PART 2—COURSE READING

FEDERAL GIFT TAXATION

Stephan R. Leimberg and Ted Kurlowicz*

PURPOSE, NATURE, AND SCOPE OF GIFT TAX LAW
1. Purpose of Gift Tax Law
  
  If individuals could give away their entire estates during lifetime without the imposition of any tax, rational people would arrange their affairs so that at death nothing would be subject to the federal estate tax. Likewise, if individuals could give income-producing securities or other property to members of their families, freely and without tax cost, the burden of income taxes could be shifted back and forth to lower brackets, and income taxes would be saved.
  
  The federal gift tax was designed to equalize the transfer tax treatment between taxpayers who make inter vivos (lifetime) transfers and those who transfer their assets at death. The unified nature of the federal estate and gift tax system combines both tax systems and a common set of rates is applicable to both inter vivos and after-death transfers.
2. Nature Of Gift Tax Law
  
  The gift tax is an excise tax. It is not levied directly on the gift itself or on the right to receive the property, but rather on the right of an individual to transfer money or other property to another for less than full and adequate consideration. (The tax is imposed only on transfers by individuals, but certain transfers involving corporations are treated as indirect transfers by corporate stockholders.)
  
  The gift tax is based on the value of the property transferred. It is computed on a progressive schedule based on cumulative lifetime gifts. In other words, the tax rates are applied to total lifetime taxable gifts (all gifts less the exclusions and deductions) rather than only to taxable gifts made in the current calendar year.
3. Scope of Gift Tax Law
  
  The Treasury regulations summarize the comprehensive scope of the gift tax law by stating that "all transactions whereby property or interests are gratuitously passed or conferred upon another, regardless of the means or device employed, constitute gifts subject to tax." Almost any transfer or shifting of property or an interest in property can subject the donor (the person transferring the property or shifting the interest) to potential gift tax liability to the extent that the transfer is not supported by adequate and full consideration in money or money’s worth—that is, to the extent that the transfer is gratuitous. Direct and indirect gifts, gifts made outright, and gifts in trust (of both real and personal property) can be subject to gift tax. The gift tax is imposed on the shifting of property rights, regardless of whether the property is tangible or intangible. It can be applied even if the property transferred (such as a municipal bond) is exempt from federal income or other taxes.
  
  This broad definition of gifts includes transfers of life insurance, partnership interests, royalty rights, and gifts, checks, or notes of third parties. Forgiving a note or cancelling a debt may also constitute a gift.
  
  Almost any party can be the donee (recipient) of a gift subject to tax. The donee can be an individual, partnership, corporation, foundation, trust, or other "person." (A gift to a corporation is typically considered a gift to the other shareholders in proportion to their proprietary interests. Similarly, a gift to a trust is usually considered to be a gift to the beneficiary or beneficiaries in proportion to their interests.)
  
  In fact, a gift can be subject to the tax (assuming the gift is complete) even if the identity of the donee is not known at the date of the transfer and cannot be ascertained.
TAX ADVANTAGES OF LIFETIME GIFTS

The unification of the estate and gift tax systems in 1976 was an attempt to impose the same tax burden on transfers made during life as on those made at death. The disparity of treatment between lifetime and testamentary gifts is minimized through the adoption of a single unified estate and gift tax rate schedule. Both lifetime and testamentary gifts are subject to the same rate schedule and are taxed cumulatively, so that gifts made during a lifetime increase the rate at which gifts made at death will be taxed. Although at first glance it seems that unification eliminated the advantages of inter vivos gifts, there are still some significant benefits.
1. $10,000 Annual Exclusion
  - First, an individual can give up to $10,000 gift tax free every year to each of an unlimited number of donees. This means that a father desiring to make a $10,000 gift to each of his four children and four grandchildren could give a total of $80,000 each year without gift tax liability. (This $10,000 annual gift tax exclusion is described in greater detail later.) Since an individual’s spouse can also make such gifts, up to $20,000 per year of money or other property—multiplied by an unlimited number of donees—can be transferred gift tax free. In the example above, the donor and spouse together could give up to $160,000 annually on a gift-tax-free basis. In fact, one spouse can make the entire gift if the other spouse consents; the transaction can then be treated as if both spouses made gifts. This is known as gift splitting. Split-gift provisions are also covered in detail later.
2. Avoidance Of Gross-Up Rule
  - A second tax incentive for making an inter vivos gift as opposed to a testamentary gift is that if a gift is made more than 3 years prior to a decedent’s death, the amount of any gift tax paid on the transfer is not brought back into the computation of the gross estate. In the case of a sizable gift, avoidance of the gross-up rule can result in meaningful tax savings. The gross-up rule means that all gift tax payable on taxable gifts made within 3 years of the donor’s death is included in calculating the value of the gross estate, even if the gift itself is not added back. For example, if an individual makes a $1 million taxable gift, the $345,800 gift tax payable (or paid) on that transfer will not be brought back into the estate tax computation if the gift was made more than 3 years before the donor died.
3. Removal Of Appreciation From Donor’s Estate
  - Third, when a gift is made during lifetime, any appreciation accruing between the time of the gift and the date of the donor’s death escapes estate taxation. This may result in a considerable estate tax (as well as probate and inheritance tax) savings. If a father gives his daughter stock worth $100,000 and it appreciates to $600,000 by the date of the father’s death 5 years later, only the $100,000 value of the stock at the time of the gift enters into the estate tax computation as an adjusted taxable gift. The $500,000 of appreciation does not enter into the computation as an adjusted taxable gift and thus does not increase the decedent’s marginal estate tax bracket. An excellent example of both advantages is a gift of life insurance made more than 3 years prior to the insured’s death. A $1 million death benefit could be removed from a donor’s estate at the cost of only the gift tax, if any, on the value of the policy at the time of the transfer (in the case of a whole life policy, usually roughly equivalent to the policy cash value plus unearned premiums at the date of the gift). If the insured lives for more than 3 years after the transfer and the premiums are present-interest gifts of $10,000 a year or less, there is no estate tax inclusion, and none of the appreciation (the difference between the death benefit payable and the adjusted taxable gift, if any, at the time the policy was transferred) is included in the insured’s estate.
4. Income Tax Savings
  - Fourth, there are often strong income tax incentives for making an inter vivos gift. This advantage derives from moving taxable income from a high-bracket donor to a lower-bracket donee. Of course, this advantage is limited by the tax rules related to unearned income of children under age 14.
5. Estate Tax Savings And Deferral
  - Fifth, gifts of the proper type of assets may enable a decedent’s estate to meet the mathematical tests for an IRC Sec. 303 stock redemption, an IRC Sec. 6166 installment payout of taxes, and the IRC Sec. 2032A special-use valuation of farms and certain other business real property.
6. No Gift Taxes Paid Until Unified Credit Exceeded
  - Sixth, no gift taxes have to be paid until the transferor makes taxable gifts in excess of the unified credit in the year of the gift. (The exemption equivalent for 1984 was $325,000. It increased to $400,000 in 1985 and to $500,000 in 1986. For 1987 and later years the exemption equivalent is $600,000.) Only taxable gifts in excess of a donor’s unused exemption equivalent cause a loss of income and/or capital because of gift taxes paid.

