Chapter 12. Gift Tax

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Chapter 12.Gift Tax

• Howard Godfrey, Ph.D., CPA
• Professor of Accounting

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• The student should be able to
• 1. Understand the concept of the unified transfer
  tax system. (Pg. 2)
• 2. Describe the gift tax formula. (Pg. 4)
• 3. Identify a number of transactions subject to
  the gift tax. (Pg. 7)
• 4. Determine whether an annual gift tax exclusion
  is available. (Pg. 16)
• 5. Identify deductions available for gift tax
  purposes. (Pg. 18)
• 6. Apply the gift-splitting rules. (Pg. 22)
• 7. Calculate the gift tax liability. (Pg. 23)
• 8. Understand how basis affects the overall tax
  consequences. (Pg. 26)
• 9. Recognize the filing requirements for gift tax
  returns. (Pg. 30

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• Highlights of Recent Tax Law Changes
• The 2001 Act reduced the unified transfer tax
  rates in 2002 by replacing the former top two
  brackets on amounts exceeding 2.5 million with a
  50 maximum tax rate. In later years, for both
  estate gift tax purposes the maximum tax rate
  is reduced in 1 increments until in 2007 the top
  rate is 45 on amounts over 1.5 million. In
  2005 the max tax rate is 47. The 2001 Act
  repeals the estate generation skipping taxes
  effective January 1, 2010. At that date, the max
  gift tax rate will decline to 35. The 35 rate
  will apply to tax bases exceeding 500,000.
  Congress retained the gift tax to make up for the
  loss in income tax revenue that could occur
  should wealthy individuals shift assets free of
  gift tax to donees in lower income tax brackets

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• Highlights of Recent Tax Law Changes
• Once the statute of limitations has expired, the
  IRS cannot argue that taxable gifts of prior
  periods were undervalued as long as a gift tax
  was paid. For gifts after August 5, 1997, this
  rule applies even if the donor paid no gift tax
  as long as the method for valuing the gift is
  properly disclosed.
• The amount of the annual gift tax exclusion is
  11,000 in 2004 and 12,000 in 2005.

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• Lecture Outline
• I. Concept of Transfer Taxes.
• Gifts and inheritances are specifically excluded
  from the income of a recipient. The donor must
  pay a gift tax on the value of property
  transferred by gift. The estate pays an estate
  tax on the value of property in the taxable
  estate.
• A. The US has had an estate tax since 1916 and a
  gift tax since 1932. The structure of these
  taxes has remained fairly constant. One purpose
  of a tax is to raise revenue. Because of the
  generous exclusion, the gift tax raises little
  revenue. The gift tax also provides a backstop
  for the estate tax. The gift tax prevents
  wealthy donors from transferring large portions
  of their assets during life to escape the estate
  tax.

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• II. The Unified Transfer Tax System.
• A. Unified Rate Schedule. Before the 1976 Act,
  there was a separate rate schedule for gift tax
  purposes that was only 75 of the estate tax
  rates. Since that time there has been a unified
  rate schedule with graduated rates, currently up
  to a maximum of 47. The 2001 Act reduced the
  unified transfer tax rates beginning in 2002 by
  replacing the former top two brackets on amounts
  over 2.5 million with a 50 maximum tax rate.
  In 2002, amounts exceeding 2.5 million will be
  taxed at a 50 max rate. In 2003, the top rate
  declines to 49 and applies to tax base above 2
  million. In later years the rate will be reduced
  until in 2007 the max rate is 45 on amounts over
  1.5 million. In 2005, the max rate is 47 on a
  base of 2 million.

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• II. The Unified Transfer Tax System.
• B. Since 1977, taxable gifts are added into the
  estate tax base. They are valued at their FMV on
  the date of gift. The addition of post-1976
  adjusted taxable gifts to the estate tax base
  results in higher marginal rates being applied to
  transfers made at death. Gift taxes paid on
  these gifts are subtracted from the estate tax
  liability.
• C. The unified credit reduces dollar-for-dollar a
  certain amount of the tax computed on the taxable
  gifts or the taxable estate. The amount of the
  credit varies depending on the year of transfer.
  For years 2002 through 2009, the amount of the
  credit is 345,800. This number is to remain
  constant while the credit for estate tax purposes
  increases.

