Originally published on Passive Activities and Other Oxymorons on February 16th, 2011.
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Judith F. Lang v. Commissioner, TC Memo 2010-286
From time to time I encounter confused people. They might for example think that they can give $13,000 to each of their kids and deduct it. That’s not the way it works. The $13,000 is the amount that you can give to as many individuals as you want to – including me by the way (I’ll tell you where to mail the check) – without having a taxable gift (Under the new regime, you can have $5,000,000 in taxable gifts before you have to start paying gift tax). Gift tax is the responsibility of the person making the gift. Income tax is the responsibility of the person receiving taxable income, which does not include gifts. So what happens if your aunt gives you $10,000,000 of low basis stock, but wants you to pay the gift tax for her ? You and your aunt can give me a call and I’ll work with you on it. This post is about something that happens with the merely wealthy.
The annual exclusion is not the only exclusion from gift tax. There is also an exclusion for gifts made for medical or educational purposes. In order to qualify for the exclusion the donor must pay the bills directly. So if you pay the medical bills of your adult children those payments are excluded for gift tax purposes (i.e. You can give the ne’er do wells who can’t pay their own medical bills $13,000 in cash on top of that without eating into your $5,000,000. They’ll still probably resent you, but you’ll need to find another blog to deal with those issues.)
Medical expenses are also deductible for income tax purposes, though. What is supposed to happen for income tax purposes when your medical bills are paid by someone else ? Judith Lang had some heavy medical expenses and was behind on her real estate taxes. Fortunately, she had a generous Mom :
Petitioner’s mother, Frances Field (Mrs. Field), paid $24,559 directly to medical providers on account of petitioner’s medical expenses and paid $5,508 directly to the city government on account of petitioner’s real estate tax. Petitioner was not a minor, and Mrs. Field was not legally obligated to pay petitioner’s expenses.
Ms. Lang thought that she should be able to deduct these payments for income tax purposes:
It is petitioner’s position that although Mrs. Field made the payments directly to petitioner’s creditors, we should consider them to have in substance passed from Mrs. Field to petitioner and then to petitioner’s creditors; therefore petitioner should be entitled to deduct the payments.
The IRS did not agree:
Respondent contends that the form of the transaction should apply and that because the money was paid directly from Mrs. Field to petitioner’s creditors, petitioner may not claim the deductions.
The Tax Court noted that the IRS did not claim that Ms. Fields had deducted the medical expenses only that Ms. Lang was precluded from deducting them because she had not paid them.
The Tax Court ruled in favor of the taxpayer with respect to both the medical expenses and the real estate taxes. With respect to the medical expenses they noted:
Although Mrs. Field and petitioner would not be subject to the gift tax, the income tax treatment in this context is not controlled by the gift tax consequence.
Petitioner should be credited with having made the payments for purposes of the income tax deduction in question.
With respect to the real estate taxes the issue was even clearer:
Mrs. Field paid $5,508 directly to the city government in discharge of petitioner’s obligation for real estate tax. Again applying substance over form, we treat petitioner as having received from her mother a gift of the $5,508 with which petitioner paid the city in satisfaction of her own real estate tax. Thus petitioner is entitled to a deduction under section 164 for that amount.
We note that there is no danger of a “double deduction” arising from our decision on this issue. See Rome I, Ltd. v. Commissioner, 96 T.C. 697, 704 (1991) (”Double deductions are impermissible *** absent a clear declaration of intent of Congress.”). Because the real estate tax was imposed upon petitioner, she is the only taxpayer who may deduct it; Mrs. Field may not. See sec. 1.164-1(a), Income Tax Regs.
This is a significant decision for some wealthy families where transfer tax concerns outweigh income tax concerns. It would be a good idea to review the individual returns of family members who have benefited from gift tax excludable medical gifts.