The gift tax is levied on individual taxpayers for all taxable gifts made during a calendar year. As explained shortly, each individual (married couples cannot elect joint filing for gift tax returns) who makes a gift in excess of the annual exclusion amount must file a gift tax return (Form 709) by April 15 of the following year.2 Exhibit 25-3 presents the com- plete formula for the federal gift tax in two parts. In the first part, taxable gifts are calcu- lated for each donee, and in the second, the gift tax is calculated using aggregate taxable gifts to all donees. We begin the first part by identifying transfers that constitute gifts.
LO 25-2
2A gift tax return reporting taxable gifts must be filed by April 15th following year-end if a taxpayer has made any taxable gifts during the current calendar year or wishes to elect gift-splitting. When taxpayers re- quest extensions for their individual income tax returns, they also receive a six-month extension for filing their gift tax returns.
EXHIBIT 25-3 The Federal Gift Tax Formula
Part 1: Calculate taxable gifts for each individual donee:
Current Gifts
Minus ẵ of split gifts (other half included in spouse’s current gifts) Plus ẵ of split gifts by spouse
Minus Annual exclusion ($15,000 per donee) Minus Marital and charitable deductions Equals Current taxable gifts
Part 2: Sum taxable gifts for all donees and calculate tax:
Total Current Taxable Gifts Plus Prior taxable gifts Equals Cumulative taxable gifts Times Current tax rates Equals Cumulative tax
Minus Tax at current rates on prior taxable gifts Minus Unused applicable credit at current rates Equals Gift tax payable
Transfers Subject to Gift Tax
The gift tax is imposed on lifetime transfers of property for less than adequate consider- ation. Typically, a gift is made in a personal context such as between family members.
The satisfaction of an obligation is not considered a gift. For example, tuition payments for a child’s education satisfy a support obligation. On the other hand, transfers motivated by affection or other personal motives, including transfers associated with marriage, are gratuitous and potentially subject to the tax. The gift tax is imposed once a gift has been completed, and this occurs when the donor relinquishes control of the property and the donee accepts the gift.3 For example, deposits made to a joint bank account are not com- plete gifts because the donor (depositor) can withdraw the deposit at any time. The gift will be complete at the time the donee withdraws cash from the account.
THE KEY FACTS Gifts Excluded from the
Gift Tax
• Incomplete and revocable gifts.
• Payments for support obli- gations or debts.
• Contributions to political parties or candidates.
• Medical and educational expenses paid on behalf of an unrelated individual.
TAXES IN THE REAL WORLD Love and Taxes
The small claims division of the Tax Court was asked to determine whether payments between former lovers constituted gifts or compensation.
Jue-Ya Yang lived with her boyfriend, Howard Shih, who was an artist and calligrapher. While they were romantically involved, Mr. Shih made payments to Ms. Yang and later deducted these payments as wages.
Ms. Yang admitted doing housekeeping and cooking, but she argued that the payments were
gifts. Mr. Shih’s testimony about the romantic rela- tionship was evasive. He admitted on cross- examination that while their relationship was more than a professional one, he could not even recall taking Ms. Yang out on dates. The court concluded that Mr. Shih’s testimony was untrue and held that the payments were gifts made because of love and affection.
Source: Jue-Ya Yang, TC Summary Opinion 2008-156 (12-15-08).
In some instances a donor may relinquish some control over transferred property but retain other powers that can influence the enjoyment or disposition of the property. If the retained powers are important, the transfer will not be a complete gift.4 For example, a transfer of property to a trust will not be a complete gift if the grantor retains the ability to revoke the transfer. If the grantor releases the powers, then the gift will generally be complete at that time because the property is no longer subject to the donor’s control. For example, a distribution of property from a revocable trust is a complete gift because the grantor no longer has the ability to revoke the distribution.
3If a donee refuses or disclaims a gift under §2518, the gift is not complete.
4§2514 addresses the treatment of general powers of appointment.
Example 25-1
On July 12th of this year Harry transferred $250,000 of FFP stock to a new trust. He gave the trustee directions to pay income to Dina for the next 20 years and then remit the remainder to her son George.
Harry named a bank as trustee but retained the power to revoke the trust in case he should need ad- ditional assets after retirement. Is the transfer of the stock a complete gift?
Answer: No. Harry retains sufficient control that the transfer of the stock to the trust is an incomplete gift.