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• III. Gift Tax Formula
• A. Determination of Gifts. A determination must
  first be made as to whether any transfers made by
  a taxpayer constitute a gift. The transfer is
  valued at the FMV of the prop on the date of the
  gift. The aggregate amount of gifts for the
  period is then determined. Aggregate gifts are
  reduced by any exclusions or deductions to
  determine taxable gifts.
• B. Exclusions and Deductions. For 2004, the
  amount of the annual exclusion is 11,000 per
  donee per year. If the amount of a gift to a
  person does not equal 11,000, the exclusion is
  limited to the FMV of the gift. Exclusions may
  be claimed for an unlimited number of donees.
  Unlimited deductions are allowed for marital
  transfers and gifts to charities. The annual
  exclusion is indexed for inflation using
  multiples of 1,000. It is 12,000 for 2006.

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• III. Gift Tax Formula
• C. Gift-Splitting Election. Congress authorized
  gift-splitting to provide for comparable tax
  results for residents of community property
  common law states. Under this provision, gifts
  made to third parties by one spouse will be
  treated as made one-half by each for purposes of
  the annual exclusion and unified credit.
• D. Cumulative Nature of Gift Tax. Computation of
  gift tax is cumulative in nature. The marginal
  tax rate depends on both the taxable gifts of the
  current and prior periods.

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• III. Gift Tax Formula
• E. Unified Credit. Prior to 1977, the Code
  allowed a 30,000 specific exemption. The
  exemption was repealed and replaced by the
  unified credit. The unified credit amount has
  changed over the years. A table showing the
  amount of the unified credit and credit
  equivalent is provided on the inside back cover.
  In 2004, the credit amount is 345,800 and
  remains at this level through 2009. In 2010, the
  credit will be 330,800, the tax on 1 million at
  a top rate of 35. There is no credit allowed for
  taxable gifts made prior to 1977.

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• IV. Transfers Subject to the Gift Tax.
• A. Transfers for Inadequate Consideration.
  Property transferred for less than adequate
  consideration in money or money's worth is deemed
  a gift. A transfer is subject to the gift tax
  even though not entirely gratuitous if the value
  of the property transferred exceeds the value of
  money or other consideration given.
• 1. Bargain Sales. Family members may wish to
  transfer property at less than adequate and full
  consideration. A part-sale, part-gift will then
  occur. The amount of the gift is the difference
  between the sales price and the property's FMV on
  the date of the transfer.
• 2. Transfers in Normal Course of Business. A
  transfer arising in the ordinary course of
  business, which is bona fide, arm's length, and
  free from any donative intent is considered made
  for adequate consideration.

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• B. Statutory Exemptions from the Gift Tax.
• 1. Payment of Medical and Tuition Expenses. A
  qualified transfer is not treated as a gift. A
  qualified transfer is defined as an amount paid
  on behalf of an individual to an educational
  organization for tuition or to any person who
  provides medical care as payment for such medical
  care. The payment must be made directly to the
  educational institution or the person or entity
  providing the medical care. It includes tuition,
  but not room, board and books. The identity of
  the person benefiting is not important and does
  not need to be a relative. If payments made are
  for the support of an individual under state law,
  the payments do not constitute a gift. State law
  determines the definition of support.
• 2. Transfers to a political organization are not
  considered gifts.

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• B. Statutory Exemptions from the Gift Tax.
• 3. Under Section 2516 property settlements in
  connection with a divorce are exempted from being
  treated as a gift. To come under these
  provisions, the spouses must adopt a written
  agreement concerning their marital property
  rights and the divorce must occur during a
  three-year period beginning one year before the
  agreement is made.
• 4. People may disclaim a gift if they are old,
  ill or very wealthy. States provide disclaimer
  statutes, which allow an individual to disclaim a
  gift. People making a qualified disclaimer will
  be treated as though they never received the
  property. State law and/or another provision in
  the will address how to determine who will
  receive the property after the original
  beneficiary declines to accept it. A qualified
  disclaimer must meet the four tests listed on p.
  C12-10. (Contrast with earning income and saying
  give it to my relative.) Assignment of income
  limit.

