Gratuitous Transfer Taxes
A gratuitous transfer is a transfer of property freely given, such as a gift from a donor or a bequest from an estate. Since governments like to tax transfers of property or money, the federal government and some states assess what are collectively known as gratuitous transfer taxes (a.k.a. wealth transfer taxes), equal to a percentage of the value of the property transferred. As of 2016, the federal gratuitous tax rate equals 40% of the property value that exceeds a very generous exemption amount of $5,450,000, adjusted annually for inflation, per donor. So parents can give almost $11 million to their children free of federal taxes.
There are 3 types of federal gratuitous transfer taxes assessed by the federal government for US residents: gift, estate, and generation-skipping transfer taxes. Different rules apply to gratuitous transfers for nonresident aliens.
Gifts are the gratuitous transfers of property by a living donor to a donee, or beneficiary. When someone dies, all their property is placed in an estate, to be distributed to the beneficiaries of that estate.
Gratuitous transfer taxes are applied to what could be referred to as the gratuitous tax base that consists of all property given as gifts after 1976 + all property of the decedent's estate. The tax code refers to gifts given after 1976 as adjusted taxable gifts, to distinguish them from gifts given before 1977, which are not included in the tax base. The value of these gifts equals their fair market value on the date of the gift. The gratuitous tax rate is then applied to the tax base after subtracting the exemption amount.
Gratuitous transfer taxes are assessed on the donor or the estate, not the donee. The donee of a gift or an inheritance incurs no income tax liability, because IRC §102(a) excludes gifts and inheritances from the recipient's gross income.
Any gift taxes paid by the donor during his lifetime is subtracted from the estate tax liability so that gifts are not taxed twice. Additionally, an annual exclusion applies to gifts, which, for 2016, is $14,000 for each donee; a married couple can double that amount. The annual exclusion is adjusted in $1000 increments for inflation. So, for instance, if you're rich enough, you could give $14,000 to as many people as you wished every year without ever incurring a gift tax. There is also an exclusion for educational or medical services provided for the donee if the donor paid the providers of the services directly.
Gift and Estate Taxes
To be effective and fair, the gratuitous transfer tax applies to both gifts and bequests, because if only estates were taxed, then donors could give most of their property away while they are still alive, thus lowering or eliminating the tax; likewise, if the tax only applied to gifts. Although all property is eventually transferred as a gift or bequest, most people do not have to pay gratuitous transfer taxes, because they can apply a very generous tax credit, referred to as the unified tax credit, because it applies to both gifts and estates, that eliminates the tax for most people.
The gift tax system and the estate tax system were fully unified in 2011, in that:
- lifetime and testamentary transfers are taxed at the same rates
- the unified credit is applied to both types of gifts (hence the name)
- the estate tax is computed by adding the taxable portion of post-1976 gifts to the taxable estate to determine the tentative tax base.
Although the gratuitous transfer tax is a progressive, marginal tax that applies to the total value of both gifts and bequests, the unified tax credit exempts a substantial amount of the transfers from taxation and the credit is adjusted annually for inflation. Because the marginal rate reaches the maximum of 40% on total gratuitous transfers exceeding $1 million and because the tax exemption on gift and estate property greatly exceeds that, the lower marginal rates never apply, which is why they are rarely published. So any tax paid on gratuitous transfers is based on the 40% rate.
A Gift for the Wealthy
Taxes usually have a negative effect on the economy. Economists refer to this as the deadweight loss of taxation. This deadweight loss is greatest from taxes on working income, or what the tax code refers to as earned income. This results from the fact that, because of taxes on employment, the buyers of labor — the employers — pay a higher price for that labor, while the suppliers of that labor — the employees — receive a lower price. As is well known from economics, higher prices for buyers leads to lower demand while lower prices for suppliers lowers supply, resulting in an economic loss from lower economic output. By contrast, there is no deadweight loss from taxing gratuitous transfers, because, regardless of the tax rate, everyone must part with their property, either by gift or by bequest, and the beneficiaries do not do anything to receive those benefits, so the tax rate on those transfers will have no effect on the transfer.