What if: Suppose $11,000 of trust income was distributed to Dina at year-end. Is the transfer of the cash to Dina a complete gift?
Answer: Yes. With the payment Harry has relinquished control over the $11,000, and thus, it is a com- plete gift.
What if: Suppose Harry releases his power to revoke the trust at a time when the shares of FFP in the trust are valued at $225,000. Would this release cause the transfer of the stock to be a complete gift and, if so, what is the amount of the gift?
Answer: Yes. By releasing his powers Harry has relinquished control over the entire trust, and the value of the trust at that time, $225,000, would be a complete gift.
There are several important exceptions to the taxation of complete gifts. For exam- ple, political contributions are not gifts. Also, the payment of medical or educational ex- penses on behalf of another individual is not considered a gift if the payments are made directly to the health care provider or to the educational institution. To avoid confusing a division of property with a gift, a transfer of property in conjunction with a divorce is not considered to be a gift (it is treated as a transfer for adequate consideration) if the prop- erty is transferred within three years of the divorce under a written property settlement.
In addition, special rules apply to transfers of certain types of property. To make a complete gift of a life insurance policy, the donor must give the donee all the incidents of ownership, including the power to designate beneficiaries. An individual who creates a joint tenancy—either a tenancy in common or joint tenancy with right of survivorship—
with someone who does not provide adequate consideration for their interest in the property is deemed to make a gift at that time. The gift is the amount necessary to pay for the other party’s interest in the property. For example, suppose the donor pays $80,000 toward the purchase of $100,000 in realty held as equal tenants in common with the donee (i.e., the donee provides only $20,000 of the purchase price). The donor is deemed to make a gift of $30,000 to the donee, the difference between the value of the joint interest ($100,000 ÷ 2 = $50,000) and the consideration provided by the donee ($20,000).
ETHICS
Rudy is a retired engineer who has three adult daughters and several grandchildren. This year Carol, his youngest daughter, approached Rudy for a $40,000 business loan. Although Carol had no collateral for the loan and did not sign any written
promise to repay the money, Rudy still transferred the funds to her account. Do you think Rudy should file a gift tax return for the transfer? Suppose Rudy has no intention of demanding repayment but has not told anyone so. Does this make any difference?
This year Harry helped purchase a residence for use by Dina and her husband Steve. The price of the residence was $250,000, and the title named Harry and Steve joint tenants with the right of survivor- ship. Harry provided $210,000 of the purchase price and Steve the remaining $40,000. Has Harry made a complete gift, and if so, in what amount?
Answer: Yes, Harry made a complete gift to Steve of $85,000, calculated by subtracting the amount paid by Steve from the price of his ownership interest ($125,000 minus $40,000).
What if: Suppose Steve didn’t provide any part of the purchase price. What is the amount of the gift?
Answer: In this case, Harry made a complete gift to Steve of half the purchase price, $125,000.
Example 25-2
Valuation Gifts are taxed at the fair market value of the donated property on the date the gift becomes complete. Remember that despite the valuation of a gift at fair market value, the donee generally takes a carryover basis for income tax purposes.5
Valuation of remainders and other temporal interests. Assigning value to unique property is difficult enough, but sometimes we must also assign a value to a stream of payments over time or a payment to be made in the future. The right to currently enjoy property or receive income payments from property is called a present interest. In con- trast, the right to receive income or property in the future is called a future interest. A present right to possess and/or collect income from property may not be permanent; if
5The carryover basis may be increased for any gift tax paid (after 1976) on the appreciation of the property.
6The §7520 rate is 120 percent of the applicable federal mid-term rate in effect during the month of the transaction.
granted for a specific period of time or until the occurrence of a specific event, it is a terminable interest. For example, the right to receive income payments from property for 10 years is a terminable interest. A right to possess property and/or receive income for the duration of someone’s life is called a life estate. The person whose life determines the duration of the life estate is called the life tenant.
At the end of a terminable interest, the property will pass to another owner, the per- son holding the future interest. In a reversion, it returns to the original owner. If it goes to a new owner, the right to the property is called a remainder and the owner is called a remainderman. For example, the right to own property after a 10-year income interest has ended is a future interest held by the remainderman. The right to property after the termination of a life estate is also called a remainder.
Future interests are common when property is placed in a trust. Trusts are legal enti- ties established by a person called the grantor. Trusts are administered by a trustee and generally contain property called the trust corpus. The trustee has a fiduciary duty to manage the property in the trust for the benefit of a beneficiary or beneficiaries. This duty requires the trustee to administer the trust in an objective and impartial manner and not favor one beneficiary over another.
