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Common Law Review
 
Dom arrow lnky arrow Issue 8 - Contract Law arrow 14: Anna Shalina - The Gift tax or free cheese: U.S. and Continental Taxation of Gifts
14: Anna Shalina - The Gift tax or free cheese: U.S. and Continental Taxation of Gifts PDF Tisk E-mail

The Gift tax or free cheese

Selected Problems of U.S. and Continental Taxation of Gifts

Anna Shalina

 

 

1. Introduction

Most people with a lot of assets want to pass along their property to their children before death in order to avoid huge property taxes. However, the free cheese is only offered in a mousetrap; the gift tax is applicable in case of transfer by gift of any property whatsoever. For tax purposes, a gift is a transfer of 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 for less than its full value or if you make an interest-free or reduced interest loan, you may be making a gift. Let’s look at the land of freedom and opportunity, i.e. the United States of America.

 

2. The US gift tax in the United States

The U.S. gift tax, which is rooted in estate tax law, was originally designed to prevent this from happening. Here is how: Your estate is the total value of all of your assets, less any debts, at the time of your death. Under the laws in effect for the 2005 tax year, if you die with an estate greater than $1,500,000, the amount of your estate that is in excess of $1,500,000 will be subject to a graduated estate tax which can climb as high as 47%. The first $1,500,000 of the estate is a so-called exclusion, that is, it does not get taxed.

So why not give your entire estate to your heirs before you die to avoid the estate tax? This is not necessarily a good idea. If you give away more than $1,000,000 in taxable gifts during your life in an attempt to reduce the value of your estate to avoid the estate tax, you, not the recipient of the gift, will still owe a gift tax of up to 47% of the gift amount over $1,000,000 anyway.

And what about the $1,000,000 limit? Yes, you get it for gift taxes, but here’s the catch: It’s the same $1,000,000 that’s available to shelter your estate. So, if you use it to shelter your gifts from gift taxes, it can no longer be used to shelter some of your estate when you die.

2.1. The inheritance aspect

There is a difference, however, if you wait to transfer estate upon your death instead of giving gifts during your lifetime. The difference has to do with the tax base of the estate the recipient gets from the donor. For example, if your son inherits your estate, his tax base would be the fair market value of the estate on the date you die. However, if he receives estate as a gift from you, his tax base is whatever your tax base was. If he sells the estate at a loss, the tax base becomes your tax base or the fair market value on the date of the gift, whichever is less. That can mean a great deal when your son goes to sell the estate.

Certainly, this raises the question: How do you determine the value of a particular asset, such as an old house? This is the original cost of the estate and any expenses incurred as part of the sale from the base for the value, as far as taxes are concerned. This tax base may fluctuate over the years, as you add a new room or demolish the barn. Of course, the fair market value (the price you could get if you sold the property on the open market) is probably a lot higher than that.

For example, let us say your mother has a house with a tax base of $60,000 and the fair market value of the house is now $300,000. If your mother gives you the house as a gift, your tax base would be $60,000. If you inherit the house after your mother’s death, the tax base would be $300,000, its fair market value. What difference does this make? If you sell the house for $310,000 shortly after you get it, your gain on the sale is $250,000 ($310,000 minus $60,000) if you got the house as a gift. Your gain on the sale is $10,000 ($310,000 minus $300,000) if you got the house as an inheritance.

Beginning 2006, the annual exclusion for gifts increased to $12,000. The applicable exclusion amount is increased to $2,000,000 for estates and remains at $1,000,000 for gifts. The annual exclusion for gifts made in 2004 and 2005 remains at $11,000. In 2006, the amount is $12,000.

 

2.2. Expected development of the tax base rates

In 2009, you can have up to $3,500,000 in assets and pay no estate tax. In 2010, it does not matter how much you have; there will be no estate tax at all. In 2011, the exclusion amount drops back to $1,000,000, unless Congress intervenes to extend the ban on estate taxes.

