Since the early 2000s, the estate tax burden on taxpayers has gradually decreased along with the number of clients who must worry about tax. Nevertheless, some of the wealthiest clients will have a taxable estate. For these select clients, making inter-vivos gifts can be tax efficient. When such gifts are made, it’s important to properly prepare a federal gift tax return (Form 709) to report the gifts and start the tolling of the statute of limitation. Preparing gift tax returns can, at first, seem straightforward. However, the many nuances in the details and the significant consequences of a mistake can make certain returns very difficult to properly complete.
There are lots of traps for the unwary. And if you fall into any of them, you'll face a lot of liability risk—not so much because of a gift tax audit in the next couple of years—but rather because when the client dies many years from now, a mountain of penalties and interest may have accrued (or tens or hundreds of thousands more in estate taxes may be owed)! Here are six traps to avoid.
Adequate Disclosure of Gift Not Provided
Under the adequate disclosure rules,1 when a gift is adequately disclosed on a gift tax return, the Internal Revenue Service can’t revalue the gifts after the three-year statute of limitations has expired. If a gift wasn’t adequately disclosed, the IRS can revalue the gifts for an indefinite period of time.2 This could ultimately impact the amount of lifetime exemption that’s been used for gift tax returns and the amount that’s available in the future for estate tax purposes.
A transfer will be adequately disclosed on the return only if it’s reported in a manner adequate to apprise the IRS of the nature of the gift and the basis for the value so reported.3 Treasury Regulations Section 301.6501-1 lists the information that’s required to be included on a gift tax return to satisfy the adequate disclosure requirement.
It’s very important to file gift tax returns that satisfy the adequate disclosure rules to start the statute of limitation period running. Additionally, carefully review previously filed gift tax returns to ensure that gifts were adequately disclosed. If gift tax returns weren’t filed for previous years, such returns should be prepared to begin the statute of limitation and help avoid future challenges by the IRS.
Failure to Allocate Generation Skipping Transfer (GST) Tax
The provisions of the tax law for allocating GST tax exemption to inter-vivos trusts were changed with the Economic Growth and Tax Relief Reconciliation Act of 2001. Previously, the only lifetime transfers that were given automatic GST tax allocation were direct skips. The 2001 Act, however, expanded automatic allocation to certain “indirect skips.” An “indirect skip” is defined as any transfer of property (other than a direct skip) made to a GST trust.4
The operation of this provision is to generally include all trusts as GST trusts and thereafter eliminate certain trusts that fall within a defined parameter. As a result, gift tax return preparers must consider several issues, some of which include: (1) Is the trust a GST trust, thereby giving rise to an automatic allocation? If it appears that the trust isn’t a GST trust, should an attachment opting out of the automatic allocation be prepared to ensure the preparer’s interpretation is that of the IRS? If the trust appears not to be a GST trust by definition, should GST tax exemption still be allocated? If the trust is a GST trust, should an attachment be prepared opting out of automatic allocation?
Preparers must implement proper procedures to ensure that a transferor’s GST tax exemption is properly allocated. The GST tax exemption is one of the most valuable exemptions in the transfer tax system, and it’s important to review each trust to determine if GST tax is being properly allocated in light of the taxpayer’s individual circumstances.
Inappropriate Election of Gift Splitting To Third Parties
If an election to gift split is made on a gift tax return, a gift made by one spouse to any person other than his spouse is considered as made one-half by the taxpayer and one-half by his spouse.5 However, if one spouse transferred property in part to his spouse and in part to third parties, gift split treatment is effective with respect to the interest transferred to third parties only insofar as the interest transferred to third parties is ascertainable at the time of the gift and severable from the interest transferred to the spouse.6 This situation is often seen when gifts are made to a trust that benefits the taxpayer’s spouse and the taxpayer’s issue.7 In such situations, the preparer should determine if the interest transferred to third parties is ascertainable at the time of the gift and severable from the interest transferred to the spouse. If it isn’t, then gift splitting isn’t an appropriate election.
Requirements Not Met for Gift and GST Tax Annual Exclusion
Each taxpayer has the ability to make gifts that qualify for the gift tax annual exclusion (currently $14,000 per taxpayer, per donee). However, where gifts are made to a trust, certain requirements must be met for a gift to qualify for the gift tax annual exclusion. One requirement is that the gift must be a “present interest.” To qualify a gift for the present interest requirement, two alternatives exist:
(1) The beneficiary may be given a Crummey right, which is the immediate right to withdraw the gift (often limited to the amount of the annual exclusion), or
(2) The donor can establish an Internal Revenue Code Section 2503(c) trust. This trust is statutorily permitted so that a gift isn’t a future interest and thus qualifies for the annual exclusion. Although the beneficiary has no Crummey right, under the terms of this trust, it must be terminated on the beneficiary reaching age 21.
Even if a trust qualifies for the gift tax annual exclusion, it doesn’t necessarily qualify for the GST tax annual exclusion. A separate set of requirements exists for a trust to qualify for the GST tax annual exclusion. These requirements are:
(1) During the life of the beneficiary, no distributions may be made to anyone other than the beneficiary; and
(2) At the beneficiary’s death, if the trust is still in existence, the trust will be included in the beneficiary’s gross estate.8
Most trusts, such as multigenerational dynasty trusts, don’t qualify for the GST tax annual exclusion. Preparers should therefore review a trust to determine if the gift tax and the GST tax annual exclusions are available.
Allocating GST to a Gift Subject to an ETIP
Although allocations of GST tax exemption are typically made for the tax year of the gift, a gift subject to an estate tax inclusion period (ETIP) can’t have GST tax exemption allocated to it. An ETIP is the period during which, should death occur, the value of the transferred property would be includible9 in the gross estate of the transferor or the transferor's spouse.10 Instead of allocating GST tax exemption to the gift when made, an indirect skip is deemed to have been made only at the close of the ETIP. For purposes of allocating GST tax exemption at the close of the ETIP, the value used is the fair market value of the trust property at the close of the ETIP.
Failure to Adequately Report Sales
Sales to grantor trusts can be very beneficial and are therefore a common estate-planning transaction for taxpayers with large taxable estates. To start the tolling of the gift tax statute of limitation, it’s prudent to report such sales on a gift tax return. Any transfer that’s reported, in its entirety, as not constituting a transfer by gift will be considered adequately disclosed if the following information is provided on, or attached to, the return—
(1) The information required for adequate disclosure under Treas. Regs. Section 301.6501(c)-1(f)(2)(i), (ii), (iii) and (v); and
(2) An explanation as to why the transfer isn’t a transfer by gift under chapter 12 of the IRC.11
Getting the statute of limitation to toll is important in the event the IRS attempts to subsequently classify the sale as a gift.
1. Applicable to gifts made after Aug. 5, 1997.
2. Internal Revenue Code Section 6501(c)(9).
3. Treasury Regulations Section 301.6501(c)-1(f)(2).
4. A “generation-skipping transfer trust” is defined under IRC Section 2632(c)(3)(B).
5. IRC Section 2513(a)(1).
6. Treas. Regs. Section 25.2513-1(b)(4).
7. See, for example, Private Letter Ruling 200551009 (Sept. 14, 2005).
8. IRC Section 2642(c)(2).
9. Other than by reason of IRC Section 2035.
10. Treas. Regs. Section 26.2632-1(c)(2).
11. Treas. Regs. Section 301.6501(c)-1(f)(4).