Scenario: You are financially well-off, maybe even wealthy. You would like to make some significant gifts to people you care about. Plus, you've heard that by transferring assets during your lifetime, you can help your estate-tax bottom line. This translates into the double bingo of exercising your generosity and saving taxes at the same time.

Or alternatively, maybe you're not extremely wealthy, but still feel rather generous and wish to make a substantial gift to a loved one.

If you're not careful about how you give away your property, the IRS could be among the recipients of your gifts to others. Is this your intention?

The IRS is fond of revenue, and applying a gift tax to certain gifts is just one more way to help satisfy the government's voracious appetite for money.

Though Congress created the gift tax game, you can learn to play.

The annual exclusion
First, let's establish a few definitions. A gift is a gratuitous transfer of value. Something is given, and nothing -- or something less than the value of what was given -- is received in return. If the gifting party, the "donor" in tax lingo, receives something back from the recipient (the "donee"), that portion of the transfer is not a gift. It's a sale and the income tax system may step in.  

Before you get too concerned about having to pay gift tax, rest assured that for most folks, this tax is not a worry. Some taxpayers might even consider the IRS to be somewhat benevolent in this particular area because tax isn't imposed until a donor makes one or more gifts to a donee within a calendar year that, in 2007, exceeds $12,000. Gifts within this amount are called "annual exclusion gifts." Better yet, you can make $12,000 gifts to as many different donees as you want each year and then start making gifts all over again Jan. 1 of the next year.

How the annual exclusion works:

If you want to make a $12,000 gift of cash, securities and so forth this year to each of your three children, there is no gift tax on the transfer. On Jan. 1, you can make annual exclusion gifts again to the same recipients.

Because this tax is indexed for inflation, in the past, it has increased every two or three years in $1,000 increments. As long as the donee has full ownership and possession when the gift is made, the transfer is not taxable, period.

And now, although hard to believe, there's more IRS indulgence. Even if you exceed the annual exclusion amount to a donee, you don't have to actually pay the IRS until you've made gifts totaling an aggregate of more than $1 million during your lifetime. However, you will have to fill out Form 709 each year your gift to a recipient exceeds the annual exclusion amount.

Here's an example of when the gift tax applies:

In simplified terms, suppose instead of gifting $12,000 this year to each of your three children, you give them $500,000 each, for a total of $1.5 million. After you subtract three annual exclusions ($1,500,000 - $36,000) you have made a gift of $1,464,000. Because you have a $1 million gift tax lifetime exemption, the only taxable portion of your $1.5 million of gifts is $464,000 ($1,464,000 - $1 million).