Gift May Create Income or Gain to Donor

Think a gift results in no income or gain to the donor? Gifts of encumbered property, installment notes and certain stock options and net gifts may trigger donor income or capital gain. This article's many examples illustrate when this may occur and offers guidance.

Boyd C. Randall, Ph.D., J.D.
Ernst & Young Professor of Taxation
School of Accountancy and Information Systems
Brigham Young University
Provo, UT

Robert L. Gardner, Ph.D.
Robert J. Smith Professor of Taxation
School of Accountancy and Information Systems
Brigham Young University
Provo, UT

Dave N. Stewart, Ph.D., CPA
Rachel Martin Professor of Taxation
School of Accountancy and Information Systems
Brigham Young University
Provo, UT

For more information about this article, contact Dr. Randall at (801) 378-2314 or Boyd_Randall@byu.edu or Dr. Gardner at (801) 378-3212 or gardner@byu.ed.

Executive Summary

• When encumbered property is transferred by gift to a donee, the determination of the transferor's potential income recognition depends on whether the donee is a charity.

• The basis of property in a bargain sale to a charity must be allocated between the sale and the gift.

• A donor will recognize income on a net gift if the tax the donee paid exceeds the donor's basis in the property transferred.

In the estate planning arena, tax professionals most often focus on transfer tax minimization. However, when a plan involves transfers of property in gift form, care should be taken that such transfers do not result in undesirable income tax consequences. This article examines situations in which gifts unexpectedly create income to a donor.

Noncash Gifts

Regs. Sec. 25.2512-8 defines a "gift" as a donor's voluntary transfer of cash or property without a receipt of valuable consideration in exchange. Because the donor receives no consideration, a gift does not usually create income or gain to him. However, a donor may receive partial consideration; such transactions are treated as a part-gift and part-sale, which may result in donor income or gain. Two of the most common part-gift and part-sale transactions are gifts of encumbered property and net gifts. Other gifts that may give rise to unexpected income to a donor include transfers of certain installment obligations and gifts of stock options. Tax advisers need to be aware of these types of gifts to ensure that both transfer and income taxes are minimized.

Encumbered Property

When encumbered property is transferred by gift to a donee, the determination of the transferor's potential income recognition depends on whether the donee is a charity. This distinction arises because different basis rules apply under Sec. 1011 to transfers of property to noncharities and charities.

Noncharitable Donees

When a taxpayer transfers property for less than its fair market value (FMV) other than in a business context, the transfer is a gift to the extent the FMV exceeds the proceeds the transferor received.¹ Thus, when a donor receives nothing in exchange for a transfer, the amount of the gift for transfer tax purposes is the property's FMV.² On the other hand, a gift of encumbered property is valued for gift tax purposes as the excess of the property's FMV at the time of the gift over any debt to which the property is subject.³ The liability encumbering the property is deemed consideration paid to the transferor, resulting in a part-gift and part-sale.⁴ Regs. Sec. 1.1001-1(e) provides that on transfers of property to a noncharity that result in a part-gift and part-sale, the donor realizes income to the extent the proceeds received (i.e., the liability encumbering the property) exceed the donor's adjusted basis.⁵

Example 1: D transferred a parcel of land to her son, S. At the time of the transfer, the land's FMV was $300,000; D's adjusted basis was $150,000. The land is encumbered by a $175,000 mortgage.

The transfer of the encumbered land is treated as a part-gift and part-sale. D must recognize $25,000 of income ($175,000 (mortgage) – $150,000 (adjusted basis)) on the gift, because the mortgage is treated as proceeds D received. The gift is $125,000 ($300,000 – $175,000).

Example 2: G created an irrevocable trust and transferred $50,000 to it. A trust provision gives G the power to change trust beneficiaries. The trust uses the $50,000 to acquire a 40% interest in a new limited liability company (LLC). In the first two years of operation, the trust's share of the LLC's losses are $55,000 and $30,000. G has sufficient basis to deduct these losses on his return. At the beginning of the LLC's third year of operations, G irrevocably renounces his power to change trust beneficiaries; at that time, the LLC has $200,000 in outstanding debt.

