If you are like many wealthy taxpayers, your CPA and/or tax attorney have just finished a grueling, down-to-the-deadline, tax filing for gift tax returns. Many of these gift tax returns were triggered out of prudent efforts by taxpayers planning to reduce their estates before the 2020 election in case the Democrats take control in Washington and pass the harsh wealth and estate tax changes they have proposed. While gift tax returns, Form 709 if you like numbers, on the surface appear seductively simple, they are anything but. Gift tax returns are incredibly complicated. Many of the complications, and errors that are often made, are not obvious (as evidenced by how common some mistakes are). Also, many of the planning twists for gift tax returns pertain to items that are independent of the return itself. There are also many creative planning ideas that can be used in preparing these returns. You might want to review your 2018 return against some of the ideas below and chat with your tax consultant. Since pre-2020 election planning is continuing in earnest in 2019, many of the ideas below will be helpful to the gift tax return you will probably have to file in 2020 for 2019 transfers.
Several of the planning ideas below will be part of an estate planning presentation that will be delivered at the 56th Annual National Association Estate Planners and Councils (NAEPC) Advanced Estate Planning Strategies Conference, at a kickoff session “Estate Planning Tips and Nuggets” November 6, 2019 in Las Vegas, Nevada.
Who Files. Should be obvious: if you make a gift, you file a gift tax return. But it’s not always so easy. Say your late spouse created an irrevocable trust. Say that trust is not exempt from the generation skipping transfer (“GST”) tax. That means in future years when it passes to grandchildren a GST tax would be triggered. One way to minimize the potential GST tax in the future is to freeze the value of assets in that trust now. That might be accomplished by the trust selling it’s assets to a trust that is GST exempt. So, the trust makes a transfer by a sale to another trust for a note. If the sale were, for example, of an interest in a family business valued at $20 million, what if the IRS challenged the value of the business as being worth $30 million? That might be argued to be an indirect gift by the beneficiaries of the trust, as trusts cannot make gifts. Many such sale transactions incorporate defined value mechanisms to deflect an IRS valuation challenge. These mechanisms are tied to the gift tax value as finally determined. So for the formulas in these mechanisms to work a gift tax return must be filed to tie into. The trust cannot file a gift tax return to report the sale to thereby toll the statute of limitations (the time period during which the IRS can audit). Should the beneficiaries of the trust file gift tax returns reporting the sale as a non-gift transaction? If they do, will that toll the statute of limitations during which the IRS can audit the trust’s sale?
Spousal Gifts. Assume most martial assets were in the wife’s name. Wife gifts some of those assets to the husband so that husband can make a gift. Should that gift be reported on the gift tax return if one is being filed in any event? Did the wife relinquish her interests in the assets husband gave as gifts to avoid any potential gift tax implications to her? Did enough time or events occur in the time between wife gifting assets to her husband and his gifting those assets to avoid the IRS arguing that his gift was really a gift by wife?
Crummey Notices. A common trust planning technique is to permit trust beneficiaries a limited period of time to withdraw gifts to the trust. That mechanism is intended to qualify gifts to the trust for the annual gift tax exclusion since the right to withdraw will make the transfers gifts of a present interest (that is a required to qualify for the annual gift tax exclusion). Many advisers do not file Crummey powers with a gift tax return. Some do. What if the Crummey notices were issued after the fact to corroborate in writing a prior verbal notice? Would that change the analysis as to whether or not they should be filed with the return? An often overlooked mistake is how many annual gifts were made to a particular donee. If you gave a trust for your son $15,000 and he had the power to withdraw that amount, that would cover the maximum annual gift you can make to him without using lifetime exemption. But what if two months earlier you gave $4,000 to your son to help him buy new furniture? Well that $4,000 used up the first $4,000 of the $15,000 of the maximum annual exclusion gifts you can gift your son, so that only $11,000 [$15,000 – $4,000] would remain for the annual exclusion gift and Crummey power for the gift to the trust. The remaining $4,000 of that give would use up some of your $11.4 million lifetime gift exemption. Often donors forget about the small dollar gifts, but they can be important. In many cases you really need a chart of all gifts, in chronological order, made directly or indirectly by each spouse to each donee to trace all these rules and calculations.
Discounts. Gift tax returns have a simple question, were any of the gifts you made subject to valuation discounts? These could be discounts for lack of control on say a 25% interest in a family business. They could include discounts for lack of marketability for such an interest because it is hard to liquidate. If the correct answer is “Yes” the question should be answered as such and a statement must be attached to the return explaining the discounts claimed on each asset gifted and the basis for those discounts. This is a high profile item for IRS audit. Too often the box is ignored, incorrect, or if checked “Yes” the appropriate detailed statement is not attached. The presence of discounts is sometimes obvious. For example, you gave 25% of the stock in the family business and the appraisal report identifies line items for each discount. But sometimes discounts are not as obvious. Consider that discounts come in many flavors: a discount for lack of marketability, a minority interest, a fractional interest in real estate, blockage, market absorption, or for any other discount. So, if you have real property that was given to a trust if the real estate appraiser factored in a blockage discount (e.g. due to the size of the property in the particular market) that must be disclosed. What if you purchased 20% of a real estate LLC from an unrelated party? That has to be the fair value of the LLC interest since you negotiated it at arm’s length. But since it is only a 20% interest you may have paid less than if it was a controlling interest. Is that a discount that might warrant disclosure?
