A Comparative Proposal to Reform the United States Gift Tax Annual Exclusion

Beginning of article

TABLE OF CONTENTS

I. INTRODUCTION

A. The U.S. Gift Tax

B. The Role of the Annual Exclusion in Estate and Gift Tax

C. Annual Exclusion Abuse

D. Annual Exclusion Reform II. THE FEDERAL GIFT TAX

A. Imposition of Gift Tax

1. Incomplete Transfers

2. Business Transactions

3. Support

4. Gratuitous Services

B. Advantages and Disadvantages of Gifts

C. Net Gifts III. THE ANNUAL EXCLUSION

A. History of the Annual Exclusion

1. Split Gifts

2. Timing of Gifts

B. Purpose of the Annual Exclusion

C. Present and Future Interests

1. Identification of Donees

2. Indirect Gifts

3. Valuation

D. Application of the Annual Exclusion to Certain Interests

1. Interests in Income

a. Non-Income Producing Property

b. Contractual Interests

2. Gifts to Minors

a. Outright Gift

b. Demand Rights

c. Section 2503(c)

d. Uniform Gifts to Minors Act IV. THE OTHER GIFT TAX EXCLUSIONS, DEDUCTIONS, AND CREDITS

A. Section 2503(e)

B. Gift Tax Deductions

C. Miscellaneous Exclusions

D. The Unified Credit

E. Interest-Free Loans

F. Generation-Skipping Tax

G. Cumulative Effect of Gift Tax Exemptions V. THE NEED FOR ANNUAL EXCLUSION REFORM

A. Complexity

B. Practical Abuse

C. Inequity

D. Comparison with International Standards

1. New Zealand

2. The United Kingdom

3. Japan

4. The Netherlands

5. Summary of International Gift Tax Laws VI. ANNUAL EXCLUSION REFORM

A. Proposed Legislation

B. Impact of the Reform Proposal VII. CONCLUSION

[T]here is nothing sinister in so arranging one's affairs as

to keep taxes as low as possible. Everybody does so, rich or

poor and all do right for nobody owes any public duty to pay

more than the law demands . . .(1)

Judge Learned Hand (1947)

I. INTRODUCTION

Uniform transfer tax laws are essential to regional and global commerce. Without consistent tax laws, it is difficult, if not impossible, for and executives to arrange their financial affairs. As a practical matter, the lack of transfer tax consistency has led to the development of a new class of refugees: wealthy executives willing to relinquish their citizenship in exchange for advantageous tax laws.(2) This Article examines the principal exemption to U.S. gift tax laws and proposes legislation designed to harmonize the gift tax laws of the United States with those of other industrialized nations, particularly New Zealand, the United Kingdom, Japan, and the Netherlands.

A. The U.S. Gift Tax

United States citizens are not required to pay estate and gift taxes! In fact, the only people who should pay such taxes are those wishing to donate money to the U.S. government.(3) Everyone else is spared this burden bemuse transfer taxes am not compulsory.

By now many readers must be asking the obvious question: How many years in prison would one receive for claiming this tax free status? The answer, quite surprisingly, is zero, as it is entirely lawful to evade estate and gift taxes in the United States. Transfer tax(4) evasion is, in fact, authorized, nay, encouraged by the Internal Revenue Code (hereinafter I.R.C.) in a provision known as the gift tax "annual exclusion."(5)

Briefly stated, the annual exclusion is the single largest loophole in the transfer tax system, and it has, in effect, converted the U.S. comprehensive estate and gift tax scheme into a system of welfare for the wealthy. If Congress is serious about reforming U.S. welfare programs, the annual exclusion should be a key part of Such reform.(6)

B. The Role of the Annual Exclusion in Estate and Gift Tax

To appreciate the importance of the gift tax annual exclusion, one must understand the role it plays in our estate and gift tax system.(7) Tax experts have maintained for decades that a death tax is an essential component of a progressive and equitable system of taxation,(8) particularly in the absence of an annual tax on accumulated wealth.(9) This conviction is debatable.(10) What is not debatable, however, is that if a tax is assessed on testamentary wealth transfers, either by means of an inheritance or estate tax, a tax must also be levied on inter vivos gratuitous transfers of property.(11) Otherwise, taxpayers can easily evade the death tax Simply by transferring all Wealth before death.(12) The gift tax, in effect operates as an estate tax avoidance device.

