Maximizing the Benefits of the
Gift Tax Annual Exclusion:
How It Works and How It Doesn’t
Nancy G. Henderson, Esq.
Henderson, Caverly, Pum & Charney LLP
Rancho Santa Fe, CA
www.hcesq.com
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Maximizing the Benefits of the Gift Tax Annual Exclusion:
How It Works and How It Doesn’t
Nancy G. Henderson, Esq.*
Henderson & Caverly LLP
Rancho Santa Fe, CA
www.hcesq.com
I. Introduction………………………………………………………………………………..1
A. Legislative Purpose and Amount of Exclusion……………………………………1
B. Scope of the Annual Exclusion………………………………………….………...1
C. Business Entities as Donors and Donees………………………………………….3
II. Gifts of Partial Interests in Property………………………...………………….…………5
III. Gifts in Trust ……………………………………………………………………………...5
A. Beneficiary’s Income Interest Can Qualify for the Annual Exclusion……………6
B. 2503(c) Trusts……………………………………………………………………..7
IV. Gifts of Interests in Entities……………………………………………………………...11
A. Gifts of Corporate Stock…………………………………………………………11
B. Gifts of Interests in Partnerships and LLCs……………………………………...11
V. Gifts Under the UTMA and the UGMA…………………………………………………16
VI. Exclusion for Payment of Tuition and Medical Expenses Under Section 2503(e)…………………………………………………………………………………...17
A. General Rule……………………………………………………………………..17
B. Definition of “Educational Organization”……………………………………….17
C. Definition of “Medical Care” and Allowable Medical Expenses……………….19
D. Specific Applications…………………………………………………………….22
VII. Gifts to Fund 529 Plans………………………………………………………………….23
A. Gifts to a 529 Plan Qualify for the Gift Tax Annual Exclusion…………………24
B. Gift Tax Consequences of a Rollover or Change in Beneficiary………………..25
C. Generation-Skipping Transfer Tax Consequences………………………………26
D. New Proposed Regulations Under Section 529(f)……………………………….26
VIII. Attempts to Multiply Available Annual Exclusion Gifts………………………………..29
A. Gifts Intended to Be Passed On to Others……………………………………….29
B. Reciprocal Gifts (or, “You Scratch My Back, I’ll Scratch Yours”)……………..30
C. Gifts to “Cristofani” Trusts………………………………………………………31
IX. Maximizing Transfers Using Gift Splitting……………………………………………...34
A. Rules and Procedures Under § 2513………………………….………………….34
B. When Gifts Cannot Be Split……………………………………………………..36
C. When is the Non-Donor Spouse Considered a Transferor?……………………..36
D. Transfers to Trusts……………………………………………………………….38
X. “Last Minute” Annual Exclusion Gifts…………………………………………………..40
A. Gifts by Incompetent Donors…………………………………………………….40
B. Deathbed Gifts: No Relation-Back of Uncashed Checks……………………….42
XI. Annual Exclusion Gifts Involving Debt…………………………………………………43
A. Gifts of Debt Relief – Debt Owed by a Natural Person………………………….43
B. Gifts of Debt Relief – Debt Owed by a Corporation…………………………….44
C. Gifts Involving Below-Market Interest or No-Interest Loans…………………...45
XII. The Annual Exclusion and the Generation-Skipping Transfer Tax……………………...47
XIII. The Annual Exclusion for Gifts to Non-Citizen Spouses………………………………48
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Maximizing the Benefits of the Gift Tax Annual Exclusion:
How It Works and How It Doesn’t
Nancy G. Henderson, Esq.*
Henderson & Caverly LLP
Rancho Santa Fe, CA
www.hcesq.com
I. Introduction
A. Legislative Purpose and Amount of Exclusion. The gift tax annual exclusion, defined under Section 2503 of the Internal Revenue Code (the “Code”), has been part of the Code since 1932. The principal purpose of the exclusion is, and has always been, to shelter from gift taxation such regular and relatively small gifts as those made for weddings, birthdays and Christmas.[1] The initial amount of the exclusion in 1932 was $5,000 per donor per donee. Eleven years after its enactment, in the midst of World War II, the exclusion was reduced to $4,000, and one year later it was reduced again to $3,000, where it remained until 1981, when it was increased to $10,000. In 1997, the gift tax annual exclusion was indexed for inflation, but adjustments are only made when the cumulative effect of an adjustment is at least $1,000, rounded down to the nearest $1,000. The last such adjustment occurred in 2009, when the exclusion increased to its current $13,000 amount.
