At the 2016 IRS Representation Conference, one panel covered gift tax returns and the dangers they pose to unwary CPAs and taxpayers. Using a sample fact pattern, the panelists covered issues surrounding adequate disclosure, proper preparation of a gift tax return, what to do if such a return comes under audit, and the impact of the generation-skipping transfer tax.
A Sample Fact Pattern
Cohen opened by noting that the panelists had prepared a fact pattern ahead of time that would drive the discussion and highlight relevant issues in preparing gift tax returns. Sklarz led off the discussion by covering the basics of the fact pattern. The fictional clients, Davida and Theo Fenway, were married and had two children, Dustin and Mariana. Among their assets were $8 million in proceeds from the sale of Davida’s public relations firm and $10 million in stock that Theo inherited from his grandfather; they have gifted approximately $3.5 million of assets to their children and grandchildren over the past four years. Theo, Dustin, and Mariana also co-own a sports information business, Beantown; due to expected growth over the next five years, Theo has consulted with the family’s financial planner on how to transfer his interest in the company to Dustin and Mariana.
Davida and Theo are 60 and 56 years old, respectively, and would like to avoid exhausting their remaining gift tax exemptions too soon while receiving some value for Theo’s Beantown membership interest and excluding the appreciation from their estate. Their planner has thus recommended an installment sale to an intentionally defective grantor trust (IDGT). Under this plan, Theo would create an IDGT and sell his membership interest to it in exchange for a promissory note for the interest’s value. The note would gain interest at the midterm AFR (applicable federal rate) rate, payable annually in arrears and in a balloon payment nine years after the sale. As the grantor, Theo would retain the right, in a non-fiduciary capacity, to reacquire the membership interest in exchange for an asset of equivalent value. Sklarz noted that this can provide some valuable advantages, based on the term of the trust.
Vitiello opined that if a preparer has done everything they are supposed to do, then “the real issue in most cases today is fighting over valuation discounts.”
Benefits and Risks of an IDGT
Sklarz then explained the planning benefits of the IDGT transaction: “The important aspect is that this is considered a completed gift for transfer tax purposes, but not a completed gift for income tax purposes.” Theo would therefore remain responsible for the trust’s income tax responsibilities. Furthermore, there would be no capital gain; Theo would effectively be paying the interest to himself, and thus not be taxed on it. The income taxes on the trust itself would further reduce his estate without incurring any gift tax liability (because he received consideration for his membership interest) or using up his exemptions.
There are also some risks to this plan, Sklarz said. He noted that regulations require the value of the interest must be properly ascertained in order to avoid being designated a gift. Finally, Sklarz reminded the audience that taking substantial discounts in minority interests in LLCs and limited partnerships may be dramatically more limited under the proposed section 2704 regulations.
Adequate Disclosure and the Gift Tax Return
Grimaldi and Vitiello then turned to the gift tax return itself, which Grimaldi noted is different from a standard income tax return. They can be “pretty voluminous,” he said, requiring valuations, elections, and disclosures. It is important, he said, to always assume that a gift tax return will be examined thoroughly by the IRS. Vitiello noted that even properly prepared gift tax returns can still be subject to litigation, and proper documentation during preparation is “the first step of your litigation defense.”
Grimaldi then turned to the subject of adequate disclosure, noting that if the IRS determines that the disclosure is inadequate—that is, reported in a manner adequate to apprise the IRS of the nature of the gift and the basis for the valuation so reported—the IRS can revalue the gift, and therefore the gift tax owed, even after the normal three-year statue of limitations has passed. The threshold, he said, is an omission that exceeds 25% of the total amount reported.
Vitiello described the standard for adequate disclosure as ambiguous: “I anticipate that there will be a significant potential amount of litigation in high-stake cases relating to adequate disclosure.” He cited a pre–adequate disclosure case where, in 1990, a father merged a business that was in the red with his son’s successful business, leading to an overall 80/20 split in the son’s favor. The merged business was sold in 1998 for $30 million, and the father died in 2001. After the son filed the estate tax return, the IRS auditors found that no gift tax return had been filed for the 1990 merger. The IRS determined that the merger qualified as a gift and eventually levied $25 million in tax, interest, and penalties. The moral, according to Vitiello, is that inadequate disclosure can have severe consequences, and that this situation could have been prevented under the subsequent adequate disclosure law and regulations.
Sklarz then returned the discussion to the sample fact pattern, under which there are both the gift of assets (the stock Theo inherited and proceeds from the sale of Davida’s business) and the sale of the Beantown membership interest to the IDGT. He and Vitiello agreed that adequate disclosure is critical in the IDGT arrangement, including filing a gift tax return; this would be true even if there were only the IDGT sale and no other gift. An audience member asked whether this would be true even if the business had zero or negative value; Vitiello conceded no return would be required in that case, but that the better course of action is to file a gift tax return to take advantage of the adequate disclosure statute of limitations and to retain proper documentation of the valuation in case of audit.
