Federal Gift Tax
The federal government has several taxes on gratuitous transfers – meaning transfers where no consideration was given, or the consideration given was less than the fair market value (FMV) of the property transferred – and includes inter vivos gifts and transfers of property from the decedent's estate. The value of most gifts is the FMV when the gift is given minus the consideration given. So if you give your daughter land worth $400,000, for which she pays you $100,000, then $300,000 (= $400,000 – $100,000) is considered a gift. Payments exceeding the legal obligation for transferring money to a given person is also a gift, such as paying your children more than what you are legally obligated to pay.
The gift tax is an excise tax on the right of an individual to transfer property to another. As such, the donor of the gift is liable for the gift tax, not the donee. Gift taxes are only imposed on the transfer of property or interest thereof, not on gratuitous services.
The gift tax is assessed only on individuals, not business entities, such as corporations. However, in certain cases, some transfers to corporations may be treated as indirect gifts by shareholders. A gift to a corporation is a gift to other shareholders in proportion to their interests; likewise, gifts to trusts are considered gifts to beneficiaries in proportion to their interests in the trust.
Besides a desire to benefit the donee, other reasons for gifts include:
- reducing probate and administrative costs and delays
- privacy, by preventing the property from entering probate to become part of a public record
- seeing the donee enjoy and use the gift
- allowing the donor to assess how well the donee manages money or property
- provide for the health, education, support, or financial well-being of the donee
- protects the gifted property from the claims of the donor's creditors
- reducing the value of an estate so that it qualifies for installment payments and other benefits for a business or farm under IRC §6166, or for stock redemptions under §303.
The relationship between the federal gift tax and estate tax has changed over the years. Before 1976, gift taxes were lower than the estate tax. However, the Tax Reform Act of 1976 equalized their rates and established the new unified transfer credit that could be applied to offset the liability of either gift or estate taxes. Gift and estate taxes were unified because the wealthy often gave gifts to reduce the value of their estate. Hence, it made sense to treat them the same. The Tax Relief Reconciliation Act of 2001 retains the gift tax, but lowers its rates so that the highest rate is equal to the highest marginal rate on income taxes, which, in 2010, was 35%.
In December, 2010, the tax law was amended so that the exemption for gift, estate, and generation-skipping transfer (GST) taxes was increased to $5 million for the tax year 2011 and will be adjusted for inflation thereafter. Beginning in 2013, the top tax rate on gratuitous transfers is 40%.
The exemption amount is in the form of a lifetime unified tax credit that can be used to offset the tax on any gratuitous transfer. Reducing the gift tax with the unified credit reduces the amount of credit remaining for additional gifts, or for the estate. There is also an additional exemption for GST taxes equal, but separate, to the exemption amount for gifts and estates that applies to gifts going to someone at least 37½ years younger than the donor.
States do not tax gifts, except Connecticut. Louisiana repealed its gift tax in 2008, North Carolina, in 2009, and Tennessee in 2012. About 20 states levy an estate or inheritance tax, so the wealthy in these states benefit by giving more gifts than having the property transferred by bequest.
What is a Gift?
Although the federal government taxes gifts, it doesn't define exactly what a gift is. However, the law has settled on the definition of a gift as a transference of property without adequate consideration for the donor. According to state law, which federal law uses to determine if the transference is a gift or not, a gift has the following 5 elements:
- the donor must be competent;
- the donor must have the intention of making a gift;
- the donee must be capable of receiving and possessing the property;
- there must be actual or constructive delivery of the property to the donee or the donee's representative;
- the donee must accept the gift.
A gift does not include the performance of services nor the lending of property for a finite duration.
Another defining attribute of the gift is that the donor must have given up sufficient control over the gift – the donor cannot later revoke, benefit, or change the owner of the gift or otherwise reverse the transference of the gift. If the donor dies without relinquishing control of the property, then it becomes part of his estate. Hence, it will be subject to estate tax but not gift tax. So, for instance, merely naming a beneficiary of an insurance policy does not constitute a gift, since the owner of the policy can change the beneficiary at any time.
Example: If Bill creates a revocable trust that pays its income to Mary with the remainder going to Christine, then there is no gift since Bill retains the right to revoke the trust until the property is actually distributed to the beneficiaries. Bill also retains liability for the income tax generated by the income of the trust. However, if the trust was irrevocable, then Bill incurs a federal gift tax liability when the property is transferred to the trust for both the gift to Mary and to Christine.
If the power to revoke or change the owner of the gift is held by a third-party, then whether it is a gift or not depends on whether the third party is an adverse party — a beneficiary who would be adversely affected by the gift or who is not related or subservient to the grantor. If control is retained by an adverse third-party, then it is not considered a gift.
However, a donation may be considered a gift, even if the donor retains power over the gift or benefits from it, if the power is limited by an ascertainable standard, such as using income from the gift only for a donor's health, education, support, or maintenance.
Generally, the IRS includes any transference of property between family members as a gift, unless the donor can prove that it was a bona fide arms-length transaction. Was the transaction conducted as if it were done with a stranger and was the consideration for the property adequate? For instance, when the IRS looks at a loan to a family member, it considers the following as indicating a bona fide transaction:
- the borrower signed a promissory note;
- a market interest rate was charged on the loan;
- the loan had a fixed term;
- the borrower was able to repay the loan;
- the borrower has made every payment during the term of the loan.
