Gift tax returns appear to be seductively simple. Failure to file a gift tax return timely and disclose transactions “in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item” in accordance with regulations that impose specific requirements for “adequate disclosure” can delay the tolling of the statute of limitations.[1] In other words, gifts not adequately disclosed may be subject to challenge indefinitely. This article will provide practical tips with the aim of helping practitioners that will be relevant through the 2020 tax season and beyond.

When filing a gift tax return, practitioners might consider attaching as much documentation as possible to ensure tolling of the statute of limitations. Reg. § 301.6501(c)-1(e) and (f) outlines what is required to be provided for a gift to be considered adequately disclosed.[2]  Some tips:

• If a valuation is provided to support the value of the assets, the preparer should review the valuation to confirm that it meets Rev. Rul. 59-60, lists the exact number of shares, units or percentage interest transferred, and value the assets as of the date of the transfer. Any appraisal done before the transfer date generally needs an update letter from the appraiser referring to the full appraisal and updating it for the required information.

   

• The preparer should be sure to check the box at the top of page 2 of the Form 709, answering YES to the question: “Does the value of any item listed on Schedule A reflect any valuation discount?” when applicable.

   

• In the description of the gift, the preparer should also provide the total discount taken and explain the basis upon which discounts were taken (if not included in a qualified appraisal).

   

• The adequate disclosure regulations require either a copy of the trust or a sufficient summary of the trust’s terms. To avoid subjective evaluation by an IRS auditor as to the sufficiency of a summary, attaching a copy of the trust is often the most practical approach, even if the trust instrument had been attached to a prior return.

Valuation Adjustment Clauses

Valuation adjustment clauses have become a favored approach, based on the mechanism upheld by the Tax Court in Wandry.[3] While the IRS issued a statement refusing to acquiesce to Wandry,[4] taxpayers continue to use Wandry clauses to limit their gifts of hard-to-value assets to a specific dollar amount, with any excess value remaining in the transferor’s estate. Gift tax return preparers should be vigilant when encountering Wandry clauses and variants structured using any one of the notable defined value cases.[5]  

Some adjustment clauses operate to move any excess value into a non-taxable receptacle such as a charity, grantor retained annuity trust (“GRAT”), marital trust, or incomplete gift trust.  Each component of these mechanisms must be evaluated to determine what must be reported.

Disclosing the Two-Tiered Valuation Adjustment Provision

A “two-tiered Wandry” arrangement could consist of a traditional Wandry transfer followed by the simultaneous sale of any shares (or other assets) left if the clause is triggered. In a typical scenario, the transferor may gift a specified value of the shares of the entity, which the transferor believes equates to a certain number of shares. The adjustment mechanism might operate such that, in the event that the value of the shares is redetermined, the transferor will have sold the number of shares that exceed that number of shares equivalent to the intended gift value, at a price equal to the value of those shares as finally determined.  In such a scenario, an escrow agent might be engaged to retain contemporaneously executed sales documents (e.g., note, security agreement) until either the gift tax statute of limitation passes, or the value is finally determined. Determine what the governing documents provide for and disclose it as appropriate.

Charitable and Marital Mechanisms for Valuation Adjustment Clauses

A common gift tax return oversight is the failure to report charitable gifts. If any omitted charitable gifts constitute a substantial understatement of gifts, the statute of limitations may be extended from a three-year period to a six-year period.[6] This can be doubly problematic where a charity is identified as the nontaxable receptacle in a valuation adjustment clause.

The preparer should a potential charitable gift that could occur if values are redetermined by operation of an adjustment clause on Schedule A Part 1, showing $0 gift tax value and $0 basis, with specific reference to the item number of the potential charitable gift, along with any other charitable gifts, on Schedule A Part 4, line 7. 

The preparer should include an explanation with reference to the Assignment instrument and valuation report about how the value of the interest conveyed to the charity will be as finally determined for gift tax purposes.  This same language should likely be incorporated on the individual’s income tax return on Schedule A.

Where a valuation adjustment clause requires any excess to be devised to a spouse or marital trust, the gift tax return preparer should report the potential marital gift on Schedule A Part 1, showing $0 gift tax value and $0 basis, referencing the specific item number of the potential marital gift on Schedule A Part 4, line 6.

Additional Thoughts on Disclosures of Adjustment Clauses

Ultimately, the gift tax return preparer may have the last best chance to:

• Review the transfer documents to confirm that instruments contain the requisite valuation adjustment language, without which the mechanism might not work.[7] In Nelson, the mechanism was deemed inadequate because it failed to refer to the “gift tax value as finally determined,” instead referencing an appraised value.
  
  
• Refer to the transfer documents and let them speak for themselves, with the gift tax return acting more as a roadmap to make the transaction easy to follow. Any amounts determined by formula should be referred to as estimated amounts, driving home that the formula controls.
  
