Gift tax

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A gift tax is a transfer tax a federal tax applied to an individual giving anything of value to another person.

For something to be considered a gift, the receiving party cannot pay the giver full value for the gift, but may pay an amount less than its full value. It is the giver of the gift who is required to pay the “gift tax.” The receiver of the gift may pay the gift tax, or a percentage of it, on the giver's behalf in the event that the giver has exceeded his/her annual personal gift tax deduction limit.

General overview

If a person gives a lot of money or property to others, they might have to pay a gift tax. But most gifts are not subject to the gift tax. For instance, in the United States one can give up to the annual exclusion amount ($12,000 in 2006 and 2007) to a person, every year, without facing any gift taxes, and without the recipient owing an income tax on the gifts. And a person can give up to $1,000,000 in gifts that exceed the annual limit, total, in their lifetime, before they start owing the gift tax. If one gives $15,000 each to ten people in one year, for example, they would use up $30,000 of their $1 million lifetime tax-free limit—ten times the $3,000 by which their $15,000 gifts exceeds the $12,000 per-person annual gift free amount.

Countries “without” and “with” gift tax legislature

There are countries that do not have a gift tax, such as: Austria, Australia, Argentina, Canada - while Canada does not levy any estate, inheritance or gift taxes, they are effectively imposed through deemed disposition provisions in income tax legislation; the Canada Revenue Agency also investigates and refutes “typical” of some gifting arrangements, where the value of the donations was, for instance, three times the cash payment; so the combined tax credit from the two donation receipts exceeded the donors’ cash outlay, resulting in a positive return to the donor of 49%” to 90% or more, depending on the province and tax rates of the taxpayer - Cyprus, UK ( except of the “seven years” rule, saying that any gift made seven years before a person's death is not subject to inheritance tax, but money given within seven years may be taxed at 40 per cent.)

Then there is a majority of countries ( in EU and elsewhere ), such as: Belgium, Czech Republic, Denmark, Chile, Finland , France, Ireland, Italy ( reintroduced in 2007 ), Japan, Netherlands, New Zealand, Phillipines Portugal, Slovakia, Slovenia, South Africa, Spain, Switzerland ( only cantonal gift tax there, no federal ), USA, etc. all with various gift limits over which the tax applies.

“’Example:”’ A fundamental difference between the UK and the French tax systems – as an example between the no-gift tax country and a gift tax country - is that in the UK, a gift for no consideration is deemed, in principle, a disposal for capital gains tax (CGT) purposes. In France, such a gift attracts gift tax but not CGT. Importantly, French gift tax is not deductible against UK CGT should both be payable on the occasion of the same gift.

Gift tax and capital gains tax liability are set out in the following table, which assumes a gift from individual to individual and is simplified:

Donor →		UK resident		French resident
Donee ↓	Gift from ↓	FGT	CGT	FGT	CGT**
UK resident	UK assets	No	Yes	Yes	No
	French assets	Yes	Yes	Yes	No
French resident	UK assets	Yes*	Yes	Yes	No
	French assets	Yes	Yes	Yes	No

FGT=French gift tax payable

CGT=UK capital gains tax payable

*If the donee has been tax resident in France for at least six tax years in the previous ten.

**The donor must not return to the UK, if previously a UK resident, within five tax years of leaving, otherwise he will face UK CGT as if he were a UK resident at the time the gift was made.

What is a gift?

For tax purposes, a gift is a transfer of property for less than its full value. In other words, if the giver is not paid back, at least not fully, the transfer is a gift.

Gifts not subject to the gift tax

The examples given in this article pertain to the United States. While the actual amounts differ in other countries, the basic principle is the same in all countries that impose gift tax.

In 2006 and 2007 in the United States, an individual could give a lifetime total of $1,000,000 in taxable gifts (that exceed the $12,000 annual tax-free limit) without triggering the gift tax. Beyond the $1,000,000 level, they would actually have to pay a gift tax.

Here are some gifts that are not considered "taxable gifts," and therefore do not count as part of the $1,000,000 lifetime total:

• Present-interest gift of $12,000 per recipient per year.