B. Scope of the Annual Exclusion
(1) Present Interest Requirement. The gift tax annual exclusion is only available for gifts of present interests in the gifted property. A present interest is an unrestricted right to the immediate use, possession or enjoyment of property or the income from property.[2] The exclusion will not apply to gifts of future interests, which include gifts of reversions, remainders, or other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession or enjoyment at some future date or time.[3] Unless the donee of gifted property is entitled unconditionally to the present use, possession or enjoyment of the property transferred, the gift is one of a future interest for which no exclusion is allowable under the statute.[4] Any restriction that postpones these rights will create a future interest that will not qualify for the annual exclusion.[5]
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(2) The Test Is When Substantial Enjoyment Begins. Whether a gift is a gift of a present interest or a future interest is a question of time. Any barrier that places a period of time between the will of the donee to immediately enjoy what has been given to him or her and the donee’s actual enjoyment will create a future interest.[6] A gift is of a future interest rather than a present interest if there is any postponement of enjoyment of specific rights, powers or privileges that would be forthwith existent if the interest were present.[7]
Importantly, the test for a present interest is not when title in the gifted property vests in the donee, but when substantial enjoyment begins for the donee.[8] Even though a postponement may be of a relatively short duration, it will be fatal to the qualification for the annual exclusion.[9] Further, it is the certainty of the postponement, not the certainty of duration that will disqualify a gift for the exclusion.[10]
A gift will not be one of a future interest simply because it involves a gift of a contractual right such as a bond, a promissory note (even if no interest will be paid until maturity), or a policy of life insurance, the obligations of which are to be discharged by payments in the future.[11] A gift of all of the incidents of ownership in an unmatured insurance policy is a gift of a present interest for which the exclusion applies, even though the policy has no cash surrender value and will lapse unless future premium payments are made. Similarly, a gift in the form of premium payments on such a life insurance policy is a gift of a present interest to the policy owner.[12]
(3) A Gift May Be a Present Interest as to Income and a Future Interest as to Corpus. For purposes of applying the gift tax annual exclusion, a gift may be separated into its component parts, less than all of which will qualify as gifts of present interests for purposes of the annual exclusion.[13] Thus, if the component comprising corpus or capital of the gift does not satisfy the present interest requirements, but the element comprising the income rights does so qualify, an annual exclusion may be allowed for the income rights.[14] A right to income will not be a present interest, however, unless, at the time of the gift, there is a requirement for a steady and ascertainable flow of income to the donee.[15]
(4) Substantial Enjoyment that Requires Action by Others Creates a Future Interest. If a donee can secure substantial enjoyment of gifted property only by joint action with others, or only with the consent of others, the gift will be a contingent gift that will be regarded as a future interest.[16] For example, the requirement that donees of a life insurance policy must act jointly to exercise certain incidents of ownership over the policy will cause a gift of an interest in the policy to fail to qualify for the annual exclusion.[17] Further, the requirement that other partners must consent to transfers of partnership interests or to the liquidation of the partnership, absent other indications of substantial immediate enjoyment, can cause a gift of a partnership interest to be a gift of a future interest that does not qualify for the exclusion.[18]
(5) The Burden of Proving Qualification for the Exclusion is on the Taxpayer. Exclusions, deductions and exemptions are matters of “legislative grace,”[19] and, as such, will be construed narrowly. The burden will therefore fall upon the taxpayer to demonstrate that a particular gift qualifies for the gift tax annual exclusion.[20]
C. Business Entities as Donors and Donees
(1) Business Entities as Donors. Corporations, partnerships, limited liability companies and other entities formed to operate a business for profit (or for collective investment to increase the wealth of the owners) do not generally make gratuitous transfers to individuals. However, if a business entity does give cash or property to an individual or to another entity that is not a shareholder, partner or member without receiving full and adequate consideration in return, the transaction will in most circumstances be treated as a dividend or a distribution to the shareholders, partners or members of the entity followed by deemed gifts by those individuals to the ultimate recipients.[21] If the asset gratuitously transferred by the entity satisfies the requirements for a present interest, then the annual exclusion will be available as between the deemed donors and the deemed donees.
(2) Business Entities as Donees
(a) Gifts to For-Profit Corporations. A gift from an individual to a corporation that is operated for profit is generally classified as an indirect gift to the corporation’s shareholders.[22] Because shareholders do not unilaterally have the power to liquidate the corporation or to declare a dividend in order to obtain the immediate use and enjoyment of the gift, such gifts are generally gifts of future interests that do not qualify for the annual exclusion.[23] On the other hand, a gift to a corporation with a single shareholder should be a gift of a present interest to that shareholder since the sole shareholder can liquidate the corporation at will. There is, however, no authority to support this outcome. Therefore, the better strategy to insure the availability of the annual exclusion is to make a gift to the individual shareholder, who can in turn contribute the gifted cash or property to the capital of the corporation.
