A comparative proposal to reform the United States gift tax annual exclusion.

• Jurisdiction: United States
• Author: Kinsler, Jeffrey S.
• Date: 01 November 1997

TABLE OF CONTENTS

1. INTRODUCTION

   1. The U.S. Gift Tax

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

   3. Annual Exclusion Abuse

   4. Annual Exclusion Reform II. THE FEDERAL GIFT TAX

   1. Imposition of Gift Tax

      1. Incomplete Transfers

      2. Business Transactions

      3. Support

      4. Gratuitous Services

   2. Advantages and Disadvantages of Gifts

   3. Net Gifts III. THE ANNUAL EXCLUSION

   1. History of the Annual Exclusion

      1. Split Gifts

      2. Timing of Gifts

   2. Purpose of the Annual Exclusion

   3. Present and Future Interests

      1. Identification of Donees

      2. Indirect Gifts

      3. Valuation

   4. Application of the Annual Exclusion to Certain Interests

      1. Interests in Income

         1. Non-Income Producing Property

         2. Contractual Interests

      2. Gifts to Minors

         1. Outright Gift

         2. Demand Rights

         3. Section 2503(c)

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

   1. Section 2503(e)

   2. Gift Tax Deductions

   3. Miscellaneous Exclusions

   4. The Unified Credit

   5. Interest-Free Loans

   6. Generation-Skipping Tax

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

   1. Complexity

   2. Practical Abuse

   3. Inequity

   4. 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

   1. Proposed Legislation

   2. 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)

1. 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.

   1. 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)

   2. 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

   3. 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)

   4. 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)

2. 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...