- Non-Acknowledged Gifts: Many clients make “informal” gifts to children and perhaps others that they do not view as gifts. Caution clients that the IRS appears to be ramping up gift tax audits. One program the IRS has instituted has involved its investigation of real property transfer records in more than a dozen states. The IRS has found that a substantial portion of deed transfers for no consideration were not reported on gift tax returns. 60-90% of gratuitous non-spousal real estate transfers were not reported on gift tax returns. If a client has simply transferred a vacation home or other property to his or her children but did not report it, a current IRS audit initiative may be quite a surprise. The client might feel that “only her hairdresser knows for sure” but they may be quite wrong. If clients have such unreported gifts it may behoove them to take the lead and file the missing gift tax returns. For most 2011-2012 transfers there is not likely to be a gift tax issue because of the $5 million exemption. However, for prior transfers when the gift exemption was $1 million (or less in earlier years) there may in fact be a tax issue.
- Unreported Gifts Have Rippling Effect of Consequences: Clients may assume that the only implication of the failure to report is the gift tax return, but this issue can extend further than the one return. If the client makes future taxable gifts and has to file a gift tax return to reports those gifts, those future returns must disclose prior gifts. This means all future gift tax returns would also be incorrect returns since the figure for prior taxable gifts would be incorrect. If the client’s executor becomes aware of an unreported gift and files an estate tax return, that too would be an incorrect return. This is a potentially substantial risk awaiting many unsuspecting taxpayers.
- Gift Splitting: To elect to gift split, both must be residents or citizens, married and alive at the time of the gifts, and neither can marry a new spouse during the year – Reg. Sec. 25.2513-1. Another 2011 and 2012 issue might arise when a client creates a trust for the benefit of his or her spouse and issue, give $10,240,000 to that trust, and elect gift-splitting so that the $5.12M gift exemption of each spouse can be applied to protect the transfer from current gift tax. Section 2513(a) allows a husband and wife to consent to treat gifts to third parties as if made one-half by each spouse. Stanley L. Wang, T.C. Memo 1972-143; Max Kass, T.C. Memo 1957-227; Rev. Rul. 56-439, 1956-2 Cum. Bull. 605. The problem that may arise in some of these types of transactions is that the non-transferor spouse may be made a beneficiary of the donee trust. It is not clear that gift-splitting is available for such a gift when the spouse to elect gift splitting is also a beneficiary of the donee trust. Gift-splitting requires that the gift be to a person other than the donor’s spouse. If gift-splitting is not allowed, only $5,120,000 of the gift will be covered by the donor’s exempt amount, resulting in $1,792,000 of gift tax at the 35% gift tax rate in effect in 2012. Carefully review prenuptial agreement provisions, or have client’s attorney do so and guide you, as to whether gift splitting is permissible.
- 2012 Gift Transfer Issues: Practitioners should be cautious in 2012 planning 2012 gifts, and cautious in 2013 reporting those gifts on gift tax returns. There are a host of unique issues that will affect 2012 gifts. A major issue that 2012 gifts is the significant incentive to consummate large gifts in 2012 to take advantage of the gift exemption, discounts, GRATs, dynast trusts and other tax benefits that may sunset or be changed.
- The compression of time to complete major gift transactions in 2012 will exacerbate proper planning – be alert in 2013 when filing 2012 gift tax returns.
- Reciprocal Trust Doctrine may be implicated when a husband and wife (or possibly other related or unrelated persons acting in concert) create identical (or perhaps even very similar) trusts for each other. Example: Husband gives $5.12 to a trust for the benefit of wife and issue, and wife gives $5.12 to a trust for the benefit of husband and issue. These trusts could appear quite similar to the typical bypass trust under a client’s will. This structure raises the specter of the reciprocal trust doctrine and the IRS or the Courts could “uncross” the two trusts and treat the wife as if she was the grantor of trust of which she is beneficiary, and ditto for husband. There is no clear safe harbor as to what constitutes sufficient differences between two trusts to avoid the application of the reciprocal trust doctrine. Therefore, the best approach is to make the trusts as different as is practicable under the circumstances. When reporting gifts to these trusts, all the relevant issues and data to corroborate the differences might be advisable to report on each spouse’s gift tax return. The fundamental concept of the reciprocal trust doctrine is that both the husband and wife are left in substantially the same economic position following the establishment of the two trusts as they were before the establishment of the two trusts. Avoiding the Reciprocal Trust Doctrine is not simple, but should be based on maximizing the number of meaningful legal differences between the trusts. This could include having one spouse as a beneficiary of the trust he or she creates, if the trust is formed in an asset protection jurisdiction such as Alaska, Delaware, Nevada or South Dakota (i.e., a domestic asset protection trust). However, the other spouse creates a trust for which he or she is not a beneficiary (i.e., not a DAPT). Use different distribution standards in each trust. Use different trustees or co-trustees. Give one spouse a noncumulative “5 and 5” power, but not the other spouse. Give one spouse a special power of appointment, but not the other. PLR 9643013. Consider these issues in planning, structuring and implementing these transactions, as well as when reporting them.