Charity. This is a major overlooked item that seems innocuous but could have important ramifications. You must report all charitable gifts on the return. In a large number of gift tax returns none are listed. This probably occurs because it’s not intuitive that charity, which isn’t subject to a gift tax, would even have to be reported. But that could be a significant mistake to miss this reporting. Why? This could prevent the tolling of the statute of limitations (the period during which the IRS can audit) based on the materiality of the charitable gifts that are unreported relative to the gifts reported.
Wandry and Other Defined Value Gifts. When large gifts or sales are made, sometimes techniques called defined value mechanisms are used to endeavor to deflect an IRS challenge to the value of the gift or sale. For example, you want to gift 20% of the membership interests in a closely held business that were appraised at $10 million to a trust. Your goal is to remove that value, and future growth, from your estate. If the IRS audits and proves the value is instead $15 million for the interests, you will owe a substantial gift tax as the additional $5 million in value will be considered a gift. One approach to try to mitigate this risk is based on a court case by the name of Wandry, and hence is called a Wandry technique or clause. Bear in mind that the IRS has said it does not agree with the case. If gifts you made were subject to a Wandry valuation clause they must not be reported on your gift tax return as gifts of a specified percentage interest (e.g. 20% of the membership interests in XYZ, LLC) but rather of a specified dollar amount that may be estimated as a particular interest (e.g., $10 million worth of membership interests in XYZ, LLC, which are appraised to be 20% of those interests). If a Wandry clause was used, but the gift tax return does not comport with the transfer mechanism used in transactions as being subject to a Wandry assignment (i.e., your gift tax return reports that you gave 20% of XYZ, LLC instead of $10 million worth of XYZ, LLC interests) that might be used by the IRS in its attack to undermine the application of that mechanism. So any gifts (or sales to trusts or family members that are reported as non-gift transactions as they are believed to be at fair market value) that were transferred subject to a Wandry mechanism perhaps should be reported in that manner. If this wasn’t done right ask your tax adviser whether your gift tax return should be amended to reflect the underlying legal documents that effected the transfer.
GST Allocation. Generation skipping transfer tax reporting on gift tax returns is complicated and sometimes overlooked entirely, or not just handled optimally. In many cases attaching an affirmative statement regarding GST allocation makes sense. Here’s a way oversimplified explanation of what this might mean. Say you gifted $10 million of closely held business interests to a trust. The same 20% of XYZ, LLC in the above illustrations. You would like the assets in that trust, including the XYZ, LLC interests to be outside the transfer tax system forever. That would mean that they would never be subject to gift, estate or GST tax ever. That is a critical planning goal for many trying to shift assets out of their estates before the 2020 election, just in case the Dems win and make the estate tax system as harsh as the proposals they have put forth. To accomplish that in this example you would need $10 million of your GST exemption allocated to the transfer to the trust. Ideally you want a trust to be fully GST exempt (in tax jargon it will have an inclusion ratio of zero) or not. That makes planning easier and more effective.
In some cases a trust might be classified by the tax laws as a “GST Trust” in which case the exemption is automatically allocated and you don’t need to say anything about it on your gift tax return. In other cases you might not want GST exemption allocated to a trust that might be so classified, so you might want to affirmatively elect on the gift tax return not to have GST exemption allocated to that trust. This is all incredibly complex and even for tax experts tough to discern. So in many cases what happens is your tax professional will make it clear on the gift tax return whether or not you want GST exemption allocated to a particular gift to a trust so that the desired result will be achieved just in case the GST automatic allocation rules don’t end up doing what you want. So check your return and see if it is clear from the return how gifts to each trust e handled. This stuff is so complex that many gift tax returns don’t get it right. Following is an illustrative clause that you might discuss with your tax adviser if it was not addressed on your return:
“Taxpayer’s gift to the Smith Family Trust should receive an automatic allocation of GST exemption with respect to any and all transfers made by the Taxpayer to the Trust in 2018 pursuant to Internal Revenue Code Section 2632(c). Further, the Taxpayer desires this treatment. In the event the Trusts for any reason are not eligible to be treated as a “GST Trusts”, the Taxpayer hereby affirmatively elects to treat the Trust as a GST Trust pursuant to Internal Revenue Code Section 2632(c) (5) (A) (ii) to which the automatic allocation provisions of IRC Section 2632(c) apply for 2018 and for all future transfers to the Trusts.”
