Income Tax Consequences of Certain Gift Transactions

From The Tax Adviser:

Income Tax Consequences of Certain
Gift Transactions

state planners most often focus on minimizing estate and gift taxes when dealing with their clients’ situations. However, when clients wish to transfer certain types of property as gifts, CPAs should advise them to be wary of possible undesirable income tax consequences.

NONCASH GIFTS

A gift is the voluntary transfer of cash or property without consideration. Because the donor receives no consideration, a gift usually does not create income or gain to him or her. Transactions in which a donor receives partial consideration, however, are treated as part gift and part sale, which may result in income or gain.

The most common of these transactions are gifts of encumbered property, net gifts and gifts of stock options.

Encumbered property. When encumbered property is given as a gift, the donor’s potential income recognition is determined by whether or not the donee is a charity.

Noncharitable donees. A gift of encumbered property is valued as the excess of the property’s fair market value (FMV) at the time of the gift over any debt to which the property is subject. The liability encumbering the property is deemed consideration paid to the transferor; thus, the donor realizes income to the extent the liability exceeds his or her adjusted basis.

Charitable donees. When a donor transfers encumbered property to a charity and the property’s FMV exceeds his or her basis, the donor will recognize income. The basis of the property transferred must be allocated between that portion considered a sale and that considered a gift, which may trigger income or capital gain to the donor.

Net gifts. Because a donor typically is liable for the tax on any gift, its value is not adjusted for federal gift tax incurred. However, if a gift is made on the condition that the donee pay the resulting gift tax liability, the transfer is a “net gift”; the gift amount is the excess of the transferred property’s FMV over the gift tax attributable to the net gift.

Generally, a donor will not recognize any income on the transfer of a net gift. However, if the value of the gifted property has appreciated over its basis and the gift tax exceeds the donor’s basis in the property, he or she may have to recognize income.

Incentive stock options. A stock option is an incentive stock option (ISO) if it meets the requirements of IRC section 422. An employee who receives an ISO does not recognize income when he or she is granted the option or when it is exercised. The treatment of the disposition of the ISO depends on whether the stock was disposed of within the later of two years from the date of grant or one year from the date of exercise. 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 stock, treated as capital gain.

If ISO stock is sold before the holding period expires, the employee must recognize income for the difference between the option’s exercise price and the stock’s FMV.

If an employee gives ISO stock before the holding period has expired, he or she must recognize compensation income for the excess of the stock’s FMV over its exercise price. If the employee waits until the holding period has passed to transfer the stock, he or she is not required to recognize income on the gift.

For discussion of these issues, see “Gift May Create Income or Gain to Donor,” by Boyd Randall, Robert Gardner and Dave Stewart, in the January 2002 issue of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser