Just over two years ago I discussed Superman’s (lack of) tax liability for crushing coal into diamonds and (actual) gift tax liability if he gave those diamonds to another person. In the comments to that post I mentioned that Superman could theoretically avoid gift tax liability by performing the gratuitous service of crushing coal into diamonds rather than giving a finished diamond. In this post I’d like to expand on that topic briefly.
I. Form Over Substance
Although it is true that gratuitous services are not taxed, it is also true that the IRS and the courts frown on tax avoidance schemes that attempt to exalt form over substance. Gregory v. Helvering, 293 U.S. 465 (1935). So a scheme by which Superman handed someone a piece of coal, fully intending to turn it into a diamond, then did so, would be tantamount to simply giving them a diamond. The IRS would focus on the substance of the transaction, not the form, and consider it a taxable gift of property.
But if, for example, Superman were at someone’s house for a barbecue and decided to thank them for dinner by crushing a lump of their own charcoal into a diamond, that would be different. In that case Superman really would be performing a gratuitous service.
This may seem like a fine distinction, but think of it in terms of a famous baseball player. If the baseball player hands someone a baseball (retail value $3) and then signs it (market value $500), that’s not really a gratuitous service. They’re really just giving the person a signed baseball. But if the baseball player signs a baseball that the recipient already owns, then that is more clearly a service rather than a gift of property.
II. Engagement Rings
Superman has crushed coal into diamonds for various reasons, but one of the best known was his gift of a ring to Lana Lang in Superman III. This raises an interesting question: is an engagement ring subject to gift tax? There is, subject to certain qualifications, an unlimited marital deduction for gifts between spouses, but what about an engagement ring, which is given in anticipation of marriage?
The law surrounding engagement rings and other pre-nuptial gifts has a long and complex history, dating back to at least the Romans. Most of the law has to do with who owns such gifts, particularly if the marriage is called off. But it turns out that none of that matters for tax purposes. If the donor and donee aren’t married at the time of the gift, then the marital deduction doesn’t apply. 26 U.S.C. § 2523(a). So an engagement ring is subject to gift tax, even if the donor and donee get married later that same year. In practice I suspect that few people actually report such gifts, even in the rare case where it would make a difference in their ultimate tax liability, but maybe Superman would actually be moral enough to do so.
Crushing coal into diamonds still doesn’t create tax liability for Superman, and he still has some ways to avoid liability if he crushes coal into diamonds for other people, but he has to be careful about it. And strictly speaking he probably should have reported that ring he gave to Lana.