General Practice, Solo & Small Firm DivisionMagazine
Gift Taxes Family, Friends, and the Tax Collector
BY DEBORAH L. O’NEIL
© American Bar Association. All rights reserved. Deborah L. O’Neil is the Advanced Planning Director of the Great Lakes Region of The Equitable Life Assurance Society of the United States. She primarily focuses on estate planning, business succession, and taxation. She is licensed in Michigan and Colorado and is currently working on her LL.M. in tax at Wayne State University.
In the beginning, the Internal Revenue Code (I.R.C.) only taxed income or the accumulation of wealth, not the transfer of wealth. In 1916, Congress adopted a tax for the transfer of a decedent’s taxable estate. Although some taxation was implemented in the 1920s for lifetime gifts, the current section of the I.R.C. governing gifts was adopted under the Revenue Act of 1932.
I.R.C. chapter 12 on gift taxes was developed to catch transfers people were making prior to death to avoid the estate tax system. Property is taxed when it is earned or when the gain is realized, and also when it is passed during life and death.
Gift and Estate Taxes
The gift and estate tax systems share a graduated tax table.1 This tax table increases from 18 percent to 55 percent with a surcharge of 5 percent for estates between $10 million and $21.04 million. The surcharge was included to recapture the benefit of the unified credit from larger estates. Although the same tax table is used for both transfers during life and at death, the resulting transfer and tax consequences can be quite different because of the tax-inclusive nature of the estate tax system and the tax-exclusive nature of the gift tax system.
In the estate tax system, the dollars that will be used to pay the tax are subject to estate tax because they are part of the gross estate. However, when transferring property during life, the gift is the amount transferred to the donee and the donor pays the tax from other sources (see figure 1).
Another similarity between the estate tax and gift tax is the availability of the unified credit.2 The unified credit is available to all citizens and residents of the United States and may be taken against the tax that would be imposed under either the estate or gift tax system. The Taxpayer Relief Act of 1997 set forth a schedule increasing the unified credit over the next several years (see figure 2).
In practice, the unified credit amount is usually referred to by the amount that may be passed rather than the credit that is allowed on the return and listed in the I.R.C.
A gift, whether direct or indirect, can be a transfer of cash, property (tangible or intangible), or realty. Services fall outside the definition of a gift.3 For a transfer to be considered a gift, the donor must relinquish dominion and control over the property that is to be transferred. Therefore, the donor cannot have any ability to determine the disposition of the property.4 Typically, this is evidenced by delivering the property to the donee. However, there can be a gift when the donee is not known or ascertainable.5
Gifting: What and When?
The nature of certain property may prevent a gift from being complete despite delivery because the donor may still control the disposition of the property. Examples of such property include joint savings/checking accounts and savings bonds placed in joint names.6 Some sales and exchanges can fall within the definition of a gift when the money or property exchanged is less than the value of the property received.
Figure 1: It’s Cheaper to Gift Than to Inherit* Gift $100,000 Tax $50,000 Total Cost $150,000 Estate $100,000 Tax $50,000 Inheritance $50,000 *For simplicity, this assumes a 50 percent estate and gift tax bracket. If the unified credit is available there would be no out-of-pocket taxes.
Certain items are not considered gifts despite transfer to a third party. Transfers that are a legal obligation of the transferor are not considered a gift. An example is a parent’s duty to provide necessities for a child, such as shelter, food, and clothing. Property that is transferred pursuant to a divorce decree will not be considered a gift. Transfers pursuant to a divorce decree must take place between one year prior to two years after the date of the divorce decree or property settlement. Transfers to a corporation are not deemed to be gifts. Property transferred to a corporation will be deemed a gift to the shareholders.
Items few people would consider a gift are low interest or no interest loans to family members. In that case a reasonable rate of interest is deemed a gift each year.
Another consideration is when the gift was completed. A gift is deemed completed and taxable after the donor has relinquished dominion and control over the property. As mentioned earlier, some joint gifts will not be deemed completed at the time of transfer because the donor is still deemed to have some control over the disposition of the property.