  
• Identify follow-up steps and key dates pertaining to the valuation adjustment mechanism and confirm which of the client’s advisors should monitor those items.
  
  
• Make disclosures on income tax returns tangential to the transaction. By way of example, where a valuation adjustment could spill some value over to a charity, perhaps a disclosure should be made on the donor’s individual income tax return.  Perhaps footnotes should be added to the income tax returns of any individual, entity or trust that might be affected by the valuation adjustment clause.

• Record the date at which the gift tax statute of limitations tolls, as that may be the trigger in the governing transfer documents for the final determination of the allocation of the interest in the asset transferred.
  
  
• Defined value mechanisms could leave open the determination of which party will own which interests in the transferred asset. For example, if the client gifted LLC interests subject to a Wandry clause to an irrevocable trust, the K-1s issued to each of the trust and the donor should reflect that the percentage interests on Form K-1 are estimates subject to the defined value mechanism. 
  
  
• Make specific disclosures on the gift tax return showing all of the related transactions in the event that the valuation adjustment is invoked.

Allocation of GST Exemption

Where multiple transactions have occurred during the tax year, a gift tax return preparer must consider how best to allocate the generation-skipping transfer (GST) exemption,[8] particularly if the valuation adjustment clause is invoked:

• In consultation with planning counsel, the trusts should be ranked, starting from the trust most likely to benefit skip persons and the last being the trust for the benefit of non-skip beneficiaries. The return should affirmatively opt in to apply GST exemption for transfers made to the first trust and the remaining trusts should elect not to be treated as GST trusts, so that a notice of allocation can be used to control the order in which GST exemption is allocated. Include a statement of the donor’s intention that GST exemption allocations should be done by formula which will change if values are modified on audit.

Gift Tax Return Reporting Relinquishment of Interests in Joint Property.

Some plans may have involved only one spouse making gifts to use up lifetime exemption while the other spouse made no gifts.  In such instances, the non-donor spouse may have had to relinquish joint property or transfer property to the donor spouse so that the donor spouse would have sufficient assets for gifting.  Transmutation agreements in community property states may have been executed in order to effectuate these inter-spousal transfers. 

A gift tax return preparer, in collaboration with the planning team, might consider disclosing such inter-spousal transactions, even though the Form 709 instructions generally provide that no return is required on gifts to a spouse unless the spouse is a non-citizen or a qualified terminable interest property (QTIP) election is required. It may be important to attach as gift tax return exhibits the documentation accomplishing the interspousal transfers, or at least obtain and retain such materials in order to deflect a potential IRS step transaction challenge.

Spousal Lifetime Access Trusts (SLATs)

Where a plan involves the creation of two spousal lifetime access trusts—that is, a trust created by each spouse for the benefit of the other—it was likely important that each trust was sufficiently different from the other to avoid application of the reciprocal trust doctrine. Gift tax return preparers reporting transactions involving nonreciprocal SLATs might consider obtaining confirmation from counsel as to the differentiation of each SLAT and the considerations supporting the respective planning.

Gift tax return reporting should dovetail the SLAT strategy:

Possible Gift Tax Disclosures for Certain Note Transactions

Practitioners considering the array of planning options available to clients may have engaged in certain note transactions that the gift tax return preparer may wish to disclose on timely filed gift tax returns, even though they are not gifts. By way of example, some taxpayers may have substituted low interest notes for higher interest notes or engaged in a sales transaction with a related party. If a client was engaged in a loan transaction, disclosing the loan on a timely filed gift tax return could toll the statute of limitations and prevent the loan from being recharacterized as a gift transaction.

Practitioners need to be alert to the possibility of these transactions to be certain that appropriate gift tax return compliance reporting is addressed. Failure to disclose these transactions could prevent the statute of limitations from tolling, leaving the taxpayer open to challenge indefinitely. Certain income tax issues might also warrant consideration as well, if, for example, anything other than a grantor trust was used for the transaction. 

For anyone who engaged in such a transaction, consider including a copy of the Note as an attachment to the gift tax return. For any Note that was secured by an existing dynasty trust guarantee that had been previously set up by for the benefit of a class of beneficiaries that might include the borrower, the elements of this part of the transaction might be disclosed on the lender’s gift tax return, with copies of the security agreement and dynasty trust instrument, and any other relevant documentation. The taxpayer should report taxable interest income received from a nongrantor trust or other third-party borrower on a timely filed income tax return.

Form 709 Mistakes to Avoid

Some of the most common mistakes/oversights are:

1. Incomplete/incorrect summary of previously filed returns and exemption amounts used reported on Schedule B of the Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.  Information from prior returns will not only be required to be listed on the current filing but could be critical in ascertaining a range of positions taken previously and whether issues exist with past reporting. This schedule is an important part of the gift tax return because the total of the taxable gifts from this schedule carries to page 1 of the return and is included in the gift tax computation. It is important to get copies of all prior gift tax returns filed by a client for whom a gift tax return is being prepared so that Schedule B can be correctly completed. If the client is not certain of what years they have filed, Form 4506, Request for Copy of Tax Return, can be filed with the IRS to attempt to obtain copies of gift tax returns that they have on file for the taxpayer. 
   