The rates will change, too. In 2009, the top estate tax rate will be 45% for estates exceeding $3,500,000. In 2010, the top estate tax rate will be 0%. In 2011, unless there is another tax law change, the highest estate tax rate will revert to a rate of 55% for estates exceeding $1,000,000.

 

2.3. Marriage influence in terms of gift base

If you are married, you and your spouse can each separately give up to $11,000 to the same person in 2002, 2003, 2004 or 2005 ($12,000 in 2006) without making a taxable gift. If one of you gives more than $11,000/$12,000 to any person in any of these years, refer to gift splitting Publication 950, Introduction to Estate and Gift Taxes. Gifts to individuals are not deductible on the donor’s income tax returns.

What does the above mean in terms of the gift tax? The lifetime gift tax exemption is $1,000,000 and will continue to be $1,000,000 as such for the indefinite future. So, you can make gifts that are worth up to a million dollars during your lifetime without paying the gift tax.

The maximum gift tax rate for gifts exceeding $1,000,000 will drop from 47% in 2005 to 45% in 2009, and to 35% in 2010 and beyond, which is the same as the maximum individual tax rate.

 

2.4. Reasoning behind the action

So why did the U.S. Congress dramatically reduces the estate tax, but keep the gift tax if the gift tax was originally created to prevent people from escaping the estate tax? Probably because of another main reason for the gift tax: preventing family members from shifting assets among themselves to equalize income-tax rates. In the U.S. progressive tax system, the gift tax restricts the ability of a family to minimize their income taxes by moving income-producing assets among the members.

The general rule is that any gift is a taxable gift. However, there are many exceptions to this rule. Gifts, which are not more than the annual exclusion ($11,000) for the calendar year include: tuition or medical expenses you pay for someone (the educational and medical exclusions); gifts to a spouse or a political organization for its use and to qualified charities (a deduction is available for these amounts) are not taxable and therefore do not count as part of your $1,000,000 lifetime total. The gift tax is only due when the entire $1,000,000 lifetime gift tax amount is reached.

It is worth knowing that in order to qualify for the unlimited exclusion for qualified education expenses; you must make a direct payment to the educational institution for tuition only. Books, supplies, and living expenses do not qualify. If you want to pay for books, supplies, and living expenses in addition to the unlimited education exclusion, you can make a gift of $11,000 to the student under the annual gift exclusion. Gifts to a spouse who is
a U.S. citizen are not taxed. Gifts to foreign spouses are subject to an annual limit of $117,000 ($120,000 for 2006), indexed for inflation. Medical payments must be paid directly to the health care provider in order to qualify for the unlimited exclusion. Qualifying medical expenses include: diagnosis and treatment of disease, procedures affecting a structure or function of the body, transportation primarily for medical care, medical insurance, including long-term care insurance.

 

2.5. Professional gifts

Adding a joint tenant to a bank or brokerage account or to a U.S. Savings bond is not considered to be a gift until the new joint tenant withdraws funds. Conversely, if you purchased a security in the names of the joint owners, rather than holding it in street name by the brokerage firm, the transaction would count as a gift. Furthermore, making a bona fide business transaction. Even if you later discover that you paid more than the item was worth, given the fair market value, the transaction is not a gift, just a bad business decision.

Certain gifts are considered to be taxable gifts when they exceed the annual gift exclusion amount (which is $11,000 in 2005). Checks are taxable gifts and become effective on the date the donor gives the check to the recipient. The donor must still be alive when the donor’s bank pays the check. (This rule prevents people from making "deathbed gifts" to avoid estate taxes.) Adding a joint tenant to real estate becomes a taxable gift if the new joint tenant has the right under state law to sever his interest in the joint tenancy and receive half of the property. Note that the recipient only needs to have the right to do so for the transaction to be considered a gift. Loaning $10,000 or more at less than the market rate of interest is also considered a taxable gift. The value of the gift is based on the difference between the interest rate charged and the applicable federal rate. Applicable federal rates are revised monthly. This rule does not apply to loans of $10,000 or less. Cancelling indebtedness or making a payment owed by someone is another type of gift to the debtor. Making a gift as an individual to a corporation is considered to be a gift to the individual shareholders of the corporation unless there is a valid business reason for the gift. Such a donation is not a present-interest gift, and thus does not qualify for the $11,000 per person per year exclusion.

