Low-Interest-Rate and Interest-Free Loans

Certain interest-free and below-market-interest-rate loans result in a taxable gift from the lender to the borrower. The lender is treated as making a gift of the amount necessary to pay the market rate of interest on the loan in excess of the actual interest rate of the loan.

For demand loans (loans due and payable at any time at the demand of the lender), the gift amount equals the amount of the foregone interest calculated by using the Applicable Federal Rate (AFR), published monthly by the Internal Revenue Service (IRS). For term loans, the gift amount equals the excess of the amount loaned over the present value of all payments due under the loan, determined as of the day the loan was made, using a discount rate equal to the AFR.

There is an exception for certain small loans: Generally, a taxable gift of the foregone interest is ignored for gift loans directly between individuals when the aggregate outstanding loans between them does not exceed $10,000.

Powers of Appointment

A general power of appointment usually exists under a trust arrangement. It is a right or power to direct the trustee to distribute assets in favor of the power holder, his or her estate, or his or her creditors. Such a power is unrestricted, and distributions are not limited by an ascertainable standard (such as only for his or her reasonable support, maintenance, education and health). The exercise of a general power of appointment, as well as the release of a general power of appointment, is a gift by the holder of the power to the recipients of the assets over which the power could have been exercised.

Similarly, the failure to exercise a general power of appointment before the power lapses is a taxable gift by the holder of the power. Unlike the release, the value of the gift is the amount by which the lapse exceeds the greater of $5,000 or 5% of the value of the trust assets over which the power could have been exercised (the 5-and-5 rule).

Lapses of powers of appointment often are associated with irrevocable trusts where the cash or other contributions to the trust are subject to limited withdrawal rights granted to the beneficiaries (Crummey rights). The Crummey withdrawal rights are powers given to the beneficiaries to withdraw all or a part of the gifted funds for a limited period of time and therefore are general powers of appointment.

Granting Crummey rights allows the gifted funds to qualify for the $10,000 gift tax annual exclusion. Assuming the withdrawal rights are not exercised, the funds are then available to pay premiums. Therefore, it is not desirable for the right of withdrawal to remain, and the Crummey rights generally are structured to lapse each year within the 5-and-5 rule discussed above, resulting in a gift with no federal gift tax consequences.

Other Unintentional Gifts

Loans and powers of appointment are not the only areas where an unintended gift can occur. Here are some common situations where unintentional gifts may be made:

Third Party Transfers. You transfer assets to a third person with the understanding that he or she will transfer the property to someone else. The assets are a taxable gift from you to the ultimate recipient of the property.

Forgiveness of Loans. You make a loan to a child or other relative with the intent of forgiving part of the debt each year in an amount equal to the gift tax annual exclusion. The whole loan amount is a taxable gift in the year the loan is made because you have no intent to collect on the loan.

Joint Bank Accounts. You establish a bank account or a brokerage account (where the investments are held in nominee or street name) as a joint account. The noncontributing joint owner makes a withdrawal from the account for his or her own benefit. This withdrawal is a taxable gift from you. (No taxable gift is made at the time the account is established.)

Life Insurance Premiums. You pay premiums on an insurance policy on your life that is owned by an irrevocable life insurance trust. The payments are taxable gifts to the trust beneficiaries. Similarly, premium payments you make on an insurance policy on your life owned by any third party are a gift to that third party.

Life Insurance Proceeds. You own an insurance policy on your life. Your spouse is named as beneficiary. You make a gift of the policy to your children to get the policy out of your estate. If you die without your children having changed the beneficiary designation to themselves, your children will have made a gift of the insurance proceeds to your spouse.

Payment of Outstanding Mortgage. You pay the outstanding balance of a mortgage on a principal residence held in a Qualified Personal Residence Trust (QPRT) after it is established and before the end of the trust term. This payment is a taxable gift to the remaindermen beneficiaries. Also, under a QPRT, any improvement or remodeling of the residence paid for by the grantor of the trust is a gift.

Relinquishing Pension Plan Rights. You relinquish your vested rights in your employer’s contributions under a nonqualified pension or profit-sharing plan and trust. You have made a taxable gift to the other plan participants.

Gift of Stock From Child to Grandchild. You transfer common stock in a family-owned corporation from you to your child. Under the new estate freeze rules, this transfer may be a taxable gift by your parents to your child if your parents own preferred stock in the family-owned corporation.

Lapse of Voting or Liquidation Rights. You lapse your voting or liquidation right in a corporation or partnership. This lapse is treated as a taxable gift by you if you and members of your family hold, both before and after the lapse, control of the entity and if the lapse occurs during your lifetime.

Disclaimers of Property. You make a disclaimer of property either later than nine months after the property interest is created or that causes the disclaimer not to be a qualified disclaimer. For federal gift tax purposes, you have made a taxable gift to those who receive the property. 

Awareness Is the Key

Lifetime gifts play a major role in many estate plans. Significant tax savings can be achieved that would not be available if the transfers were delayed until death. However, a gifting program should occur by intent and not by default.

The federal gift tax laws contain many different provisions that can cause unintended gifts by an estate owner. All intrafamily transactions involving corporations, limited liability companies, partnerships, trusts and buy-sell agreements can give rise to gift tax consequences and should be carefully planned.