Since a future interest is essentially a promise of a future payment, we estimate the value of the remainder by discounting the future payment to a present value using a mar- ket rate of interest. For example, suppose property worth $100 is placed in a trust with the income to be paid to an income beneficiary each year for 10 years, after which time the property accumulated in the trust will be distributed. The remainder is a future interest with a value we estimate by calculating the present value of a payment of $100 in 10 years as follows:
Value of remainder interest =Future payment (1 + r)n
where r is the market rate of interest, and n is the number of years. The interest rate used for this calculation is published monthly by the Treasury as the §7520 rate.6 If the §7520 rate is 6 percent, we calculate the value of a remainder of $100 placed in trust for 10 years as follows:
Value of remainder interest = $100
(1 + .06)10 = $100
(1.791) = $55.83
The value of property consists of the present interest (the right to income) and the future interest (the remainder). Hence, once we have estimated the value of the remainder, we compute the value of the income interest as the difference between the value of the re- mainder and the total value of the property.
Value of remainder interest = Total value − Value of remainder
= $100 − $55.83
= $44.17
If the terminable interest is a life estate, the valuation of the remainder is a bit more com- plicated because payment of the remainder is delayed by the duration of the life estate. To estimate this delay, we base the calculation upon the number of years the life tenant is expected to live. To facilitate the calculation, the regulations provide a table (Table S) that calculates the discount factor by including the life tenant’s age at the time of transfer.
Exhibit 25-4 includes a portion of Table S from the regulation with interest rates by column and the age of the life tenant by row.
THE KEY FACTS Valuation of Remainders
and Income Interests
• Future interests are valued at present value, calculated by estimating the time until the present interest expires.
• The present value calcula- tion uses the §7520 inter- est rate published by the Treasury.
• If the present interest is measured by a person’s life (a life estate), then we estimate the delay by reference to the person’s life expectancy as pub- lished in IRS tables.
• The value of a present in- terest, such as an income interest or life estate, is determined by subtracting the value of the remainder interest from the total value of the property.
Harry transferred $500,000 of FFP stock to the DG Trust, whose trustee is directed to pay income to Dina for her life and, upon Dina’s death, pay the remainder to George (or his estate). At the time of the gift, Dina was 35 years old and the §7520 interest rate was 5.8 percent. What are the values of the gift of the life estate and of the remainder interest?
Answer: Harry made a $59,460 gift of the remainder to George and a $440,540 gift of the life estate to Dina. Under Table S (see Exhibit 25-4), the percentage of the property that represents the value of George’s remainder is .11892. Thus, George’s remainder is valued at $59,460 ($500,000 × .11892).
Dina’s life estate is the remaining value of $440,540 ($500,000 − $59,460).
Example 25-3
The Annual Exclusion One of the most important aspects of the gift tax is the annual exclusion, which operates to eliminate “small” gifts from the gift tax base. The amount of the exclusion has been revised upwards periodically over the years and is now indexed for inflation.7 In 2018, the annual exclusion amount is $15,000.
The annual exclusion is available to offset gifts made to each donee regardless of the number of donees in any particular year. For example, a donor could give $15,000 in cash to each of 10 donees every year without exceeding the annual exclusion. One important limitation to the annual exclusion is that it applies only to gifts of present interests; that is, a gift of a future interest is not eligible for an annual exclusion.
7The exclusion is indexed for inflation in such a way that the amount of the exclusion only increases in in- crements of $1,000. The annual exclusion was $10,000 from 1981 through 2001, but was $11,000 for 2002 through 2005, $12,000 for 2006 through 2008, $13,000 for 2009 through 2012, and $14,000 from 2012 through 2017.
