Tuesday, February 10, 2015

Why Tax Gifts?

-- Posted by Neil H. Buchanan

In my Dorf on Law post this past Friday, I discussed the mini-controversy that erupted regarding the tax treatment of the Most Valuable Player award (a Chevrolet truck) that New England Patriots quarterback Tom Brady won on February 1 in the Super Bowl.  Professor Dorf, in the comments section of that post, offered an interesting question/musing that, I think, deserves some further thought.  Here, after summarizing the controversy, I will offer some preliminary thoughts on the purposes of taxing gifts.

The short version of the story is this: Brady wins truck.  Truck is Gross Income for income tax purposes.  If truck is worth $34,000 and Brady is in the top income tax bracket (39.6%), he will pay a bit less than $13,500 in income taxes.  Or, to put it differently, he is able to buy a $34,000 truck for $13,500, a $20,500 discount from what mere mortals would pay.  But Brady clearly does not need a truck (or anything else, having made $150 million during his playing career thus far, with $50 million or so still on the horizon), so he thinks it would be nice to give the truck to the guy who saved the game, Malcolm Butler, who was paid a total of about $550,000 in salary for the year.

If Brady does so, he will potentially pay a gift tax.  It turns out that Brady and his wife could automatically exclude the first $28,000 of the gift from gift tax liability, and they could decide to exclude the remaining $6,000, with the possible consequence that the tax-free portion of their estate when they die will be reduced by $6,000.  If they do pay the 40% gift tax on the $6,000 today, they will pay $2400 to give Butler a $34,000 gift.  As I noted in an update on Friday's post, there is some controversy over Brady's ability to, as has now been reported, avoid any tax liability by disclaiming the truck and asking that it be given directly to Butler, who will now (assuming that he is in the top bracket, which is far less likely) pay $13,500 for a $34,000 truck that he might actually want.  (If he does not want it, he can sell it and keep the cash.)

In my post, I argued that this situation is a perfect distillation of the "what happens next?" question that arises when people decry taxes.  If we do not collect the gift tax (which is the net result of allowing Brady to disclaim ownership of the truck, rather than saying that he owns it and must pay the gift tax if he gives it away), then what do we do about the $2,400 that he would have paid in gift taxes?  Although that number is, in the grand scheme of things, the rounding error of a rounding error, it still captures the three possibilities: (1) Have someone or everyone else make up the $2400 by increasing their taxes above where they would otherwise have been, (2) Cut $2400 in government spending that we would not have cut anyway, or (3) Increase the deficit by $2400.  The second and third possibilities (and, in a slightly different way, the first possibility as well) boil down to the same thing: We are allowing Tom Brady to avoid $2400 in taxes, with the consequence that the potential recipient of the next-best use of those funds -- the kid who would fill the next slot in a Head Start program, another part-time staff member at a Veterans hospital, a person whose taxes might have been reduced, and so on -- is told that "there is no money" for them.

Again, although the numbers are small in this example, this is the logic that attends any decision to say, "Well, let's give this guy a break!"  As the conservative icon Milton Friedman insisted on repeating throughout his life, there is no free lunch.  One cannot simply say, "We don't need that money," without asking who is left in the lurch by not collecting the legally owed taxes.  And we must also ask exactly the same question when we decide whether to change how much money to collect in taxes in the first place.  No matter whether we fail to collect the $2400 via "prosecutorial discretion" ("Ah, heck, he's a Super Bowl hero") or by enacting an explicit tax cut, there are consequences to not collecting that money.

Which brings us to Professor Dorf's query:
While I share Prof. Buchanan's lack of sympathy for the reflexively anti-tax position, I wonder whether something else might be said here. A person can do more or less three things with his or her stuff (including money): 1) consume it; 2) save it; or 3) give it away. The federal govt does not tax consumption (although states and localities impose sales taxes that function as consumption taxes to varying degrees). Nor does the federal govt tax savings (as opposed to interest and capital gains on saved assets). But the federal govt does tax givings away, albeit only above a very high threshold. Why?

In my view, the gift tax serves mainly to prevent the wealthy from evading estate tax by giving away their assets to their heirs while they are still alive. Now this is a loose fit, to be sure, especially because the high threshold for the estate tax and the possibility of estate tax avoidance through estate planning make the estate tax non-salient in many circumstances. Still, I do think the gift tax is best seen as a backstop to the estate tax. Otherwise, it's hard to make sense of why the federal govt would tax giving but not consuming or saving.

And so . . . one might think that the gift tax is not aimed at cases like Brady-to-Butler because we have difficulty imagining that but for the truck gift, Butler would be in Brady's will. That's not to say that the gift tax SHOULDN'T be applicable to this sort of case; only that it may feel like a misapplication of the motivating principle behind the gift tax. 
There is a lot to be said for this view.  Indeed, the common usage among tax types is to refer to the "estate, gift, and generation-skipping transfer taxes" as a coherent whole, and it is clear that the people in past Congresses who have thought about such things have understood that the three taxes must be understood as backups to each other.  As Professor Dorf suggests, failing to do so simply begs clever planners to find ways to evade tax liability through timing ploys.

