STRATEGIC GIFTING

AND

THE GIFT TAX RETURN

Clackamas Chapter

OREGON ASSOCIATION OF TAX CONSULTANTS

October 17, 2016

By

Judi Krussow

PO Box 424

Corbett, OR 97019

503-313-9722

JUDI KRUSSOW

Judi is a Licensed Tax Consultant and Enrolled Agent. She is a member of the Oregon Association of Tax Consultants, the National Association of Tax Consultants, the Oregon Society of Tax Consultants, and the National Association of Enrolled Agent. Currently, Judi is operating a small tax business out of her home.

She has over 50 years’ experience in the tax field preparing not only personal income tax returns, but has specialized in the preparation of estate and trust returns. She has taught personal income tax classes and fiduciary classes for several professional organizations in Oregon and Washington. Ms. Krussow is a 2002 recipient of PESI’s Excellence in Education Award.

TABLE OF CONTENTS

Page

General Comments 1

What is a Gift 1

Indirect Gifts, Interest-Free & Family Loans 2

Debt forgiveness of $14,000/year 3

Transfers not considered gifts 4

Transfers with a Retained Life Estate 5

Creation of Joint Interests 6

Family Limited Partnerships 7

Charitable Remainder Trusts 8

FILING REQUIREMENTS & EXCLUSIONS

Who must file, due dates of returns 11

Extensions, Where to file 12

Annual Exclusion 12

Gift Splitting 13

Adequate Disclosure 13

Form 709

Page 1

Page 1

GIFT TAX

General Comments

The federal gift tax was first enacted in 1924, approximately eight years after the adoption of the estate tax. As originally enacted, the tax was largely ineffective because it was computed on an annual basis without regard to gifts made in prior years.

The tax was repealed in 1926, revived in 1932, and has remained in effect since that date. Unlike its predecessor, the 1932 tax was computed on a cumulative basis—that is, the tax rates applicable to a gift were determined by reference to the total amount of taxable gifts made by the donor during his life, rather than by reference only to taxable gifts made in a given year.

The gift tax is a tax on the transfer of property by one individual to another while receiving nothing, or less than full value in return. The transfer may be direct or indirect (e.g. in trust) and is measured by the value of the property passing from the donor.

The gift tax applies to the transfer by gift of any property. You make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return. If you sell something at less than its full value or if you make an interest-free or reduced-interest loan, you may be making a gift.

Surprise!! – Mom & Dad give you a nice check! Maybe it’s enough for dinner, or maybe it’s more of an “early inheritance”. Either way, do you need to worry about paying tax on your gift?

First, a gift must be quite substantial before the IRS takes notice. A gift of $14,000 or less in a calendar year (2015) doesn’t even count. If a couple makes a gift from joint property, the IRS considers the gift to be given half from each. Mom & Dad can give $28,000 with no worries.

A couple can also give an additional gift of up to $14,000 to each son-in-law or daughter-in-law. The effective annual limit from one couple to another couple, therefore, is $56,000 ($14,000 X 4 = $56,000).

What is a Gift?

When a beneficial interest in property is transferred for less than full and adequate consideration in money or money’s worth, a gift subject to gift tax occurs. Code Section 2511(a) provides that the gift tax is to apply “whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.”

Reg. 25.2511-1(c)(1) states that “any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax.”

Thus, a taxable gift tax can occur by creating a trust, forgiving a debt, making interest-free or below-market interest rate loans, assigning a judgment, or by assigning the benefits of a life insurance policy, as well as by direct transfer of cash or other property.

Gift tax is not an issue for most people

The person who makes the gift (donor) files the gift tax return, if necessary, and pays any tax. If someone gives you more than the annual gift tax exclusion amount ($14,000 in 2015), the donor must file a gift tax return. That still doesn’t necessarily mean they owe gift tax.

For example, if someone gives you $20,000 in one year, and you and the donor are both single, the donor must file a gift Tax return, showing an excess gift of $6,000 ($20,000 - $14,000 exclusion = $6,000). Again, while there is not a gift tax, the gift tax return still must be filed.

Each year, the amount a person gives other people over the annual exclusion accumulates until it reaches the Lifetime Gift tax exclusion. Currently, a taxpayer does not pay a gift tax until they have given away over $5,430,000 (2015) in their lifetime.

Small Gifts are Gifts

Most taxpayers know that direct transfers of cash or property are subject to the gift tax. However, many may not recognize that birthday and holiday gifts must be considered when determining the amount of total gifts for the year.

NOTE: Practitioners should develop procedures for identifying all the gifts made by their clients during the year to ensure they do not inadvertently exceed their annual exclusion ($14,000 for 2015).