In order to operate efficiently, a gift tax must exempt from taxation certain customary gifts, such as birthday, holiday, and wedding presents.(13) No one could Imagine paying tax on the "loan" of a cup of sugar to a neighbor or on a meager birthday gift to a child.(14) Not only Would it be unduly burdensome to account for such gifts, but any system taxing Inconsequential transfers among friends and family would be rife with fraud. Not surprisingly, in those countries in which gratuitous transfers of wealth are taxed, such as the United States, the United Kingdom, Japan, and New Zealand, no gift tax is assessed unless the gifts made by a taxpayer In a single year exceed a certain threshold amount

C. Annual Exclusion Abuse

In the United States, the amount exempted from gift taxation is known as the "annual exclusion.(15) The annual exclusion was designed to obviate the necessity of keeping an account of and reporting numerous small gifts. As such, It was get at an amount sufficient to cover Most Wedding, holiday, and birthday gifts.(16) In 1942, the annual exclusion was get at $3000, but It was raised to $10,000 in 1981. Since that time, the annual exclusion has become the principal artifice of wealthy U.S. citizens to avoid transfer taxes.(17)

The annual exclusion enables a taxpayer to transfer $10,000 each to as many people as he or she chooses every year without incurring taxation. A married couple can double this amount This means that a married couple with five children and fifteen grandchildren can transfer $400,000 a year to their descendants free of gift tax, over a thirty-year period, the couple can use the annual exclusion to transfer twelve million dollars to their descendants, thereby saving millions of dollars in transfer tax.(18)

What was designed to exempt customary gifts from taxation, such as train sets and bicycles, is being used to transfer millions of dollars, tax-free, from generation to generation.(19) Even more troubling, "the exclusion has come to be thought of as an estate planning device for transfers in addition to birthday and Christmas presents,"(20) and consequently is being used to shield large transfers of securities, real estate, and cash to a donor's children, as though the donor gave them nothing else during the year, not even a teddy bear or a bicycle.(21)

D. AnnuaL Exclusion Reform

The purpose of this article is twofold: first, to examine the gift tax annual exclusion from a pragmatic, historical, and comparative perspective--an examination that will prove the annual exclusion is neither designed, nor used, to exempt occasional gifts from taxation, but rather has developed into a welfare entitlement for the wealthy.(22) and second. to propose new legislation that is simpler, fairer, and more in keeping with the original purpose of the annual exclusion. The gift tax laws of New Zealand the United Kingdom, Japan, and the Netherlands are used as prototypes for the proposed legislation.(23)

II. THE FEDERAL GIFT TAX

When the federal estate tax was enacted in 1916,(24) no corresponding gift tax was established.(25) Only gifts made "in contemplation of death" were subject to estate tax.(26) In the absence of a gift tax, the estate tax was easily evaded by taxpayers Who Simply transferred an property before death.(27) Besides its susceptibility to estate tax evasion, courts found it difficult to determine which gifts were made in contemplation of death:

Scrutiny of the circumstances surrounding inter vivos transfers, however,

imposed a heavy burden on tax administrators. "Life motives" and "death

motives" were used by courts in determining whether transfers had been

made "in contemplation of death" The results under this approach were

unsatisfactory and contributed to enactment of a federal gift tax in 1924

as a necessary corollary to estate and income taxes.(28)

The United States has made only two excursions into the gift tax field.(29) The first was the 1924 gift tax, mentioned above, which was short-lived.(30) Unlike the current gift tax, the 1924 tax was calculated on an annual, non-cumulative basis.(31) it provided an annual per-donor exclusion for the first $50,000 of gifts, as well as a per-donee exclusion of $500.(32) Considering the magnitude of such exclusions, especially in 1924 dollars, many taxpayers used the exclusions to Completely avoid estate taxation.(33)