Present-interest means that the person receiving the gift has an unrestricted right to use or enjoy the gift immediately. An individual can give amounts up to $12,000 to each person, gifting as many different people as they want, without triggering the gift tax.

• Charitable gifts.

• Gifts to a spouse who is a U.S. citizen.

Gifts to foreign spouses are subject to an annual limit of $120,000 in 2006 ($125,000 for 2007), indexed for inflation.

• Gifts of educational expenses.

To qualify for the unlimited exclusion for qualified education expenses, a direct payment must be made to the educational institution for tuition only. Books, supplies, and living expenses do not qualify. In order to pay for books, supplies, and living expenses in addition to the unlimited education exclusion, a gift of $12,000 can be made to the student under the annual gift exclusion.

Example: An uncle who wants to help his nephew attend medical school sends the school $15,000 for a year's tuition. He also sends his nephew $12,000 to help with books and supplies. Neither payment is reportable for gift tax purposes. If the uncle had sent the nephew $27,000 and the nephew had paid the school, the uncle would have made a taxable gift in the amount of $15,000 ($27,000 less annual exclusion of $12,000) which would have reduced his $1,000,000 lifetime exclusion by $15,000.

The "gift tax" is only due when the entire $1,000,000 lifetime gift tax amount is reached. Payments to Qualified State Tuition programs are gifts, so the annual $12,000 amount can be excluded.

In fact, an individual can give up to $60,000 in one year, using up five year's worth of the exclusion, if they agree not to make another gift to the same person in the following four years.

Example: A grandmother contributes $60,000 to a qualified state tuition program for her grandchild. She decides to have this donation qualify for the annual gift exclusion for the next five years, and thus avoids using $48,000 of the $1,000,000 gift tax exemption. As a result, she must wait five years before she can give her grandchild a $12,000 gift without affecting her gift tax exemption.

• Gifts of medical expenses.

Medical payments must be paid directly to the person providing the care in order to qualify for the unlimited exclusion. Qualifying medical expenses include:

1. Diagnosis and treatment of disease.
2. Procedures affecting a structure or function of the body.
3. Transportation primarily for medical care.
4. Medical insurance, including long-term care insurance.

In addition to these gifts that are not taxable, there are some transactions that are not considered gifts, and therefore are definitely not taxable gifts:

• Adding a joint tenant to a bank or brokerage account or to a U.S. Savings bond.

This is not considered to be a gift until the new joint tenant withdraws funds. On the other hand, if you purchased a security in the names of the joint owners, rather than holding it in street name by the brokerage firm, the transaction would count as a gift.

• Making a bona fide business transaction.

Even if you later find out that you paid more than the item was worth, given the fair market value, the transaction is not a gift, just a bad business decision.

Gifts subject to the gift tax

The following gifts are considered to be taxable gifts (when they exceed the annual gift exclusion amount, which was $12,000 in 2006 and 2007) Also, taxable gifts count as part of the $1,000,000 an individual is allowed to give away during their lifetime, before they must pay the gift tax:

• Checks

The gift of a check is effective on the date the donor gives the check to the recipient. The donor must still be alive when the donor's bank pays the check. (This rule prevents people from making "deathbed gifts" to avoid estate taxes.)

• Adding a joint tenant to real estate.

This transaction becomes a taxable gift if the new joint tenant has the right under state law to sever his interest in the joint tenancy and receive half of the property. Note that the recipient only needs to have the right to do so for the transaction to be considered a gift.

• Loaning $10,000 or more at less than the market rate of interest.

The value of the gift is based on the difference between the interest rate charged and the applicable federal rate. Applicable federal rates are revised monthly. This rule does not apply to loans of $10,000 or less.

• Canceling indebtedness.

• Making a payment owed by someone else.

This is a gift to the debtor.

• Making a gift as an individual to a corporation.

Such a donation is considered to be a gift to the individual shareholders of the corporation unless there is a valid business reason for the gift. Such a donation is not a present-interest gift, and thus does not qualify for the $12,000 per person per year exclusion.

