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Substantial Compliance in Reporting Taxable Gift Sufficient to Start Statute of Limitations

The Court ruled that a disclosure package submitted to IRS adequately disclosed transfer of company and related foreign accounts.

In Schlapfer v Commissioner (T.C. Memo 2023-65), the Tax Court held the statute of limitations for assessing a gift tax had expired where a taxpayer triggered the start of the assessment period by substantially complying with Treasury regulations describing adequate disclosure of a taxable gift.

Anyone Can Make Something Complicated

In 2002, Ronald Schlapfer, a Swiss-born non-citizen living in the United States, formed a foreign corporation that managed investments and held marketable securities and cash (the Company), which he solely owned.

On July 7, 2006, Schlapfer applied for a universal variable life policy (the policy), with the stated intent of his mother, aunt and uncle using such policy to benefit his orphaned nephews. The application listed: Schlapfer as owner; his mother, aunt and uncle as the insured lives; Schlapfer and his spouse as the beneficiaries; and Schlapfer’s children as the contingent beneficiaries.  The policy was issued on Sept. 22, 2006 and was funded by a $50,000 premium payment from the Company on Aug. 21, 2006, followed by a transfer of all of the Company stock to an account in the policy’s name on Nov. 8, 2006.

On Jan. 23, 2007, Schlapfer requested that his mother be immediately substituted as the policy’s owner.  On April 23, 2007, Schlapfer and his mother jointly requested that his mother, aunt and uncle be named as joint policyholders and that the beneficiary designations in place be rendered irrevocable.  These changes were effective on May 31, 2007.

All Ashore: Disclosure Package

On May 18, 2007, Schlapfer applied for U.S. citizenship, which he obtained in 2008.

On Nov. 20, 2013, Schlapfer submitted a disclosure package to participate in the Offshore Voluntary Disclosure Program (OVDP).  OVDP offers taxpayers a compliance avenue to address income tax and tax reporting obligations relating to offshore assets.  OVDP requires taxpayers to disregard entities through which undisclosed assets are held and to pay all tax, interest and penalties related to undisclosed assets during the most recent eight years. 

Schlapfer’s disclosure package included, in relevant part, a $6 million check for tax years 2004-2011, a gift tax return for 2006 (the Form 709 for 2006) and amended Form 1041s for 2004-2009, which including Forms 5471 for the Company.  The Forms 5471 provided information regarding the Company’s shares, income statement, balance sheet, earnings and profits for the relevant years. 

Of particular significance were two statements included in the disclosure package:

  1. In an Offshore Entity Statement, Schlapfer disclosed that he established the Company in 2003 and owned it until July 6, 2006, when he gifted his entire interest in the Company to his mother; and
  2. In an attachment to the Form 709 for 2006, Schlapfer indicated he made a gift of controlled foreign company stock valued at $6,056,686 on July 6, 2006 and that the return is intended as a protective filing as he (as a non-citizen with no intent to remain permanently in the United States) wasn’t subject to U.S. gift tax at the time of the gift. 

Uncle Sam Comes Knocking

On June 4, 2014, the Internal Revenue Service issued a request for additional documentation relating to the gift of the Company and related foreign accounts to Schlapfer’s mother. 

Schlapfer promptly responded by providing documentation reflecting a transfer of his ownership in the Company to the policy’s account and his gift to his mother (including a copy of the January 2007 documentation reflecting the substitution of his mother as policy owner).  Schlapfer also included a statement in which he: (1) maintained that the 2007 transfers of the policy’s ownership were intended to correct a scrivener’s error that resulted in Schlapfer being listed as the policy’s initial owner, and (2) agreed to a revised gift date based on the issuance date of the policy (that is, treating Sept. 22, 2006 as the date of the gift, rather than using the policy application date in July).

An agent next contacted Schlapfer on Jan. 6, 2016 to open an examination of the 709 for 2006.  On May 17, 2016, an agent interviewed Schlapfer, and on June 14, 2016, Schlapfer signed a Form 872 extending the time to assess tax for an additional year until Nov. 30, 2017.

In August 2016, the IRS issued its conclusion that no gift was made in 2006 as Schlapfer didn’t relinquish control over the policy until May 31, 2007.  (Note that Schlapfer asserted that he had no intent to remain in the United States in 2006 and was therefore exempt from gift tax at that time.  Schlapfer refused to concede that the gift was made in 2007 (after his May 18, 2007 citizenship application) and withdrew from the OVPD.  

On Oct. 17, 2019, the IRS issued a notice of deficiency for 2007 for a total of $8,749,149 of combined gift tax liability, interest and penalties based on a substitute 2007 gift tax return for Schlapfer prepared by the IRS. 

Schlapfer appealed, and the IRS and Schlapfer each filed for summary judgment.  The key issue before the Tax Court was whether the limitations period for assessing gift tax was triggered by an adequate disclosure of Schlapfer’s gift on the Form 709 filed in 2013 and consequently expired before the IRS issued a notice of deficiency in 2019.

Missing the Forest for the Trees

Internal Revenue Code Section 2501(a)(1) imposes a tax on the transfer of property by gift.  Individuals who make a gift and are subject to the gift tax are required to file a gift tax return for the year of such transfer under IRC Section 6019.  Under IRC Section 6501(a), (c), the Commissioner generally has three years from the filing of a gift tax return to assess gift tax.  Under Treasury Regulations Section 301.6501(c)-1(f)(5), this applies even if the gift disclosed is ultimately determined to be an incomplete transfer.  However, Section 6501(c)(9) provides that gift tax may be assessed at any time when a reportable gift wasn’t reported.  Treas. Regs. Section 301.6501(c)-1(f)(2) says that this exception applies unless the gift has otherwise been “reported in a manner adequate to apprise the Internal Revenue Service of the nature of the gift and the basis for the value so reported.” 