ALLOWABLE REDUCTIONS FOR GIFT TAX

Gift tax rates are applied to a net figure—taxable gifts. Before the tax on a transfer is computed, certain reductions are allowed. These reductions may include

gift splitting
an annual exclusion
a marital deduction
a charitable deduction

Gift Splitting

The tax law permits a married donor—with the consent of the nondonor spouse—to elect to treat a gift to a third party as though each spouse has made one-half of the gift. The election must be made on the applicable gift tax return of the donor spouse.

Gift splitting is an artificial mechanism: even if one spouse makes the entire gift, for tax computation purposes the single transfer is treated as though each spouse made only one-half of the gift. This means that the rate of tax that each will pay is calculated separately by reference to each spouse’s prior gifts.

Furthermore, if a nondonor spouse agrees to gift splitting, it has a direct effect on the future gift tax and estate tax that the nondonor spouse may eventually have to pay if the gift exceeds the annual exclusion. Even though the nondonor spouse did not actually make one-half of the gift, to the extent it exceeds the $10,000 annual exclusion it becomes an adjusted taxable gift to be added (1) to all other gifts deemed to have been made for purposes of calculating the future gift tax bracket and (2) to the taxable estate at the nondonor spouse’s death.

Gift splitting applies only to gifts by a married donor to a third party and only with respect to noncommunity property. It was introduced into the tax law to equate the tax treatment of common-law taxpayers with that of community-property residents. When one spouse earns a dollar in a community-property state, 50 cents is automatically and immediately deemed to be owned by the other spouse. Therefore if the couple gives that dollar to their daughter, each spouse is treated as giving only 50 cents.

Gift splitting places the resident of a common-law state in the same position. For example, if a married individual in a common-law state gives her son a gift worth $20,000 and the requisite gift-splitting election is made, this individual is considered to have given only $10,000 for purposes of the gift tax computation. Her spouse is treated as if he has given the other $10,000—even if none of the gift was his property.

If the spouses elect to split gifts to third parties, all gifts made by either spouse during that reporting period must be split.

The privilege of gift splitting applies only to gifts made while the couple is married. Therefore gifts made by the couple before they were married may not be split, even if they were married later during the same calendar year. Likewise, gifts made after the spouses are legally divorced or after one spouse dies may not be split. But gifts made before one spouse dies may be split even if that spouse dies before signing the appropriate consent or election; the deceased spouse’s executor can make the appropriate election or consent.

The Annual Exclusion

Purpose of the Exclusion

A de minimis rule is one that is instituted primarily to avoid and lessen administrative record keeping. The annual gift tax exclusion is a classic example of such a rule. It was instituted to eliminate the need for a taxpayer to keep an account of or report numerous small gifts. Congress intended that the amount of the annual exclusion be set large enough so that no reporting is required in the case of wedding gifts or other occasional gifts of relatively small amounts.

Effect of Gift Splitting Coupled with the Exclusion

Generally the annual exclusion allows the donor to make, tax free, up to $10,000 worth of gifts (other than future-interest gifts, defined below) to any number of persons or parties each year. Since an exclusion of up to $10,000 is allowed per donee per year, the total maximum excludible amount is determined by multiplying the number of persons to whom gifts are made by $10,000. For example, if an unmarried man makes cash gifts this year of $2,000, $8,000, and $16,000 to his brother, father, and son, respectively, the $2,000 and the $8,000 gifts are fully excludible, and $10,000 of the $16,000 gift to his son is excludible.

TABLE 1 Effect of Gift Splitting with Annual Exclusion
Donee	Amount of Gift toDonee	Treated as if Donor Gave	Exclusion	Subjectto Tax	Treated as if Nondonor Spouse Gave	Exclusion	Subject to Tax
Brother Father Son Totals	$ 2,000 8,000 16,000 $26,000	$ 1,000 4,000 8,000 $13,000	$ 1,000 4,000 8,000 $13,000	0 0 0 $0	$ 1,000 4,000 8,000 $13,000	$ 1,000 4,000 8,000 $13,000	0 0 0 0

If the same individual is married and his spouse consents to split the gift, each spouse is deemed to have made one-half of the gift. This means that both spouses can maximize the use of their annual exclusions. Assuming the nondonor spouse makes no gifts, the preceding table shows that none of the $26,000 is subject to tax.

Present versus Future Interest

An annual exclusion is allowed only for present-interest gifts and is denied to gifts of future interest. A present interest is one in which the donee’s use, possession, or enjoyment begins at the time the gift is made. Stated technically, a present interest is an immediate, unfettered, and ascertainable right of the donee to use, possess, or enjoy the gift.

A future interest refers to any interest or estate in which the donee’s possession or enjoyment will not commence until some period of time after the gift is made. Technically, "future interest is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time."

Clearly the outright and unrestricted gift of property to a donee (even a minor) that passes legal and equitable title qualifies as a present-interest gift.

A single gift can be split into two parts: one is a present interest that qualifies for the annual exclusion, and the other is a future interest that does not.

Example: A widowed donor creates a trust this year and places income-producing property in the trust. The income is payable annually to the donor’s son for life, and at the son’s death the remainder is payable to the donor’s grandson. The gift to the son of the right to receive income annually for life is a present-interest gift since he has an unrestricted right to its immediate use, possession, or enjoyment. If the son is 30 years old at the time of the gift and $100,000 is placed into the trust, the present value of that gift is $91,617 ($100,000 times .91617, which is the present value of an income stream payable for the life of a 30-year-old based on a principal amount of $100,000. The factor for the life interest (.91617) is based on the current—at the time of this writing—interest rate of 6.6 percent and current mortality. The valuation of life estates, term interests, and remainder interests is based on an interest rate adjusted monthly as mandated in IRC Sec. 7520. . . . Since the annual exclusion is available for the gift of a life income interest, $10,000 of the $91,617 gift is excludible.

If the donor in the above example is married and the appropriate election and consent are filed, each spouse can claim a $10,000 exclusion even though only the donor places property in the trust. No exclusion is allowed with respect to the ultimate gift of the corpus to the grandson, since his possession or enjoyment may not commence until sometime in the future.

