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Lesson 1: Introduction to Taxation and How to Research
Gift Tax
The IRS defines a gift inter vivos in the definition of gift tax.
The gift . . . is . . . the transfer of property by one individual to another while receiving nothing, or less than full value, in return. . . . You make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return. If you sell something at less than its full value or if you make an interest-free or reduced-interest loan, you may be making a gift (Internal Revenue Service, 2016).
By this definition, gifts inter vivos include
- property (including money) or the use of or income from property that one person gives to another person without expecting to receive something of at least equal value in return,
- the difference between the market value and the sale price of something that is sold at less than its full value, and
- the amount of interest that should have been charged and paid to someone who makes an interest-free or reduced-interest loan.
What Constitutes a Gift?
In contrast, some items are not considered gifts and therefore are not taxable. Most of the items listed above are self-explanatory but must be followed carefully—for instance, in the following ways:
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Tuition or medical expenses: Tuition and medical expenses must be paid directly to the institution. The amount cannot be paid to an individual to pay the expenditure him- or herself.
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Gifts to your spouse: Gifts to a spouse must be given to a spouse that is recognized under federal tax law, which includes same-sex marriages. There are several rules concerning alien (non-U.S. citizen) spouses.
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Gifts to a political organization for its use: Gifts to political organizations must be made directly to the organization, not to a specific candidate.
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Gifts to charities: Gifts to charities may seem simple, but the charity must be recognized by the IRS as a qualified charity adhering to the rules of not-for-profit organizations.
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Annual gifting exclusion: The annual exclusion is an annual amount that each taxpayer is allowed to give per recipient before incurring a gift tax and is the most important rule to remember.
This law allows each taxpayer to gift a certain amount each year to as many recipients as the taxpayer wants. In English, that means that with the current annual exclusion set at $15,000, you can give each person in the world $15,000 each year without incurring any gift tax. However, if you give any one person $16,000, then you will have to report a taxable amount of $1,000 because you've exceeded the limitation. It doesn't matter if you give one person $13,000 and another person $16,000—you cannot average the amount between the recipients. You still have to pay tax on that $1,000 difference.
Ultimately, a gift follows these three primary rules:
- It is irrevocable—you cannot take it back.
- It is not an exchange of services or goods. That is a trade or a sale and may be taxable.
- It has no strings attached—you cannot include any instructions in the way the gift must be used.
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At Thanksgiving dinner, Mason announced that he and his husband Kendall are buying a house. Mason's mom and dad, Sharla and Carl, want to give them $20,000 to help with the purchase. Will they be taxed on the $6,000 that exceeds the $15,000 annual exclusion? Actually, that depends on the details. Sharla and Carl have several ways to structure the $20,000 gift so that it isn't considered a tax event:
- Sharla and Carl can gift $15,000 this year at Christmas, and the rest ($5,000) next year when Mason and Kendall make their down payment in order to split the gift across tax years.
- Sharla can give Mason $15,000 and Carl can give the remainder ($5,000).
- Sharla and Carl can give $15,000 to Mason and the remainder ($5,000) to Kendall.
Despite the confines of gift tax law, there are still legal ways to work for the best interest of the family without incurring additional taxes.
Unified Credit
The value of gifts that a taxpayer gives to each person is tracked during the year. If the total of the gifts to an individual in a year exceeds the annual exclusion amount, the IRS will tax the excess at the gift tax rate. At least that's usually the case, but taxpayers may be able to reduce or eliminate gift taxes each year completely through the unified credit: a joint credit for gift and estate taxes.
To understand the unified credit, think back to the estate tax. As you may remember, only estates valued over $5.6 million are subject to estate tax. Why $5.6 million? Because that's the deduction allowed for computing estate taxes. The unified credit allows taxpayers to reduce the value of any gifts they grant while alive by preemptively applying this $5.6 million estate tax deduction to the gifts as credit. In this way, they can eliminate taxable gifts during their lifetime and consequently also gift taxes. In addition, taxpayers can opt to use the $5.6 million unified credit to pay any gift taxes that exceed the annual exclusion each year. Because gift tax rates are 40% at their highest level, most taxpayers opt to use a portion of the $5.6 million deduction now in order to reduce gift taxes on taxable gifts over their lifetime.
So, what happens to taxpayers who use up all $5.6 million of this deduction in gift tax credits during their lifetime? At death, their deduction would be $0.00, and their estate would be taxed without the deduction. Eventually, the taxpayer always pays tax on transferred items, be they gifts during their lifetime or an estate at death.
Read on for an example of this very interesting integrated taxing system (gifts and estates).