 

2.6. Gifts to a foreign partner/spouse

A gift of foreign real estate from a U.S. citizen is obviously taxed, as well as gifting real or tangible estate located in the U.S. This is subject to the gift tax rules, even if the donor and the recipient are not U.S. citizens or residents. Non-resident aliens who give real or tangible property located in the U.S. are allowed the $11,000 annual present-interest gift exclusion and unlimited marital deduction to U.S. citizen spouses, but are not allowed the $1,000,000 lifetime gift tax exemption.

 

2.7. Gifts to a minor

If you give an amount up to $11,000 to each child each year, your gifts do not count toward the million dollars of gifts you are allowed to give in a lifetime before triggering the gift tax. But what counts as a gift to a minor?

Gifts to minors include those gifts made outright to the minor or gifts made through a custodial account such as that under the Uniform Gifts to Minors Act (UGMA), the Revised Uniform Gifts to Minors Act, or the Uniform Transfers to Minors Act (UTMA). One disadvantage of using custodial accounts is that the minor must receive the funds at majority, as defined by state law (generally age 18 or 21), regardless of your wishes.

A parent’s support payments for a minor are not gifts if they are required as part of a legal obligation. They can be considered a gift if the payments are not legally required.

 

2.8. Advantages of making gifts

Advantages of making a gift may earn you more than gratitude: Reduced estate taxes. Transferring property as a gift was traditionally a strategy to reduce estate taxes. With the new tax laws, this reason for gifting has become less of an incentive. Furthermore, income taxes are reduced as well. If you give property that has a low tax base (such as a rental house that has depreciated way below its fair market value) or property that generates a lot of taxable income, you may reduce income taxes paid within a family by shifting these assets to family members in lower tax brackets.

 

2.9. Disadvantages of making gifts

Disadvantages of making a gift begin with no step-up in tax base as it would if the estate was inherited. A gift recipient has two different tax bases; one for property sold at a gain, and one for property sold at a loss. If the estate is inherited before 2010, most property will receive a "step-up" (increase) in tax base to fair market value on the date of death.

Another disadvantage is that it reduces your net worth. You need to reserve enough assets to care for yourself throughout a long or extended retirement or illness. The Kiddie Tax is applicable. Giving funds to children under the age of 14 may subject them to the Kiddie Tax. In 2005, portfolio earnings over $1,600 are subject to taxation at the parent’s tax rate.

Until 2010, property that you pass to your heirs is treated as taxable to your estate based on its fair market value on the date of your death. Your estate pays the taxes from of whatever cash it has, and if it does not have enough cash, property may need to be sold to raise the cash to pay the taxes.

Under the new tax law, in 2010, the estate of every decedent who is a U.S. citizen or resident will receive an increase in tax base in its estate. The increase could be as much $1.3 million (limited by the fair market value on the date of death). The increase will be limited to $60,000 for estates of non-resident aliens.

Moreover, an estate passed to a surviving spouse will be eligible for an additional step-up in base of up to $3 million. The base must be allocated asset-by-asset, so that the beneficiaries know which estate or it’s part received that special "step-up" and which didn’t. This is important because it affects how much taxable gain the beneficiary would have if he sells the items he inherits.

 

3. Swiss gift tax regulations

Switzerland has very different approach to inheritance and gifts. There is no federal inheritance and gift tax in Switzerland. The inheritance and the gift taxes are only levied by the cantons and/or municipalities. There is no harmonization in respect of such taxes. Thus, each canton has a different inheritance and gift tax law. Inter-cantonal allocation is governed by case law.

