May 5, 2023
Gifts – Deceptively Simple
Wealthy individuals are regularly encouraged by their advisors to make gifts of their assets while alive. Lifetime gifts remove the asset, and any future asset appreciation, from the donor’s taxable estate. In addition, if the gifted asset is income-producing, then the donee will report and pay the tax on that income, presumably at a lower marginal income tax bracket than the donor’s tax bracket. That said, while several benefits are associated with lifetime gifts, lifetime gifts are deceptively simple.
Donative intent: For property law purposes, a valid gift in Michigan has three elements: (i) the donor must possess the intent to transfer title to property gratuitously; (ii) there must be actual, or constructive, delivery of the property to the donee, unless the donee is already in possession of the property; and (iii) the donee must accept the property.
Under federal law that imposes gift taxes, neither donative intent nor an identifiable donee is actually required for a taxable gift to occur. Instead, for a taxable gift to exist there must be a completed transfer and the transfer must be for less than full and adequate consideration. Consequently, what might not appear to be a gift under Michigan’s property law will nonetheless be treated as a taxable gift for federal gift tax purposes.
Direct and indirect gifts: A direct gift, as the term suggests, is the transfer of property directly to the donee. However, a donor can make a taxable gift without being aware of it. An example of an indirect gift is the sale of an asset to a child for an amount of money that is later determined by the IRS to be less than the asset’s fair market value. Direct gifts are obvious. Other transactions though may be classified as a taxable gift without the donor even being aware that a taxable gift has occurred. For example, a below-market interest rate that is charged on a loan constitutes a gift by the lender to the borrower on the use of the loan proceeds, the taxable gift being the difference between the interest rate used and the federal applicable rate of interest for the month of the loan. Another example is when an individual holds a general power of appointment with respect to property held in trust and later exercises that power of appointment in favor of another person; the powerholder has made a taxable gift. Or, an individual who releases, or allows to lapse, a power to withdraw assets from a trust may also have made a taxable gift simply by doing nothing.
Present interest annual exclusion gift: In 2023, an individual donor may gift up to $17,000 a year to each donee gift tax-free. This annual exclusion gift opportunity of $17,000 covers all gifts made by the donor during the calendar year, including birthdays, Christmas, graduations, etc. However, this tax-free gift opportunity only applies to a present interest gift. Gifts of a future interest, like a gift to an irrevocable trust for the donee’s benefit, will not qualify for the gift tax annual exclusion; a gift in which the donee’s right of enjoyment in the transferred property is deferred until some future date will not qualify for the gift tax annual exclusion. For example, if the donor owns vacant land and transfers that land to an LLC, and then proceeds to gift some of the LLC units to the donee, those gifted LLC units may not satisfy the present interest requirement if the LLC’s Operating Agreement limits the transfer or sale of LLC units, or the LLC does not generate any present income that is distributable to the donee-member.
Gifts to a minor’s trust: The present interest condition does not apply when a gift is made to a trust that is established for a minor beneficiary. To qualify as a minor’s trust only the minor child can be the trust’s beneficiary, the child must possess the right to withdraw all trust assets upon reaching the age 21 years, and all of the trust assets must be included in the minor’s taxable estate should he or she die prior to age 21 years.
Revocable gifts to a 529 account: Gifts can be made to a qualified education IRC 529 account that is established for a donee-beneficiary. The donor may make up to five years of annual exclusion gifts in one year to the one 529 account, or $85,000 at one time. However, the donor cannot make any future annual exclusion gifts to the beneficiary for the following 5-year period. Unlike other tax-free gifts made by the donor which are irrevocable, the donor to the 529 account can either (i) change the beneficiary of the 529 account or (ii) revoke the gift and regain the contributed funds from the 529 account, albeit subject to a 10% penalty and income tax on the 529 account’s earnings at the time of the termination of the account.