If the donor provides that her son is to receive income for 10 years and then the principal is to pass to her grandson, and the donor places only $1,000 in the trust, the exclusion for the gift of the income interest is $472.25 ($1,000 times .47225, the value of a 10-year term interest at the current— at the time of this writing—interest rate of 6.6 percent). Gift splitting with a spouse does not increase the amount of the exclusion, and each spouse is allowed a $236.12 exclusion. Again, no exclusion is allowed for the gift of the future interest (remainder) that passes to the grandson at the end of 10 years, even though he has an interest that cannot be forfeited. This is because he does not have the right to immediate possession or enjoyment; any delay in the absolute and immediate right of use, possession, or enjoyment of the property or the income therefrom is fatal to the gift tax annual exclusion.

Note that if the trustee in either situation above is given the power or discretion to accumulate the income, rather than distribute it, the donor’s son would not receive the unfettered and immediate use of the income, and it would be impossible to ascertain the present value of the income interest. For example, assume the trustee is directed to pay the net income to the son for as long as the son lives but is authorized to withhold payments of income during any period the trustee deems advisable and add such payments to corpus. In this case, even the income interest is a gift of a future interest, and no annual exclusion is allowed.

When the trust agreement requires the trustee to accumulate income for a time (or until the occurrence of a specified event), the income interest is also a future interest.

Gifts of Life Insurance. An outright, no-strings-attached gift of life insurance qualifies for the annual exclusion. Life insurance (and annuity policies) are subject to the same basic test as any other type of property in ascertaining whether the interest created is a present or future interest, even though the ultimate obligation under a life insurance policy—payment of the death benefit—is discharged in the future. It is not necessary that a policy have cash value at the time of the gift for the transfer to be a present interest. But the annual exclusion is lost if the donor prevents the donee from surrender-ing the policy or borrowing its cash value or limits the donee’s right to policy cash values in any way.

Gifts of Life Insurance to Trusts. If the grantor transfers a life insurance policy to a trust, the present-interest rules instead of the future-interest rules discussed above apply. That is, the annual exclusion is available only if the donee-beneficiaries receive a present interest. Simply transferring life insurance to a trust does not typically create a present-interest gift. The life insurance trust usually pays no income, or the income is used to provide premium payments and is not currently available to donees. Qualifying as a present interest would be a significant hurdle for the life insurance trust if there were no exceptions to the general rule. Remember that, typically, the initial cost of the life insurance policy transferred to the trust and the annual premiums that must be contributed to the trust by the grantor each year are under $10,000. Therefore, if the annual exclusion applies, most irrevocable life insurance trusts will not incur gift tax liability. Fortunately it is possible to design an irrevocable life insurance trust that qualifies as a present-interest gift for annual-exclusion purposes.

Crummey Powers. The present-interest requirement for annual-exclusion purposes indicates that a gift in trust has to currently provide the donees with an unfettered right to use, possess, and benefit from the trust. The benefit could be a current disposition of income or corpus, or the beneficiaries could be provided with current withdrawal rights or powers. Tax rules provide that if each trust beneficiary has, at a minimum, the so-called Crummey demand powers, the transfer to the trust qualifies as a present-interest gift for the beneficiaries. The demand powers held by the beneficiary should allow the beneficiary the noncumulative right to demand the lesser of (1) the annual addition to the trust, (2) $5,000, or (3) 5 percent of the trust corpus at the time the power is exercised. When there is more than one beneficiary, the Crummey powers should be given ratably to each. Since there is no chance that the beneficiaries can request an amount greater than the grantor’s annual addition to corpus, the insurance policy will not be stripped by the beneficiaries. In actual practice, the beneficiaries cooperate since they realize that the long-term benefit of the trust is more important than the current demand rights. For the irrevocable life insurance trust with Crummey powers to qualify as a present-interest gift, the trustee must notify each beneficiary of the right to exercise the powers. This right must exist for a reasonable period of time each year (such as 30 days). If each beneficiary’s demand power is limited to the amounts specified above, the annual lapse of this power is not treated as a taxable gift by the lapsing beneficiaries.
Identity of Donees

The number and amount (or availability) of annual exclusions depend on the identity of the donee(s), the type of asset involved, and the restrictions, if any, placed on the asset. When a gift is made in trust, the beneficiaries of the trust (and not the trust itself) are considered the donees. For instance, if there are three life-income beneficiaries, up to three annual exclusions could be obtained. Conversely, if five trusts are established for the same beneficiary, only one exclusion is allowed. (Technically, the actuarial value of each gift in trust to that beneficiary is totaled and added to direct gifts the donor made to that beneficiary to ascertain whether and to what extent an annual exclusion remains and is allowable for the present transfer.)

Transfers to two or more persons as joint tenants with right of survivorship, tenants by the entirety, or tenants in common are considered multiple gifts. Each tenant is deemed to receive an amount equal to the actuarial value of his or her interest in the tenancy. If, for example, one person has a one-half interest in a tenancy in common, a cash gift of $6,000 to the tenancy is treated as a $3,000 gift to that person. This is added to other gifts made directly to the donee by the same donor to determine how much of the exclusion is allowed. (However, note that a tenancy by the entirety, where neither spouse can sever an interest without the other’s consent, is considered a future-interest gift and does not qualify for the annual exclusion.) In all probability, gifts to partnerships should follow the same rules: a gift to a partnership should be treated as if made to each partner in proportion to his or her partnership interest.

Gifts to Minors

Outright gifts to minors pose no particular qualification problem concerning the annual exclusion. The IRS states in a revenue ruling that "an unqualified and unrestricted gift to a minor, with or without the appointment of a guardian, is a gift of a present interest." But there are, of course, practical problems involved, especially with larger gifts. Although minors can buy, sell, and deal with some limited types of property, such as U.S. savings bonds, gifts of other types of property create difficulties. For example, some states do not give minors the legal capacity to purchase their own property, care for it, or sell or transfer it. Some states forbid the registration of securities in a minor’s name, and a broker may be reluctant to deal in securities titled in a minor’s name. In many states, a minor has the legal ability to disaffirm a sale of stock sold at a low price that later rises in value. Furthermore, a buyer receives no assurance of permanent title when a minor signs a real estate deed. Legal guardianship of the minor is not a viable answer in many situations. Since guardianship laws are rigid, a guardian must generally post bond, and periodic and expensive court accounting is often required. Most important, a parent may not want to give a minor control over a large amount of cash or other property.