Switzerland has concluded inheritance (but no gift) tax treaties with the following countries: USA, Austria, Denmark, Finland, France, Germany, Netherlands, Norway, Sweden, and UK.

 

3.1. Specifics of the subject matter

In general, inheritance and gift taxes are levied by the canton of residence of the decedent (or donor) for movables or by the canton of rei situs (location of real estate) in regard to immovable estates.

The taxpayer is the recipient (heir or donee). In certain cantons the donor is subject to a joint liability for gift taxes. The tax is normally calculated on the net value of assets transferred. Debts (e.g. mortgage) are deductible. Assets are valuated at the fair market value. Estate, however, is taxed at its fiscal value which usually is 20% – 50% lower than fair market value.

In most cases, there are some applicable deductions. For instance, in Bern there is a deduction of CHF 100, 000 for children and CHF 10,000 for other recipients, and 50% of the tax if an active business is transferred.

 

3.2. The tax base

As mentioned above, the tax rate differs from canton to canton. In general, the rates are progressive, depending on the degree of relationship and the amount received. Nearly all cantons do not tax transfers between spouses. In about 13 out of 26 cantons transfers between parents and children are tax-free too. Where children are taxed, the rates are usually very low, i.e. 1% – 3% to maximum about 6%. Transfers between non-related persons are taxed at much higher rates, up to 50% or even 60% in certain cantons.

 

4. Czech gift tax legislation

In the Czech Republic, the recipient is the taxpayer unless the gift goes abroad, in which case the donor (irrespective of the fact whether
he/she is Czech national, foreigner with short term permit or long term residence as well as area of residence) is responsible for paying said tax. If the estate is located outside of the Czech Republic, the tax is not applicable unless otherwise stated by the relevant International Treaty. What is interesting is that, if there are several recipients, each pays the tax separately of others according to their share of gift received.

Further, the tax is not payable if the estate given covers the parent child relationship on condition of mutual support obligations. Other transfers such as pension, housing subsidies, or specified special cases are also excused from paying the gift tax, which also referred to as the “transfer” tax.

 

5. Conclusion

Generally speaking, Czech law sets tax rates similar to the U.S. tax rates, which for gifts can be anywhere between 6% – 47% and for inheritance is about 3% – 23%. The Czech tax rate however depends upon the value of the estate as well as degree of closeness. Whereby immediate relatives (1st group) are excused from paying the inheritance tax on immovables and distant or no relation receivers (2nd and 3rd group respectively) may be excused from paying the tax only when it concerns movables.

The gift and inheritance tax scheme is a classic example of the overlap of the legal profession with financial accounting, meaning actual tax advising and requires either an in depth understanding of both or close collaboration to insure best results.

 

 

Mgr. Anna Shalina, A.G. graduated from the Law Faculty of the Anglo-American College in Prague in 2000 and finished her Cambridge Diploma in English and EU Law in 2001. She continues to work on the Holocaust cases. Currently she is establishing a non-profit organization to help students and senior musicians & artists with accommodation-related issues (e.g. building and renovating lodging, students dorms, etc).

 

 

Bibliography:


Law for Business, A. James Barnes, J.D., Terry Morehead Dworkin, J. D., Eric L. Richards, J.D., Publisher: Irwin McGraw-Hill, editor in chief: Michael W. Junior, Publisher: Craig S. Beytien


Accounting Concepts and applications, K. Fred Skousen,
PhD, CPA, Bringham Young University, Senior editor: David L. Shaut


Fundamental Accounting Principles, 15th Edition, Kermit
D. Larson, University of Texas at Austin, John J. Wild, University of Wisconsin at Madison, Irwin McGraw-Hill


www.irs.gov


www.turbotax.com

 
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