EXHIBIT 25-4 Discount Factors for Estimating the Value of Remainders Regulation Section 20.2031-7(d)(7)
Table S.—Based on Life Table 2000CM Single Life Remainder Factors Applicable After May 1, 2009
[Interest rate]
Age 4.2% 4.4% 4.6% 4.8% 5.0% 5.2% 5.4% 5.6% 5.8% 6.0%
0 .06083 .05483 .04959 .04501 .04101 .03749 .03441 .03170 .02931 .02721 1 .05668 .05049 .04507 .04034 .03618 .03254 .02934 .02652 .02403 .02183 2 .05858 .05222 .04665 .04178 .03750 .03373 .03042 .02750 .02492 .02264 3 .06072 .05420 .04848 .04346 .03904 .03516 .03173 .02871 .02603 .02366 4 .06303 .05634 .05046 .04530 .04075 .03674 .03319 .03006 .02729 .02483 5 .06547 .05861 .05258 .04726 .04258 .03844 .03478 .03153 .02866 .02610 6 .06805 .06102 .05482 .04935 .04453 .04026 .03647 .03312 .03014 .02749 35 .19692 .18423 .17253 .16174 .15178 .14258 .13408 .12621 .11892 .11217 36 .20407 .19119 .17931 .16833 .15818 .14879 .14009 .13204 .12457 .11764 37 .21144 .19838 .18631 .17515 .16481 .15523 .14635 .13811 .13046 .12335 38 .21904 .20582 .19357 .18222 .17170 .16193 .15287 .14444 .13661 .12932 86 .79825 .79044 .78278 .77524 .76783 .76055 .75340 .74636 .73944 .73264 87 .80921 .80176 .79443 .78722 .78014 .77316 .76630 .75956 .75292 .74638 88 .81978 .81268 .80569 .79880 .79203 .78536 .77880 .77234 .76598 .75971 89 .82994 .82317 .81651 .80995 .80349 .79712 .79085 .78467 .77859 .77259
Most gifts will only qualify for an annual exclusion if the donee has a present in- terest (the ability to immediately use the property or the income from it). However, a special exception applies to future interests given to minors (under the age of 21).
Gifts in trust for a minor are future interests if the minor does not have the ability to access the income or property until reaching the age of majority. These gifts will still qualify for the annual exclusion as long as the property can be used to support the minor and any remaining property is distributed to the child once he or she reaches age 21.8
Example 25-5
Harry transferred $48,500 of cash to the George Trust. The trustee of the George Trust has the discre- tion to distribute income or corpus (principal) for George’s benefit and is required to distribute all as- sets to George (or his estate) not later than George’s 21st birthday. Is this gift eligible for the annual exclusion? If so, what is the amount of the taxable gift?
Answer: Yes, Harry will be entitled to an annual exclusion for the transfer despite the fact that George’s interest is a future one, because the gift is in trust for the support of a minor and the property must distribute the assets to George once he reaches age 21. The amount of the gift is $48,500, reduced to a taxable gift of $33,500 after application of the $15,000 annual exclusion.
8The courts have created another exception to the present interest rule called Crummey power. A discussion of this exception is beyond the scope of this text.
Taxable Gifts
In part 1 of the formula in Exhibit 25-3, current gifts are accumulated for each donee, and this amount includes all gifts completed during the calendar year for each individual.
Current gifts do not include transfers exempted from the tax, such as political contribu- tions. Several adjustments are made to calculate current taxable gifts for each donee. As we’ve seen, each taxpayer is allowed an annual exclusion applied to the cumulative gifts of present interests made during the year to each donee. Next, if a married couple elects to split gifts (discussed below), half of each gift is included in the current gifts of each spouse. The marital deduction for gifts to spouses and the charitable deduction for gifts to charity are the last adjustments to calculate taxable gifts for each donee. We discuss each in turn.
When Harry transferred $500,000 of FFP stock to the DG Trust (Example 25-3), he simultaneously made two taxable gifts, a life estate to Dina and a remainder to George. What is the amount of the tax- able gift of the life estate to Dina and the remainder interest to George, after taking the annual exclusion into account?
Answer: Dina’s life estate is a present interest and would qualify for the annual exclusion. However, George’s remainder is a future interest and will not qualify for the annual exclusion. Harry would file a Form 709 to report total taxable gifts of $485,000 consisting of a $425,540 taxable gift to Dina ($440,540 less the annual exclusion of $15,000) and a taxable gift of $59,460 to George (no annual exclusion is available for a future interest).
Dina George Harry’s Gift Tax Return
Current gifts $440,540 $59,460 $500,000
Annual exclusion −15,000 −0 −15,000
Taxable gifts $425,540 $59,460 $485,000
Example 25-4
THE KEY FACTS Annual Exclusion
• Most gifts are eligible for an annual exclusion of
$15,000 per donee per year.
• Gifts of present interests qualify for the exclusion.
• Gifts of future interests placed in trust for a minor can also qualify for the exclusion.