Income tax vs. gift tax - dependants as donees.

Most CPAs are aware of the income tax rules governing the claiming of a personal exemption for a dependent. But are they also aware that the same support payments that determine who claims the personal expemption can, in some cases, be classified as taxable gifts?

Personal exemptions

The Code and Treasury regulations have identified five tests that must be met before an exemption for a dependent is allowed. (As is typical with the income tax laws, there are exceptions to the general rules; however, they are too numerous to cover here.) If all five tests are satisfied, the taxpayer may claim the person as a dependent. 1. The dependent's gross income must be less than the exemption amount ($2,350 for 1993) for the calendar year, unless the dependent is the taxpayer's child and is either under age 19 or a full-time student under age 24. 2. The taxpayer must provide over half the dependent's total support for the calendar year. There are exceptions for multiple support agreements and children of divorced parents. 3. The dependent and the taxpayer must meet one of the defined relationships: * Child, stepchild, adopted child or grandchild. * Brother or sister. * Half-brother or half-sister. * Stepbrother or stepsister. * Mother or father or ancestor of either. * Stepmother or stepfather. * Niece or nephew. * Aunt or uncle. * One of various in-laws. * A member of the taxpayer's household for the entire tax year. 4. The dependent cannot have filed a joint return with his spouse. 5. The dependent must generally be a citizen, national or resident of the United States.

Gifts

A gift is a voluntary transfer of property by one person to another without consideration or compensation. A gift generally requires three elements: (1) the intention on the donor's part to make the gift, (2) the delivery by the donor of the subject matter of the gift and (3) the acceptance of the gift by the donee. The IRS attempted to remove the requirement of donative intent by classifying the transfer of property for less than adequate and full consideration as a gift to the extent the value of the property exceeds the value of the consideration. Case law, however, has generally provided that all three elements of a gift, including the intent to make a gift, must be present.

When support is provided to a dependent, the issue arises as to whether or not the taxpayer has made a gift to the dependent under the gift tax laws. For example, a taxpayer may claim an adult brother or sister as a dependent if the sibling has less than $2,350 of income and the taxpayer provides more than half of his support. For income tax purposes, it is clear that the taxpayer is entitled to a personal exemption for that sibling. However, the gift tax provisions operate independently from the income tax provisions. In this example, the taxpayer has also made a gift to the sibling, even though the taxpayer is entitled to a personal exemption for income tax purposes.

The wording of the Code and regulations in the gift tax area seems to indicate that all payments made in support of dependents should be treated as gifts. This would appear to include payments made for dependent children. However, the courts have generally decided, sometimes in the face of opposition from the IRS, that transfers made solely in discharge of a legal obligation of support are not gifts. In addition, the IRS applies a strict rule in determining whether a legal support obligation exists. This issue is determined by the laws of each state. It is, therefore, incumbent on the CPA to determine the extent of the support obligation between parties in his state. Unless an enforceable legal obligation of support exists between the transferor and transferee, any transfers, even for such basic support items as food, clothing and shelter, will be deemed gifts.

In determining the necessity of filing a gift tax return, the CPA should consider the various exceptions to the gift tax rules. The Code provides that gifts of a present interest in property are excluded from the gift tax for the first $10,000 of such gifts per recipient each year. In addition, a husband and wife can elect to split their gifts such that a gift of up to $20,000 per recipient may be made by one spouse if the other spouse consents to making the gift. Gift splitting requires the filing of a gift tax return, but does not cause a taxable gift to occur. Gifts between spouses are also exempt from the gift tax provisions. Nonspousal gifts in excess of the annual exclusion require filing a gift tax return and will cause the use of a portion of the unified estate and gift tax credit.

The Economic Recovery Tax Act of 1981 also added a new exclusion from taxable gifts for qualified transfers on behalf of an individual made directly to persons who provide education or medical care to that individual. Therefore, any person can make a gift in any amount to any other person for tuition or medical care, as long as the payment is made directly to the person or organization providing the education or medical care. The exception for tuition payments does not apply to other fees, such as room and board, or books and supplies.

Conclusion

CPAs must consider all aspects of the Code when providing services to their clients. It may be prudent to add an item to the income tax return preparation checklist to address the issue of taxable gifts when a client claims exemptions for dependents other than minor children. Practitioners must also be aware of the laws of the state in which they reside on the issue of the legal obligation of support.