Estate and Gift Taxes

The Internal Revenue Code defines a gift as a "transfer … in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible." Generally, a gift is any completed transfer of an interest in property to the extent that the donor has not received something of value in return, with the exception of a transfer that results from an ordinary business transaction or the discharge of legal obligations, such as the obligation to support minor children. This definition of gifts does not require the intent to make a gift. An individual may make gifts of both present interests (such as life estates) and future interests (such as remainders) in property (26 U.S.C.A. § 2503(b)).

From a tax standpoint, gifts have two principal advantages over transfers at death. First, gifts allow a donor to transfer property while its value is low, allowing future appreciation in property value to pass to others free of additional gift or estate tax. Second, provided that the gift is of a present interest in property, a donor may transfer up to $11,000 exempt from tax to each donee every calendar year, which allows the donor to reduce the size of the estate remaining at death without any transfer tax consequences.

To constitute a gift, a transfer must satisfy two basic requirements: It must lack consideration, in whole or in part (that is, the recipient must give up nothing in return); and the donor must relinquish all control over the transferred interest. To constitute a tax-exempt gift, a transfer also must constitute a present interest in property. (A present interest is something that a person owns at the present time, whereas a future interest is something that a person will come to own in the future, such as the proceeds of a trust.)

Lack of Consideration A transfer is not a gift if the transferor receives consideration, or something of value, in return for it. For example, if A sells B a used car worth $5,000 and receives $5,000 in exchange, the transfer is not a gift because it is supported by "adequate and full consideration" (26 U.S.C.A. § 2512(b)). But if A sells B the same car for only $2,000, the transfer constitutes a gift of $3,000 because A exchanges $3,000 worth of car for nothing. Finally, if A gives B the car without receiving anything in return, the transfer constitutes a gift of $5,000. Although consideration may be whole or partial, not all transfers for partial or insufficient consideration result in gifts. An arm's-length sale—that is, a sale free of any special relationship between buyer and seller—will not be considered a gift where no intent to make a gift exists, even if the consideration is not adequate. This limit on the definition of gifts excludes bad business deals and forced sales from gift tax treatment.

The Completeness Requirement A transfer constitutes a gift for tax purposes only if the donor has parted with the ability to exercise "dominion and control" over the property transferred. Many transfers of property satisfy this condition. For example, if A takes B out for a birthday dinner, the act of purchasing the dinner is a gift because A cannot regain control over the food that B consumes, or revoke the acts of purchasing and consuming the meal. When the donor has not relinquished absolutely the ability to control or manage the property or its use, however, the "gift" may not be complete for tax purposes. The most common example of an incomplete transfer is a transfer of property to a revocable trust, in which the donor retains the right, as trustee, to alter, amend, or rescind the trust. The gift is not completed because the donor could restore ownership in the trust property to himself or herself, or change his or her mind about who will enjoy or later receive the property.

This distinction between complete and incomplete transfers determines whether property will be included in an estate at death, as well as the value of that property. The value of property that was incompletely transferred during life will be included in the gross estate at death (26 U.S.C.A. §§ 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. Accordingly, if A transfers 1,000 shares of XYZ stock outright to B when it is worth $10 per share, the value of the transfer subject to tax equals zero because A can take advantage of the annual exclusion described in the following section. If A transfers the same stock to a revocable trust for B's benefit, however, and that stock is worth $100 per share on the date of A's death, the entire $100,000 is included and taxable in A's estate. Moreover, any income distributions from the trust after the transfer of property to the revocable trust are taxable gifts to B for which A must pay tax.

Sometimes people make incomplete transfers, rather than completed gifts, in order to retain control over the property, even though appreciation in property value is taxed as a consequence of an incomplete transfer. For various reasons, a person might not want to give up that control. An individual might wish to control the distribution of income from a gift to a trust, or even to receive the income distributions from a trust. Or an individual may create a trust for non-gift reasons, such as to ensure property or investment management. Parents might not trust their children to manage gifts of stock or cash effectively, and thus might retain control to ensure that transfers are not squandered. Occasionally, donors mistakenly believe that revocable trusts are effective devices to avoid paying estate taxes, and simply do not realize that transfers to revocable trusts are incomplete for gift purposes.

Present versus Future Interests: The Annual Exclusion Each individual may make taxexempt gifts of up to $11,000 to each donee every year. To qualify for this so-called annual exclusion, a gift must be of a present interest in property (26 U.S.C.A. § 2503(b)). Completed transfers of future interests, such as remainder interests in real estate or the vested right to the distribution of trust principal on the donor's death, constitute gifts for tax purposes but do not qualify for the annual exclusion.

Only the unrestricted right to use, enjoy, or possess property in whole or in part constitutes a present interest. For example, if A transfers a life estate in his home to B, with a remainder to C, only the life estate to B, which is a present interest in the home, qualifies for the annual exclusion. The remainder interest to C is a completed gift, but does not qualify for the annual exclusion because it is a gift of a future interest. A more subtle and common illustration of this principle involves trust property. For example, A creates an irrevocable trust giving B, the trustee, complete discretion over the distribution of income to C for ten years, at which time the trust will terminate and the entire trust corpus and accumulated income will be paid to C. In this case, A has made a completed gift of the entire trust corpus, but the gift does not qualify for the annual exclusion because C has no present right to the trust income.