Specifically, joint bank accounts will not be deemed completed until the funds are withdrawn from the account by the donee. This is because the donor may still withdraw funds, thus changing the disposition of the property. Jointly held U.S. savings bonds fall within this category as well and will not be a completed gift until the bonds are surrendered and the donee has received the cash. Similarly, a check to a donee will be considered completed when the donee presents the check for payment to the bank.
Some transfers are subject to a recapture rule even though the gift is completed. This rule will pull the value of the gift, including any growth, back into the estate if death occurs within three years of the transfer. These transfers include property of life insurance as well as property that had certain retained interests.
Exclusions and Deductions
After it is determined that a gift has taken place, we must ask whether there is an exemption available that places it outside the scope of taxation. The annual exclusion found in § 2503(b) is probably the most common. The annual exclusion allows a donor to transfer up to $10,0007 per year per donee to any number of donees as long as it is a present interest gift. If the donor is married, she may have her spouse join in the gift.8
This is called gift splitting and all gifts for that tax year will be deemed gifted one-half by each spouse. For example, a donor may gift individually owned property of $20,000 to one donee and if the spouse joins in the gift than the gift will be within the $10,000 annual exclusion of each spouse.
A present interest gift means that the donee must have full control over the property at the time of transfer. The donee must be able to do anything he wishes with the property. Many times when a gift of cash is made to a trust the beneficiaries will be given a Crummey Power. The Crummey Power is actually a general power of appointment that gives the beneficiary the right to access the funds for any purpose for a limited period of time, usually 30 days. The use of the Crummey Power changes a transfer that would be considered a future interest gift to a present interest gift so it may pass under the annual exclusion.
There is a statutory exception to the present interest requirement for minors under § 2503(c), which states that transfers to a trust for a minor will be considered present interest gifts if certain requirements are met. A common vehicle used for these types of transfers are gifts in accordance with the Uniform Gifts to Minors Act or the Uniform Transfer to Minors Act.
I.R.C. § 2503(d) also excludes transfers directly to a school for tuition or to a medical professional for providing medical services. These payments are excluded whether or not the donor had an obligation to pay them. These payments must be paid to the person providing the services or to the college. The medical payments cannot be reimbursable by insurance and are defined in § 213.
Although the payments allowed are defined in § 213, there are no percentage limitations similar to the income tax deduction side. Payments can include those for medical insurance. The funds paid to a college can be for a full-time or part-time student for tuition. (The exclusion includes only tuition and does not include incidentals such as books, supplies, room, or board. Payment of any incidentals will be considered a taxable gift.) Payments under either the medical or tuition exclusion are made without reducing the donor’s annual exclusion for that donee.
Two deductions that may be used to reduce or eliminate taxable gifts are the unlimited marital deduction and the charitable deduction. The unlimited marital deduction allows a donor to transfer unlimited amounts of property directly to a spouse during the course of the year without any gift tax consequences. If the donee spouse is a non-U.S. citizen, this deduction is limited to $100,000 annually. The charitable deduction under § 2522 allows a charitable deduction for gifts made to or for the use of a charitable organization when the annual exclusion is disallowed. The charitable gift deduction is not limited to certain percentages as in the income tax system. The I.R.C. limits these two deductions so they do not reduce taxable gifts that are outside the realm of these two deductions.9
Figure 2: Increases to the Unified Credit Year of Transfer Unified Credit Transfer Equivalent 1998 $202,050 $625,000 1999 $211,300 $650,000 2000/2001 $220,550 $675,000 2002/2003 $229,800 $700,000 2003 $229,800 $700,000 2004 $287,300 $850,000 2005 $326,300 $950,000 2006 $345,000 $1,000,000
The value of a gift is calculated at the time a gift is deemed completed. The value is the price the property would command if it were to change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and each having a reasonable knowledge of the relevant facts.10 Some gifts do not transfer the property immediately; rather, the donor retains an interest in the property for a period into the future. When certain requirements are met, the transfer is deemed to be a gift at the date of the transfer but the value of the gift may be reduced by the interest the donor retained.