To minimize these and other practical problems involved with most large gifts to minors, such transfers are generally made in trust or under some type of guardianship or custodian arrangement. An incredible amount of litigation developed over whether such gifts qualified for the annual exclusion. Sec. 2503 of the Internal Revenue Code provides clear and precise methods of qualifying gifts to minors for the annual exclusion. There are three basic means of qualifying cared-for gifts to minors under Sec. 2503:

a Sec. 2503(b) trust
a Sec. 2503(c) trust
the Uniform Gifts (Transfers) to Minors Act

Sec. 2503(b) Trust. To obtain an annual exclusion for gifts to a trust, an individual can establish a trust that requires income to be distributed at least annually to (or for use of) the minor beneficiary. Income is the actual accounting income of the trust as determined by the trust agreement and state law. The trust agreement states how income is to be used and gives the trustee no discretion as to its use. The minor receives possession of the trust principal whenever the trust agreement specifies. A distribution does not have to be made by age 21; corpus may be held for as long as the beneficiary lives—or for any shorter period of time. In fact, the principal can actually bypass the income beneficiary and go directly to the individuals whom the grantor—or even the named beneficiary—specifies. The trust agreement can also control the dispositive scheme if the minor dies before receiving trust corpus. Trust assets do not have to be paid to the minor’s estate or appointees.

In reality, the mandatory payment of income to (or in behalf of) beneficiaries seems onerous—especially while the beneficiary is a minor. But such income can be deposited in a custodial account and used for the minor’s benefit or left to accumulate in a custodial account until the minor reaches majority (at which time the unexpended amount is turned over to the beneficiary).

Although the entire amount of property placed in a 2503(b) trust is considered to be a gift, for exclusion purposes it is split into two parts: income and principal. The value of the income—measured by multiplying the amount of the gift by a factor that considers both the duration over which the income interest will be paid and the discounted worth of $1 payable over the appropriate number of years—is eligible for the annual exclusion. The balance of the gift (principal) does not qualify for the annual exclusion.

For example, assume a donor places $10,000 into a Sec. 2503(b) trust that is required to pay her 10-year-old daughter all income until she reaches age 25. The present value of the income the daughter receives over those 15 years is $7,793.66. If the income is payable for her entire life, the present value jumps to $9,894.90.

It is important to note that, according to at least one revenue ruling, the annual exclusion is denied for a 2503(b) trust that permits the principal to be invested in non-income-producing securities, real estate, or life insurance policies.

Sec. 2503(c) Trust. The Sec. 2503(b) trust described above has the advantage of not requiring distribution of principal when the minor reaches age 21, but it does require a current (annual) distribution of income. The Sec. 2503(c) trust, on the other hand, requires that income and principal be distributed when the minor reaches age 21 but does not require the trustee to distribute income currently.

Certain requirements make it possible for a donor to obtain the annual exclusion by a gift to a minor under Sec. 2503(c): the trust must provide that (1) income and principal are expended by or on behalf of the beneficiary, and (2) to the extent not so expended, income and principal pass to the beneficiary at age 21, or (3) if the beneficiary dies prior to that time, income and principal go to the beneficiary’s estate or appointees under a general power of appointment. (The annual exclusion is not lost merely because local law prevents a minor from exercising a general power of appointment.)

A substantial amount of flexibility can be built into the 2503(c) trust. Income that has been accumulated, as well as any principal in the trust, can be paid to the donee when the donee reaches age 21. This may be indicated if the sums involved are not substantial. But the donor may want the trust to continue to age 25 or some other age. It is possible to provide continued management of the trust assets and at the same time avoid forfeiting the annual exclusion by giving the donee, at age 21, a right for a limited period of time to require immediate distribution by giving written notice to the trustee. If the beneficiary fails to give written notice, the trust can continue automatically for whatever period the donor provided when the donor established the trust. Alternatively, some states have lowered the age of majority from 21 to 18, or some in-between age. A trust can provide that the distribution can be made between the age of majority and age 21 without jeopardizing the Sec. 2503(c) exclusion. (The rule is that 21 is the maximum rather than the minimum age at which the trust assets must be made available.)

A 2503(c) trust has a number of advantages over the type of custodianship found in the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) arrangements described below, as shown in table 2.

Uniform Gifts (Transfers) to Minors Act. The Uniform Gifts (Transfers) to Minors Act (or comparable laws, such as the Model Gifts to Minors Act) provides an alternative to the Sec. 2503(c) trust. The Uniform Gifts to Minors and Uniform Transfers to Minors Acts are frequently utilized for smaller gifts because of their simplicity and because they offer the benefits of management, income and estate tax shifting, and the investment characteristics of a trust with little or none of the document drafting costs.

The Uniform Gifts to Minors Act, a model statute that has been adopted by all states in some form, permits adults to make gifts of certain statutorily permissible property to minors with the property registered in the name of a custodian. The custodian, who may be the donor, holds the property for the minor. The initial forms of UGMA statutes included restrictive limits on the categories of investments permitted for a UGMA transfer. For example, a UGMA transfer could not include real property.

Many states amended their statutes to include broader investment powers, and approximately one-half of the states adopted a new statute—the Uniform Transfers to Minors Act (UTMA). The UTMA statutes generally permit any type of property transfer.

For example, in Pennsylvania the UGMA gift may be made as follows

if the subject of the gift is a security in registered form, by registering it in the name of the donor, other adult person, or trust company, followed in substance by the words "as custodian for (Name of Mi-nor) under the Pennsylvania Uniform Gifts to Minors Act"

TABLE 8-2 Gifts to Minors
Trust	UGMA or UTMA	UGMA or UTMA
Type of property Dispositiveprovisions Investmentpowers Time of distribution of assets	Donor can make gifts ofalmost any type of property. Donor can provide for disposition of trust assets if donee dies without having made disposition. Trustee may be given broad, virtually unlimited investment powers. Trust can continue automatically even after beneficiary reaches age 21. Trustee can make distribution between state law age of majority and age 21.	Type of property must be permitted by appropriate statute. Gift of real estate may not be permitted. Disposition must follow statutory guidelines. Custodian limited to investment powers specified by statute. Custodial assets must be paid to beneficiary upon reaching majority.

if the subject of the gift is a security not in registered form, by delivering it to an adult other than the transferor or to a trust company, accom-panied by a statement of gift in the following form or substance, signed by the donor and the person designated as custodian: I, (name of transferor or name and representative capacity if a fiduciary), hereby transfer to (name of custodian), as custodian for (name of minor) under the Pennsylvania Uniform Transfers to Minors Act, the following: (Insert a description of the custodial property sufficient to identify it.)