Additionally, creating a joint ownership for property, such as bank accounts, where the other owner does not contribute to the property will be deemed a gift and the entire amount may be includable in the estate of the contributor. For instance, if you add your child as a joint owner to a checking or savings account, then any amount withdrawn by the child will be deemed a gift, or if you buy real estate and name your child as a joint owner, even though the child did not contribute anything for the property, then child's interest in the property will be deemed a gift.
A disclaimer is an irrevocable and unconditional refusal by the gift recipient to accept the gift, thereby causing the gift to go to the alternate beneficiary specified by the donor of the gift. Even though a disclaimer transfers the property interest, it is not considered a gift by the disclaimant, as long as it complies with IRC §2518 as a qualified disclaimer:
- the disclaimer is in writing;
- the disclaimer is executed within 9 months of the party receiving the property interest or 9 months of the disclaimant reaching age 21;
- the disclaimant never benefited from the disclaimed property;
- and the disclaimant does not determine whom receives the disclaimed property, but it simply passes to the alternate beneficiary specified by the donor of the gift.
If these requirements are not satisfied, then the disclaimant will have been considered to have made a gift to the person who receives the disclaimed property.
A gift tax will only be incurred if the transference satisfies the legal requirements for a gift and the value of the gift is determined when all of the legal requirements for the gift have been satisfied. Gift tax applies to all gifts made by United States residents and on all property located in the United States or property received by a resident from a foreigner.
The donor of the gift is generally liable for the gift tax, but if he is unable to pay, then the donee must pay it — aka the doctrine of transferee liability, §6324(b).
The gift tax is assessed on the fair market value of the gift at the time the gift was made, but the donee receives the donor's tax basis in the property, which is referred to as the carryover basis. However, any gift tax paid on the property will increase the donee's basis in the property. Prior to 1977, the basis of gifted property was increased by the donor's payment of gift taxes. For post-1976 transfers, the increase in basis of gifted property for the donee is more complicated: only a portion of the gift tax can be added to the donee's basis:
|Donee's Basis||=||Donor's Basis||+||Amount of Property Appreciation from Acquisition Date to Gift Date|
Property FMV – Exclusions – Deductions
Assuming that this taxpayer has used up his unified credit, this is how the donee's basis in the gifted property would be calculated if the gift was given in 1975 or if it was given in 2016.
|Case #1: Gift of Land in 1975|
|Donor's Basis in the Land||$100,000|
|Land FMV in 1975||$250,000|
|Gift tax paid||$23,000|
|1975 annual exclusion||$3,000||The annual exclusion is not subtracted for gifts given before 1977.|
|Donee's basis in the land||$123,000||= Donor's Basis + Paid Gift Tax|
|Case #2: Land Gifted in 2016, same as Case #1 except:|
|Land FMV in 2016||$400,000|
|2016 Annual Exclusion||$14,000|
|Gift Tax Paid||$154,400||= (Property FMV – Annual Exclusion) × 40%|
|% of Gift Tax that is added to the Donee's Basis||0.78||= (Property FMV – Donor's Basis)/(Property FMV – Annual Exclusion)|
|Donee's Additional Basis Due To Gift Tax||77,720.21||= Gift Tax Paid × (Property FMV – Donor's Basis)/(Property FMV – Annual Exclusion)|
|Donee's basis in the land gifted in 2016||$177,720||= Donor's Basis + Additional Basis Due To Gift Tax|
Gift Tax Annual Exclusion
There is also a gift tax annual exclusion, wherein no tax liability is incurred on the gift if it is a present interest, meaning that the beneficiary benefits from it immediately, and its value does not exceed the exclusion amount. A gift of a future interest, which does not benefit the beneficiary until sometime in the future, does not qualify for the annual exclusion. In 1997, Congress set the annual exclusion at $10,000, to be increased in $1000 increments according to inflation, but rounded down to the nearest thousand. In 2013, the amount was increased to $14,000 from the $13,000 that applied to 2009 - 2012.
|2013 - 2016||$14,000|
|2009 - 2012||$13,000|
|2006 - 2008||$12,000|
|2002 - 2005||$11,000|
|1998 - 2001||$10,000|
Examples of Present and Future Interests
Example: You transfer $500,000 worth of property to an irrevocable trust for your son. Your son is to receive all trust income, but when your son dies, then the trust corpus goes to your granddaughter. Therefore, your son has a present interest in the trust while your granddaughter has a future interest. Therefore, only 1 annual exclusion, for the gift to your son, is available, so the taxable gift equals $500,000 – $14,000 = $486,000.
Example: You fund an irrevocable trust with $900,000 for your 3 children. However, the trust is discretionary, allowing the trustee to pay distributions to your children depending on what he deems to be in the best interest of each beneficiary. Therefore, it is possible that a particular beneficiary will not receive anything. Therefore, no present interest is created for any the beneficiaries, so there is no annual exclusion that can be applied, making the entire $900,000 subject to gift tax.