Example: A son owns a corporation worth $100,000. His father wants to help his son and gives the corporation $1,000,000 in exchange for a one percent interest in the company. This is a taxable gift from father to son in the amount of $1,000,000 less the value of one percent of the company.

• A gift of foreign real estate from a U.S. citizen.

For example, if a U.S. citizen gives 100 acres he owns in Mexico to someone (whether or not the recipient is a U.S. citizen or a foreigner), it is subject to the gift tax rules if the land is worth more than $12,000.

• Giving real or tangible property located in the U.S.

This is subject to the gift tax rules, even if the donor and the recipient are not U.S. citizens or residents. Nonresident aliens who give real or tangible property located in the United States are allowed the $12,000 annual present-interest gift exclusion and unlimited marital deduction to U.S. citizen spouses, but are not allowed the $1,000,000 lifetime gift tax exemption ( IRS Publ. 950 ).

Gifts to minors

If you give an amount up to $12,000 to each child each year, your gifts do not count toward the million bucks of gifts you are allowed to give in a lifetime before triggering the gift tax. The following gifts count as gifts to a minor:

• Gifts made outright to the minor.

  Gifts made through a custodial account.

Such accounts include those that fall under the Uniform Gifts to Minors Act (UGMA), the Revised Uniform Gifts to Minors Act, or the Uniform Transfers to Minors Act (UTMA). One disadvantage of using custodial accounts is that the minor must receive the funds at maturity, as defined by state law (generally age 18 or 21), regardless of your wishes.

A parent's support payments for a minor are not gifts if they are required as part of a legal obligation. They can be considered a gift if the payments are not legally required.

Example: A father pays for the living expenses of his adult daughter who is living in New York City trying to start a new career. These payments are considered a taxable gift if they exceed $12,000 during the year. However, if his daughter were 17, the support payments would be considered part of his legal obligation to support her and therefore would not be considered gifts.

Advantages of making a gift

Giving a gift may earn more than gratitude:

• It reduces estate taxes.

Moving money out of your estate via lifetime gifts can pay off even if those gifts trigger the gift tax. How? By removing future appreciation on the asset from your estate. Say, for example, that you give your daughter real estate worth $1,012,000, using up your $12,000 exclusion and your entire $1,000,000 lifetime gift exclusion. If the property is worth $3,012,000 when you die, that's $2,000,000 less to be taxed in your estate.

• It reduces income taxes.

If you give property that has a low tax basis (such as a rental house that has depreciated way below its fair market value) or property that generates a lot of taxable income, you may reduce income taxes paid within a family by shifting these assets to family members in lower tax brackets.

• Teaches the family to manage wealth.

Giving family members assets early allows the giver to monitor their ability to handle their future inheritance.

Disadvantages of making a gift

• No step-up in tax basis.

Gifted property generally carries a tax basis equal to the basis the property had when it was owned by the donor.

• Reduces your net worth.

You need to keep enough assets to care for yourself throughout a long or extended retirement or illness.

• The Kiddie Tax.

Giving funds to children under the age of 18 may subject them to the Kiddie Tax, which applies the parents' tax rates to investment earnings of their children that exceed a certain amount. For 2006 and 2007, the kiddie tax trigger is $1,700, so a dependent under age 18's investment earnings above that amount are taxed at the parent's top rate.

General theory behind the gift tax

The federal gift tax exists for one reason: to prevent citizens from avoiding the federal estate tax by giving away their money before they die.

The gift tax is perhaps the most misunderstood of all taxes. When it comes into play, this tax is owed by the giver of the gift, not the recipient. You probably have never paid it and probably will never have to.

The law completely ignores gifts of up to $12,000 each year that you give to any number of individuals. (You and your spouse together can give up to $24,000 a year.)

If you have 1,000 friends on whom you wish to bestow $12,000 each, you can give away $12 million a year without even having to fill out a federal gift-tax form. That $12 million would be out of your estate for good. But if you made the $12 million in bequests via your will, the money would be part of your taxable estate and would trigger an enormous tax bill.