Name: _________________________________________
______________________________________________
(Signature)
(name of custodian) acknowledges receipt of the property described above as custodian for the minor named above under the Pennsylvania Uniform Transfers to Minors Act.
Dated:________________________________________
_______________________________________________ (Signature of custodian)
if the subject of the gift is money, by paying or delivering it to a broker or financial institution for credit to an account in the name of the transferor, an adult other than the transferor, or a trust company followed in substance by the words "as custodian for (name of minor) under the Pennsylvania Uniform Transfers to Minors Act"
if the subject of the gift is a life or endowment insurance policy or annuity contract, by causing the ownership of such policy or contract to be recorded on a form satisfactory to the insurance company or fraternal benefit society, in the name of the transferor, an adult other than the transferor, or a trust company, followed in substance by the words, "as custodian for (name of minor) under the Pennsylvania Uniform Transfers to Minors Act," and having the policy or contract delivered to the person in whose name it is thus registered as custodian

How Type of Asset Affects the Exclusion

The type of asset given and the restrictions placed on that asset may prevent the donor from obtaining the annual exclusion.

Clearly, an outright gift of non-income-producing property qualifies for the gift tax exclusion. Does the same property qualify if placed in a trust? The IRS uses three arguments to disallow annual exclusions: (1) the right to income (which is the only current right given to a life beneficiary) from a gift of non-income-producing property is a future interest since its worth is contingent on the trustee’s converting it to income-producing property; (2) it is impossible to ascertain the value of an income interest in property that is not income producing at the time of the gift; and (3) if a gift tax exclusion is allowable, the exclusion must be limited to the actual income produced by the property (or expected to be produced) multiplied by the number of years over which the income beneficiary is expected to receive the income—discounted to its present value according to tables in government regulations.

Non-dividend-paying stock held in trust is a good example of property that may not qualify for the gift tax exclusion. In a number of cases, the IRS has been successful in disallowing an exclusion for gifts in trust that consisted of stock in closely held corporations paying no dividends. Gifts in trust of life insurance policies pose the same problem: a mother assigns policies on her life to a trust created to provide financial protection for her daughter. The trust provisions do not provide the daughter with Crummey withdrawal powers. At the mother’s death, the policy proceeds will be reinvested and the daughter will receive the net income of the trust for life. Is the mother allowed the exclusion for the present value of her daughter’s income interest? The regulations say no, since the daughter will not receive income payments until her mother dies.
Summary of Rules for Ascertaining the Amount and Availability of the Gift Tax Annual Exclusion

The rules regarding the annual exclusion can be summarized as follows:
- A gift in trust is a gift to a trust’s beneficiaries and not to the trust for determining the number of annual exclusions to which a donor is entitled.
- The value of an income interest in a trust qualifies for the exclusion if the trustee is required to distribute trust income at least annually—even if the value of the remainder interest does not qualify.
- The gift of an interest that is contingent upon survivorship is a gift of a future interest. (If a gift in trust is made with income going to the grantor’s son for life and then to the grantor’s daughter for life, the gift to the son will qualify but the daughter’s interest will not.)
- A gift is one of a future interest if enjoyment depends on the trustee’s discretion. (The nature of the interest must be present as of the date of the gift and is not, for example, determined by what the trustee may subsequently do or not do in the exercise of a discretionary power.)
- A gift must have an ascertainable value to qualify for the exclusion. (The exclusion is denied if the donor or anyone else can divert the income from the beneficiary.)

Exclusion Of Transfers For Educational And Medical Expenses

For public policy reasons, Congress provided another exclusion for specific qualified transfers. A gratuitous transfer is excluded from taxable gifts if made on behalf of an individual (1) for tuition to an educational institution for the education or training of the individual or (2) to a provider of medical services for medical care received by the individual. This exclusion is not limited in amount and is independent of the annual exclusion. However, it is important to note that the payments must be made directly to the provider of services to qualify for the exemption. Payments made directly to an individual as reimburse-ment for educational or medical expenses incurred are taxable gifts unless such gifts are eligible for an annual exclusion.
Gift Tax Marital Deduction

An individual who transfers property to a spouse is allowed an unlimited deduction (subject to certain conditions) known as the gift tax marital deduction. The purpose of the gift tax marital deduction is to enable spouses to be treated as an economic unit.
1. Requirements to Qualify for Gift Tax Marital Deduction
  
  For a gift to qualify for the gift tax marital deduction, the following conditions must be satisfied:
  - The recipient of the gift must be the spouse of the donor at the time the gift is made.
  - The recipient spouse must be a U.S. citizen.
  - The property transferred to the donee spouse must not be a terminable interest that disqualifies the gift for the marital deduction.
  Most of the qualifications above are self-explanatory. The terminable-interest rule for marital-deduction gifts is similar to the rule employed for estate tax purposes. The effect of these rules is that generally no marital deduction is allowed if the donee spouse’s interest in the transferred property terminates after a lapse of time or on the occurrence or nonoccurrence of a specified contingency at which time the donee spouse’s interest passes to another person who receives his or her interest in the property from the donor spouse and who did not pay the donor full and adequate consideration for that interest. The exception is for a gift of qualifying terminable interest in property (QTIP) assets. (In the past, a gift or bequest of a terminable interest in property—one that could end at a spouse’s death, for example, and therefore escape taxation—was not eligible for the gift or estate tax marital deduction.)
  
  Current law provides that if a donor spouse gives a donee spouse a qualifying income interest for life, it qualifies for the gift (or estate) tax marital deduction. To qualify for QTIP treatment the following requirements must be met:
  - The surviving spouse must be entitled to all the income from the property (and it must be payable annually or more frequently).
  - No person can have a power to appoint any part of the property to any person other than the surviving spouse.
  - The property must be taxable at the donee spouse’s death. (In the case of a bequest, the first decedent’s executor makes an irrevocable election that the property remaining at the surviving spouse’s death is taxable in the survivor’s estate.)
2. Lifetime Gifts to an Alien Spouse
  
  The marital deduction is denied for gifts to a spouse who is not a U.S. citizen. Presumably, the purpose of this limitation is to prevent the avoidance of the federal estate and gift tax system by permitting deductible transfers to an alien spouse, who could, conceivably, avoid the transfer tax system entirely by leaving the country with the gifted assets. However, a special provision was enacted to permit significant nontaxable transfers to an alien spouse as an exception to the rule. Transfers to an alien spouse qualify for a special annual exclusion of $100,000 each year if
  - the gift otherwise qualifies as an annual-exclusion gift
  - the gift meets the requirements for a gift tax marital deduction (except for the requirement that the donee is a U.S. citizen)
3. The Gift Tax Charitable Deduction
  
  A donor making a transfer of property to a qualified charity may receive a charitable deduction equal to the value of the gift (to the extent not already covered by the annual exclusion). The net effect of the charitable deduction—together with the annual exclusion—is to avoid gift tax liability on gifts to qualified charities. There is no limit on the amount that can pass gift tax free to a qualified charity.
  