G's transfer of $50,000 to the trust was an incomplete gift under Regs. Sec. 25.2511-2(c), because G retained a power to change trust beneficiaries. Thus, the trust is treated as a grantor trust under Sec. 674(a). According to Regs. Sec. 25.2511-2(f), G's renunciation of his retained power at the beginning of the third year completes the transfer to the trust as a gift to the beneficiaries. At the time of the gift, G's LLC basis is $45,000, computed as follows:

G's transfer is treated as a part-gift and part-sale. G's $80,000 share of the LLC's debt is treated as an amount G received. Because G's basis in his LLC interest is only $45,000, G must report $35,000 income ($80,000 – $45,000) on the gift (i.e., his renunciation of the retained power).⁶

In summary, a donor's gift of encumbered property to a noncharity will result in donor income recognition when the liability on the gifted property exceeds the donor's basis. The above examples illustrate that both transfer and income tax consequences must be considered when contemplating such a gift.

Charitable Donees

Under Sec. 1011(b), a bargain sale to a charity is treated as a part-sale and part-gift. A gratuitous transfer of encumbered property to a charity is a bargain sale; the mortgage or other liability is treated by Regs. Sec. 1.1011-2(a)(3) as an amount the donor realized, even if the charity has not agreed to assume or pay the debt. However, unlike a transfer of encumbered property to a noncharity (in which the property's entire basis is measured against the transferred liability to compute the realized gain), the basis of property in a bargain sale to a charity must be allocated between the sale and the gift. This may trigger income or capital gain to the donor.

Under Sec. 1011(b), the property's adjusted basis for determining gain on a bargain sale is that portion of the adjusted basis that bears the same ratio to the total adjusted basis as the amount realized bears to the property's FMV. The adjusted basis is then subtracted from the amount realized (i.e., the liability transferred) to determine the donor's income or gain.⁷ If the transferred liability exceeds the adjusted basis allocated to the liability, the donor will recognize gain to the extent of the excess.

Example 3: D transferred a parcel of land to a charity. At the time of the transfer, the land's FMV was $400,000 and D's adjusted basis was $150,000. The land is encumbered by a $100,000 nonrecourse mortgage.

Because the transfer is a bargain sale to charity, the property's basis must be allocated between the gift and the sale. The $100,000 liability is the amount D realized on the transfer. The basis allocated to the liability is $37,500 ($150,000 (basis) x [$100,000 (liability)/$400,000 (FMV)]). Thus, D recognizes $62,500 income ($100,000 (liability) – $37,500 (basis)) on his charitable gift of land.

Example 4: D, age 50, transferred a parcel of land to a charitable remainder annuity trust (CRAT) on Jan. 1, 2002. At the time of the transfer, the land had a FMV of $1,000,000 and is encumbered by a $400,000 mortgage. D's basis in the land was $500,000. D retained a $40,000 annual annuity for life payable on January 15 each year. At the time of the transfer of the land to the trust, the Sec. 7520 rate was seven percent.

The value of the remainder that D transferred to charity (and that qualifies as a charitable contribution) is $139,943, computed as follows:

footnote 8

Because D transferred mortgaged land to a charity, the transfer is a bargain sale. The liability is treated by D as an amount realized.⁹ It may seem appropriate to allocate a portion of the liability to the donor's retained life annuity. However, the Service has made it clear that the entire liability should be treated as an amount the donor realized as part of the sale transaction, rather than the gift transaction. Hence, the basis allocated to the liability is $200,000 ($500,000 (basis) x [$400,000 (liability)/$1,000,000 (FMV)]). D recognizes $200,000 income ($400,000 (liability) – $200,000 (basis)) on the transfer of land to the CRAT.

In summary, whenever a donor transfers encumbered property to a charity and the property's FMV exceeds the donor's basis, the donor will recognize income; further, under Sec. 1011(b), the property's basis has to be allocated between the transaction's gift and sale portions. As illustrated in Example 4 above, this is the case even if the donor is transferring only a remainder interest to charity.

Net Gifts

Because a donor (rather than a donee) is liable under Sec. 2502(c) for the payment of any gift tax, a gift's value is not adjusted for Federal gift tax incurred in the transaction. However, if a gift is made on the condition that the donee will pay the resulting gift tax liability, the transfer is a "net gift"; the amount of the gift is the excess of the transferred property's FMV over the gift tax attributable to the net gift.¹⁰ The net gift depends on the amount of the gift tax which, in turn, depends on the amount of the net gift. The following formula is used to determine the gift tax and the net gift:¹¹

Generally, no income is recognized on the transfer of a net gift. However, income may result if the value of the gifted property has appreciated over its basis, causing the gift tax incurred in the transaction to exceed the donor's basis in the property. In this case, the donor will recognize income to the extent the gift tax paid by the donee exceeds the donor's basis in the transferred property.¹²

Example 5: D made no taxable gifts in preceding years. In 2001, D gifted a parcel of land to A on condition that A pay the resulting gift tax. The land's FMV on the date of the gift was $900,000 (after deducting the annual exclusion); D's basis was $50,000. The tax and the taxable gift are computed as follows:

Thus, the gift tax is $62,050; the net gift is $837,950 ($900,000 – $62,050). Because A pays the $62,050 gift tax, D must recognize $12,050 income ($62,050 (gift tax imposed) – $50,000 (basis)) on the gift of land to A.