The 1924 gift tax was repealed in 1926(34) as part of an overall tax reduction package.(35) In its place, Congress enacted an estate tax provision under which gratuitous transfers made within two years of death were conclusively presumed to have been made in contemplation of death and therefore Subject to estate tax.(36) It Was thought that this provision would frustrate most efforts to avoid estate tax.(37) The Supreme Court, however, held the conclusive presumption unconstitutional in 1932,(38) inducing Congress to revisit the gift tax field.(39)

The antecedent to our modern gift tax was enacted in 1932 in an effort to increase federal revenues during the Great Depression.(40) The gift tax was thought to be a necessary companion to the estate tax, serving as a backstop to prevent estate tax avoidance.(41) The 1932 gift tax provided a $50,000 lifetime exemption and a $5000 per-donee annual exclusion.(42) Unlike its predecessor, the 1932 gift tax was cumulative in nature.(43) Hence, the more gifts a person made during life, the higher his or her marginal gift tax rate.(44)

The 1932 gift tax was designed to discourage transfers for the purpose of avoiding estate tax.(45) Nevertheless, there remained Several incentives for Making lifetime gifts.(46) First, the gift tax rates were approximately twenty five percent lower than the estate tax rates.(47) Second, although the gift tax was calculated on a cumulative basis, gifts completed more than three years before death were generally not included in the donor's estate tax base.(48) Third, the gift tax had an annual exclusion for which there was no estate tax counterpart.(49) Finally, the gift tax was tax-exclusive (no tax assessed on the tax payment itself), while the estate tax was tax inclusive (tax assessed on the property transferred as well as the tax payment itself).(50) The latter two advantages continue to exist today.(51)

In 1976, the transfer tax system was unified by adopting a single progressive rate schedule that applies to the cumulative total of lifetime and testamentary transfers.(52) Under the Unified tax system, the gift tax is assessed on the value of property transferred by the donor.(53) The tax is imposed on the donors(54) and determined by reference to all gifts made by the donor during the relevant tax period.(55) It is computed on a progressive schedule based on cumulative gifts made by the donor in his or her lifetime or, at least, since 1976.(56) Testamentary transfers are, for the most part, treated as though made in the final year of life. The marginal rate of tax is based on all taxable gifts (total gift minus exclusions and deductions) made by a donor, both during life and at death.(57) yet even after the unification of the estate and gift taxes, there remain several advantages to transferring property before death, the most important of which is the annual exclusion. This has been especially true since 1981, the year Congress raised the amount of the annual exclusion to $10,000.

A. Imposition of Gift Tax

Before one can appreciate the intricacies of the annual exclusion, one must have a general understanding of the application of the gift tax. Consequently, this section of the Article examines the scope of the federal gift tax. First of all, the gift tax is an excise tax imposed on the transfer of property.(58) Unlike an income tax which is assessed on the receipt of money or property, an excise tax is imposed on the disbursement of property(59) More particularly, I.R.C. Section 2501(a) assesses a tax on the "transfer of property by gift."(60) Section 2001, the corresponding estate tax statute, is supported by detailed provisions defining the term taxable estate."(61) By contrast, there is no comprehensive definition of the phrase "transfer of property by gift" undertaken In the gift tax sections of the I.R.C.(62)

Although the I.R.C. does not define the term "gift," it does provide that "[w]here property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property exceeds the value of the consideration shall be deemed a gift."(63) Donative intent, a necessary element of a gift at common law, is not required for gift taxation.(64) The gift tax is imposed on the basis of the objective factors of the transfer and the circumstances under which it was made, not on the basis of the subjective motives of the donor.(65) Some courts, however, continue to look for donative intent in determining whether a taxable gift has been made.(66)

The gift tax applies to all gratuitous transfers of property, "whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible."(67) "Any transaction in Which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax."(68) The tax applies to cash gifts, gifts of realty, and gifts of tangible and intangible personal property.(69) It also applies to transfers of life insurance, royalty rights, notes to third parties, gifts to shareholders of a corporation, and the cancellation of debt.(70) To eliminate any doubt that the gift tax had a broad scope, Congress declared:

the terms "property," "transfer," "gift," and "indirectly" are used in the

broadest and most comprehensive sense: the term "property"

reaching every species of right or interest protected by law and

having exchangeable value.