The purpose of the annual exclusion is to eliminate the need to report or pay tax on numerous gifts such as those given at weddings or during Christmas. Any gift that qualifies for the exclusion does not reduce the lifetime limit on gifts or bequests that can be transferred tax-free (IRC §2503). However, there is no carryover for any unused portion of the annual exclusion. So if you give $10,000 to your daughter this year, the annual exclusion is not increased by $4000 the next year — it is still only $14,000 for the next year, or whatever the statutory limit is for that year.
Property can also be transferred tax-free to multiple heirs, even if the property is more than the annual exclusion, by providing for joint ownership of a property that is not easily divisible, such that the value of each ownership interest is less than the annual exclusion.
In addition, a gift of 5 times the annual exclusion can be given to a donee through a 529 educational plan as long as the donor does not give any more gifts to the donee within 5 years and the donor lives at least that long. If the donor dies within the 5-year period, then the amount excluded = Annual Exclusion × Years Donor Lived During 5-Year Period. So if the donor lived only 3 of the 5 years, then only $14,000 × 3 = $42,000 qualifies for the annual exclusion.
Example — Fair Market Value, Carryover Basis, and Gift Tax Annual Exclusion
Carl buys 10,000 shares of XYZ stock for $10 per share. Carl gives Amanda the stock in 2009 when the stock was $20 per share and the annual gift exclusion was $13,000. Amanda subsequently sells the stock for $30 per share.
- Gift tax is assessed on Carl for $100,000 - $13,000 = $87,000.
- Amanda pays capital gains tax on $300,000 - $100,000 = $200,000.
IRC §2513 authorizes spouses to elect to split gifts, allowing the donor-spouse to add the annual exclusion of the other spouse to his own, effectively doubling the annual exclusion, even if the donor-spouse is giving the entire amount. Gift-splitting is an annual election that applies to all gifts made during the year by both spouses. At the time of the gift, the donor-spouse must be married to the spouse consenting to the split gift when the gift is made and not remarried before year-end. However, any unpaid gift tax will be a joint and several liability of the spouses. Both spouses must agree to split the gift, and Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return must be filed with the IRS, even if no tax is due. Of course, if both spouses are giving the gift, then gift-splitting is not necessary, since each spouse has the same annual exclusion for each donee. The tax return filed for split gifts can be late if the only reason for the gift tax return is to show that the gift was split. If the spouse dies in the year of the gift, then the gift tax return can be filed up to the due date of the federal estate tax. When gifting community property, there is no need to split the gift, since the property is owned equally by both spouses, so no gift tax return needs to be filed for a split gift, as would be the case in separate property states.
Gift Splitting Example
Bill and his wife, Susan, decide to split their 2009 gifts, with Bill giving his nephew, Carl, $22,000, and Susan giving her niece, Tina, $18,000. Although each gift is more than the $13,000 annual exclusion, gift splitting eliminates gift tax liability, since Bill's gift to Carl is treated as ½ ($11,000) from Bill and ½ ($11,000) from Susan, and Susan's gift to Tina is treated as ½ ($9,000) from Susan and ½ ($9,000) from Bill. Thus, each apportioned gift is less than the annual exclusion; therefore there is no gift tax liability. Nonetheless, a gift tax return must be filed to notify the IRS of the gift splitting.
Note that if Bill had actually given Carl $11,000 and Tina $9000 and Susan had actually given Carl $11,000 and Tina $9000, then no gift splitting would have been required, since all 4 gifts would be within the $13,000 annual exclusion limit for each donor-donee gift, and no gift tax return would have to be filed.
Example: With Gift Splitting, Large Amounts of Wealth Can Be Transferred Tax-Free
In 2010, Mitt Romney, a 2012 presidential candidate, had 5 sons and 18 grandchildren. Since he and his wife were in their early 60s, and could easily live another 30 years, how much wealth could they transfer tax free, using only gift splitting and the annual gift exclusion?
|Gift-Splitting Annual Exclusion||$26,000|
|Number of Heirs||23|
|Amount that can be transferred tax-free annually||$598,000|
|Total Amount that can be transferred over 30 years||$17,940,000|
As can be seen in the above table, they can transfer quite a bit of wealth every single year and almost $18 million of net present value, since the annual exclusion is adjusted for inflation, over the next 30 years. Actually, this is a conservative calculation. There are various means of actually giving much more and still remain within the annual exclusion, by, for instance, giving property, or shares of property, that is conservatively valued. By using the gift annual exclusion, none of their unified credit is used up, so, if they wanted to, they could give $10,240,000 tax-free to their descendants in 2012, then continue giving the annual exclusion.
Lifetime Gift Exclusion
A tax liability is incurred for any gift with a value exceeding the annual exclusion, but the law gives each donor a lifetime unified tax credit that allows at least $5 million worth of property to be given as a gift that is above the annual exclusion. However, the lifetime gift exemption is a unified credit that also applies to gifts from the donor's estate. Any use of the unified credit to reduce gift taxes reduces the remaining unified credit available to offset the estate tax. So that the IRS can keep track of the amount of gifts given that are above the annual exclusion amount, the donor of the gift must file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, even though no gift tax needs to be paid if the exemption amount has not been exceeded.
