It's the IRS's job to look for estate planning strategies that cross the line from clever to forbidden. Here are a few gift-giving strategies frowned on by the feds. Even if you're not making gifts in order to save on gift and estate tax, you don't want to inadvertently stir up a gift tax problem.
Loans That Are Really Gifts
Some parents have made large loans to their children, intending to forgive the repayments each year, in an amount equal to the annual gift tax exclusion amount. The IRS, skeptical of these arrangements to start with, makes it difficult for families to prove that they are bona fide loans, not gifts in disguise. But the bottom line seems to be that if you are meticulous about your paperwork, this strategy can be successful.
The IRS starts with the presumption that a transfer between family members is a gift. You can get around that presumption by showing that you really expected repayment and intended to enforce the debt. In making that determination, the IRS pays attention to whether or not:
- The borrower signed a promissory note.
- You charged interest.
- There was security (collateral) for the debt.
- You demanded repayment.
- The borrower actually repaid some of the loan.
- There was a fixed date that the loan was due to be repaid.
- The borrower had the ability to repay.
- Your records or those of the recipient indicated that the transfer was a loan.
- The transaction was reported, for federal tax purposes, as a loan.
In the case that prompted this slew of considerations, a woman had loaned $100,000 to each of her two sons. They signed promissory notes, and the loans were duly recorded in the books of the family's business, but there was no deadline for repayment. One of the sons made a $15,000 repayment. Their mother never demanded any payments, and each year she sent a letter to the sons, stating that she had forgiven (canceled) some of the debt. The IRS ruled, and the federal Tax Court agreed, that the loans had actually been gifts. The mother ended up not only owing gift tax on the whole amount, but missing out on the years when she could have been (and thought she was) making tax-free annual gifts. (Elizabeth B. Miller, Tax Court Memo 1996-3.)
Don't try this yourself. If you want to set up an elaborate plan for forgiving debts, form is everything. See a lawyer who's experienced in setting up such deals so that they pass IRS scrutiny.
Gifts Made to One Person but Intended for Another
The IRS won't be fooled if you give property to one person but it's obvious that the intended recipient is someone else. For example, the IRS went after the estate of a man who had given annual gifts of stock to his son, daughter-in-law, and grandchildren, classifying each gift as exempt because of the annual gift tax exclusion. For 14 years, the daughter-in-law had faithfully transferred her stock to her husband on the same day she received it. The IRS ruled that the stock was really for the son, and that the gifts to him had exceeded the annual exclusion amount. (Estate of Joseph Cidulka, Tax Court Memo 1996-149.)
The gift tax problem doesn't affect the probate-avoidance aspect of the transaction—the stock was out of the man's estate. But shaving a little off your probate costs may be much more trouble than it's worth if it lands you in a skirmish with the IRS.
Gifts With Strings Attached
If you give it, give it. Don't try to hang onto any control over what you've given away, or you'll turn your gift into something else.
EXAMPLE: Carl deeds his house over to his son, Ishmael, but retains the right to receive rent from the property. The transaction is not a legal gift. When Carl dies, the house will still be part of his estate, which means it may be subject to estate tax.
Make a paper trail. If you think a gift might be questioned later, write up and sign a little statement that explains your intent to make a gift. It will be evidence that you meant to make a gift, if that's ever needed. Such a statement can't turn what is really a loan into a gift, and other evidence may contradict and finally outweigh it—but it can't hurt.