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|Ad valorem tax · Consumption tax |
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Gift tax · Income tax
Inheritance tax · Land value tax
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|Flat tax · Progressive tax |
Regressive tax · Tax haven
A gift tax is a transfer tax, a tax applied to an individual giving anything of value to another person. For something to be considered a gift, the transfer must be gratuitous (without compensation) or the receiving party pays an amount less than the item's full value. It is the giver of the gift who is required to pay this “gift tax.” Gift taxes are usually of little import in the generation of revenue; their main purpose is to thwart the use of gifts as a means of avoiding estate taxes (inheritance taxes) that are due on the death of a person of wealth.
However, most gifts are not subject to the gift tax, due to exemptions on gifts to charitable organizations, educational institutions, and others that serve the public good as well as exclusion amounts, which may be substantial. 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. There are countries that do not have a gift tax, and there are also countries that have alternative methods of accomplishing a similar result.
When countries have different systems, the complexity is multiplied. Thus, the gift tax, while not applicable to many and bringing limited revenue to governments, is quite significant in terms of collection and administration. The need for such a tax underscores the problems inherent in all forms of taxation, issues that cannot be solved by legislation because they reflect weaknesses in human nature. It is only when human nature changes from selfishness to caring for others and society as a whole that these problems can be resolved, both by those designing the system and by those paying and collecting the taxes.
What is a gift?
Gift tax is levied on transfers of money or property that are deemed gifts. 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, and the giver may have to pay a gift tax.
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 a gift tax. It is the giver, not the received, who pays 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 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:
- Diagnosis and treatment of disease.
- Procedures affecting a structure or function of the body.
- Transportation primarily for medical care.
- 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.
All business transactions are sales, and therefore subject to sales tax or its equivalent, not gifts. Even if it is later discovered that the amount paid was more than the item was worth, given the fair market value, the transaction is not considered a gift, merely 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:
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 Publication 950).
Gifts to minors
If a person gives an amount of up to $12,000 to each of their children each year, their gifts do not count toward the million dollars of gifts one 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 the donor's 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 one's estate via lifetime gifts can pay off even if those gifts trigger the gift tax. For example, an individual can give their child real estate worth $1,012,000, using up the $12,000 exclusion and the entire $1,000,000 lifetime gift exclusion. If the property is worth $3,012,000 when they die, there is $2,000,000 less to be taxed in the estate.
- It reduces income taxes.
If an individual gives property that has a low tax basis (such as a rental house that has depreciated far below its fair market value) or property that generates considerable taxable income, they may reduce income taxes paid within a family by shifting these assets to family members in lower tax brackets.
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 net worth.
Giving away too much of one's assets can be a problem during 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 was $1,700, which means that the investment earnings of a dependent under age 18 above that amount are taxed at the parent's top rate.
Countries “without” and “with” gift tax legislature
There are countries that do not have a gift tax, including Austria, Australia, Argentina, and Cyprus. The United Kingdom has no "gift tax," per se. However, there is the “seven years” rule which says that any gift made at least seven years before a person's death is not subject to inheritance tax, but money given within seven years may be taxed at 40 percent.
There are also countries that have alternative methods of accomplishing a similar result. For example, 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 percent to 90 percent or more, depending on the province and tax rates of the taxpayer.
Additionally, a large number of countries, including Belgium, Czech Republic, Denmark, Chile, Finland, France, Ireland, Italy (reintroduced in 2007), Japan, Netherlands, New Zealand, Philippines, Portugal, Slovakia, Slovenia, South Africa, Spain, Switzerland (which imposes only cantonal gift tax, not national), and the United States, which all have various limits on gifts over which the tax applies.
When gifts are made between countries with different systems, the situation becomes even more complex. For example, a fundamental difference between the UK and the French tax systems—as an example of a 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 resident||UK 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.