For many years, the lifetime gift exclusion was $1,000,000 for the value of gifts above the annual exclusion amount over the lifetime of the donor. However, in 2010, the lifetime gift exclusion had been increased considerably and is now adjusted for inflation:
Example — Lifetime Gift Exclusion
In 2015, you give your daughter $5,444,000. You incur a tax liability for the $5,430,000 that is more than the annual exclusion of $14,000, but you can use your unified tax credit to offset your liability, assuming that you have not used any of your credit previously. You must also file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return with your 2015 tax return. When you die, your entire estate will be subject to the estate tax since you used up all of your unified credit for the gift to your daughter.
Special Rules for Particular Types of Transfers
Special rules apply to particular types of transfers that may affect whether the property transferred is actually a gift, its valuation, or whether it qualifies for the annual exclusion.
Gifts of Future Interests
A gift of a future interest in property is considered a gift, although for tax purposes, its value will be less since it only becomes possessory in the future. The gift tax is assessed on the present value of the future interest. Likewise, contingent future interests, or future interests subject to divestment, are still considered property interests that can be transferred as a gift. However, the uncertainty of possession reduces its value below that of an unqualified future interest. Generally, the value of conditional future interests are equal to the present value of the interest multiplied by the probability that the event will happen, when it is ascertainable.
Value of Conditional Future Interest = Present Value of Interest × Probability of Contingent Event
However, unlike other gifts, most gifts of future interests in property do not qualify for the annual gift exclusion. Hence, a gift tax return must be filed for any gifts of future interest, regardless of the amount. If a minor receives a future interest in property from what is sometimes called a §2503 trust, then it may be considered a gift of a present interest and qualify for the annual gift exclusion if the following is true:
- the property and interest are given to the minor before the age of 21 for his benefit;
- the property and all income is given to the minor when the minor reaches 21;
- if the minor dies before then, all of the property is added to his estate. IRC 2503 (c).
IRC §7520 determines the interest rate used in valuing the present value of gifts that will be received in the future. Current values can be found in interest rate tables published by the IRS. This interest rate is rounded to the nearest 0.2%, which is 120% of the federal midterm rate applicable for the month of the transfer. Additionally, the IRS actuarial tables must be updated every 10 years to reflect actual mortality experience. Generally, a gift of income or a remainder interest from a trust is valued according to the present value of those interests and also on actuarial tables when the time that the gift will be received is dependent on someone else's lifetime, such as a remainder interest.
Gifts to Groups
Transfers to a corporation are treated as a gift with the future interest to its shareholders. Transfers to any type of common ownership, such as a joint tenancy or tenancy by the entirety is a gift to each of the tenants in proportion to their interest. Likewise, a gift to a partnership is a gift to each of the partners in proportion to their partnership interest. However, a joint gift, where any party cannot divest of their interest in the gift without the other's consent, is a future interest.
Gifts Within 3 Years of Death Rule
Gifts made within 3 years of the decedent's death plus any gift taxes paid on these gifts are added to the estate.IRC §2035 This prevents tax avoidance strategies, such as giving a life insurance policy to beneficiaries when the death of the insured seems imminent; otherwise, the federal government would collect much less transference taxes because the value of a life insurance policy while the insured is still alive is always considerably less than the actual payout, which the beneficiaries, as the new owners of the policy, would receive tax-free.
The 3-year rule on insurance policies only applies to gifts of insurance policies, not the sales of such policies by the grantor to a trust. The 3-year rule is avoided by having the grantor transfer cash to the trust, which the trust uses to purchase a policy from the grantor. There is no income tax consequences for this type of sale involving a grantor trust.
Because both the gift and paid gift tax reduces the estate of the donor, the IRS includes any gift and the associated taxes paid within 3 years of the decedent's death as being part of the estate. However, credit is given for any gift taxes that were paid but added to the estate.
Gifts of Property
When property is given as a gift, then the eventual sale of the gift may result in a capital gain or loss, the tax treatment of which depends on whether it is long-term or short-term. Tax rates for long-term gains are lower than short-term gains. The holding period is long-term if the property was held for more than 1 year. If a gift tax return must be filed for a non-cash gift, then the value of the gift should be appraised, since without a bona fide appraisal, the adequate disclosure rules are not satisfied, so the statute of limitations on the gift never begins, thus allowing the IRS to challenge the value of the gift at any time.
Treasury Regulations stipulate that stocks and bonds are equal to the mean of the highest and lowest selling price on the date of the gift. Additionally, bonds that are exempt from federal income tax are not exempt from the federal gift tax. With a joint bank account, a gift is made when one of the depositors withdraws more than he deposited. Because, under most state laws, joint tenants are considered to have an equal ownership in the property, a gift is made to any joint owner where the ownership interest exceeds the value of that owner's consideration paid. So if you buy real estate for $500,000 and name your son as a joint owner, then you have made a gift of $250,000 to your son. However, joint ownership rules do not apply to spouses.
