Gift tax returns that have been extended can provide a breather for tax preparers. That time should be used to plan the return, obtain relevant information, and identify issues that might require follow-up. Using the extension time to merely defer prep work represents a lost opportunity. When reviewing gift tax returns, the author routinely encounters common mistakes, which often appear to be a result of using a less-than-ideal process to prepare the return. Other common mistakes are more technical and deserve attention. This article will review common issues and provide practical suggestions for addressing them.
Gather Relevant Information
If a taxpayer made simple gifts of cash or securities to heirs, that reporting may not require input from the client’s estate planning attorney. But even common gifts, such as gifts to an insurance trust, may require input. Preparers should be certain to have a copy of the complete trust in the permanent file for the trust; they should have at least some understanding of the trust the gifts were made to. If preparers are not comfortable reviewing the trust to understand the key points needed to file the income and gift tax returns, at least a brief web meeting between the preparer and the planning attorney is recommended. It is helpful to have a template of key trust provisions that affect the tax prep work (which will vary depending on the scope of the engagement) that one can annotate during that meeting, noting the characteristic of each attribute for the particular trust and references to the page and section number so that relevant provision can be quickly identified in the future. These might include the following:
- The character of the trust (grantor or complex)
- Whether there are annual demand or “Crummey” powers and, if so, how they work (whether there are hanging powers and, if so, who is tracking them)
- Whether the trust is a generation-skipping (GST) trust for automatic allocation of GST purposes
- Powers of appointment and whether they are general or limited
- The identity of the beneficiaries and the distribution provisions; this can be critical in minimizing trust federal income taxation by managing distributions or state income taxation by making distributions to beneficiaries in no- or low-tax states.
If a trust involves more than plain vanilla planning—such as gifts subject to defined value mechanisms, note sales, split dollar insurance payment arrangements—tax preparers will need additional information and explanations. Clients often do not understand the complexity of planning. Although clients may be concerned about their CPA and attorney both reviewing these matters (two clocks billing), the reality is that if the planning is complex, an hour spent with the drafting attorney may not only save many hours of struggling with the planning, but also increase the likelihood of a more accurate return. If a client won’t authorize this type of meeting, preparers should consider sending a letter to the client confirming that they would not authorize the recommended meeting and that, as a result, misinformation or a misunderstood transaction may adversely affect the return.
In all events, preparers should ask the attorney if they have prepared any memoranda, schematics, or checklists for the transactions. Sometimes a simple schematic can save considerable time in figuring out which transactions need to be reported. If the attorney had a closing checklist (e.g., for a complex note sale plan), it can help one understand the details of the transaction, know which documents to request, and serve as a starting point for creating an exhibit checklist for Form 709 in order to meet the adequate disclosure requirements. These require specified, comprehensive disclosures if the statute of limitations for auditing the return is going to toll.
Why start all of the above now if one has months before the extended return is due? It takes time to get client authorization and schedule a meeting with the attorney, and for the attorney to organize records prepared in a time crunch. Waiting until shortly before the due date will almost ensure that one won’t be able to proceed as outlined above.
It is unfortunately common for transactions to be reported in different ways by different professionals. For example, consider a client that gifts $10 million of Smith Family LLC to the Smith Family Dynasty Trust. The rationale for denominating the gift (or sale) as a fixed-dollar figure is to use a mechanism to deflect a later gift tax valuation challenge. Assume the $10 million of LLC interests was determined by a qualified appraiser to equate to 50% of the LLC membership interests. If on audit the IRS succeeds in increasing the value to $20 million, a gift of $10 million rather than a gift of 50% will mean that only 25% of the LLC membership interests will be given, but that no gift tax should be able to be assessed; had the gift been of 50%, a substantial gift tax would be due. In many cases, if the attorney structured such a gift—called a “Wandry” transfer after the case that approved the mechanism (Wandry v. Comm’r, T.C. Memo 2012-88)—CPAs unknowingly might report the membership interests transferred on a gift tax return as a 50% interest instead of a $10 million fixed-dollar transfer. On Schedule K-1, the same gift is often reported as a 50% interest as well. Attaching a statement confirming the correct nature of the transfer would make the income tax return consistent with the underlying legal documentation. The gift tax return should report the transfer pursuant to the Wandry mechanism. If the trust records maintained by the trustee also incorrectly list the interest held as 50% of the LLC instead of $10 million of the LLC, the record would contain further inconsistencies that might undermine the plan on audit.