The words "transfer . . . by gift" and "whether . . . direct or indirect"

are designed to cover and comprehend all transactions . . . whereby

and to the extent . . . that property is donatively passed to or

conferred upon another, regardless of the means or the device employed

in its accomplishment.(71)

The courts have construed the gift tax liberally to effectuate the intent of Congress.(72) Nevertheless, the definition of a taxable gift is one of the most complex concepts in gift taxation.(73) There am, however, certain types of transfers not encompassed by the broad reach of gift taxation.

1. Incomplete Transfers

Gift tax is not imposed unless a transfer of property is complete. A gift is complete when "the donor has so parted with dominion and control so as to leave him no power to change its disposition, whether for his own benefit or for the benefit of another . . . ."(74) Accordingly, a mere promise to make a gift is not complete unless and until it becomes legally enforceable.(75) likewise, revocable transfers, usually made in trust form, are not complete for gift tax purposes as long as the donor retains the right to revoke.(76) If, however, the donor relinquishes the power of revocation or if income is distributed to a beneficiary, such transfers are considered complete for gift tax purposes.(77) In addition, the execution of a trust instrument, without a corresponding transfer of funds, is an incomplete gift.(78)

A transfer is also incomplete if the transferor retains the power to change the recipient of a gift or to change the interests of various beneficiaries.(79) For instance, a gift in trust is not complete if the donor retains the unfettered power to change the beneficiaries of the trust. By contrast, a gift is complete if the donor retains only the right to alter the time and manner of enjoyment of the gift by the donee.(80) Likewise, a gift is not rendered incomplete simply because the transferor confers upon another the exclusive power of revocation.(81)

2. Business Transactions

Section 2512(b) provides that "[w]here property is transferred for less than an adequate and full in money or money's worth, then the amount by which the value of the Property exceeds the value of the consideration shall be deemed a gift."(82) If full consideration is received by the taxpayer, the taxpayer's gross estate is not diminished and thus a gift tax would be inappropriate.(83) The Value of the consideration received does not necessarily have to equal the value of the consideration relinquished. A bad bargain between two unrelated parties in a bona fide business transaction is not a gift.(84) The fact that one of the parties to the transaction acquired less than he or she bargained for is harsh enough; there is no reason to compound the problem by assessing a gift tax on that person.

The presence of valid contractual consideration will not prevent a transfer from being a gift unless the consideration is full and adequate in terms of money or moneys worth.(85) Consideration such as love. affection, and promises to marry, though valid at common law, are insufficient under the gift tax laws. Moreover, some transactions not considered gifts for income tax purposes may qualify as gifts for gift tax purposes, as there is no uniform definition of the term "gift" in the I.R.C.(86)

Not an business transactions are outside the scope of the gift tax laws. Only sales or exchanges in the "ordinary course of business" will be considered adequate and hill consideration in money or moneys worth.(87) For this purpose, the term "ordinary course of business" means more than normal business operations.(88) It means bona fide, arm's-length transactions made in the ordinary course of business that are free of donative intent.(89) A car dealer, for example, who sells a car listed at $10,000 to a customer for $9000 has not made a gift; nor has a butcher who sells meat at or below cost as an inducement to customers to patronize the store.(90) The negotiated sale of inventory to strangers is precisely what is meant by the term "ordinary course of business."

