Take-Away: We now are in that time of the year where thoughts turn to making gifts as part of end-of-the-year tax planning. Yet often trusts are funded with incomplete gifts for federal gift tax reporting purposes. An incomplete gift is one of the salient features of an intentional non-grantor trust (ING-trust) that is designed to avoid state income taxation of accumulated trust income. Some completed gifts are readily apparent, while other completed gifts arise from how title is held. It is timely for a short refresher on gifts.

Background: Lifetime gifts are an important part of any estate plan, especially when the goal is to shift future appreciation of the gift asset away from the donor in order to avoid federal estate taxes. Perhaps there will be less emphasis on lifetime gifts over the next several years due to: (i) the dramatic increase in the federal estate tax exemption ($11.40 million per person next year); (ii) portability of a deceased spouse’s unused applicable exemption amount; and (iii) the desire to obtain income tax basis adjustment on the death of the owner of appreciated assets. [IRC 1014.] The rules surrounding completed gifts, and incomplete gifts, are pretty straightforward, but sometimes a gift can arise without being labeled as such, and sometimes as a surprise to the deemed donor.

  • Gift Basics- Property Law Perspective: For property law purposes, a completed gift requires: (i) the intent to make a gift; (ii) the delivery of the gift to the donee; and (iii) acceptance of the gift by the donee.
  • Gift Basics- Tax Law Perspective: For federal gift tax purposes, neither a donative intent, nor an identifiable donee is required for a taxable gift to occur. Rather, the requirements for a taxable gift only include the following: (i) a completed, irrevocable transfer of property from one person to another, usually described as the donor’s loss of dominion and control over the property; and (ii) the transfer of property must be for less than full and adequate consideration.  [Treas. Reg. 25.2511-2(b).]
  • Gift Tax Calculation: It is always important to keep in mind the key difference between the calculation of the federal gift tax and the federal estate tax. The gift tax is calculated on a tax exclusive basis: that means that the gift tax is paid by the donor, but the gift tax paid is not, itself, subject to gift taxes. In contrast, the federal estate tax is calculated on a tax inclusive basis: that means that the assets of the decedent that are used to pay the federal estate taxes are also subject to the estate tax.
  • Net Gifts: Some gifts can be net gifts, in that the donor shifts the payment of any gift tax liability due onto the donee. The impact of a net gift is a smaller amount that is the ultimate subject of the gift inasmuch as there is consideration received by the donor in exchange for the gift, in the form of the donee paying the donor’s gift tax obligation. There is also the concept of a net, net gift, when the donee also agrees to pay any federal estate tax caused by the taxable gift occurring within three years of the donor’s death, where the gift tax paid on the lifetime gift is also added back to the deceased-donor’s taxable gross estate to calculate the ultimate federal estate tax that is due.
  • Gift Tax Payment: Usually the federal gift tax is filed by April 15 of the year following the year of the gift (with a six-month extension in which to file, but NOT to with regard to the payment of the gift tax, which is still due on April 15.) For the calendar year in which the donor dies, the federal gift tax return must be filed no later than the due date for the donor’s estate tax return.
  • Incomplete Gifts: Following the basic definition of a taxable gift, if the donor can revoke the transfer of property, no completed gift occurs. An example of this would be where the donor, acting as trustee of the irrevocable trust to which the donor transferred property, retains the right to terminate the trust, or to redirect who receives the assets held in trust.  The same result occurs if the donor reserves the power to change the disposition of the property, such as by reserving a power of appointment over the transferred property to the trust. An example of this situation is when the donor transfers property to himself/herself as trustee of a trust and the trustee’s power is not limited by an ascertainable standard; the absence of any ascertainable standard that restricts the donor-trustee’s control over the property causes the transfer to the trust to be incomplete for gift tax reporting purposes- if no gift occurs, then no federal gift tax is owed.
  • A taxable gift does not occur until the donor’s transfer is irrevocable. As such, creating a joint bank account is not a taxable gift, since the donor/transferor possesses the right to remove all of the funds from the joint account at any time. Therefore, the donor’s transfer to the joint account is an incomplete But when the non-contributing joint owner withdraws funds from that joint account, the transfer is complete at that time, and a taxable gift by the donor has occurred. This same treatment applies to US savings bonds and joint brokerage accounts.
  • If the donor creates an irrevocable trust in a jurisdiction where the donor’s creditors can still attach the assets [i.e. a conventional irrevocable trust, not a statutorily authorized self-settled asset protection trust] the donor will be viewed as having retained sufficient dominion and control over the trust’s assets because under local law the donor is able to relegate his/her creditors to the trust’s assets. [Rev. Ruling 77-378; Paolozzi v. Commissioner, 23 T.C. 182 (1954.)]
  • Delayed Gifts: Assume that the donor transfers property but retains control over the transferred asset in such a way that the gift is incomplete, e.g. the retained ability to revoke the transfer. If that retained power is later released or lapses, the transfer then becomes irrevocable and a taxable gift occurs at that time. It is the value of the assets at the time that the donor’s retained power is revoked or lapses that is to be valued for purposes of calculating the federal gift tax. Example: I create an irrevocable trust over which I retain a general power of appointment for the first 5 years after the trust is created; merely with the passing of the 5 years, my power to exercise the power of appointment lapses, and I will be treated as having made a taxable gift 5 years after the initial transfer to the trust. If the lapse of the retained power of appointment occurs at the time of my death, then the previously transferred assets will be taxed in my taxable estate for federal estate taxes, not federal gift taxes.