Grimaldi asked if filing the gift tax return by itself would increase the likelihood of an audit. Vitiello thought not: “The number of gift tax return audits, last time I checked, is under 1% of those filed.”
Returning to disclosure, Grimaldi then discussed the concept of safe harbor. Safe harbor requires a description of the transferred property and any consideration received for it, an identification of the relationship between donor and donee, a description of the trust (in this fact pattern), an appraisal of the transferred property, and a statement describing any position in the return contrary to any proposed temporary or final regulations or revenue ruling. The appraiser must be an independent party, and his qualifications must be included in the appraisal.
Vitiello explained why adequate disclosure is so important. “We don’t want the IRS to have more than three years to audit the return,” he stressed. “We don’t want to get into an audit over the value 10, 15 or 5 years down the road.” He also urged CPAs to use a qualified appraiser instead of just providing financial statements. Most ethics rules permit a CPA to use another arm of the firm to appraise the business interest for gift tax purposes, but one should consider using an outside valuation firm to avoid arguments of conflict of interest by the IRS.
On the issue of the final criterion for safe harbor, the statement of contrary position, Vitiello said that he has never actually seen it on a gift tax return. Nevertheless, he said, making the statement, as opposed to asserting that the disclosure is statutorily adequate without it, is a case of “better safe than sorry.”
Returning again to the fact pattern, Grimaldi noted that non–gift transfers are considered adequately disclosed if reported properly by all parties for income tax purposes; no gift tax return is required. The transfer must also be in the ordinary course of business, and the income tax return must contain an explanation of why the transfer is not a gift. Vitiello, however, said that under the fact pattern, a gift tax return is still the best strategy because the transfer in this case is “income tax-neutral; there’s nowhere to really disclose it except on a gift tax return.” An audience member brought up the possibility of filing a Form 1041, which Vitiello said would not satisfy adequate disclosure requirements in this case because the form does not include the necessary information; that is, the value of the transferred asset and how it was determined.
Preparing the Gift Tax Return
Grimaldi then turned to the subject of amending a gift tax return. Revenue Procedure 2000-34 provides the method for amending a gift tax return to address adequate disclosure, even if these is no explicit duty to do so if an error is discovered. Vitiello, however, noted the possibility that filing an amended return could increase the risk of being audited.
On preparing the gift tax return itself, Grimaldi recommended viewing the IRS’s instructions for Form 709 and making a checklist of what materials and information need to be collected. “What you really have to do,” he said, “is put your head around the whole transaction.” Reviewing the trust document is particularly important, he said, as is the issue of gift splitting, which may require filing two separate returns, one for the donor spouse and one for the non-donor spouse.
“In our office, normally, we’ll prepare two returns,” Grimaldi said. “It just signifies that there is consent even though the non-donor spouse is required to consent on the donor spouse’s [Form] 709.” With regard to omitting charitable contributions on the return, Vitiello said that, in his experience, “failure to disclose most charitable gifts doesn’t have any bite because there’s no gift tax exemption used.”
Audits of Gift Tax Returns
Vitiello moved on to the subject of audits. He reiterated that proper preparation of a return includes planning for a potential audit defense. Cohen then discussed how a gift tax return comes under audit; the process is similar to that of an ordinary income tax return.
Notice is then sent to the taxpayer and, possibly, the representative; Cohen noted that filing a power of attorney (Form 2848) can help ensure that the taxpayer’s representative is included on the notice. The audit can take three forms, he said: a request to perfect the return, a limited review of certain items, or a full-blown audit. He and the other panelists recommended that practitioners with clients under a gift tax audit brush up on the relevant portions of the Internal Revenue Manual, with Cohen going to far as to say that failure to do so is “almost committing malpractice.”
Vitiello opined that if a preparer has done everything they are supposed to do, then “the real issue in most cases today is fighting over valuation discounts. … And if you’ve gotten the right appraisals, you’ve basically increased your credibility when you walk into a negotiation.” With detailed information backing up the return, he said, that negotiation is less likely to exhaust the lifetime exemption or result in a gift tax liability.
As a final point, Sklarz asked about the generation-skipping transfer tax. Vitiello noted that “you have to make the choice when you’re filing a gift tax return whether to opt out of the automatic allocation [of the generation-skipping tax exemption] or allow the allocation.” Grimaldi said that his firm affirmatively allocates on the return, or opts out.
The comments below represent the speakers’ own views and do not necessarily represent those of their partners, affiliates, or employers, nor do they represent official policy of the government or any government agency.