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Chapter 12. Gift Tax

Chapter 12. Gift Tax

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Chapter 12. Gift Tax

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  1. Chapter 12.Gift Tax Howard Godfrey, Ph.D., CPA Professor of Accounting Corporate Tax

  2. 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 Corporate Tax

  3. 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 Corporate Tax

  4. 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. Corporate Tax

  5. 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. Corporate Tax

  6. 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. Corporate Tax

  7. 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. Corporate Tax

  8. 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. Corporate Tax

  9. 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. Corporate Tax

  10. 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. Corporate Tax

  11. 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. Corporate Tax

  12. 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. Corporate Tax

  13. 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. Corporate Tax

  14. 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. Corporate Tax

  15. 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. Corporate Tax

  16. 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. Corporate Tax

  17. 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. Corporate Tax

  18. 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. Corporate Tax

  19. 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. Corporate Tax

  20. 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. Corporate Tax

  21. 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. Corporate Tax

  22. 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. Corporate Tax

  23. 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. Corporate Tax

  24. 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. Corporate Tax

  25. 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. Corporate Tax

  26. 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. Corporate Tax

  27. 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 unlessone of the rules limiting the interest deduction applies. Corporate Tax

  28. 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. Corporate Tax

  29. 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. Corporate Tax

  30. 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. Corporate Tax

  31. 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. Corporate Tax

  32. 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. Corporate Tax

  33. 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. Corporate Tax

  34. 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. Corporate Tax

  35. 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. Corporate Tax

  36. 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. Corporate Tax