Interplay between the gift tax and the estate tax

Your estate is the total value of all of your assets, less any debts, at the time you die. Under the laws in effect for the tax year 2006, if you die with an estate greater than $2,000,000, the amount of your estate that is over $2,000,000 will be subject to a graduated estate tax that climbs as high as 46%.

That $2,000,000 is an exclusion, meaning that the first $2,000,000 of your estate does not get taxed.( The $2,000,000 exclusion stays the same in 2007, but the top tax rate on estates falls to 45%.)

Some may ask, why not give all of your property to your heirs before you die and avoid that estate tax? Clever though, but all the government's thought of this case, too.

As noted above, you can move a lot of money out of your estate using the annual gift tax exclusion. Go beyond that, though, and you begin to eat into the exclusion that offsets the bill on the first $1,000,000 of lifetime gifts. Go beyond the $1,000,000 and you'll have to pay the gift tax—at rates that mirror the estate tax, up to 46 percent in 2006.

And, that exclusion that protected you from the tax on the first $1,000,000 of gifts? Every $1 you use to pay the tax on lifetime gifts reduces by $1 the exclusion that otherwise would offset estate taxes on up to $2,000,000 after your die.

Bottom line: You can't avoid the estate tax by giving your wealth away. That does not mean there are no estate planning advantages to making gifts. There are, but you will have to consult the gift tax specificities in individual countries.

Effect of estate tax on gifts to charities

Many believe that this has had the beneficial effect of increasing charitable giving. This is far from certain. ( Note: In the U.S. the IRS seems relatively neutral in its recognition of charities, although particular cases of bias may exist. In other countries, however, the exemption has been used as a form of systematic discrimination. Shultz (1926, p. 301), for example, reports that governments in predominantly Catholic countries have discriminated against the Church because the Church’s countervailing power threatens the state (Tabarrok, 1997).

In any case, however, consider a simple example: A man with an estate of $2 million wishes to leave $1 million to his son. With no estate tax he leaves $1 million to his son and the remaining $1 million to charity. If an estate tax of 50 percent is introduced he leaves the entire $2 million estate to his son so his son inherits $1 million and the charity receives nothing. If the estate tax is raised to 100 percent he can no longer leave his son any inheritance and the entire $2 million goes to charity.

Depending on the level of the tax the charity receives $1 million, $0, or $2 million. As with the savings decision the total effect of the estate tax can be decomposed into the price effect, the wealth effect, and the often-ignored base effect (the effect on the heirs).

The exemption reduces the price of charity bequests relative to family or other bequests. If the tax rate is 25 percent, for example, a dollar given to charity costs 75 cents in family bequests. If the tax rate rises to 75 percent a dollar given to charity costs only 25 cents in family bequests.43 As the price of giving to charity falls more is given to charity relative to family. The price effect always works to increase charitable giving.

As the estate tax rises, the testator’s real wealth declines, this gives rise to the wealth effect. Bequests are a normal good --- as wealth increases bequests increase --- the decrease in wealth caused by the tax causes all bequests including bequests to charity to decline. Because the price effect and the wealth effect work in opposite directions no theoretical prediction can be made about the combined effect.

Family fortunes are often amassed over generations, thus if the father’s estate is taxed the son’s estate will be smaller than it otherwise would be. The estate tax, therefore, reduces the size and number of family fortunes ( he base from which the tax is collected ). Since charitable contributions increase with wealth, the reduction in the number and size of family fortunes reduces charitable contributions ( ibid., 1997 ).

No data to exists on this effect. But including the reduction of the tax base in the above calculations pushes one towards the conclusion that the estate tax reduces charitable giving even with the exemption ( ibid., 1997 ).

The “basis issue"

As you consider making gifts, keep in mind that very different rules determine the “tax basis” of property someone receives by gift versus receives by inheritance.

For example, if your son inherits your property, his tax basis would be the fair market value of the property on the date you die. That means all appreciation during your lifetime becomes tax-free.

However, if he receives the property as a gift from you, his tax basis is whatever your tax basis was. That means he'll owe tax on appreciation during your life, just like you would have had you sold the asset. The rule that "steps up" basis to date of death value for inherited assets saves heirs billions of dollar each year.