The "loose fit" that Professor Dorf describes is also important.  Under current law, if a taxpayer holds onto his wealth (no matter whether he accumulated it during his life, or, as is still quite common at the higher ends of the wealth spectrum, he simply inherited it and lived off the unearned income throughout his life), when he dies any capital gain will be untouched by the income tax.  We then allow the estate's executor to give up to $5.43 million per spouse in bequests to designated inheritors, who pay nothing in income taxes.  Even if the decedent would have owed taxes on, say, $4 million in untaxed gains had he cashed in before death, his heirs could turn around and sell any amount of inherited assets and act as if they had received a net gain of $0.  $4 million is never taxed.  Indeed, President Obama's 2015 budget includes a proposal to eliminate this tax break for large estates.  If anything, therefore, the "fit" between the estate and gift taxes is set up to encourage people to hold appreciating assets during life, then allowing the decedents to give the assets tax-free to heirs.

But is there any other purpose to taxing gifts?  I think so.  Professor Dorf notes that the federal government does not tax consumption or savings (other than by taxing income in the first place, with consumption and saving being derived from after-tax incomes), and thus it might seem odd to tax the other option -- gifts given during life.  Note first that the federal government has, at various times, imposed "luxury taxes" of various sorts, which are consumption taxes that are aimed at people who "have enough" (because they are now buying extra-large yachts, for example) and are thus deemed to be able to turn over some of their bounty for the use of people who are less fortunate.

It is this motivation, I think, that justifies the gift tax on its own merits.  If a person chooses neither to consume nor to save, but has enough money that they can give it away in large amounts, then they are certainly signaling that they "have enough" and that they are willing to share it with someone else.  Current law appropriately allows such transfers in smaller amounts, so that parents can give their children a down payment on a first home, and so on.  The tax on large gifts, then, says that if Tom Brady is fortunate enough to be able to give someone $34,000, then he has the ability to pay for something beyond increasing the pleasure of a highly-compensated friend.

One might object that this approach presumes that the government possesses more wisdom about "appropriate" uses of money than wealthy people do.  I am actually quite willing to support that general proposition, but it is not necessary to do so here.  Current law allows tax-free gifts to charity both during life and at death, so that a person can give away $100 million and never pay gift or estate taxes, so long as the recipients are legitimate 501(c)(3) organizations (and $10.86 million can still go to one person tax-free).  Personally, I think that we should tighten up the rules on what counts as a legitimate charitable purpose, but that is beside the point here.

Therefore, even if there were no necessary strategic overlap between estate, gift, and other wealth transfer taxes, the gift tax could be justified on its own as a statement by society that large gifts cannot be concentrated on a small number of recipients.  The motivating principle behind the gift tax, then, could properly be understood as follows: A person who is thinking of giving his money away can either give the money to larger numbers of people on his own, or he can give it to a charitable organization to do so on his behalf, or he can pay a fraction of the gift in taxes that the government will use to do the same.


Michael C. Dorf said...

I'm persuaded that the gift tax is a useful way of channeling largesse towards charitable organizations. I wonder what the actual motivation is for the sorts of gifts that typically do trigger the gift tax. E.g., what fraction of them are intra-familial, etc.

Hashim said...

Isn't there a simpler, and more neutral, answer to Mike's point? Namely, the gift is income to the donee. But the Govt doesn't want to tax donees (partly because it reduces the joy of receiving a gift, and partly because of liquidity concerns where the gift isn't cash). So it exempts gifts from their income and instead simply taxes the donor, who is presumably better able to pay the tax.

David Ricardo said...

An excellent exposition by Mr. Buchanan, and it does provide one answer as to why to tax the donor for a large gift in addition to the rationale that the gift tax must be part of the estate tax regime in order to make estate taxes operative. And there is, I think an additional rationale for taxing gifts.

The ability to privately accumulate a large amount of assets and to transfer those assets to another individual is a privilege created by and protected by government. The concept of the right of private property is a philosophical choice that our society has made, and is in fact a discretionary decision. Societies can exist and have existed without the provision for private property. But once a society determines that it will allow the right of private ownership and the right to transfer that property to new private ownership government is necessary to support and protect those rights. So one could look upon the gift tax as conforming to the ‘benefits received’ theory of taxation, that the gift tax provides support for government police and judicial services that in return protect the rights of private property and the right to transfer that property to another.

And note that this argument is consistent with the position that one reason for progressive taxation is that the greater one's income and wealth the greater the benefit received from government police, judicial and civil protections.

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