  The gift tax deduction is allowed for all gifts made during the calendar year by U.S. citizens or residents if the gift is to a qualified charity. A qualified charity is defined as (1) the United States, a state, territory, any political subdivision, or the District of Columbia, if the gift is to be used exclusively for public purposes; (2) certain religious, scientific, or charitable organizations; (3) certain fraternal societies, orders, or associations; and (4) certain veterans’ associations, organizations, or societies.
  
  Technically, the charitable deduction is limited and is allowable only to the extent that the gift is included in the total amount of gifts made during the year. The phrase total amount of gifts refers to gifts in excess of the annual exclusion.
  
  Example: This year a single client makes total gifts of $45,000: $20,000 to his daughter and $25,000 to The American College. After taking annual exclusions, the client’s gross gifts are $10,000 (the gift of $20,000 to the daughter, less a $10,000 exclusion) and $15,000 (the $25,000 gift to The American College, less the $10,000 annual exclusion). Therefore the client’s charitable deduction is limited to $15,000.
  
  The reason for the rule that the annual exclusion is taken first is obviously to prevent the allowance of a charitable deduction equal to the total amount of the gift, which, in turn, when added to the allowable annual exclusion, would result in an extra $10,000 exclusion. In certain cases, a donor transfers a remainder interest to a qualified charity. A noncharitable beneficiary is given all or part of the income interest in the transferred property, and the charity receives the remainder at the termination of the income interest. When a charitable remainder is given to a qualified charity, a gift tax deduction is allowable for the present value of that remainder interest only if at least one of the following four conditions is satisfied:
  - the transferred property was either a personal residence or a farm
  - the transfer was made to a charitable remainder annuity trust
  - the transfer was made to a charitable remainder unitrust
  - the transfer was made to a pooled-income fund
  The terms charitable remainder annuity trust, charitable remainder unitrust, and pooled-income fund are defined in essentially the same manner as they are for estate and income tax purposes.

CALCULATING GIFT TAX PAYABLE

Computing the gift tax payable begins with ascertaining the amount of taxable gifts in the current reporting calendar year. To find the amount of taxable gifts, all gifts are valued first. If appropriate, the gift is then split, and annual exclusions as well as the marital and charitable deductions are applied. Note that the unified gift and estate tax credit and the issue of whether gift tax actually has to be paid are irrelevant for the limited purpose of computing taxable gifts. An example and computation format illustrates the process.

Calculating Taxable Gifts For A Single Donor

Assume a single donor makes certain outright gifts in the last month of this year: $60,000 to his son, $2,500 to his daughter, $4,000 to his grandson, and $5,000 to The American College (a total of $71,500).

	Computing Taxable Gifts

Step 1	List total gifts for year		$71,500

Step 2	Subtract one-half of gift deemed to be made by donor’s spouse (split gifts)	$______0

	Gifts deemed to be made by donor		$71,500

Step 3	Subtract annual exclusion(s) ($21,500)

	Gifts after subtracting exclusion(s)		$50,000

Step 4	Subtract marital deduction	$______0

Step 5	Subtract charitable deduction	$______0

	Taxable gifts		$50,000

Although there were four donees, the annual exclusion is $21,500 and does not total four times $10,000 or $40,000. This is because the annual exclusion is the lower of (1) $10,000 and (2) the actual net value of the property transferred. In this example, the annual exclusion for the $2,500, $4,000, and $5,000 gifts is limited to the actual value of each gift.

Calculating Taxable Gifts For A Married Donor With Gift Splitting

A slight change in the facts in the example above illustrates the computation when the donor is married and his spouse consents to splitting their gifts to third parties. In this case, only one-half of the gifts made by the donor is taxable to the donor (one-half of the gifts made by the donor’s spouse to third parties is also included in computing the donor’s total gifts). A separate (but essentially identical) computation is made for the donor’s spouse. That computation would show (a) the other half of the husband’s gifts to third parties plus (b) one-half of the wife’s actual gifts to third parties (since all gifts must be split, if any gifts are split).

	Computing Taxable Gifts

Step 1	List total gifts for year		$71,500

Step 2	Subtract one-half of gift deemed to be made by donor’s spouse (split gifts)	($35,750)

	Gifts deemed to be made by donor		$35,750

Step 3	Subtract annual exclusion(s) ($15,750)

	Gifts after subtracting exclusion(s)		$20,000

Step 4	Subtract marital deduction	$______0

Step 5	Subtract charitable deducted $_____ 0

	Taxable gifts		$20,000

(The calculation on the wife’s return parallels this return.)

Note that in this example the annual exclusions are computed after the split and each donor’s exclusions are

gift to son	$10,000
gift to daughter	1,250
gift to grandson	2,000
gift to The American College	2,500
	$15,750

If the married donor in this example also makes an outright gift of $120,000 to his wife, the computation is as follows:

	Computing Taxable Gifts

Step 1	List total gifts for year		$191,500

Step 2	Subtract one-half of gift deemed to be made by donor’s spouse (split gifts)	($ 35,750)

	Gifts deemed to be made by donor		$155,750

Step 3	Subtract annual exclusion(s) ($ 25,750)

	Gifts after subtracting exclusion(s)		$130,000

Step 4	Subtract marital deduction	($110,000)

Step 5	Subtract charitable deduction	$______0

	Taxable gifts		$ 20,000

Calculating Gift Tax Payable

When the total value of taxable gifts for the reporting period is found, the actual tax payable is computed using the following method:

	Computing Gift Tax Payable

Step 1	Compute gift tax on all taxable gifts regardless of when made (use unified rate schedule)	$_______

Step 2	Compute gift tax on all taxable gifts made prior to the present gift(s) (use unified rate schedule)	$_______

Step 3	Subtract step 2 result from step 1 result	$_______

Step 4	Enter gift tax credit remaining	$_______

Step 5	Subtract step 4 result from step 3 result to obtain gift tax payable	$_______

Calculating Taxable Gifts And Gift Tax Payable With A Charitable Gift

For instance, a widow gives $200,000 to her daughter and $25,000 to The American College in the last month of this year. Both transfers are present--interest gifts. If she has made no previous taxable gifts in prior years, the computa-tion is as follows:

	Computing Taxable Gifts

Step 1	List total gifts for year		$225,000

Step 2	Subtract one-half of gift deemed to be made by donor’s spouse (split gifts)	$_______0

	Gifts deemed to be made by donor		$225,000

Step 3	Subtract annual exclusion(s) ($20,000)

	Gifts after subtracting exclusion(s)

Step 4	Subtract marital deduction	$_______0

Step 5	Subtract charitable deduction	$15,000

	Taxable gifts		$190,000

To find the gift tax payable on this amount, the procedure is as follows:

	Computing Gift Tax Payable

Step 1	Compute gift tax on all taxable gifts regardless of when made	$ 51,600

Step 2	Compute gift tax on all taxable gifts made prior to the present gift(s)	$_______0

Step 3	Subtract step 2 result from step 1 result	$ 51,600

Step 4	Enter gift tax (unified) credit remaining	$192,800

Step 5	Subtract step 4 result from step 3 result to obtain gift tax payable	$_______0

The step 1 entry, $51,600, is found by using the unified rate schedule for estate and gift taxes, which shows that the tax on $150,000 is $38,800 and that there is a 32 percent tax on the remaining $40,000, which comes to $12,800 ($38,800 + $12,800 = $51,600). Note that the unified rate table is used regardless of when the gifts were made.