In the case of gifted property, capital gains or losses are determined by the sale price minus the donee's basis in the property. The donee's basis in the property is equal to the greater of donor's basis in the property or the fair market value (FMV) at the time of the gift, and the holding period for the property is equal to the combined holding periods of both the donor and the donee. However, if the property was sold at a loss, then the basis in the property is the lower of the donor's basis or the FMV of the property at the time of the gift. If the sales price is between the FMV and the donor's basis, then no gain or loss is recognized on the sale. So if the donee sold stock for $7000 that had a fair market value of $9000 when it was given and for which the donor had a $10,000 basis, then the capital loss will be equal to the fair market value minus the sale price, or $2000. If the stock was sold for $9500, the no gain or loss is recognized. If the stock was held for longer than 1 year and the donee sold the property for $12,000 immediately after receiving it, then the donee must claim a tax basis of $10,000 and report $2000 in profits, which will be treated as a long-term capital gain. On the other hand, if the gifted stock was worth only $9000 when it was given, and the donee sold it for $13,000 6 months later, then the donee would report a profit of $3000, which is $13,000 minus the donor's basis of $10,000. If the stock was worth $11,000 when it was gifted, then the donee still gets to claim the $10,000 basis.
Summary of Rules for Determining Capital Gain or Loss for Gifted Property
- If Sale Price > Donor's Basis and FMV, then
- Donee's Basis = Greater of Donor's Basis or FMV
- Capital Gain = Sale Price – Donee's Basis
- Else If Donor's Basis < Sales Price < FMV or
- Else If FMV < Sale Price < Donor's Basis, then
- No gain or loss is recognized.
- Else If Sale Price < Donor's Basis and FMV
- Donee's Basis = Lower of Donor's Basis or FMV
- Capital Loss = Donee's Basis – Sale Price
If your adjusted basis in the gifted property exceeds the property's FMV on the date of the gift, then you should sell the property rather than gift it, because the property's basis is not increased by any gift taxes paid nor can any losses be claimed.
With a gift of income-producing property, the value of the gift is equal to the present value of the future income, whether or not the donee actually receives more or less than the determined amount. No adjustment of the gift tax calculation is allowed even if the income turns out to be substantially less than what was calculated at the time of the gift.
Marital Property Settlements
Because the settlement of marital property rights during divorce is generally not for consideration, such transfers could be subject to federal gift tax. However, if the transfers of property interests are made pursuant to the terms of a written agreement between the spouses to settle their marital property rights or to provide support for children, then §2516 deems the transfers to be for adequate consideration if the divorce occurs within 2 years of the written agreement, even if the written agreement is not part of the divorce decree.
Gifts to Foreign Spouses
There is no gift tax on gifts to spouses who are United States citizens because of the unlimited marital deduction, but if the spouse is not a citizen, then there is an annual limitation, adjusted annually for inflation, on the amount that could be given tax-free:
This exemption amount does not reduce the lifetime gift tax exclusion that applies to gratuitous transfers to others.
Gifts from Foreign Sources
Although gift recipients generally do not pay or need to report gift tax, they do have to report gifts from foreign sources if they exceed threshold amounts, by filing Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. A foreign gift is considered to be any money or property received by a United States person from a foreign person, defined as a nonresident alien, or a foreign corporation, partnership, or estate and that is not reported as income. Foreign trusts are subject to special rules, which can be found in 2015 Instructions for Form 3520.
The threshold amounts depend on the donor. If the donor is a nonresident alien individual or foreign estate, then the gift only has to be reported if it exceeds $100,000. If the donor is a foreign corporation or foreign partnership, including foreign persons related to those entities, then a gift exceeding the reportable value, adjusted for inflation) must be reported. These thresholds apply to the aggregate gifts received from related parties and to the aggregate gifts received from each donor during the year.
So if you receive $60,000 from one foreign person and $70,000 from another foreign person in the same year who is related to the 1st donor, then those gifts must be reported, since their aggregate value for the year exceeds $100,000. However, foreign gifts of payments made directly to a school for tuition or to a medical facility for the benefit of a United States citizen is exempted.
The penalty for not filing Form 3520 or willfully neglecting to provide complete or correct information, is the greater of $10,000 or:
- 35% of the gross value of the property transferred or
- 5% of the gross value that the US person owns in the trust
Gifts from Covered Expatriates
Many people renounce their US citizenship to avoid US taxes, but often, they leave family and friends behind, who often receive gifts and bequests from these expatriates. Of course, the tax code does have special expatriation rules, to try to collect taxes on assets that will be leaving the country, but much of that property and money will still, nonetheless, escape taxation. So that the US can collect some taxes that were avoided previously, recipients of gifts and bequests may have to pay tax on foreign gifts that they receive from covered expatriates. Special rules apply to gratuitous property transfers from covered expatriates, as defined under IRC §877A, which may impose a tax under IRC §2801 on transfers received after June 17, 2008 from former US citizens or permanent residents.
A gift in trust is a gift to the trust beneficiaries, not to the trust; if the trustee is required to distribute income at least annually, than the income qualifies as a present interest and therefore can benefit from the exclusion; any contingent gift such as on survivorship or the discretion of the trustee is not a present interest but a future interest, so it does not qualify for the annual exclusion; a gift with no ascertainable value also does not qualify for the exclusion, which often arises when the donor or a contingency can reduce the value of the gift before it is actually received.