So why, then, is work so highly taxed, while gratuitous transfers are lightly taxed? Because it benefits the wealthy! Of course, the wealthy argue that they need the exemption to protect farms and businesses. The wealthy can solve that liquidity problem by buying life insurance and the tax code already gives estates with farms and businesses at least 14 years to pay the estate tax. Of course, they still get the generous unified tax credit even if the estate is all cash. On the other hand, what about poor people who need to buy hearing aids or to get their teeth fixed, or to even buy a decent home? If rich people can receive an inheritance tax-free, why shouldn't poor people be able to receive all their earnings tax-free? Moreover, allowing poor people to keep more of their money will reduce the need for government handouts and it will stimulate the economy, because poor people always spend all their money, because they have no choice. Another example of how the wealthy are treated better under the tax code than the poor is the fact that the child tax credit, unlike the unified tax credit, is not indexed for inflation, and indeed, the additional child tax credit, which is the portion of the credit that can be used to offset employment taxes, was not even a permanent part of the tax code until 2016. On the other hand, the unified tax credit is a permanent part of the tax code and is indexed for inflation, allowing the wealthy to transfer ever greater amounts of wealth.
For instance, in 2016, the unified tax credit allowed the exemption of $5,450,000 worth of property for each taxpayer, thus allowing parents to transfer almost $11 million tax-free to their children. Additionally, wealthy people can take advantage of many other tax loopholes to reduce or eliminate taxes on property value that exceeds the exemption amount, such as Crummey trusts. This is a major advantage that the tax code confers upon the wealthy, allowing them to become ever richer, leading to ever greater inequality. On the other hand, earned income is the most highly taxed income — taxed not only by the federal government, but also by states and municipalities — which is why it is difficult for people to increase their wealth by working for it — better to have it handed to them by wealthy parents!
Example: In 2016, you give your daughter $10 million and pay $50,000 to her college for her education. Therefore, you would have to pay gift tax = 40% of ($10 million – exemption amount – annual exclusion) = ($10,000,000 – $5,450,000 – $14,000) × 40% = $1,814,400. Because the $50,000 is paid directly to your daughter's college, you do not have to include that amount when calculating the gift tax. However, your unified tax credit would be all used up, so, on your death, the entire value of your estate, minus expenses, will be subject to estate tax.
Case #2: Same as the above example, but you are married, so you and your spouse's combined exemption of $10,900,000 could exempt the entire gift to your daughter, leaving a $900,000 exemption available for both of your estates.
2018 Estate Tax Update
In December 2017, the Republicans have passed their major tax plan, known as the Tax Cuts and Jobs Act, with most of the benefits going to the wealthy. Part of that plan includes decreasing the top estate tax rate from 40% to 35% and doubles the exemption to $11 million for each individual, which will allow a couple to leave $22 million to their heirs tax-free. The Republicans argue that this is to protect small farms and businesses. However, according to Who pays the estate tax? | Tax Policy Center, in 2017, only 690 businesses and farms were large enough to owe an estate tax, and just 80 of them were small farms or businesses. Moreover, the tax code already allows taxpayers to pay the estate tax over 14-year period, if at least 35% of the value of the estate is a farm or business. Then there is life insurance, another solution. Nonetheless, the Republicans will advance any argument to rationalize giving most of the tax breaks to the wealthy, even though it is estimated that the US deficit, now more than $20 trillion, will increase by another $1.5 trillion over a 10-year period. Republicans argue that the deficit will not be greater than that since economic growth will help pay for the tax cuts. My bet is that the total debt will increase much faster than that, since the economy is not likely to continue growing at 3 or 4% for the next 10 years, especially since it is already reaching its potential output.
Generation-Skipping Transfer Taxes
Another type of gratuitous transfer tax is the generation-skipping transfer tax. When Congress 1st implemented the estate tax in 1916, they probably thought that they could tax each generation, as wealth was transferred from parent to child. But an easy way to circumvent that double taxation was to bequeath property to grandchildren or later generations rather than giving it to their own children, since they were usually wealthy in their own right. Congress responded by enacting the generation-skipping transfer tax in 1986, which is an additional tax on top of the estate or gift tax on any property given to a skip person, defined in the tax code as someone who is at least 37½ years younger than the donor.
The GST tax is a flat rate tax, equal to the highest estate tax rate, currently 40%. The tax code defines a generation thus: any person not younger than 12½ years is considered to be of the same generation, and each additional 25-year period is considered to be a succeeding generation. Hence, the second-generation consists of all those people 37½ years younger than the donor.