There are several types of valuation adjustment mechanisms, and the preparer of the gift tax return must understand which mechanisms were used and which of the many variants of the particular mechanism were used [e.g., McCord v. Comm’r, 461 F.3d 614 (2006), rev’g 120 T.C. 358 (2003); Estate of Petter v. Comm’r, T.C. Memo. 2009-280; Estate of Christiansen v. Comm’r, 130 T.C. 1, 13, (2008), aff’d 586 F.3d 1061 (8th Cir. 2009)].
The instructions for Form 709 state: “If you are required to file a return to report noncharitable gifts and you made gifts to charities, you must include all of your gifts to charities on the return.” Yet in many cases, tax preparers neglect to report these. Some commentators have raised the concern that the failure to report charitable gifts may extend the statute of limitations. For example, assume that there is no gift reported on the gift tax, only a large note sale which is reported as a non-gift item, or a grantor retained annuity trust (GRAT) that has a nominal, almost zeroed-out value. Failing to report gifts may result in a substantial understatement and extend the statute of limitations for auditing the return.
Create an Exhibit List
Many returns simply reference attachments in the schedules and do not create an exhibit list. It is important, if not vital, for many returns to create a detailed exhibit list. The list should be organized by the type of transaction reported on the return. This can help identify missing documents that are critical to meeting the adequate disclosure requirements to toll the statute of limitations on audits. Consider also that a complete, well-organized return will make it easier in future years to identify key documents or recall the nature of the transactions.
Annual demand powers can be applied to reduce the amount of lifetime exemption used. If there are such powers provided for in a trust to which gifts were made, preparers should request copies of the written notices sent for each trust affected. The power provision provided in the trust should be reviewed to make certain that the notices issued conform with the terms of the trusts. One common mistake is that clients make outright gifts, and gifts to trusts, and exceed the maximum permitted for annual exclusion gifts. To address this, preparers should create a chart of each gift and determine under any trust instruments whether there are ordering provisions. This may be necessary to determine which trusts received gifts that qualify for the annual exclusion, and which gifts did not. The sequence of gifts may be important to this analysis.
Often, several improvements can be made to the GST statements that might be attached to a return. Preparers should consider having a GST allocation statement attached that is comprehensive, addressing any trust to which GST may be allocated or not. Having a list of every client trust and clarifying the intended GST status will make it easier in each successive year to identify the correct reporting treatment.
Some tax professionals intentionally opt out of the GST automatic allocation rules, then affirmatively elect a GST allocation. The author instead suggesting attaching a statement indicating that the taxpayer believes that the trust is properly characterized as a GST trust as defined in IRC section 2632 (assuming this is the case), so that the transfers to the trust are subject to the automatic allocation of GST tax exemption. If for any reason the trust is not properly characterized as a GST trust, however, then the taxpayer should—and hereby does—affirmatively elect to allocate sufficient GST exemption to the trust to result in a GST inclusion ratio of zero (or as close to zero as possible).
Preparers should also consider an ordering provision in the GST statement, allocating GST exemption first to the trust or trusts that are the priority in terms of GST exemption, then to other trusts sequentially. In that way, if transfers are made to all trusts that are believed to be within the GST exemption, but an audit adjustment increases the values so that there is not sufficient GST exemption to exempt all transfers, it is clearly documented which should receive the allocation, and in which order.
Use the Time Wisely
Tax professionals should use the additional time afforded by extended gift tax returns to proactively pursue the information needed to facilitate the proper preparation of these returns.