Example: You fund a revocable trust with $1 million, designating your child as a beneficiary. The following year the trust disperses $50,000 to your child. When the trust is funded, there is no gift; the next year, the trust distributes $50,000 to your child, then a gift is made in that amount, subject to gift tax. Because the gift is only completed when the child receives the property (it is not a future interest), the amount subject to gift tax can be reduced by the annual exclusion.
Case 2: Same as above, but 3 years later, you amend the trust document to make it irrevocable. By then, trust assets have appreciated to $1.5 million. Therefore, the $1.5 million is considered a completed gift, eligible for the annual exclusion.
The number of annual exclusions for a trust depends on the number of beneficiaries receiving a present interest. So if there are 3 beneficiaries for trust, then there are 3 donees who each qualify for the annual exclusion. On the other hand, if there are 3 trusts for a single beneficiary, then there is only one annual exclusion applicable to all 3 trusts.
A gift is considered completed when the donor no longer has any control over the property. Thus, property transferred to a trust is not considered a gift unless the trust is irrevocable, where the grantor retains no control over the trust. If control is retained, then the gift is not completed even if the donor receives no more benefit from the property. Transfers to a revocable trust are not considered gifts, because the grantor can revoke the trust at any time, so the gift is not considered completed until it is distributed to a beneficiary; then the grantor may have to pay gift tax on that property. Gifts to an irrevocable trust are treated as gifts to the underlying trust beneficiaries. The value of a gift of income from an irrevocable trust is determined both by the IRC §7520 interest rate and — because future income is usually determined by the lifetimes of the beneficiaries — by IRS actuarial tables.
If non-income producing property is placed in a trust, it will generally not qualify for the gift tax exclusion because:
- the right to income is only produced if the property is converted into income-producing property, making it a future interest
- if it is impossible to ascertain the value of the income interest at the time the gift, then it is considered a future interest
- if the gift tax exclusion is allowed, then it is limited to the actual income produced or expected to be produced by the property during the term when the beneficiary is expected to receive the income, discounted to present value.
Gifts of non-income producing property to a trust may qualify for the annual exclusion if the beneficiary can require the trustee to sell the property for income-producing property. If an income beneficiary of a trust terminates his interest by transferring it through a special power of appointment, then the transfer may be treated as a gift whose value is equal to the present value of the income interest forfeited by the life tenant.
A mandatory trust that distributes income to beneficiaries is a present interest and qualifies for the annual exclusion for each beneficiary. However, a discretionary trust does not create a present interest for any of the beneficiaries, because there is no guarantee that they will receive anything nor is it known how much they will receive. So while money transferred to an irrevocable trust will be subject to gift tax, with a discretionary trust, there is no annual exclusion, since no beneficiary has a present interest in the trust.
Summary of Trust Transfers Subject to Gift Tax
Complete transfers are subject to gift tax:
- Property transferred outright.
- Property transferred to an irrevocable trust where the donor retains no powers over the trust.
For partial transfers, only the completely transferred portion is subject to gift tax, such as property transferred to an irrevocable trust where the donor retains some discretionary powers over income or the remainder interest.
Incomplete transfers are not subject to gift tax:
- Property transferred to a revocable trust is not a gift, because the grantor can revoke the trust at any time.
- Property transferred to a irrevocable trust where the donor retains discretionary powers over income and the remainder interest is not a gift because the beneficiary has not received the property or income.
A special type of trust, called a Crummey trust (aka irrevocable gift trust), allows a wealthy grantor to transfer the proceeds of a life insurance policy to an irrevocable life insurance trust so that it is not included in the grantor's estate, where it would be subject to estate tax. The premiums of the life insurance policy are paid by the trust with money received from the grantor, which are considered gifts to each of the beneficiaries by allowing them to withdraw the gift within a short time of its deposit in the trust — which is called a Crummey withdrawal right. The Crummey withdrawal right allows a gift to be considered one of present interest and therefore eligible for the annual gift exclusion for each beneficiary. The beneficiaries are expected not to withdraw the money so that it could be used to pay the premiums on the life insurance policy, the proceeds of which will be paid to them when the grantor dies, free of estate taxes.
It is difficult to see how a Crummey withdrawal right can be considered a gift, since it is not intended to be a gift to the beneficiaries nor do the beneficiaries actually receive the gift at the time that it is given nor are they expected to take delivery of it, thus violating 2 of the requirements of a gift, in that the owner must have intended it to be a gift and the recipient must actually receive it. In fact, the donor expects the money to pay the premiums for the life insurance policy, not to go to the beneficiaries, and the beneficiaries expect the same thing, which is why the Crummey withdrawal right is never exercised. And if it is not a gift, then it should not qualify for the annual exclusion. Although the Crummey trust does not seem to be legally valid, the IRS has acquiesced to this sham that was 1st allowed by the courts in 1968.
Gift-Tax Saving Tips
- If property has already appreciated significantly, then it is better to leave it as part of the estate, since it will receive a stepped-up basis.