Business transactions between family members are presumed not to be in the ordinary course of business.(91) Bemuse family members am natural objects of the taxpayers bounty, the issue is Whether the transaction is free of donative intent.(92) Courts Win closely scrutinize family transactions to ensure that they am bona fide, especially when the property transferred has no readily ascertainable fair market value.(93) The sale of the car, mentioned above, which was listed for $10,000 to a customer for $9000 may very well be a gift if the buyer and seller are closely related.(94)

3. Support

The gift tax does not apply to transfers in satisfaction of an obligation of support.(95) It is generally accepted that a gratuitous transfer of property from a parent to a minor child is not a taxable gift so long as the transfer is in discharge of a legal obligation imposed Upon the transferor to provide Support for the child.(96) While this position is virtually a truism, there is little authority for it in the I.R.C.(97) "Presumably the proposition that one does not incur a gift tax liability by supporting a spouse and children in an amicable family setting was thought so obvious as not to require an explicit statement."(98) Yet this was not always the case. The proposed regulations released after the enactment of the 1954 I.R.C. provided that "current expenditures by an individual on behalf of his spouse or minor child in satisfaction of his legal obligation to provide for their support are not taxable gifts."(99) Although no longer expressed in the regulations, this principle continues to be recognized.(100)

What is included within the obligation of support? The extent and value of the support obligation must be ascertained from the facts and circumstances of each case.(101) The extent of the support obligation is a matter of local law, which in many jurisdictions depends on the obligor's earning ability, means, situation, and condition in life.(102) Certainly, the "necessaries" (food, clothing shelter, etc.), as defined by the law of contact, are considered to be support obligations and thus free of gift taxation.(103) Support, however, is more inclusive than the necessaries.(104) Indeed. "[m]ost amounts expended on behalf of persons owed support will not be subject to the gift tax because of the Support obligation."(105) One author defined payments in discharge of the support obligation as those transfers that do not "build-up wealth" for the donee.(106)

Fortunately, most of the difficult issues involving the support obligation have been averted by the enactment of various gift tax provisions.(107) For example, nearly an transfers between Spouses am now free of gift tax,(108) as are most transfers resulting from divorce or separation.(109) In addition, there is no longer my question that an obligor can pay the college tuition or medical expenses of an adult child without exposure to gift tax(110) And most importantly, the $10,000 annual exclusion exempts most other support payments from gift taxation.(111)

4. Gratuitous Services

Not every gratuitous transfer is Subject to gift tax.(112) "For the gift tax to be imposed there must be a transfer of at least one property right, and the transfer of services is not considered to be a transfer of a property right."(113) "[T]axpayers with substantial talent or technical knowledge can transfer enormous wealth to their children through the rendering of gratuitous services and yet avoid the gift tax."(114)

For instance, in Commissioner v. Hogle,(115) the taxpayer, a professional stock broker, established several trusts for the benefit of his children. The taxpayer retained the right to manage the securities that he had transferred to the trust. As a result of his expertise, the taxpayer was able to significantly increase the value of the trusts. The I.R.S. maintained that the taxpayer's service to the trusts was a taxable gift, but the court disagreed, concluding that the rendering of investment advice was not a gift to the trusts because no property was transferred by the taxpayer. Congress has, according to the court, chosen to tax "property" transferred by gift, not Services.(116)

B. Advantages and Disadvantages of Gifts

In 1976, Congress integrated the gift and estate taxes in an attempt to treat both types of gratuitous transfers alike. Yet, there remain Several advantages to disposing of Wealth during life.(117) First, and most important is the $10,000 annual exclusion from gift tax for which there is no estate tax equivalent.(118) Second, the gift tax is tax-exclusive (no tax assessed on the tax payment itself), while the estate tax is tax-inclusive (tax assessed on the property transferred as well as the tax payment itself).(119) Third, if a taxpayer makes a gift of property that is likely to appreciate In value, the future gain will be experienced by the donee, not the donor.(120) Often the donee will be in a lower marginal income tax bracket than the donor.(121) Indeed, some property, such as life insurance policies, naturally becomes more valuable each year.(122) Hence, the longer the transferor waits to dispose of such assets, the higher the taxable gift.(123) Fourth, in some cases the donor can reduce his or her income taxes by transferring income-producing property to others.(124) Fifth, payments of a donee's college tuition and medical expenses made by the transferor during life are free of gift tax, while those same payments made at death may be subject to estate tax(125) Finally, assets transferred prior to death are not subject to formal probate administration,(126)