The court therefore concluded that the crucial point in time for purposes of the limitations period was the filing date of Schlapfer’s Form 709 for 2006 and that whether the reported gift was complete in 2006 was immaterial.  

Skirting the Line

Treas. Regs. Section 301.6501(c)-1(f)(2) (the Adequate Disclosure Regulation (ADR)) provides, in relevant part, that transfers reported on a gift tax return will be considered adequately disclosed if the return (or an attached statement) provides the following:

  1. A description of the transferred property and any consideration;
  2. The identity of, and relationship between, transferor and transferee;
  3. A detailed description of the method used to determine the fair market value of the gift.

Two IRS Arguments

Strict Compliance Necessary. The IRS argued that strict compliance with the ADR was required for a gift to be deemed adequately disclosed. 

Whether strict or substantial compliance with regulatory requirements is necessary hinges on whether such requirements can be categorized as essential to the statute (in which case strict compliance is required) versus merely procedural (in which case substantial compliance is sufficient). 

Section 6501(c)(9) provides, in relevant part, that the limitations period begins to run for an gift disclosed “in a manner adequate to apprise the Secretary of the nature of such item.”  The essence of the disclosure requirement is to provide the Secretary with a viable method of identifying gift tax returns suitable for audit with minimal expenditure of resources.  Therefore, the ADR is intended to provide taxpayers with guidance as to what satisfies the requirement to “adequate[ly].. apprise the Secretary of the nature of such item.”  Based on this logic, the court concluded that substantial compliance with the ADR is sufficient to constitute adequate disclosure and trigger the beginning of the limitations period. 

Four Corners Analysis. The IRS argued that the Form 709 for 2006 alone (to the exclusion of the other documents in Schlapfer’s disclosure package) should be considered in ascertaining whether Schlapfer adequately disclosed his gift.

Drawing on adequate disclosure caselaw in the income tax arena, the court concluded that documents attached to a return, as well as informational documents referenced in a return, may be considered in determining whether an item has been adequately disclosed.  Therefore, in beginning its adequate disclosure analysis, the court considered the entirety of the disclosure packet  filed by Schlapfer.

Too Little, Too Late. Or Not.

The court thoroughly analyzed Schlapfer’s compliance with the ADR’s specific categories of necessary information, based on the entirety of the disclosure packet.

What: A description of the property and consideration. The first category of information listed in the ADR is a description of the gifted property and any consideration received by the transferor.  By considering the entirety of the discloser packet, the court was comfortable concluding that “assuming the gift is the [Company] stock,” the Schlapfer provided sufficient detail as to the gifted property to strictly comply with the ADR’s first category. 

“However, if the gift is the [Policy]…’” the court conceded that Schlapfer failed to strictly comply with this requirement by neglecting to provide any information directly referencing or describing a transfer of a life insurance policy.  However, the court found that the Schlapfer (in a mistaken application of the instruction to disregard entities holding foreign assets) sufficiently disclosed the assets held by the policy, which provided sufficient information to alert the IRS as to the nature of the gift, substantially complying with this requirement. 

Who: Identity and relationship between transferor and transferee. In his filings, Schlapfer asserted that he transferred stock in the Company to his mother, while in reality, his mother, aunt and uncle were all transferees of this gift.  While the court acknowledged that these assertions failed to strictly comply with the requirement to identify transferees and their relationships to the transferor, it concluded that Schlapfer provided the IRS with sufficient information to understand the nature of the transfer, namely that the transfer involved a gift to Schlapfer’s family member.

How: Detailed description of valuation method. In the disclosure packet, Schlapfer stated that he “made a gift of controlled foreign company stock valued at $6,056,686” with no further explanation as to how such value was computed.  The court acknowledged a failure to strictly comply with the ADR’s requirement to provide a detailed description of the valuation method of the gift.  However, the court concluded that by providing Forms 5471 for 2004-2006, Schlapfer provided sufficient financials for the Company to show the basis for valuing its stock on the Form 709 for 2006 and therefore substantially complied with this requirement.  The court’s conclusion remained consistent whether the gift was comprised of the Company stock or the policy, of which the principal asset was such stock.

Court Ruling: Substantial Compliance

Based on its conclusions that the entirety of the disclosure packet should be considered and that substantial compliance with the ADR was sufficient, the court held that the limitations period began with the filing of the Form 709 for 2006 (in 2013) and concluded before the IRS issued the notice of deficiency to Schlapfer in 2019.

More Holes Than Swiss Cheese

In reviewing the court’s logic and analysis, one gets the strong sense that the court was driven as much by a sense of equity as by the underlying facts and law.  For example, one could easily conclude that failing to mention the existence of two-thirds of the transferees constituted a failure to substantially comply with the ADR’s requirement to identify transferees and their relationships to the transferor.   

However, superfluous phrases such as Schlapfer “attempted to comply with applicable U.S. tax laws” in describing his participation in OVDP and that he “promptly responded” to the IRS’ requests for additional information, in contrast to the IRS having “little contact” with the Schlapfer for an 18-month period during the investigation, provide a clue as to the basis of the court’s conclusions.  The opinion conveys a strong sense of sympathy for a taxpayer who attempted to comply with U.S. tax laws and responded diligently throughout an audit and a (mild?) sense of frustration with the speed at which the IRS acted during the same process.  

The court possibly also considered the dissuasive effect a holding for the IRS would have on future participation in OVDP.

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