Calculating Gift Tax Payable With Prior Years’ Gifts

If the donor in the example above made $100,000 of additional taxable gifts in prior years, the computation is as follows:

	Computing Gift Tax Payable

Step 1	Compute gift tax on all taxable gifts regardless of when made	$ 84,400

Step 2	Compute gift tax on all taxable gifts made prior to the present gift(s)		$ 23,800

Step 3	Subtract step 2 result from step 1 result		$ 60,600

Step 4	Enter gift tax credit remaining ($192,800 – $23,800)		$169,000

Step 5	Subtract step 4 result from step 3 result to obtain gift tax payable		$_______0

This illustrates the cumulative nature of the gift tax (the $100,000 prior taxable gifts pushed the present $190,000 of taxable gifts into a higher bracket) and the progressive rate structure. The tax on $290,000 is $84,400, and the tax on $100,000 of prior taxable gifts is $23,800. The difference, $60,600, is the tax on the current gifts.

Credits

The Tax Reform Act of 1976 unified the gift and estate tax systems and created a unified credit against gifts made either during lifetime or at death. The gift tax credit, which provides a dollar-for-dollar reduction of the tax otherwise payable, is $96,300 in 1984, $121,800 in 1985, $155,800 in 1986, and $192,800 in 1987 and later years. In other words, each individual has available to him or her during lifetime or at death one unified credit against the gift or estate tax. If not exhausted by lifetime gifting, the unified credit remaining is available against the estate tax after death.

REPORTING GIFTS AND PAYING TAX
1. Future-Interest Gifts
  
  A gift tax return is required for a gift of a future interest regardless of the amount of the gift. For example, if a grantor transfers $100,000 to an irrevocable trust payable to the grantor’s spouse for life and then to the grantor’s son, a gift tax return is required regardless of the value of the son’s remainder interest. The term future interest is defined in the same manner as for annual exclusion purposes: a gift in which the donee does not have the unrestricted right to the immediate use, possession, or enjoyment of the property or the income from the property.
2. Present-Interest Gifts
  
  Because of the annual exclusion no gift tax return is due until present-interest gifts made to one individual exceed $10,000. At that point, a return must be filed on an annual basis when a gift to one person in one year exceeds $10,000, even if no gift tax is due (such as when gift-splitting provisions eliminate the tax). For example, if a married woman gives $10,001 to her son, the transfer is tax free. However, a gift tax return is required, because the gift exceeds the annual-exclusion limit and because the gift is split. A return must be filed when a couple elects to split gifts.
  
  A gift tax return must be filed and the gift tax, if any is due, must be paid by April 15 of the year following the year in which the taxable gifts were made. If an extension is granted for filing the income tax return, the time limit for filing the gift tax return is automatically extended also.
  
  Gifts to a spouse that qualify for the marital deduction do not require the filing of a gift tax return.
3. Gifts To Charities
  
  No return must be filed and no reporting is required for charitable contribu-tions of $10,000 or less—except when a noncharitable gift is also made. In that case, the charitable transfer must be reported at the same time the noncharitable gift is noted on a gift tax return. If the value of the charitable transfer exceeds $10,000, the general rule is that the transfer must be reported on a gift tax return for that year.
  
  If a split-interest gift is made to a charity (when there are charitable and noncharitable donees of the same gift), the donor cannot claim a charitable deduction for the entire value of the transfer. In this case, the donor must file and report the transfer subject to the filing requirements discussed above. For example, if an individual establishes a charitable remainder trust with the income payable to the individual’s daughter for life and the remainder payable to charity at her death, a gift tax return must be filed.
4. Liability For Payment
  
  The donor of the gift is primarily liable for the gift tax (Sec. 2502(c)). However, if the donor for any reason fails to pay the tax when it falls due, the donee becomes liable to the extent of the value of the gift (Sec. 6324(b)). This liability begins as soon as the donor fails to pay the tax when due.
  
  Generally the tax must be paid at the time the return is filed. However, reasonable extensions of time for payment of the tax can be granted by the IRS—but only on a showing of undue hardship. This means more than inconvenience. It must appear that the party liable to pay the tax will suffer a substantial financial loss unless an extension is granted. (A forced sale of property at a sacrifice price is an example of a substantial financial loss.)
RELATIONSHIP OF THE GIFT TAX SYSTEM TO THE INCOME TAX SYSTEM

When the gift tax law was written, one of its principal purposes was to complement the income tax law by discouraging taxpayers from making gifts to reduce their taxable income. It is true that to some extent the gift tax does supplement the income tax system and there is some overlap. However, it is important to note that the tax treatment accorded a given transaction when the two taxes are applied will not necessarily be consistent.

A lack of consistency between the gift and income tax systems forces the practitioner to examine three different issues:
- Is the transfer one on which the gift tax will be impo-sed?
- Will the transfer con-sti-tute a taxable exchange subject to the income tax?
- If the transfer was made in trust, will the income from the transferred property be taxable to the donor, or will the incidence of taxation be shifted to the recipient of the property (the trust or its beneficiaries)?
In summary, the treatment of a transaction for gift tax purposes is not necessarily consistent with the income tax consequences. Therefore it is important not to place undue reliance on the provisions and interpretations of the income tax law when determining probable results or potential interpretations of the gift tax system (or vice versa).

DETERMINATION OF THE BASIS OF GIFT PROPERTY

When property is transferred from a donor to a donee and the donee later disposes of the property through a sale or other taxable disposition, gain or loss depends on the donee’s basis. In return, the donee’s basis is carried over from the donor. This means the donor’s basis for the gift property immediately prior to the gift becomes the donee’s basis for that property.

For example, if an individual pays $10 a share for stock and transfers it when it is worth $20, and the donee sells it when it is worth $30, the donee’s basis for that property is the donor’s $10 cost. The gain therefore is the difference between the amount realized by the donee, $30, and the donee’s adjusted basis, $10.