Example 6: In a prior year, H created a qualified terminable interest property (QTIP) trust. Trust income was payable at least annually to W for life, with the remainder to their son, S, or his heirs. H transferred stock to the trust with a $1,000,000 FMV and a $100,000 basis. At the time of the gift, H made a QTIP election under Sec. 2523(f). During the current year, W gave her life interest in the trust to her sister. At the time of the gift, W was 60 years of age, the property in the trust had a $1,200,000 FMV and the Sec. 7520 interest rate was eight percent. W has used all of her unified credit and has a gift tax rate of 55%. W paid the gift tax due on the entire transfer. Under Sec. 2207A(b), S reimbursed W for the gift tax paid on the remainder portion of the transfer.

When W transferred her life interest in the QTIP trust, she made a gift of her qualifying income interest under Sec. 2511 and was deemed under Sec. 2519 to have made a gift of the remainder interest. The qualifying income interest is valued at $878,472 ($1,200,000 x (1 2 0.26794))¹³; the remainder interest is valued at $321,528 ($1,200,000 – $878,472).

Sec. 2207A(b) provides that if gift tax is paid by a donor on a Sec. 2519 transfer, he can recover the tax attributable to the transfer from the donee. S received the remainder interest; thus, he reimbursed W for the gift tax she paid on the transfer of the remainder interest. On similar facts, Letter Ruling 9736001¹⁴ concluded:

...with respect to the gift tax imposed as a result of the transfer under 2519, 2207A(b) statutorily shifts the burden, but not the liability, for paying the gift tax to the donee. In reimbursing the donor for the gift tax paid pursuant to the statute, the donee provides consideration for the gift. The donee's payment inures to the benefit of the donor because it reimburses the donor for gift tax that the donor was liable for and would otherwise be required to pay out of the donor's own funds...Accordingly, net gift treatment of a transfer under 2519 is implicit under 2207A(b). (Emphasis in original.)

Thus, the gift of the remainder is a net gift because of S's reimbursement to W for the gift taxes she paid on the remainder. The tax paid on the gift of the remainder is $114,090; the value of the net gift of the remainder is $207,438, computed as follows:

In Example 6, W recognizes income to the extent the gift tax S paid exceeds W's basis in the remainder interest. Under Sec. 1015, W's basis in the stock transferred to the trust is $100,000 (carryover of H's basis). W's basis in the remainder interest is computed under the uniform-basis concept; thus, the same actuarial tables used to determine the value of the partial interests are used to determine the basis of each.¹⁵ Using this concept, W's basis in the remainder interest is $26,794 ($100,000 x 0.26794). Thus, W recognizes income of $87,296 ($114,090 (gift tax reimbursement by S) – $26,794 (basis of remainder interest)) from her gift of the QTIP trust interest.

In summary, when gift tax is paid by a donee, either by agreement with the donor or under Sec. 2207A(b), the Service treats the transaction as a net gift. In such a case, if the tax paid by the donee exceeds the donor's basis in the property transferred, the donor will recognize income. This result is not obvious; tax advisers must take care to counsel potential donors and donees of this somewhat unexpected result.

Installment Obligations

Under Sec. 453B(a), if an installment obligation is distributed, transmitted or disposed of other than by sale or exchange, gain must be recognized to the extent of the excess of the obligation's FMV at the time of distribution, transmission or disposition, over its basis. Thus, if a donor gifts an installment obligation, the gift is a disposition of the obligation by the donor; the donor must recognize the excess of the obligation's FMV on the date of the gift over the donor's basis in the obligation.

Example 7: D transferred to an irrevocable trust a note she received in an installment sale. At the time of the transfer, the installment obligation had a $100,000 FMV and a $20,000 basis. Trust income must be paid to D's son, A, or his heirs for eight years. After that time, the trust will terminate and the trust assets will be distributed to A or his heirs.

