By Rick Kissel and Aaron Snellenbarger
When giving gifts to children, we think about birthdays and achievements, but we rarely question whether those gifts are taxable or reportable. Even if only using a portion of your lifetime exemption, be sure gifts to children are reported when necessary. This article shall serve as a brief overview of the federal gift tax applicable to transfers between parents and children.
Taxable gifts to children
A gift to a child under Indiana common law is defined as occurring when: (1) the parent is competent to make the gift; (2) the parent intends to make a gift; (3) the gift is completed with nothing left undone; (4) the property is delivered by the parent and is accepted by the child, and; (5) the gift is immediate and absolute (a “common law gift”). Heaphy v. Ogle, 896 N.E.2d 551 (Ind. Ct. App. 2008); Brackin v. Brackin, 894 N.E.2d 206 (Ind. Ct. App. 2008); Dunnewind v. Cook, 697 N.E.2d 485 (Ind. Ct. App. 1998); In re Estate of Warman, 682 N.E.2d 557 (Ind. Ct. App. 1997); Shourek v. Stirling, 652 N.E.2d 865 (Ind. Ct. App. 1995); In re Estate of Deahl, 524 N.E.2d 810 (Ind. Ct. App. 1988).
A federal taxable gift to a child must also be a transfer for less than fair market value. 26 U.S.C. §§ 2512, 2501, and 2511; 26 C.F.R. §§ 25.2511-1(c)(1) and 25.2511-1(g)(1). Therefore, the parent must make a completed gift to a child under Indiana law for less than the fair market value to make a federal taxable gift.
There are three gifts that are specifically excluded from being taxable gifts by the Internal Revenue Code: (i) an annual gift for less than the annual exclusion amount (currently, $15,000), (ii) a gift for qualified tuition for an unlimited amount, and (iii) a gift for qualified medical expenses for an unlimited amount.
Annual exclusion gifts are completed transfers of a present interest to anyone that is less than the annual exclusion amount (currently, $15,000). The use of the annual exclusion to make a gift to a child may be doubled by splitting the gift with a spouse.
A transfer to a qualified educational organization is a nontaxable gift for qualified tuition if it is made directly to the educational institution and the payment is for tuition. 26 U.S.C. § 2503(e). Therefore, payments for housing expenses (including dorm rooms), books, school supplies, food or any other expense that is not tuition and is not within an obligation of support (see below) is a gift for federal tax purposes. 26 C.F.R. §§ 25.2503-6(b)(2) & (c)
Similar to the nontaxable gift for qualified tuition, a nontaxable gift for qualified medical expenses must be made directly to the medical provider or to the medical insurance provider for premiums. 26 U.S.C. § 2503(e) & 26 C.F.R. § 25.2503-6(b)(3)
Therefore, transfers to a child with the intent he or she pay the medical provider or insurance company are taxable gifts.
There are two exceptions to a federal taxable gift. A federal taxable gift does not include a transfer in the ordinary course of business (which rarely occurs between a parent and child) and a transfer under an obligation of support.
A transfer pursuant to an obligation of support is a seldom-discussed exception. See John Steinkamp, Common Sense and the Gift Tax Annual Exclusion, 72 NEB. L. REV. 106 (1998). The scope of the exception depends on the extent of the obligation under state law. See Revenue Ruling 59-357 & Revenue Ruling 56-484.
Under Indiana Code section 31-16-6-6, a parent has a duty to support a child until the child attains the age of 19 years unless, among other things, the child is emancipated or has attained the age of 18 years and has not attended a secondary school or postsecondary educational institution for the prior four months and is not then enrolled in such a school. Further, the obligation of support requires a parent to provide for a child’s educational needs until he or she reaches age 21.
This exception clearly extends to the necessities of life, such as food, clothing, shelter and likely even to reasonable gifts for birthdays and achievements. But it is difficult to determine where obligation ends and gift begins. See Allan J. Parker, How to Avoid Fraud Penalties in Estate Planning, 7 Inst. On Est. Plan 13-1 (1973). For example, is a nice Swiss watch a reasonable birthday gift under an obligation of support?
The Tax Court seems to think that, at least to some extent, the determination of whether a transfer is under an obligation of support depends on the parent’s income. In Braun v. Commissioner, T.C. Memo 1984-285, the Tax Court held that in taking into consideration the parents’ financial ability, the parents were required under an obligation of support to send their children to a private high school. In Stone v. Commissioner, T.C. Memo 1987-454, the Tax Court held that the parents’ obligation of support extended to private school expenses because under state law the parents were obligated to support and educate their children to the extent the parents were able, taking into consideration the parents’ earnings or earning capacity.
In that the purpose for the gift tax is to avoid the inter vivos transfer of wealth in the avoidance of federal estate tax, any transfer under an obligation of support should likely be reasonable. Therefore, a gift of loose diamonds or gold bullion to a child for his or her birthday looks like an attempt to transfer wealth and is likely a taxable gift; whereas, a transfer of an equivalent value for a nice Swiss watch may not be unreasonable, depending on the financial ability of the parent.
Gift reporting and tax
A transfer that is either (i) a taxable gift (i.e., gift tax is required to be paid), (ii) a transfer where spouses elect to split a gift, or (iii) a transfer that uses a parent’s lifetime exemption amount (currently, $11.4 million) must be reported on Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return) in the year the transfer was made. If no tax is owed, there is currently no penalty for the late filing of a Form 709. Therefore, it is in every parent’s best interest to report those gifts to a child that should be reported. If a parent is unsure as to whether a gift is reportable, he or she should contact an estate planning attorney.•
• Rick Kissel — [email protected] — is a partner and Aaron Snellenbarger — [email protected] — is an associate in Taft Stettinius & Hollister’s private client group. Opinions expressed are those of the authors.