accelerated 529 gifts.

Finally, Tennessee does not mirror federal law when it comes to assets that pass at your death. Federal estate tax is only due when you leave more than $1.5 million in assets to non-spouse beneficiaries. This increases to $2 million next year.

However, if you want to avoid Tennessee inheritance tax, the maximum you can leave non-spouse beneficiaries is $950,000 this year and $1,000,000 in 2006.

I hope this clears up some of the confusion. May you have a generous aunt!

Best wishes,

Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to yourmoneymatters@gmail.com , along with your name and phone number.