Indirect Gifts

Indirect gifts can occur when an economic benefit is transferred, even though the transfer is not characterized as a gift. For example, a surviving spouse, the income beneficiary of a QTIP trust created by her husband’s estate, permitted her children, who were the trustees, to take excessive trustee fees. The IRS ruled that the surviving spouse had made gifts to the children by consenting to the excessive fees because she was allowing the children to take funds that should have been distributed to her (TAM 200014004).

The same result can occur when a mandatory income beneficiary fails to take distributions from a trust and allows those funds to go to other beneficiaries. If wealth is transferred from one family member to another, the IRS will attempt to classify all or part of the transfer as a gift regardless of how the transfer is labeled.

Interest-Free, Family, and Low-Interest Loans

An indirect gift may occur if a creditor forgives a debtor’s obligation to pay accrued interest on a loan, or if the creditor makes a low-interest (or interest-free) loan to the debtor. In general, below-market interest rate loans are re-characterized to impute the payment of interest by the borrower at the applicable federal rate (AFR), compounded semiannually. The lender is treated as providing the funds to the borrower for payment of the imputed interest, thereby creating a gift from the lender to the borrower.

A below-market interest rate loan between family members will generally be treated as a gift loan. If the gift loan is a below-market term loan, the lender makes a gift on the date the loan is made in an amount equal to the excess of the amount loaned over the present value of all required payments under the terms of the loan. The present value is determined on the date of the loan by using a discount rate equal to the AFR [IRC Sec. 7872(f)(1)]

In the case of a demand loan (a loan which carries no fixed repayment date), the amount of the gift is determined by subtracting any interest payments due under the loan from the amount of the interest that would have accrued under the AFR (i.e., the foregone interest) [Prop Reg. 1.7872-6(c)].

Example: Interest-free loan to a son

On January 2, Don loaned his son, Michael, $300,000, payable on demand. Don did not charge interest on the loan. On December 31, the entire loan remained outstanding.

Assuming the Applicable AFR is 5%, Don is deemed to have made a gift to his son on December 31 in the amount of $15,188 ($300,000 x 5%, compounded semiannually). Don must report the gift on Schedule A of Form 709. For each year or part of the year in which the outstanding loan balance exceeds $10,000, Don must file a gift tax return for the amount of foregone interest.

The IRS allows an exception for below-market rate de minimis loans of $10,000 or less. For any days on which the aggregate outstanding amount of the loan does not exceed $10,000, there is no imputed interest and no gift (IRS Sec 7872(c)(2)(A)].

"Transactions within a family group are subject to special scrutiny, and the presumption is that a transfer between family members is a gift". Harwood v. Commissioner [Dec. 40,985],

That presumption may be rebutted by an affirmative showing that at the time of the transfer the transferor had a real expectation of repayment and an intention to enforce the debt. Estate of Van Anda v. Commissioner, supra at 1162.

Forgiving Debt of $14,000 per Year

However, some donors may want to gift larger amounts rather than just the annual exclusion ($14,000 for 2015). A common technique has been for a donor to gift the amount allowed by the annual gift tax exclusion and take a note for any excess. Then, instead of the borrower making payments on the note, the donor simply forgives a portion of the principal (and interest) each year equal to the annual gift tax exclusion. However, a Tax Court decision (affirmed by the 9th Circuit) highlights the potential pitfalls of using this approach with clearly establishing a bona fide debtor-creditor relationship (Elizabeth B Miller v Commissioner).

Whether a transfer is a gift or a loan depends on all of the facts and circumstances, such as whether:

  1. a promissory note or other evidence of indebtedness existed,
  2. interest was charged on the notes,
  3. there was any security or collateral for the notes,
  4. the notes have a fixed maturity date,
  5. a demand for repayment was made
  6. any payment were actually made on the notes
  7. the recipients have the ability to repay their notes, and
  8. the records of the transferor and/or transferee reflect the transfers as loans.

Example: Loan to children treated as gifts

Laura Morgan loaned her two adult sons (Ben & Bill) $100,000 each. Each son signed non-interest bearing notes for $100,000 that were payable on demand or, if no demand, at the end of three years. Within the three-year period, Laura forgave a portion of each loan. Ben also made a $15,000 payment on his loan. However, when the notes matured at the end of the three year, both still had a balance due on them. Laura never made a demand for repayment nor took any steps to enforce collection or to renew the notes. Instead, over the next several years, she forgave the remaining principal due on the loans.

Although there is no one deciding factor on whether these transfers are loans or gifts, the Tax Court was troubled by evidence showing that when the loans were made, there was no apparent intention of demanding repayment. Thus, the Tax Court found that a bona fide creditor-debtor relationship was lacking and that the transfers to each son were in fact gifts rather than loans (Elizabeth B Miller v Commissioner).