   
2. Reporting gifts in the wrong section of Schedule A. Each transfer must be reported in the part of the form corresponding to its category and, too often, practitioners are not cautious about properly characterizing where these are reported. Following is a brief primer on where certain transfers should be disclosed:
   
   

A. Schedule A Part 1: Gifts made to nonskip persons and subject only to the gift tax, broadly speaking, an outright gift or a gift to a trust with no GST potential.


B. Schedule A Part 2: Gifts made to skip persons. An inter vivos direct skip is a transfer made during the donor's lifetime that is subject to the gift tax and made to a skip person, whether an individual or to a trust for the benefit of only skip persons.



C. Schedule A Part 3: Gifts that are subject only to the gift tax but that may be later subject to the GST tax, e.g., a gift to a trust that includes children (who are not skip persons), as well as further descendants (e.g., grandchildren) who are skip persons. If a statement is made opting into or out of automatic allocation of GST exemption (see below), indicate that in the correct column. If such an election was made in a prior year, indicate what kind of election and the year it was made to facilitate preparation next year.

3. To the extent that a Code Sec. 529 plan was funded in the current year, the preparer may need to make an affirmative election to treat the transfer as made ratably over a five-year period had been made. Be sure to reconcile any gifts made in prior years to Sec. 529 plans to avoid doubling up on annual exclusion gifts that are deemed to have been made as part of a previous Sec. 529 transfer. The ratable portion of the Sec. 529 gift should be shown on gift tax returns for the succeeding four years until the five-year period has expired in order to avoid losing track of this previously utilized amount of annual exclusion.
   
   
4. Incorrect/lack of GST exemption allocations. Carefully monitor usage of GST exemption and consult with counsel to ensure exemption is being correctly allocated. 
   
   
5. A common mistake is netting out the annual exclusion amount before applying GST exemption when the annual exclusion may only apply for gift but not GST tax. The rules differ: Code §2642(c) provides that the GST annual exclusion applies to gifts to a trust only if the trust is for only one beneficiary and is included in that beneficiary’s estate upon that beneficiary’s death.
   
   
6. Incorrect elections or acknowledgement of GST automatic allocation. Code §2632(c)(3) allocates GST exemption automatically to an “indirect skip,” which means a transfer to a “GST trust.” The §2632(c)(3)(B) definition of “GST trust” can be confusing.  Rather than spending any time analyzing that provision (and risking a mistake), practitioners might consider affirmatively electing under  §2632(c)(5) to treat transfers to a particular trust as an indirect skip; that is to say, the practitioner might report the transaction as a transfer to a GST trust and then include an affirmative GST election.
   
   
7. Some preparers affirmatively opt out of automatic allocation and allocate GST exemption via a notice of allocation. If a future gift tax return is late, a late allocation of GST exemption can be time-consuming. In most cases, one should consider opting to allocate GST exemption automatically and then later opting out of allocating GST exemption if that is desirable.
   
   
8. If GST exemption is expected to decrease after December 31, 2020, consider allocating GST exemption to all trusts with GST potential so as to fully use it before it goes away.

Conclusion

Gift tax returns are often incredibly complicated with layers of issues, technical decisions, and disclosure requirements. Gift tax return preparation practice should be viewed by practitioners as the danger that it is. 

Joy Matak, JD, LLM, is a partner at Sax, LLP and co-leader of the firm’s trusts and estates practice. She has more than 20 years of diversified experience as a wealth transfer strategist with an extensive background in providing tax services. She received a Master of Laws, Taxation, with distinction, from Georgetown University Law Center, a Juris Doctor, cum laude, from Vermont Law School, and a Bachelor of Science, Mathematics, cum laude, from Seton Hall University.

Steven B. Gorin, CPA, Esq., CGMA, is a partner in Thompson Coburn LLP. Before practicing law, Steve practiced accounting for eight years and was a partner in a local CPA firm and actively participates in the Missouri Society of CPAs.  Steve is a Regent of the American College of Trust & Estate Counsel and former chair of the Business Planning Group of Committees of the American Bar Association’s Real Property, Trust & Estate Law Section. He is a member of NAEPC’s Estate Planning Hall of Fame.

Martin Shenkman, CPA, MBA, AEP, JD, is an attorney in private practice in Paramus, N.J. and New York City. His practice concentrates solely on estate and tax planning and estate administration. He is a prolific author, having published 36 books and more than 700 articles. He received a Masters degree in Business Administration from the University of Michigan, with a concentration in tax and finance. He received his law degree from Fordham University School of Law.