Non-Taxable Gifts: Many transfers avoid being classified as taxable gifts under the Tax Code. Some of those common exceptions to constituting a taxable gift include the following:

  • Transfers Incident to Divorce: Even though assets change hands between former spouses in a divorce, as a generalization, the transfer of title to assets will be treated as an arms-length transaction and no gift tax results in transfer of the assets between former spouses that is incident to a divorce;
  • Disclaimers: If the technical requirements of IRC 2518 are satisfied the individual who makes a qualified disclaimer is not treated as having made a taxable gift to the ‘taker in default.’ If those technical requirements, e.g. a disclaimer within 9 months of the interest being created, are not fulfilled a taxable gift will occur on the property recipient’s disclaimer, even if it is a valid property interest transferred under the state’s disclaimer statute;
  • Annual Exclusion Gifts: A transfer of $15,000 of a present interest in property to a donee is gift-tax free. [IRC 2503.] But gifts of future interests, like a transfer to a trust for the benefit of a beneficiary, will not qualify as an annual exclusion gift.
  • Direct Gifts for Tuition and Medical Care: A direct transfer from a donor to an educational institution for tuition, or a direct payment from the donor to a provider of medical and health care services is treated as a non-taxable gift. Unlike the annual exclusion gift, which is limited to $15,000 per year per donee, an unlimited amount can be directly paid for tuition or medical and health expenses, and those direct payments will not be treated as annual exclusion gifts. Example: I could pay my child’s hospitalization expenses of $45,000 and still gift to my child $15,000 in the same calendar year. My wife could join in that gift to my child, and we could gift my child $30,000 in a calendar year and still directly pay that child’s hospital expenses.
  • Marital Deduction Gifts: Normally the transfer of a property interest to a spouse will be covered by the unlimited marital gift tax deduction. [IRC 2523.] These gifts can take place either outright, by the creation of joint tenancies, or by the transfer to a qualifying marital trust, e.g. a qualified terminable interest trust (QTIP trust.)
  • Split Gifts: The spouse of an individual donor, for gift tax purposes, may elect to be treated as the donor of one-half (50%) of the value of the gifts the donor makes from his/her separate funds. Consequently, the gift tax liability can be split between the two spouses, even though only the donor spouse possesses the asset that is transferred. [IRC 2513.] Note, an election to split gifts applies to all gifts made by the married donor during the calendar year, i.e. no ‘cherry picking’ of transferred assets subject to the split gift- it is all or none.  Note: an election to split gifts is not effective with respect to a transfer by the donor-spouse to a trust in which the other spouse has a beneficial interest, unless the beneficiary-spouse’s interest is ascertainable, or severable, at the time of the gift.
  • Charitable Gifts: A gift tax charitable deduction is available for transfers to tax exempt entities. [IRC 2522.] Note that if the gift to the charity is in excess of $15,000, a federal gift tax return reporting the gift will be required.

“Unexpected” Taxable Gifts: Occasions can arise when a taxable gift occurs yet the donor is unware that a taxable gift has been made. Common examples of these unexpected gifts follow:

  • Assignment of benefits of an insurance policy;
  • Permitting another to use a vacation home rent-free;
  • Forgiving an outstanding debt;
  • Entering into below-market interest rate loans, which loans are treated as a gift to the borrower under IRC 7872;
  • Selling stock in a closely held business for less than the stock’s fair market value;
  • Exercising a lifetime power of appointment in favor of someone other than the holder himself/herself;
  • The release or lapse of the power of appointment [a release outside the statutory exception of a lapsing “5 and 5” power of withdrawal] under IRC 2514(e);]and
  • Some intra-family transactions that use entities like LLCs and limited partnerships may result in the donor’s retained interest being valued a $0.00, the result being a taxable gift of the full fair market value of the assets transferred to the entity, despite the transferor-donor retaining a valuable interest in the entity. [IRC 2701.]

Conclusion: This is the time of the year when gifts for gift tax purposes are finalized. When making an end-of-the-calendar-year gift, remember the dollar limits for the annual exclusion ($15,000), the all-or-nothing rule that applies to split gifts by spouses, and also keep in mind that not all taxable gifts are readily determined on their face and that some unexpected gifts may have occurred during that calendar year when other transactions occurred.