- Give rapidly appreciating property to beneficiaries at the beginning of the year so that the appreciation is not included in the value of the gift.
- For charities, give at the end of the year so that you can enjoy the income from the property until the very last moment.
Transferences Not Subject to Gift Tax
Because the gift tax and estate tax apply to different property, to avoid double taxation, any property subject to the gift tax is not subject to the estate tax, and vice versa.
Since work is the most heavily taxed form of income, the federal government would lose much revenue if property transfers in the course of business could be considered a gift. Therefore, Treasury Regulations stipulate that any property transferred in the normal course of business will not be considered a gift, regardless of the FMV of the property or the consideration given. Hence, business transactions between unrelated parties are not considered gifts, but transactions between related parties may be suspect.
Also excluded are payments for the education or medical expenses for another if they are paid directly to the provider of the services and not to the donee. IRC §2503(e)
Tax tip: Not only are direct payments to providers of educational or medical services not subject to gift tax, but if the payments would otherwise be deductible by the donee if the donee had paid them, then they can also be deducted by the donee even though the expenses were paid by the donor. In several court cases, the IRS has argued that they should not be deductible since the donee did not pay them, but the court has overruled them. The court interpretation makes sense because the donor could have given the money directly to the donee, who could then have paid for the expenses. Therefore, the expense should be deductible, because the deductibility of an expense does not ordinarily depend on the source of the money to pay it.
Also excluded from the gift tax are the following:
- gifts to charities;
- payments satisfying an obligation of support, which is determined by state law;
- transfers to political organizations.
Unlike the charitable deduction available to lower income tax liability, there is no AGI limits for claiming the gift tax deduction for charitable contributions, but the claimed deduction is lowered by the annual exclusion. A gift tax return does not have to be filed if all gifts were to charitable organizations; a gift tax return would only have to be filed if some of the beneficiaries were noncharitable donees.
Example: you give $54,000 to your alma mater. Therefore, the charitable deduction for gift tax purposes is equal to $54,000 – $14,000 = $40,000. The charitable deduction available for reducing your income tax is $54,000, subject to a AGI limitations.
Although not available for reducing income, transfers to foreign charitable organizations — but not to foreign governments — are deductible under gift tax rules.
There is also a marital deduction which allows a spouse to give an unlimited number of gifts with unlimited value to the other spouse – whether inter vivos or testamentary – incurring neither the gift nor estate tax. The marital deduction is allowed since the U.S. government expects that the value of the property will be included in the spouse's estate when she dies, which is why if the spouse is not a U.S. citizen, then only $60,000 of property qualifies for the marital deduction.
Like the charitable deduction, the actual marital deduction is reduced by the annual gift tax exclusion that would apply.
Sometimes a trust is set up to benefit the surviving spouse while she is still alive, but the trust property — the terminal interest — eventually passes to someone else. Because the surviving spouse never owns the property, it is not includable in her estate, and therefore does not qualify for the marital deduction. The rationale for not allowing a marital deduction for terminal interests is that gifts given to a spouse will be includable in her estate or given as a gift by that spouse, who will then be subject to estate or gift taxes, said taxes are eventually paid on the property transfer. For a terminal interest, however, the spouse has never owned the property, so it never becomes taxable either as a gift or as a bequest.
However, a terminal interest is only nondeductible if the property eventually passes to a third-party. However, if no one else obtains an interest in the property after the termination of the interest, then it qualifies as a marital deduction. So, for instance, giving your spouse a patent still qualifies as a marital deduction because, even though the patent will eventually terminate, no other party will have an interest in it after that termination, since it ceases to exist.
However, giving the spouse a general power of appointment over the property will qualify the property transfers as a marital deduction because the appointed property will be taxable.
Determining Gift Tax Liability
The marginal rate for the gift tax and the total gift tax liability is determined by the cumulative total of gifts given by the donor since 1932 and the amount of the unified tax credit that has been used up since 1977. Gifts before 1977 are counted to determine the cumulative lifetime gift value, but are not included in the unified tax base, to which the unified credit can be applied. Consequently, the donor must keep a record of all taxable gifts given since 1932. The marginal tax rate applied to gifts is determined by the total gifts in the current period + all gifts given in prior years. Higher total gift values result in higher marginal tax rates, topping out at 40%. The gift tax rate has varied over the years, but the marginal gift tax rate is determined by the current rate — rather than the tax rate that was in effect at the time of the gift — and the total value of the cumulative gifts over the donor's lifetime. The unified tax credit available for reducing gift tax liability in future years is calculated each year by subtracting the amount used in the current year from what was available previously. Therefore, the procedure for determining gift tax liability is fairly involved:
- Determine taxable gifts for the tax year.
- Total the fair market value of the gifts for the tax year
- – the greater of amounts given to donees that does not exceed the annual exclusion or the annual exclusion
- if the gift is split with the spouse, then the amount attributed to each spouse is the amount given divided by 2; the portion attributed to each spouse that exceeds the annual exclusion is taxable
- Example: You give $30,000 to your son, but split this gift with your spouse. You are considered to have made a gift of $15,000 and your spouse, another $15,000; both you and your spouse exceed the annual exclusion by $1000, which is subject to gift tax. Therefore, you add $1000 to your cumulative gifts, and your spouse does likewise, even though you paid the entire gift.