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• C. A gift does not occur until a transfer becomes
  complete. A gift is complete and thus is deemed
  made and valued when the donor has parted with
  dominion and control so as to leave him without
  power to change its disposition, whether for his
  own benefit or the benefit of another.
• 1. A transferor who conveys property to a
  revocable trust has not made a completed
  transfer. If the trustee makes a distribution
  from a revocable trust to a beneficiary, a
  completed gift is made.
• 2. Transfers to an irrevocable trust may not be
  deemed complete with respect to the portion of
  the trust that the creator keeps control over.
  If a donor reserves any power over the property's
  disposition, the gift may be wholly or partially
  incomplete depending upon the facts in the case.
  A gift is incomplete to the extent the donor can
  name new beneficiaries or change the interests of
  beneficiaries.

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• D. Valuation of Gifts.
• 1. General Rules. All gifts are valued at FMV on
  the date of the gift. FMV is the price at which
  such property would change hands between a
  willing buyer and a willing seller, neither being
  under any compulsion to buy or sell, and both
  having reasonable knowledge of relevant facts.
• 2. Life Estates and Remainder Interests. The
  value of a transfer of a life estate or a
  remainder interest is determined based upon
  actuarial tables found in Appendix H. Table S is
  used for valuing life estates and remainders and
  Table B for term certain interests. The interest
  rate is to be revised every month to the rate
  that is 120 of the Federal midterm rate
  applicable for the month of the transfer. (See
  Examples C12-19 through C12-22.) You may at this
  point wish to use the Stop and Think example,
  which illustrates the effect the age of the
  income beneficiary has on the value of the
  remainder interest.

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• D. Valuation of Gifts.
• 3. Special Valuation Rules Estate Freezes.
  Congress became concerned that individuals were
  able to shift wealth to other individuals,
  usually in a younger generation, without paying
  their fair share of the transfer taxes. An
  approach commonly used was the estate freeze,
  where a corp was recapitalized. In 1990 Congress
  addressed this problem by enacting new Chapter 14
  (Secs. 2701 through 2704). These rules are too
  complex for discussion here. Several examples
  are provided in the text on p. C12-13.

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• E. Gift Tax Consequences of Certain Transfers.
• 1. Funding a joint bank account is an incomplete
  transfer. A gift occurs when one party withdraws
  an amount in excess of the amount they deposited.
  
• 2. A completed gift occurs when a transferor
  titles real estate or other properties in the
  names of him and another as joint tenants. Each
  joint tenant is deemed to have an equal interest
  in the property. The person furnishing
  consideration for the property is deemed to have
  made a gift to the other joint tenant in an
  amount equal to the value of the donee's pro rata
  interest in the property.
• 3. Naming of another as beneficiary on a life
  insurance policy is an incomplete transfer. If
  the owner of a policy irrevocably assigns all
  rights in the policy to another, a completed gift
  has been made. Ownership rights include the
  ability to change the beneficiary, borrow against
  the policy, and cash the policy in for its cash
  surrender value. The payment of premiums on a
  policy is considered a gift to the policy's owner
  in the amount of the premium paid.

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• E. Gift Tax Consequences of Certain Transfers.
• 4. A power of appointment exists when a person
  transfers property and grants someone else the
  power to specify who will eventually receive the
  property. Powers can be general or special. A
  person possesses a general power of appointment
  if he has the power to appoint the property to
  himself, his creditors, his estate, or the
  creditors of his estate. A gift occurs when a
  person exercises a general power of appointment
  and names some other person to receive the
  property. The gift is made to the person
  receiving the property. The exercise of a power
  of appointment in favor of the holder of the
  power is not a gift.
• 5. A net gift occurs when an individual makes a
  gift to a donee who agrees to pay the gift tax as
  a condition to receiving the gift. The amt of
  the gift is the excess of the value of the
  transferred property over the amount of the gift
  tax paid by the donee.

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• V. Exclusions
• A. The amount of the gift tax exclusion is
  11,000 for 2005. It is available annually for
  an unlimited number of donees. The exclusion is
  indexed for inflation with adjustments rounded to
  the next lowest multiple of 1,000.
• B. Present Interest Requirement. A donor
  receives an exclusion for a gift only if it is a
  gift of a present interest.
• 1. A present interest is an unrestricted right to
  the immediate use, possession, or enjoyment of
  property or the income from property.
• 2. A future interest is the opposite of a present
  interest. Gifts of a future interest are not
  eligible for the annual exclusion. A future
  interest is a legal term and includes reversions,
  remainders, and other interests..., which are
  limited to commence in use, possession, or
  enjoyment at some future date or time.