(b) Gifts to Non-Profit Corporations. Whether a gift to a non-profit corporation operated for charitable, public, political, or similar purposes is a gift to the corporation or to the individual shareholders or members depends upon the facts and circumstances surrounding the gift.[24] Because the annual exclusion is not required to shelter gifts to qualified charitable organizations from taxation, this issue most typically arises in the context of 501(c)(7) social clubs and other forms of non-charitable tax exempt organizations.
Unfortunately, there is no apparent bright line test for determining when a gift to a non-profit is a gift to the members of the non-profit or a gift to the entity itself. For example, in PLR 9323020, contributions by certain members of a Section 501(c)(7) social club to pay for new facilities were treated as indirect gifts to the non-contributing members. Because the non-contributing members would have the use and enjoyment of the new facilities, the gifts were gifts of present interests to which the annual exclusion applied. Similarly, in PLR 9104024, funds donated to a 501(c)(7) social club to build a clubhouse for the exclusive benefit of the members were treated as gifts to each of the members. Because club members had the immediate and exclusive benefit and enjoyment of the transferred property, the annual gift tax exclusion applied as to each of them.
Contrast, however, the Service’s ruling under similar facts in PLR 9818042. In this ruling, a gift to a Section 501(c)(7) social club for the purpose of making building improvements was deemed a gift to the corporation rather than a gift to its members because the members did not have the right to withdraw the contributed capital. However, because the corporation itself would have the immediate and unrestricted use of the gift, the gift constituted a gift of a present interest to which the annual exclusion applied.
(c) Gifts to Partnerships and LLCs. A gift of cash or property to a partnership or LLC is a gift to the individual partners or members in the same proportions that the gifted cash or property is allocated to the partners’ or members’ respective capital accounts.[25] Such gifts will be gifts of present interests in the contributed cash or property so long as the donee partners have the unrestricted right to withdraw their capital.[26]
II. Gifts of Partial Interests in Property
The value of a gift of a life estate in property will qualify as a gift of a present interest, so long as the donee will have substantial immediate use and enjoyment of the property (such as by producing current income to the donee or by serving as the donee’s personal residence).[27] Similarly, gifts of fractional interests in property are gifts of a present interest, but only if the donee has substantial and immediate use and enjoyment of that property.[28] If, however, the donee’s ability to use and enjoy the gifted fractional property interest is restricted, the gift may be a gift of a future interest. For example, a gift of a fractional interest in real estate subject to an unexpired, prepaid leasehold interest that resulted in delaying the donee’s use of the property by three months was a gift of a future interest in the gifted property that did not qualify for the annual exclusion.[29]
III. Gifts in Trust
It is well settled that gifts in trust are to be regarded for gift tax purposes as gifts to the beneficiaries rather than to the trustees.[30] Such gifts will therefore be considered gifts of future interests unless the beneficiaries have the immediate right to the substantial use and enjoyment of the gifted property or to the income from the property, or if certain statutory exceptions to the present interest requirement are met. The most commonly recognized means for qualifying gifts in trust as gifts of a present interest is, of course, by providing one or more individual trust beneficiaries a “Crummey” power;[31] that is, the power to immediately withdraw cash or property gifted to the trust up to the amount of gift tax annual exclusion. Crummey powers, however, have their disadvantages, including potential gift, income and estate tax consequences to the power holder, the risk of subjecting trust assets to claims of the power holder’s creditors, as well as the actual risk to the donor that the power holder (or the guardian acting for a minor power holder) will exercise his or her withdrawal rights. It is therefore important to be aware of other means pursuant to which gifts in trust may qualify, in whole or part, for the gift tax annual exclusion.
A. Beneficiary’s Income Interest Can Qualify for the Annual Exclusion. It is possible to create a trust in which the beneficiary’s income interest qualifies for the annual exclusion although the principal interest does not so qualify.[32] For gifts made after April 30, 1989, the value of such a qualifying income interest is determined under the valuation rules of Section 7520 of the Code. The valuation tables are contained in IRS Pubs. 1457 and 1458, which are revised every 10 years. Under these tables, if the income interest is for a substantial period of time (such as for the life of a younger income beneficiary), the value of the income interest in the gifted property could represent a substantial portion of the entire gift, and this portion of the gift will qualify for the annual exclusion even if the beneficiary’s right to principal is limited or even non-existent.