General theory behind the gift tax
The general purpose of a gift tax is to prevent citizens from avoiding estate tax by giving away most of 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. Most people probably have never paid it and probably will never have to. Current federal law in the United States ignores gifts of up to $12,000 each year (for married couples, $24,000 per year), that can be given to any number of individuals.
Thus, if an individual had 1,000 friends on whom they wished to bestow $12,000 each, they could give away $12 million a year without even having to fill out a federal gift-tax form. That $12 million would be out of their estate for good. By contrast, if the same individual made the $12 million in bequests via their will, the money would be part of their taxable estate and would trigger an enormous tax bill.
Interplay between the gift tax and the estate tax
An individual's estate is the total value of all of their assets, less any debts, at the time that they die. Under the laws in effect for the tax year 2006, if one dies with an estate greater than $2,000,000, the amount of the estate that is over $2,000,000 is subject to a graduated estate tax that climbs as high as 46 percent.
That $2,000,000 is an exclusion, meaning that the first $2,000,000 of the estate is not taxed. (The $2,000,000 exclusion remained in effect for 2007, but the top tax rate on estates fell to 45 percent.)
As noted above, an individual can move a lot of money out of their estate using the annual gift tax exclusion. Beyond that, though, eats into the exclusion that offsets the bill on the first $1,000,000 of lifetime gifts. Beyond the $1,000,000 triggers the gift tax—at rates that mirror the estate tax.
Additionally, using the exclusion that exempts the first $1,000,000 of gifts reduces, by the same amount, the exclusion that otherwise would offset estate taxes up to $2,000,000.
Thus, estate tax cannot be avoided by giving away wealth. That does not mean there are no estate planning advantages to making gifts, but they depend on 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.
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. 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).
- Price effect
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. 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.
- Wealth effect
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.
- Base 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 (the 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" (Tabarrok 1997).
No data exists on this effect to date. 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 (Tabarrok 1997).
The “basis issue"
For example, if a son inherits property from his father, his tax basis would be the fair market value of the property on the date the father died. That means all appreciation during the father's lifetime becomes tax-free.
However, if the son receives the property as a gift, his tax basis is whatever the father's tax basis was. That means he will owe tax on appreciation during not only the time of his ownership but on his father's lifetime too, just as the father would have had he sold the asset. The rule that "steps up" basis to date of death value for inherited assets saves heirs billions of dollar each year.
For example, an individual owns a house with a tax basis of $60,000. The fair market value of the house is now $300,000. If this individual gives the house to a son as a gift, the tax basis of the new owner would be $60,000. If, instead the son inherited the house after his parent's death, the tax basis would be $300,000, its fair market value.
What difference does this make? If the son sells the house for $310,000 shortly after receiving it:
- His (taxable) gain on the sale is $250,000 ($310,000 minus $60,000) if he received the house as a gift
- His (taxable) gain on the sale is $10,000 ($310,000 minus $300,000) if he received the house as an inheritance
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.
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 also 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.
NOTE: This article has analyzed mostly only the U.S. Gift Tax environment. Although the gift tax rules vary quite considerably country by country, almost all of the major basics mentioned here, apart from the different percentage rates and exclusion amounts, hold true for every country.
ReferencesISBN links support NWE through referral fees
- Internal Revenue Service. Frequently Asked Questions on Gift Taxes.
- Internal Revenue Service. 2007. IRS publication 950. Introduction to Estate and Gift Taxes. Retrieved June 17, 2008.
- Jacobs, Deborah L. 2008. When Generosity Bumps Into Gift Tax. New York Times. Retrieved June 17, 2008.
- Shultz, William J. 1926. The Taxation of Inheritance. Boston: Houghton Mifflin.
- Tabarrok, Alex. 1997. Death Taxes: Theory, History, and Ethics. Essays in Political Economy. Ludwig von Mises Institute. Retrieved June 21, 2008.
All links retrieved June 21, 2017.
- IRS article, 7 Things You Should Know About Gift Tax
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