Transfers Not Considered a Gift

Some transfers of money are never considered to be gifts, no matter the amount.

For purposes of the gift tax, it’s not a gift if:

  1. It’s given to a husband or wife who is a US Citizen. Special rules apply to spouses who are not US Citizens.
  2. It’s paid directly to
  3. an educational institution for tuition expenses [IRC Sec. 2503(e)],
  4. a medical facility for someone’s medical or dental expenses [IRC Sec. 2503(e)],
  5. gifts to a political organization
  6. gifts to a qualified charity.

You do not have to file a gift tax return to report gifts to your spouse regardless of the amount of these gifts and regardless of whether the gifts are present or future interests.

Medical and Educational Expenses:

For the medical or educational exception, it doesn’t have to be a child, or even a relative, for this exception to apply. These gifts do not count towards any of the limits.

For Educational Expenses, the exclusion applies to tuition for full or part-time students paid directly to the educational institution. Amounts paid for books, room, board, other supplies, or entertainment are not eligible for the exclusion (Reg. 25.2503-6).

The amounts paid for Medical Expenses must meet the requirements for deductibility under IRC Sec. 213(d) and generally include expenses paid for diagnosis, cure, mitigation, treatment, or prevention of disease. Amounts paid for medical insurance are also eligible.

Completed Gift Requirement

A gift is complete if the donor has parted with all dominion and control over the transferred property, leaving the donor with no power to change its disposition, whether for the benefit of the donor, or for the benefit of others.

If the donor reserves any power over the disposition of the property, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon the facts of the case [Reg. 25.2511-2(b)]. An incomplete gift will be included in the donor’s gross estate upon his death.

The distinction between complete and incomplete transfers determines whether property will be included in an estate at death. The value of property that was incompletely transferred during life will be included in the gross estate at death (Code Sections 2035-2038). Therefore, any appreciation in the value of incompletely transferred property will be included and taxed in the estate, whereas none of the value of completely transferred property will be included in the estate.

Gift Paid by Check

Many individuals make gifts at year end to take advantage of the annual exclusion. The IRS ruled that a gift will be considered complete for transfer tax purposes on the date the donee deposits the check, cashes it against his available funds, or presents the check for payment if

(Rev. Rul. 96-56):

  1. The check was paid by the drawee bank when first presented to the drawee bank for payment.
  2. The donor was alive when the check was paid by the drawee bank.
  3. The donor intended to make a gift.
  4. Delivery of the check by the donor was unconditional.
  5. The check was deposited, cashed, or presented in the calendar year for which completed gift tax treatment is sought and within a reasonable time of issuance.

Example:

On December 15th of the current year, Donna gave her daughter a check for $14,000 dated December 13th as part of an annual giving program Her daughter deposited the check in her account on December 30, and the check cleared Donna’s account on January 3rd of the next year.

Since the gift meets all the requirements of Rev. Rul. 96-56, it is considered complete in the year the check was deposited. Thus, Donna is entitled to use her current year annual exclusion to offset the gift.

NOTE: If the donor dies before the check clears the bank, a non-charitable gift will not be complete and will be included in the donor’s estate (Newman).

Transfers with Retained Life Estate

Transfers with a retained life estate are covered in Code Sec. 2036. Life estates are most commonly used with real estate and are created by the owner of the real estate by signing and delivering a deed to the property to the person(s) that the owner wants to give it to, but that contains a clause “Reserving unto the Grantor a Life Estate in the Property conveyed hereby”.

An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express, or implied, that the interest or right would later be conferred [20.2036-1(a)(1)].

The transfer/gift of the property to the persons who are deeded the property is a completed gift. Detailed regulations exist that specify the value of the asset transferred (known as the remainder interest) and the value of the retained life estate (Reg. 1.170A-12) (Reg. 20.2031-7). A gift tax return must be filed with respect to the transfer made of the remainder interest.

Example:

If a person who is 70 years old deeds away their property that is worth $100,000 and retains a life estate, they are deemed to have given away a remainder interest worth $39,478 (39.48%) and to have retained a life estate worth $60,522 (60.52%).

The value of the life estate is important if there is a sale of the property prior to the death of the person holding the life estate.

Creation of Joint Interests

The creation of a joint tenancy with right of survivorship may create a taxable gift, depending on the type of asset involved, the rights of the various joint tenants, and their relative contributions toward the acquisition of the property.

When one joint tenant contributes a disproportionate amount toward the acquisition of property held in joint tenancy, a taxable gift usually results. For example, when one joint tenant purchases property with their own funds and has the title conveyed to themselves and another person as joint tenants with right of survivorship, the purchaser is deemed to have made a gift of half of the property’s value to the noncontributing joint tenant [Reg. 25.2511-1(h)(5)]