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• V. Exclusions
• 3. Parents creating trusts for children under the
  age of 21 can provide that income be accumulated
  in the trust and the trust will qualify for the
  annual exclusion provided the trust meets the two
  Sec. 2503 trust requirements on p. C12-17.
• 4. A Crummey trust is a technique that allows a
  donor to set up a trust and obtain an annual
  exclusion. The trust can terminate at whatever
  age the donor specifies and can be created for an
  individual of any age. A "Crummey power"
  entitles each beneficiary to demand a
  distribution of the lesser of a specific amount
  or the amount transferred to the trust that year.
  If the power is not exercised by a certain date,
  it expires. The demand power is held to be a
  present interest.

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• VI. Gift Tax Deductions
• A. Marital Deduction. The marital deduction
  results in tax-free interspousal transfers.
  There is an exception for terminable interests.
• 1. The marital deduction is unlimited. Transfers
  of community property are eligible for the
  deduction.
• 2. Gifts of Terminable Interests - A terminable
  interest ends or is terminated when some event
  occurs (or fails to occur) or a specified time
  passes. A marital ded is denied only when the
  transfer is a nondeductible terminable interest.
• 3. Under QTIP provisions, transfers of qualified
  terminable interest property are eligible for the
  marital deduction. Donors can take the marital
  deduction without having to grant their spouse
  full control over the property. The deduction is
  elective. If the donor claims the marital ded,
  the donee-spouse must include the QTIP property
  in their estate.

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• B. Charitable Contribution Deduction. Gifts to
  charitable organizations do not have to be
  reported on a gift tax return provided a
  charitable contribution deduction is available
  and the charitable organization receives the
  donor's entire interest in the property. There
  is no percentage limitation for a charitable
  contribution for gift tax purposes. An income
  tax deduction can also be claimed subject to the
  percentage of AGI limitations. (See Example
  C12-38.)
• 1. A gift tax deduction is allowed for a gift to
  a charitable organization. A deduction is
  available for gifts to the categories of
  organizations on p. C12-21.
• 2. Split-Interest Transfers. Special rules apply
  when a transfer is made for both private and
  public purposes. An example would be a gift of a
  residence made to a sister for life, and with the
  remainder to a college or university.

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• VII. The Gift-Splitting Election
• The gift-splitting provisions allow spouses to
  treat a gift that is made to a third party as if
  each spouse had actually made one-half of the
  gift. Each year's election stands alone and is
  not binding on future years. Upon the death of
  the actual donor or the spouse who consented to
  gift splitting, the amount of such decedent's
  adjusted taxable gifts must be included in the
  estate tax base. Adjusted taxable gifts include
  only the portion of the gift that is taxable on
  the gift tax returns filed by the donor-decedent.
  The Stop and Think example at this point
  illustrates a situation where gift splitting may
  not be desirable.

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• VIII. Computation of the Gift Tax Liability
• The gift tax computation is a cumulative process.
  All previous gifts made in 1932 or later years
  plus the taxable gifts for the current year
  affect the marginal tax rate at which the current
  gifts will be taxed.
• Congress enacted a unified credit for transfers
  made in 1977 and later years. The amount of the
  credit has been increased over the years. In
  2004 the credit is 345,800 and will remain this
  amount through 2009. Any credit used in
  post-1976 gift transfers reduces the amount of
  the credit currently available.

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• X. Basis Considerations for a Lifetime Giving
  Plan.
• Prospective donors should consider lifetime
  gifts. There are estate tax savings, and income
  tax savings through the removal of income to a
  return with lower marginal tax rates. There are
  disadvantages as well.
• A. Carryover basis rules apply to property
  received by gift. All of the gift taxes paid are
  added to the donor's basis for pre-1977 gifts.
  For post-1976 gifts, only the gift tax on
  appreciation in the property's value is added to
  the donor's basis. In no event can this
  adjustment plus the donor's basis exceed the FMV
  of the property on the date of the gift. If the
  FMV is less than the donor's basis on the date of
  the gift, the FMV is the donee's basis for
  purposes of determining loss. No gain or loss is
  recognized if the donee sells the property for an
  amount between the FMV and the adjusted basis.
  Prospective donors should sell property that has
  declined in value instead of gifting it.
• B. Property received from a decedent has a basis
  equal to its FMV on the date of death or
  alternate valuation date.