Health and tuition transfers not gifts: A donor can make unlimited gifts to pay for certain tuition and medical expenses of the donee without incurring any gift tax liability. However, the gift must be in the form of a direct payment from the donor to the medical expense provider or the school for the donee’s tuition. Giving the money to the donee to pay these expenses will not qualify for this exception for unlimited health or tuition gifts. These direct payments are not even treated as annual exclusion gifts; they are in addition to annual exclusion gifts to the donee. The definition of medical expenses is fairly broad while the definition for tuition is narrow and literal.
Refusal to accept a gift: A disclaimer is an irrevocable and unqualified refusal to accept an interest in property. The individual who makes a qualified disclaimer is not treated as having made a taxable gift. However, if the individual’s disclaimer fails to satisfy the conditions imposed under the Tax Code, and it is not made within 9 months after the interest has been conferred on the disclaiming individual, then the non-qualified disclaimer is treated as a taxable gift by the disclaiming individual for gift tax purposes, even when their disclaimer meets the requirements of a valid disclaimer under Michigan’s disclaimer of property interest laws. For example, a father dies and leaves assets in trust for his children; one son disclaims his beneficial interest in the trust, but the disclaimer is made 10 months after his father’s death. That is a non-qualified disclaimer; the result is a taxable gift of the interest in the trust is made by the son.
Gifts to a spouse: The marital deduction for federal gift tax purposes is of an unlimited amount, unless the spouse is a non-citizen. As such, a gift tax-free transfer can be either: (i) outright; (ii) by creation of joint tenancy between the spouses; or (iii) by the creation of certain qualifying interests in irrevocable trusts, called QTIP trusts. However, transfers of assets made prior to the marriage or after a divorce do not qualify for the federal gift tax unlimited marital deduction. To qualify for the unlimited marital deduction the gift to a spouse must be a nonterminal interest; loosely translated, this means that a transferred property interest will terminate or fail upon the lapse of a period of time, or upon the occurrence or non-occurrence of an event, such as a life estate, a term of years, or an annuity interest. For example, a gift in trust for the benefit of a husband for 20 years will not qualify for the marital deduction, because after 20 years the husband’s interest in the property ends, even if the husband is still alive. Similarly, a gift in trust to a wife who is to receive all income from the trust, unless she remarries, is also a terminal interest that does not qualify for the unlimited marital deduction. These terminal interests will cause the transferring spouse to pay a federal gift tax.
Gifts to charity: A tax-free gift can also be made to charity, but there are numerous limitations on the type of gift made and/or the amount that can be claimed as a charitable income tax deduction. One important limitation is that the gift to a charity cannot be a split-interest unless the gift takes a specific form. For example, a gift in trust where the donor retains the right to all trust income for life will not qualify for a federal income tax charitable deduction; the donor’s retained right in the trust must take the form of a fixed annuity amount or an annual percentage of the trust’s assets for the donor to be able to deduct the value of the remainder interest in the trust that passes to the charity. Also, for such a gift in trust that ultimately passes to the charity, the charity’s present interest in the trust must be at least 10% of the value of the assets that are gifted into the trust by the donor.
Pros and cons of gifts: One negative to making a lifetime gift is that if the property that is given has a low income tax basis, that low basis will not be adjusted to its fair market value on the donor’s death. Thus, the opportunity to avoid capital gains after the death of the donor will be lost when the asset is sold; there will be a tax basis adjustment only on the death of the donee.
One positive to a lifetime gift (candidly, seldom viewed as such by the donor!) is that the gift tax that is actually paid by the donor is tax exclusive. This means that the 40% gift tax is only paid on the value of the asset that is actually transferred by the donor – no gift tax is imposed on the money that is used to pay the gift tax. In contrast, the federal estate tax, also assessed at a flat 40%, is tax inclusive, which means that the federal estate tax is also assessed on the money that is actually used to pay the federal estate tax. Thus, it is more tax-effective, if a tax must be paid, to pay a gift tax on lifetime gifts than it is to pay the federal estate tax when assets are transferred on the donor’s death.
Advising an individual to make lifetime gifts is a good strategy. As always seems to be the case, the “devil is in the details.” Any time the Tax Code uses the word qualified, that should be “code” that there will be conditions that have to be met.