- if the gift is split with the spouse, then the amount attributed to each spouse is the amount given divided by 2; the portion attributed to each spouse that exceeds the annual exclusion is taxable
- – the marital deduction
- – charitable contributions
- = Taxable gifts for the tax year
- Determine Total Gift Tax Liability
- Taxable gifts for the tax year
- + Taxable gifts for all prior periods
- = Cumulative taxable gifts
- Tentative Tax = Cumulative Taxable Gifts × Current Gift Tax Rate
- – Tax on Prior Gifts (= Cumulative Value of Prior Gifts × Current Gift Tax Rate)
- = Tax on Taxable Gifts given during the tax year
- - the Greater of 0 or (Unified Credit for this period – Unified Credit used in prior periods)
- = Tax Payable for tax year
Net Gift Tax Liability
Sometimes the donor may not have cash to pay the gift tax or any unused unified credit to eliminate the tax liability, in which case, the donee may have to pay the gift tax. However, calculations are more complicated, since the amount of the gift tax depends on the value of the gift which is reduced by the tax paid. However, if the gift tax exceeds the donor's basis in the gift, then the donor must recognize the difference as income. Additionally, even though the donee pays the tax, the donee cannot use his own unified credit to offset the gift tax liability, since the gift tax is assessed on the donor, not the donee.
To determine the gift tax on a net gift, determine the net value of the gift, then subtract the net value from the total gift defined the gift tax due:
- Net Gift Value = Total Gift Value × (1 + Gift Tax Percentage Rate)
- Gift Tax = Total Gift Value – Net Gift Value
Net Gift Tax Example
If the total gift value of a future interest (where the annual exclusion does not apply) is $5 million and the gift tax rate is 40%, then the net gift tax will equal:
- Net Gift Value = $5,000,000 ÷ (1 + .4) = $5,000,000 ÷ 1.4 = $3,571,428.57
- Gift Tax = $3,571,428.57 × 40% = $1,428,571.43 = Gift Value – Net Gift Value = $5,000,000 – $3,571,428.57
Filing Form 709, United States Gift Tax Return
For any gift for which there is a gift tax liability or for any split gift, the donor must file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return with his tax return, even if no gift tax is due.
Additional documents that must be attached include:
- copies of appraisals of any gifted property,
- copies of relevant documents regarding the transfer,
- documentation of any unusual items shown on the return, including partially-gifted assets, or other items relevant to the transfer that may affect tax liability.
The IRS usually audits gifts when it audits estate tax returns, so any deficiencies will incur gift taxes, interest, and penalties.
Reporting and Paying Gift Tax
Tax reporting for gifts are based on a calendar year, so gifts must be reported no later than April 15, or October 15 with an extension. However, if the donor dies after making a gift, then the gift may have to be reported sooner, because the information is necessary to calculate the estate tax.
A gift tax return must be filed for any calendar year when property is transferred except:
- gifts that qualify for the marital deduction
- gifts whose value falls within the annual exclusion or is exempted as payments to educational or medical facilities that provided services for the donee
- gifts to charitable organizations, but only if the organization receives the donor's entire interest in the property
Interest is assessed for any gift tax not paid by April 15. Form 8892, Application for Automatic Extension of Time to File Form 709 and/or Payment of Gift/Generating Skipping Transfer Tax should be filed if the taxpayer anticipates gift tax liability or needs an extension only for the gift tax return. No estimated tax payments are required for gift taxes.
The statute of limitation for gift taxes is 3 years after the later of when the gift tax return was filed or the due date. However, the statute of limitations increases to 6 years if the total property gifted was 25% more than what was reported, which would only be ascertained after an audit. If no gift tax return was filed, then there is no statute of limitations that applies for any gifts for that year.
Gift Taxes of Other Countries
Although most other countries tax gifts, the law concerning gifts varies widely. Below are a few examples:
- Australia, Canada, and New Zealand do not have gift taxes.
- Most countries tax the donor of gifts, but in India, the recipient is taxed.
- Germany taxes gifts between spouses.
- Norway, Portugal, Spain, and Switzerland do not apply the gift tax to gifts to spouses and children.
- England subjects gifts to an inheritance tax if the donor dies within 7 years of giving the gift at a tax rate that is inversely proportional to the length of time that the donor survives after giving the gift; otherwise no gift tax is due. A donor can also give a gift of any amount to anyone free of tax if the gift comes from earned income that is over the amount necessary to pay basic living expenses. For instance, if someone earns £30,000 pounds annually but requires only £10,000 to live, then the worker can give £20,000 annually to anyone. Parents of the bride or groom can give £5000 to their child as a wedding gift; grandparents can give £2500 and anyone else can give £1000.
- If the gift is property that can appreciate, then either the donor or the recipient may be liable for capital gains tax when the property is sold.
- Many countries also tax conditional gifts, which are gifts that are completed only if specific conditions are satisfied. Conditional gifts are often considered the property of the donor, since the donor has not relinquished complete control of the gift.