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• XI. Below Market Loans Gift Income Tax
  Results.
• One of the most interesting issues in recent
  years has been whether interest-free loans
  constitute a gift. Historically the government
  has held that a gift of the foregone interest
  occurs in each period the loan is outstanding.
  The lower courts had held that interest-free
  demand loans did not constitute a gift. The
  Supreme Court held in the Dickman case (1984)
  that the gratuitous transfer of the right to use
  money is a transfer of property for purposes of
  determining whether a gift is made. The Court
  did not address how to value the gift.

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• XI. Below Market Loans Gift Income Tax
  Results.
• A. General Rules. Section 7872 provides
  definitive rules concerning both the income and
  gift tax consequences of below-market loans. The
  lender is treated as making a gift to the
  borrower and receiving interest income. The
  borrower is treated as paying interest expense.
  In the case of a demand loan, the lender is
  treated as making a gift in each year the loan is
  outstanding. The foregone interest is treated as
  being retransferred from the borrower to the
  lender on the last day of each calendar year the
  loan is outstanding. The lender reports the
  foregone interest as income for the year. The
  borrower gets an interest expense deduction
  unless one of the rules limiting the interest
  deduction applies.

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• B. De Minimis Rules. Neither the income nor the
  gift tax rules apply to any gift loan made
  directly between individuals for any day on which
  the aggregate loans outstanding between the
  borrower and the lender are 10,000 or less. All
  loans are counted irrespective of their interest
  rate. For loans of 100,000 or less, the amount
  of interest income and expense that is imputed
  for income tax purposes is limited to the amount
  of net investment income of the borrower. If the
  borrower's net investment income for the year is
  1,000 or less, the amount of net investment
  income is treated as zero.

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• XII. Tax Planning Considerations.
• A. Tax-Saving Features of Inter Vivos Gifts.
• 1. If gifts are made to several individuals early
  in a person's lifetime, substantial amounts of
  property can be transferred free of tax- Annual
  exclusions.
• 2. Post-gift appreciation is removed from an
  estate through gifting property.
• 3. With one exception, gift taxes paid by the
  donor are removed from the transfer tax base.
  Gift taxes paid on gifts made within three years
  of death are included in the tax base for estate
  tax purposes.

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• XII. Tax Planning Considerations.
• 4. The compression of income tax rates beginning
  in 1987 has lessened the benefits of income
  shifting. Income tax benefits that do accrue
  will do so over a period of years and may become
  quite sizable.
• 5. Gift in Contemplation of Donee-Spouse's Death.
  A terminally ill spouse may have few assets. If
  they die, their unified credit may be wasted. If
  the healthier spouse is wealthy, gifts can be
  made to the terminally ill spouse to take
  advantage of that spouse's unified credit. (That
  spouse will leave the assets to kids.)
• 6. All states except Nevada levy a death tax. In
  most states with a gift tax, the state tax cost
  of lifetime transfers is lower than for transfers
  at death.
• 7. When charitable transfers are considered, the
  income tax implications should be considered as
  well. Transfers during one's lifetime are
  eligible for both the gift tax charitable
  contribution deduction and the income tax
  charitable contribution deduction.

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• B. Negative Aspects of Gifts.
• 1. The donee receives no step-up in basis for
  property acquired by gift. Also, keep in mind
  that any gain on the sale of gifted property is
  likely to be taxed at a 15 rate and property
  remaining in the estate may be taxed at a rate as
  high as 48.
• 2. Prepayment of Estate Tax. A donor making
  gifts in excess of the exemption equivalent must
  pay a gift tax. The tax paid during the donor's
  lifetime reduces the amount of estate taxes to be
  paid. The payment of gift taxes results in the
  prepayment of estate taxes. Time value of money.