Example: Your mother has a house with a tax basis of $60,000. The fair market value of the house is now $300,000. If your mother gives you the house as a gift, your tax basis would be $60,000. If you inherit the house after your mother's death, the tax basis would be $300,000, its fair market value.

What difference does this make? If you sell the house for $310,000 shortly after you get it:

• Your gain on the sale is $250,000 ( $310,000 minus $60,000 ) if you got the house as a gift.

• Your gain on the sale is $10,000 ( $310,000 minus $300,000 ) if you got the house as an inheritance.

Conclusion

Supporters of the estate tax and gift tax in the United States argue that it provides progressivity in the federal tax system, provides a backstop to the individual income tax and appropriately targets assets that are bestowed on heirs rather than assets earned through their hard work and effort. However, progressivity can be obtained through the income tax; the estate and gift tax is an imperfect backstop to the income tax.

Critics argue that the tax discourages saving, harms small businesses and farms, taxes resources already subject to income taxes, and adds to the complexity of the tax system. Critics also suggest death is an inappropriate time to impose a tax. However, the effect on savings is uncertain, most farms and small businesses do not pay the tax, and complexity could be reduced through reform of the tax.

The gift tax exists in order to prevent people from having an easy way to avoid or bypass the federal estate tax. If people could easily make unlimited gifts to their heirs, few taxpayers would ever be subject to the estate tax—which can consume up to 50 percent of an estate in excess of $1 million.

The law does permit an unlimited amount of gifts (or bequests) to a spouse without any gift tax or estate tax. But gifts to children or others are subject to a gift tax if the value of the gifts exceeds the available exemptions.

There is an exemption (for 2004) of $1 million of assets from the federal estate and gift tax. It's a "unified" exemption from the tax—which means that it applies to the accumulated total of gifts and to the total of an estate. Technically it's a tax credit that eliminates the estate or gift tax on the first $1 million of an estate.

In most cases, gifts of stock in a family owned corporation or a family limited partnership are treated as gifts of a present interest. However, if the donor retains all control over a corporation or partnership and the donee never derives any income or other benefit from the property, there is a chance the IRS may dispute whether the gift is of a present interest. A popular estate and gift tax planning technique being used currently is to put financial assets into a family owned limited partnership (LP) or limited liability company (LLC).

The parents then make gifts of an ownership interest as limited partners or as members of the LLC. Due to restrictions on the free transferability of such security interests, they are not worth as much to a buyer as an equal share of the underlying assets in the LP or LLC.

Example: Suppose a LP has financial assets of $1 million, a 40 percent share of the LP might only be worth $250,000 to an unrelated buyer. Thus a gift of a 40 percent interest in the LP to a son or daughter would be valued at $250,000 instead of $400,000. The IRS has been trying for years to find a way to stop this practice but thus far with very limited success.

NOTE: In this article, we have only analyzed mostly the U.S. “Gift Tax” environment. Although the world-wide governments’ “Gift Tax” rules vary quite wildly country by country, almost all of the major “Gift Tax” basics mentioned here—with, obviously, different percentages “in” and “out” of the “gift tax heaven”—hold for every country .

References

ISBN links support NWE through referral fees

• Shultz, W. J., The Taxation of Inheritance, Houghton, Mifflin Boston,1926

• Tabarrok, A.” Death Taxes: Theory, History, and Ethics” in: Essays in Political Economy, Ludwig von Mises Institute (Auburn University, Auburn, AL ) USA, 1997; translated into Spanish as Impuestos a la herencia: teoría, historia y ética (Eseade, 2002)

• IRS Publication 950, Introduction to Estate and Gift Taxes.

External links

• IRS article, Estate and Gift Taxes
• IRS publication 950, Introduction to Estate and Gift Taxes
• IRS publication 950, Introduction to Estate and Gift Taxes
• IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return
• Instructions for Form 709, Instructions for Form 709
• Instructions for Form 709, Instructions for Form 709
• French Taxes: Wealth, Inheritance/Succession, Gift and Property Tax

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