An addition to basis is allowed for a portion of any gift tax paid on the transfer from the donor to the donee. The addition to basis is for that portion of the tax attributable to the appreciation in the gift property (the excess of the property’s gift tax value over the donor’s adjusted basis determined immediately before the gift). This increase in basis may be added to the donee’s carryover basis for the property. Stated as a formula, the basis of gifted property is the donor’s basis increased as follows:

Net appreciation in ___value of gift___x	Gift tax paid
Amount of gift

This means that the basis carried over from the donor is increased only by the gift tax on the net appreciation in the value of the gift. For example, an individual bought stock worth $40,000 and gave it to his daughter when it was worth $100,000. If the donor paid $18,000 in gift taxes at the time of the gift, the daughter’s basis is as follows:

Donor’s basis	$40,000

plus

Gift tax on net appreciation in value (here, the difference between the $100,000 value of the gift at the time of transfer and the donor’s cost, $40,000)

	$ 60,000	x $18,000 = $10,800
	$100,000

	equals

	Daughter’s basis $50,800

RELATIONSHIP OF THE GIFT TAX SYSTEM TO THE ESTATE TAX SYSTEM

The 1976 Tax Reform Act provided for a unified estate and gift tax system. The unification correlates the two systems in three essential ways:
- Lifetime gifts and testamentary transfers are taxed by using the same tax rates (so-called unified tax rates), rather than separate and different rates.
- There is a single unified tax credit that can be applied to lifetime and testamentary gifts. The unified tax credit replaces what was previously a specific estate tax exemption and a specific gift tax exemption.
- The estate tax imposed at death is found by adding gifts made during lifetime (after 1976) to the taxable estate (any gift tax paid on post-1976 transfers can be subtracted to arrive at the estate tax liability).
For these reasons there are many correlations between the two tax systems. Like the income tax law, however, the gift tax law is not always consistent with the estate tax law. When a gift is made, certain issues must be considered. In spite of the lifetime transfer, will the transferred property be included among the other assets in the donor’s gross estate on the donor’s death? Will the property a donor transfers during his or her lifetime be subjected first to a gift tax and later included in the donor’s gross estate? For example, if the donor transfers property but retains a life interest, both gift and estate taxes will be payable. Although any gift tax paid (after the unified credit is exhausted) may be subtracted in arriving at the estate tax liability, because of the time value of money—that is, the donor’s loss of the use of the money paid in gift taxes—the net result is less favorable than a mere washout (that is, in essence, it is a prepayment of the death tax).
GIFT SELECTION FACTORS

Gift tax strategy must be part of a well-planned and carefully coordinated estate planning effort. This, in turn, requires careful consideration as to the type of property to gift. There are a number of strategies and factors that must be examined in selecting the types of property that are appropriate for gifts. Some of the general considerations in planning gift tax property are as follows:
- Is the property likely to appreciate in value? Other things being equal, planners generally try to pick property that will appreciate substantially in value from the time of the transfer. Removal of the appreciation in the property (as well as the income from the property) from the donor’s estate should save a meaningful amount of estate taxes. The most suitable type of property will have a low gift tax value and a high estate tax value. Life insurance, for example, is property with a low present value but a high appreciation potential. If held until the date the insured dies, its appreciation in value is guaranteed. Furthermore, since there are no carryover-basis problems, the proceeds are exempt from income tax. However, if the death of the donor is imminent, gifts of donor-owned life insurance are not recommended. The 3-year rule under IRC Sec. 2035 will cause inclusion of the policy proceeds in the decedent-donor’s estate if the policy is gifted within 3 years of death.
- Is the donee in a lower income tax bracket than the donor? Income splitting between the donor and the donee can be obtained by transferring high-income-producing property to a family member in a lower bracket. Naturally, high-income-producing property is best for this purpose. Generally, though, high-income-producing property should not be gifted to children under the age of 14 because of the kiddie tax rules. High-dividend participating preferred stock in a closely held business or stock in a successful S corporation is a good example of high-income-producing property. (Note: S corporation stock should not be gifted if the transfer will terminate S status.) Conversely, if the donor is in a lower bracket than the donee (for instance, if the parent who is retired makes a gift to a financially successful middle-aged child), the use of low-yield, growth-type property may be indicated.
- Is the property subject to indebtedness? A gift of property subject to indebtedness that is greater than its cost to the donor may result in a taxable gain. A gift of such property causes the donor to realize capital gain on the excess of the debt over basis.
  
  Example: the gift of a building that cost the donor $10,000, appreciated to $100,000, and was mortgaged to $70,000 results in an income tax gain to the donor on the difference between the debt outstanding at the time of the transfer and the donor’s basis (assume $70,000 and the donor’s basis of $10,000). In this example, the gain is $60,000. It is realized at the time the gift becomes complete.
- Is the donor likely to need or want to use the property in the future? If there is a reasonable possibility the donor may want the property, such as a residence, at some later time, other gift property should be selected.
- Is the property necessary for qualification of favorable tax benefits under Secs. 303 (special provision for capital gains for redemptions), 6166 (installment payment of estate taxes), and 2032A (special-use valuation)? To qualify under these Internal Revenue sections, a decedent’s estate must include specified percentages of certain businesses or farm property.
- Is the gift property’s basis above, below, or approximately the same as the property’s fair market value? Income tax law forbids the recognition of a capital loss if the subject matter of the gift has a basis above the property’s present fair market value. Neither the donor nor the donee can recognize a capital loss with respect to such property. Furthermore, if the gift property’s basis is above present fair market value, there is no gift tax addition to basis because that addition depends on appreciation at the time of the transfer. Since there is no appreciation, no gift tax addition is allowed.
Conversely, if the donor’s basis for income tax purposes is very low relative to the fair market value of the property, it might be advantageous to retain the property until death because of the stepped-up-basis-at-death rules. (This is especially true if inclusion of the property will generate little or no estate tax because it will pass to a surviving spouse and qualify for a marital deduction, or if the asset owner is sheltered by the unified credit.) The result of the stepped-up-basis provision is that a portion of the future capital gain is avoided in the event the property is later sold by the estate or heir. But if the property should be sold, it may pay to transfer it to a low-bracket family member by gift; that individual could then sell it and realize a lower capital-gains tax.

A third possibility is that the donor’s basis is approximately the same as or only slightly below fair market value. Again, the rules providing for a gift tax addition to basis are of little help, since the addition to basis is limited to the gift tax allocable to appreciation in the property at the time of the gift. One further factor that should be considered is whether the donee will want or need to sell the property in the foreseeable future. If this is not likely, the income tax basis (except for depreciable property) is relatively meaningless.

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