The GST tax is not reduced by the unified tax credit, but is instead reduced by the GST exemption amount, equal to the exemption amount for gifts and estates, resulting in no taxes on property valued less than the applicable exemption amount. The annual gift exclusion of $14,000 is also excluded from the GST tax, as is the exclusions for tuition and medical expenses paid directly to the providers of those services for the donee.
The GST tax exemption is also adjusted for inflation, equalizing it to the exemption amount for gifts and estates.
Tax Policy Objectives of Gratuitous Transfer Taxes
The tax policy objectives of gratuitous transfer taxes are to prevent the accumulation of wealth within families, but given the large exemptions from the tax, even modestly wealthy families do not have to worry about these taxes. On the other hand, there is no exemption amount for earned income — income earned by working for it. And this is ironic. For the deadweight loss of taxation is greatest on earned income. This deadweight loss is created because taxes on earned income reduce the amount of money received by the suppliers of labor while also increasing the cost of labor to employers, thereby reducing both the supply and demand of labor, which reduces the economic wealth of a nation, since it is only working people who actually increase it. On the other hand, there is no deadweight loss for gratuitous transfer taxes, because people who receive a gift or bequest do not have to do anything for it, which, of course, is why it is referred to as a gratuitous transfer. As economists like to say, the supply of death is completely inelastic and the demand for gifts or bequests is completely elastic. The supply of death is inelastic because everyone must die — tax rates will not change that. And because people cannot take their money or their property with them when they die, somebody else must receive the property, so they will receive it regardless of the tax rates. In other words, gratuitous tax rates will not affect the amount of gratuitous transfers, at all.
Of course, befitting a tax code that favors the wealthy, credits that apply to working income are small and available only to the poor, and some of those credits, such as the child tax credit, are not even indexed for inflation. If people could apply a tax credit as generous as the unified tax credit to their earned income, most people would never have to pay a penny of federal tax for their entire lives. Moving up the social ladder would be much easier!
History of Wealth Transfer Taxes
The United States has had an estate tax since 1916 and a gift tax since 1932. In 1976, the Tax Reform Act of 1976 (TRA) enacted the unified transfer tax schedule for gifts and estates.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) phased in increases to the unified credit and reductions in the unified tax rate, starting in 2002. The phase-in ended in 2010, when gratuitous transfer taxes were eliminated entirely for 2010 only. But if no further legislation was passed, then, to comply with the provision of the Congressional Budget Act of 1974, the rules would revert to the rules in effect before the EGTRRA. So the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Tax Relief Act) was enacted in December 2010, instituting a top rate of 35% for both gift and estate taxes, with the unified tax credit being adjusted for inflation for 2012, allowing an exemption of $5.12 million.
From 2002 to 2010, the unified credit for the gift tax was different from the unified credit for estates, making the calculation of gratuitous transfer taxes more complicated. The unified tax credit for gifts was limited to $345,800, exempting $1,000,000 of gifts. The unified credit for the estate tax varied from $1,500,000 in 2004 and 2005 to $1,455,800 in 2009.
|For Gift Tax Purposes:||For Estate and GST Tax Purposes:|
|2010||345,800||1,000,000||No estate tax, but no step-up|
in property basis.
|2006 - 2008||345,800||1,000,000||780,800||2,000,000|
|2004 - 2005||345,800||1,000,000||555,800||1,500,000|
|2002 - 2003||345,800||1,000,000||345,800||1,000,000|
In 2010, the estate tax was suspended, but there was no step-up in property basis to its fair market value when the decedent died. Donees had to accept the donor's basis in the property, which increased capital gains or lessened capital losses when the property was sold.
For all other years, the donee receives a stepped-up basis in the property, equal to the fair market value of the property on the date of the decedent's death. Although the unified credit was different for gifts and estates, applying the credit to gifts still reduced the available credit for estates. For instance, in 2009, the unified credit was $345,800 for gifts and $1,455,800 for estates, exempting $1,000,000 of gifts and $3,500,000 of estate property from taxes. Although the 2 credits differed, they were still unified, in that any gift tax credit used reduced the credit for the estate tax. Hence, if a taxpayer uses the $345,800 credit for gifts during his lifetime, then his estate credit will be reduced to $1,110,000, allowing only $2,500,000 worth of property to pass tax-free.
The American Taxpayer Relief Act of 2012 (ATRA 2012) increased the tax rate to 40%, equalized the unified credit for both gifts and estates, and retained the annual inflation adjustment to the unified tax credit.