When a remainder interest gift is transferred to a child, the donor must reduce the value of the gift by what is retained in accordance with I.R.C. chapter 14. Often, remainder interest gifts are completed in the form of Grantor Retained Annuity Trusts (the grantor retains the right to an income stream for a number of years) or Qualified Personal Residence Trusts (the grantor retains the right to live in the home for a number of years).
Generally, the value of a stock or bond is the mean between the highest and lowest selling prices quoted on the valuation day. If only the closing selling price is available, then the mean of the closing selling prices on the valuation day and the prior day is used. Stocks of closely held corporations are valued based on a number of factors, such as net worth, earnings, dividend capacity, and other relevant factors for the particular type of business.
Some business interests qualify for discount adjustments. Discount adjustments can reduce the value of a gift because the property lacks control or marketability. Discount adjustments can be heavily scrutinized by the IRS, especially if the underlying assets of the business entity consist of marketable securities.
Prior to the Taxpayer Relief Act of 1997, the IRS could review gifts made during life at the time of death. This allowed the IRS to revalue many gifts with a reduced discount adjustment. The Taxpayer Relief Act of 1997 revised the statute of limitations for reassessing the value of property. Now, if a gift tax return is filed, the IRS cannot reevaluate the value of the property after the statute of limitations runs out, generally after three years.11 It is anticipated that this will increase the number of gift tax returns filed annually as people make taxable gifts to start the statute of limitations running. This will lock in the discounts used to pass the property during their lifetime and prevent the IRS from reassessing the value at death.
The gift tax return Form 709 is due on April 15th the year following the gift. The gift tax return only needs to be filed if there are gifts above the annual exclusion or if the gifts included future interest gifts. When a spouse decides to join in gift splitting, Form 709 must be filed indicating that the spouse is participating in the gift. When this election is made, the election applies to all gifts made to third parties during the calendar year by either spouse. A gift of community property is assumed made one-half by each spouse. This requires each spouse to file a gift tax return.
The donor is responsible for paying the gift tax; however, if the gift tax is not paid when due, the donee becomes personally responsible for the tax to the extent of the value of the gift.12 The tax is calculated on the amount of taxable gifts made during the course of one year after subtracting any allowable exclusions and deductions. Because the gift tax is cumulative, taxable gifts of prior years are added to the current year’s gifts, pushing each additional gift dollar into a higher tax bracket. When there is gift tax due, the unified credit must be used first prior to paying any tax out-of-pocket.
Generally, the donee who receives a gift also receives the donor’s basis in the property for purposes of determining future gain.13 The basis may be increased by the amount of any tax paid that is attributable to the net appreciation of the gift.
Think About This
The gift tax section of the I.R.C. is comprehensive and is intended to capture many transactions that individuals may not think of as falling within the parameters of a taxable gift. When analyzing whether a gift occurred, additional sections of the I.R.C. must also be reviewed. One example is chapter 13,14 generation skipping transfers, which was created to prevent a person from escaping a level of gift or estate taxes by skipping an intervening generation. Whenever a donee is two or more generations younger than the donor, the generation skipping transfer tax may apply.
Also, when the donor retains an interest in the property that is being gifted, chapter 14,15 recapitalization, should be reviewed to ensure that the value of the gift can be reduced by what the donor is retaining. Of course, donees may chose not to accept a gift by following the I.R.C.’s rules for a qualified disclaimer.16 CL
1. I.R.C. § 2001
2. I.R.C. §§ 2010, 2505.
3. Treas. Reg. § 25.2511-1(a).
4. Treas. Reg. § 25.2511-2.
5. Treas. Reg. § 25.2511-2(a).
6. Treas. Reg. § 25.2511-1(h)(4).
7. Indexed beginning in 1999.
8. I.R.C. § 2513.
9. I.R.C. § 2524.
10. Treas. Reg. § 25.2512-1.
11. I.R.C. § 6501(c)(9).
12. I.R.C. § 6324(b).
13. I.R.C. § 1015.
14. I.R.C. §§ 2601-2663.
15. I.R.C. §§ 2701-2704.
16. I.R.C. § 2518.