Because the transfer of the installment obligation is a disposition of the obligation by D, he must recognize $80,000 ($100,000 – $20,000) income on the transfer to the trust.

Stock Options

ISOs

A stock option is an incentive stock option (ISO) if it meets the Sec. 422 requirements. Under Regs. Sec. 1.83-3(a)(2), an employee who receives an ISO does not recognize income at the grant, because he has not received property. Nor does the employee recognize income when the ISO is exercised, according to Sec. 422(a). The tax treatment of the disposition of ISO stock depends on whether the stock was disposed of within or after the statutory holding period (the later of two years from the grant date or one year from the exercise date). When ISO stock is sold after the completion of the holding period, the gain recognized is the amount received in excess of the employee's basis in the ISO stock (generally, the price paid for the stock on option exercise); the character is capital gain.

When ISO stock is sold before the holding period expires, it is a disqualifying disposition. A disqualifying disposition under Sec. 421(b) causes an employee to recognize as compensation income the difference between the option's exercise price and the ISO stock's FMV at the time of exercise. Any amount realized in excess of the FMV of the ISO stock at the time the option was exercised is capital gain.

Under Sec. 424(c)(1), a gift is treated as a disqualifying disposition. Thus, if an employee gifts ISO stock before the statutory period has expired, he will recognize as compensation income the excess of the ISO stock's FMV at exercise over the exercise price.¹⁶

Example 9: D, an employee of X Corp., was granted ISOs to purchase 100 shares of X stock at $20 per share (the FMV of X stock at the time the ISO was granted). D exercised all of his ISOs when X stock was $25 per share. Before the expiration of the holding period, when the ISO stock's FMV was $28 per share, D transferred his ISO stock to a charitable remainder trust.

Because the gift of the ISO stock to the charitable remainder trust is a disqualifying disposition, D must recognize $500 (100 x ($25 – $20)) of compensation income at the time of the gift. Because the disposition was a gift rather than a sale, D recognizes no capital gain.¹⁷ If D had transferred the ISO stock to the charitable remainder trust after the expiration of the statutory holding period, he would not be required to recognize income on the gift.¹⁸

NQSOs

If an employee receives a nonqualified stock option (NQSO) and the option has a readily ascertainable FMV at the time of grant, Sec. 83 will apply; on the grant date, the employee will recognize as compensation income the option's FMV.¹⁹

If the option does not have a readily ascertainable FMV at grant, the employee will recognize compensation income when the option is exercised or disposed of (as long as the disposition is an arm's-length transaction). In such case, the compensation income is the difference between the stock's FMV and exercise price on the date of the disposition or exercise. If, however, the disposition of the option is not an arm's-length transaction, the employee's total compensation income is not determined until the option is either exercised or disposed of in an arm's-length transaction.²⁰ A transfer of an NQSO to a family member or a trust for the benefit of family members is also a non-arm's-length transaction.²¹

The transfer of an NQSO to a family member or trust for the benefit of family members for no consideration is not a completed gift under Sec. 2511 until the donee's right to exercise the option is no longer conditioned on the donor-transferor's performance of services.²² Hence, the transfer of an NQSO is not a completed gift until the later of the date of (1) transfer or (2) the grant becomes exercisable.

Example 10: X Corp. grants D, in consideration for services rendered or to be rendered, options to buy 5,000 shares of X common stock at $20 per share. The options may be exercised in whole or in part over 10 years. At the time of the grant, the options do not have a readily ascertainable FMV. Several years later, after all of the options are exercisable, D transfers them to an irrevocable trust established for his children's benefit. D retains no control over the trust or the options. At the time D transferred the options to the trust, X common stock had a FMV of $40 per share. The trust retained the options for three years, then exercised all of them. On the date the options were exercised, X common had a FMV of $50 per share.

Because the options did not have a readily ascertainable FMV at the time of the grant, D recognized no compensation income at that time. The transfer of the options to the trust was a non-arm's-length transaction; thus, D recognized no compensation income on the transfer. However, when the trust exercised the options, D (or his estate) recognized $150,000 (5,000 x ($50 – $20)) compensation income.

Conclusion

Generally, taxpayers focus on transfer tax issues when contemplating inter vivos or testamentary transfers of property. However, when making gifts of encumbered property, net gifts, or gifts of an installment note or certain stock options, a donor must also carefully consider the income tax consequences of such transfers to avoid unpleasant surprises.