There is another twist to all of this. Consider the issue raised in the prior discussion of Wandry clauses. What if the IRS successfully argues that the gift of 20% of XYZ, LLC is worth $11 million, not $10 million? You really would want an additional $1 million of GST exemption allocated to the trust so that the entire trust and all growth in it remain outside the transfer tax system. But if your gift tax return allocated a fixed dollar amount, $10 million in this example, of GST exemption, that won’t accomplish your goal. So what many gift tax returns do is provide a formula allocation of $10 million and something along the lines of the following: “that the smallest amount of the Taxpayer’s GST exemption shall be allocated to the value of the assets as finally determined for federal gift tax purposes to have been so transferred to the Trust as may be necessary to produce an inclusion ratio for GST purposes, as defined in the Internal Revenue Code Section 2642(a), which is closest to, or if possible, equal to zero.” If something like this is not in your GST allocation (usually a statement appended after the forms) ask your tax adviser why. It might be that there is another explanation, or perhaps you might discuss with your adviser whether the return should be amended.
What about sales that are not intended as gifts? They might also warrant GST allocation. Assume you are selling stock in a closely held corporation to a trust for what you believe is fair market value. That should not trigger any gift or GST implications. But if the IRS successfully challenges the value of the transfer, that may create a gift component. That may have both gift tax and GST tax implications. As for GST, you may wish to have a formula allocation, like that above, apply if the IRS successfully imputes a gift to the sale. That will require that you disclose the sale on the gift tax return and have a formula allocation clause that applies in case of a change.
So, since you didn’t scream “Uncle” we’re going to twist your GST arm one more time. This GST stuff has more twists then Chubby Checker. Here’s another consideration for those having made several transfers to several trusts. Say your tax adviser included language in GST statements attached to your return allocating GST exemption using a formula approach in case the value of a transfer is changed on audit. Is that enough? It is certainly more than happens on some gift tax returns, but you might consider going a step further. If you have multiple trusts and multiple GST allocation formulas, what if there are adjustments by the IRS to several trusts, but limited GST exemption remaining? Perhaps your gift tax return might provide a priority of which trust gets an allocation of your GST exemption first, which second and so on. That might be helpful to direct the allocation of remaining GST to the trust where it will be most beneficial first. For example, you might have two trusts, one with marketable securities and one with the family business. Perhaps you believe the growth in the family business is likely to be much higher and that the business is the most important asset to safeguard. So perhaps your formula clauses can go a step further and direct GST allocation to that trust first.
Exhibit List. So, a major goal of a gift tax return may be to provide sufficient information on the return so that three years after the return is filed, the right of the IRS to audit the return will end. That requires providing sufficient information that you meet what are called the “adequate disclosure” rules. One way to help be sure your return has all the information necessary to meet this requirement is to have a listing of all the exhibits you are attaching to the return. If that list is organized with captions so that it’s clear what is being attached, it can help you and the tax adviser better identify what is missing. It also makes it easier for an IRS auditor to follow what is going on in the return. That is not a bad thing but a good thing. Making a return complicated to follow and interpret is not going to endear any IRS agent to you if you are audited. A well-organized return will make the audit easier and perhaps even make an auditor less suspicious. But what it will really do, is improve the likelihood of your return disclosing what you need to. Many returns include no exhibit list, some of those that do include one list only certain items and not all the required disclosures. Let’s say you made a gift of one or more business entities, e.g. family LLCs, to the trust. For each entity indicate in the Exhibit list the name of the entity and under that list all relevant documents for the entity. This might include the certificate of formation, operating agreement, purchase contract if you bought the interest and the value is what you paid, a gift letter if you gifted it to a trust, an assignment of the entity interests to the trust, and amended and restated operating agreement reflecting the trust as an owner after the gift, etc. The attachments will differ by entity and by the circumstances of the transfers you made.
QTIP and 2519. Let’s say your spouse died and left you substantial assets in a martial trust (“QTIP”). The assets in that trust avoided estate tax on your spouse’s death, but they will be included in and taxable in your estate on your death. In some cases that is a good thing as those assets will get a step up in income tax basis on your death. You want to withdraw some of those assets and transfer them to other trusts to remove them from your estate, especially in light of concerns over what a Democratic sweep in 2020 might mean to the estate tax. If the Dems win the exemption might drop to $3.5 million and the estate tax rate increased so that having QTIP assets included in your estate under the new regime may be a bad thing (the estate tax may outweigh the benefit of a basis step up). You should consider disclosing all documents for the entirety of the transfer process including from the QTIP to you as the surviving spouse. Otherwise you might not toll the statute as to those transfers. For example, one risk is that the IRS may argue that the transfers from the QTIP to you, and from you to new trusts were tantamount to your relinquishing an income interest in the QTIP (e.g. a 2519 challenge to the QTIP). That’s could be a calamitous result in that it could, under the tax laws, be deemed as if all the assets of the entire QTIP trust were transferred triggering a huge gift tax cost. This happened in a major case called Kite, but the facts were egregious, and it is not clear how this type of challenge might apply in a more reasoned planning scenario, if at all. Nonetheless, if you had a QTIP distribution to you so that you could make the gifts that were reported on your gift tax return, you might chat with your tax adviser as to whether further disclosures were worth making.