On the other hand, there are some potential disadvantages to inter vivos gifts.(127) First, if the property has already appreciated in value, It may be best to transfer the property at death. In such cases, the donee will receive the "stepped-up" basis (fair market value at time of death) for Income tax purposes.(128) The income tax savings from the stepped-up basis may more than offset the estate tax burden. Second, if the property is eligible for an income tax loss and has declined in value in the hand of the donor, it may be prefer-able for the donor to sell the property, realize the loss, and then transfer the Cash to the donee.(129) Otherwise, the loss May be squandered.(130) Third, the donor loses the use of any money transferred as a gift, money that may be needed in the donor's later years.(131) No one can estimate his or her life span, not to mention the amount necessary for Support during retirement.(132) Finally, a donor should not make gifts in excess of the annual exclusion after he has used up his entire unified credit To do so would be the equivalent to prepaying estate taxes.(133) All things considered, however, it is usually preferable to transfer property during life rather than waiting until death.

C. Net Gifts

The donor is primarily liable for the gift tax resulting from a gratuitous transfer.(134) Because of the prospect of paying federal gift tax, a potential donor may be deterred from making a gift.(135) One way to overcome this dilemma is to make a net gift.(136) A net gift occurs when the donor transfers property on the condition that the donee pay any resulting gift tax.(137) The payment of gift tax must be an express condition of the gift, otherwise, it is assumed that the donor retains primary liability for the gift tax.(138)

The net gift is computed by reducing the gross value of the gift by the amount of the tax the donee must pay; the gift tax actually paid is based on the remainder.(139) A determination of the amount of tax owed by the donee requires the use of an algebraic computation. One commentator explained this complex formula as follows:

The tax on a gift of $100,000 is $23,800. But under the net gift theory, the amount of the gift is not $100,000, but only $76,200. The tax on a gift of $76,200 is not $23,800, but is only $17,212. This means that the gift is not really $76,200, but rather $82,788. The tax on a gift of $82,788 is not $17,212, and so on.(140) Fortunately, assistance with this calculation is provided by the Internal Revenue Service (hereinafter I.R.S.).(141)

In addition, them am income tax consequences to net gift.(142) When the donee pays the gift tax, the donor is enriched by the amount of the tax.(143) payment of the gift tax by the donee relieves the donor of indebtedness, and relief from debt is income to a solvent taxpayer.(144) Hence, the donor has income to the extent the gift tax paid by the donee exceeds the donor's adjusted basis in the transferred property. For example, if a person transfers a parcel of land with an adjusted basis of $15,000 to a donee on the express condition that the donee pay the gift tax imposed on the transfer, the transferor will realize income to the extent the gift tax paid by the donee exceeds $15,000. The transfer is treated, in effect, as a part-Sale and part-gift.(145)

III. THE ANNUAL EXCLUSION

Section 2503(b) provides that "[i]n case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not . . . be included in the total amount of gifts made during such year."(146) "Because the exclusion is computed on a per-donee basis, a taxpayer can give away $10,000 each to an unlimited number of donees without incurring any gift tax liability, and this process can be repeated year after year."(147) The exclusion is "annual" because the $10,000 amount is available anew each year, and it is "per-donee" because $10,000 transfers to each and every donee may be excluded by a single donor.(148) For example:

[A]ssume the donor has three children. She can thus transfer $30,000

per year--$10,000 to each child--without Incurring any gift tax

consequences. And if each child is married, the donor can transfer an

additional $30,000 per year--$10,000 to each spouse. Over a ten-year

period this donor can deplete her estate by $600,000--the amount

equivalent to the unified credit--without using up any of that credit

or even filing a gift tax return.(149)

There is no limit on the number of donees for whom the donor may claim annual exclusions.(150) However, unused portions of the annual exclusion cannot be carried forward for use in future years, nor back for use in prior years.(151) Moreover, because the annual exclusion is calculated on a per-donee basis, an unused amount from one donee May not Shifted to another donee.(152) For example, if a donor makes two gifts in a calendar year--$15,000 to his son and $5000 to his daughter--the transfers are …