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• XIII. Compliance and Procedural Considerations.
• A. Donor files Form 709 (United States Gift Tax
  Return) or a simpler Form 709A when annual gifts
  to an individual exceed 11,000. A return is not
  filed for gifts to charitable organizations if
  the gift is deductible and the organization
  receives the donor's entire interest in the
  property. A return is not filed for gifts to a
  spouse, unless the gift to the spouse is a
  qualified terminable interest.
• U.S. persons who receive aggregate foreign gifts
  or bequests in excess of 11,000 a year that they
  treat as gifts or bequests must report such
  amounts as prescribed by the Regulations. The
  11,000 is to be indexed for inflation.
• B. Gift tax returns must be filed on a calendar
  year basis, by April 15 after the gift year. An
  extension for the filing of the income tax return
  is deemed an automatic extension for the filing
  of the gift tax return. Estimated payments are
  not required for gift taxes.

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• XIII. Compliance and Procedural Considerations.
• C. In order for gifts to be computed under the
  gift-splitting provisions, both spouses must
  consent to gift splitting by one of the ways
  listed on p. C12-31.
• D. A gift tax return is necessary for gift
  splitting even if no gift tax return is due.
  Form 709A can be filed.
• E. The gift tax is paid by the donor and, if the
  spouses consent to gift splitting, the entire
  gift tax is a joint and several liability of the
  spouses.
• F. The determination of value for a gift is one
  of the most difficult problems. This is
  especially true for stock in a closely held
  business, an oil and gas property, or land in an
  area where few sales occur. If property is
  difficult to value, it should be appraised before
  filing the gift tax return.
• 1. Section 6662 imposes a penalty at varying
  rates on underpayments of gift and estate taxes
  resulting from a valuation understatement.

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• XIII. Compliance Procedural Considerations.
• G. Statute of Limitations. The statute of
  limitations is three years for gift tax purposes.
  This is extended from three to six years if the
  donor omits from the gift tax return gifts whose
  value in total is more than 25 of the gifts
  reported on the return. If no return is filed,
  the tax may be assessed at any time. Once the
  statute of limitations has expired, the IRS
  cannot argue that taxable gifts of prior periods
  were undervalued (and thus that the current
  period's gifts should be taxed at a higher rate
  than that used by the donor) as long as a gift
  tax was paid on the earlier gifts. For gifts
  after August 5, 1997, this rule applies even if
  the donor paid no gift tax.

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• Court Case Briefs
• Arthur W. Clark,, 65 T.C. 126 (1975).
• Arthur Clark made gifts of interests in Central
  Wisconsin Motor Transport Co. stock, which was
  the principal of two Clifford trusts that had
  been set up for the benefit of Clark's two sons.
  In the years of these gifts, Clark claimed the
  then-applicable annual gift tax exclusion of
  3,000 per donee in his annual gift tax returns.
  The IRS contended that the stock represented
  future interests and the gift tax exclusion was
  not allowable. The court upheld the common law
  doctrine of merger under Wisconsin law, which
  meant that the income beneficiaries had all the
  rights and full possession of the stock upon
  execution of the principal interests in the
  stock. The gift tax exclusion was therefore
  allowable.

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• U.S. v. Ray Dodge, 443 F. Supp. 535 (DC OR,
  1977).
• Ezra Bonnie Royce were brothers who engaged in
  several very successful joint businesses. Bonnie
  had no children and made an oral agreement with
  Ezra in 1938 that one-half of Bonnie's estate
  would go to Ezra's only child, Eunice, if Ezra
  took care of Bonnie's business and served as
  executor for Bonnie's estate with no pay. Ezra
  fulfilled these obligations. The brothers were
  later estranged and Bonnie prepared new will
  which did not include Eunice. Upon Bonnie's
  death Eunice sued to have the 1938 agreement
  recognized and to collect one-half of Bonnie's
  estate. Such recovery was granted, two years
  after Ezra's death. The IRS tried to include the
  right to this property in Ezra's estate as a
  taxable gift by Ezra to Eunice because Eunice was
  only entitled to the property because Eunice
  fulfilled his obligation to Bonnie. The court
  held that the right to this property was
  uncertain enough at the time of Ezra's death that
  Ezra could not have passed this right on to
  Eunice. Ezra's estate was not liable for tax
  thereon or to include the "gift" in the estate.