- Step-Transaction doctrine. The IRS can collapse a series of steps in a single integrated transaction and treat them as one. In 2012 one acute risk could arise in the following likely common scenario. The husband has title to most family wealth and makes a gift of $5 million to an irrevocable trust to use most of his exemption. The husband also gifts $5 million to wife which she almost immediately gifts to a trust she establishes to use most of her exemption. Was it a gift by virtue of the step transaction doctrine of husband to wife’s trust as well? This could trigger approximately a $5 million taxable gift.
- DSUEA - Portability and ordering rules Affect Gift Reporting: The $5 million 2011 and the $5.12 million 2012 “Deceased Spouse Unused Exclusion Amount” (DSUEA) is available for gifts and must be considered in planning and reporting all gifts post 2010. The issues are not simple. Are there ordering rules? So far there does not seem to be. Thus, it may be feasible to use the 2011 or 2012 DSUEA prior to using the surviving spouse’s own exemption. That would certainly be advantageous to avoid the risk remarriage and death of a new spouse would have to the prior deceased spouse’s unused exemption amount. Specifically, if the new spouse dies it will eliminate the old spouse’s DSUEA.
- Can new spouse gift split and circumvent privity rule: The privity rule prevents a new spouse from using the unused exemption from the deceased spouse. This can be illustrated more readily: If H-1 dies, W-1 can use his exclusion, but if W-1 remarries to H-2, H-2 can “inherit” W-1’s exclusion but not the exclusion H-1 “gave” to W-1. This is because of the privity rule that limits the use of unused exemptions. Some say there may be a means of circumventing this limitation through gift splitting. While it is not clear that this has been expressly prohibited it does appear to be contrary to the intent of the portability rules and practitioners should exercise considerable caution in taking this position on a gift tax return. Again, an example can illustrate: W-1 can use H-1s exclusion if she makes lifetime gifts. If W-2 remarries to H-2, can H-2 join W-1 in gift splitting? Gift splitting might arguably enable one spouse to make a large gift and have the other non-donor spouse treat the gift as if were one-half theirs. Can H-2 make a gift and have W-1 gift split thereby using some of H-1s exclusion to cover a gift by H-2? While the law is not clear, this may be a possibility. Consider carefully reporting and disclosing this position in detail on the return and in a comprehensive attached statement.
- Trust Administration Affects Gift Reporting: Practitioners report transactions that were gifts (or certain non-gift transactions like sales to grantor trusts). Reporting is based on the transaction as consummated. For example, if there was a sale, the sales contract, note from the trust to the client/seller, and other key documents will be relied upon to corroborate the transaction. However, as most practitioners are aware, many of the successful challenges by the IRS of various transactions occur as a result of the conduct of the taxpayer, trustee, and other often related parties and entities after the initial transaction is concluded. Practitioners should advise clients to meet after the gift tax return is over to discuss administration of the reported gift transactions so that the formalities of administration can be adhered to, and that if that is not done, the transactions as reported may not be respected. When a transaction is successfully challenged on audit many clients will blame the practitioners involved in the transaction, when, in perhaps a large majority of sophisticated gift transactions, it is the post-gift administrative errors and oversights that torpedo the plan. Too many practitioners view their role as one of compliance, but the follow up is essential if the manner in which a transaction is reported is not respected afterwards.
- What is a Gift: The term “Gift” under tax law definitions is broader then colloquial usage would imply. The gift tax is a tax charged on the right to give away, gratuitously, assets during your lifetime. Common usage of the term "gift" implies a donative intent; tax law does not require that you had any particular intent. All that the tax laws require to trigger the gift tax is a transfer of assets for less than full payment of value (consideration). Consider reciting that “no consideration was received in exchange for this transfer” in the transfer documents – use a gift letter to corroborate. The main issue with this broad definition is many clients will not realize the scope of what actually has to be reported as a gift. Practitioners should endeavor to explain to clients the scope of transfers that may be subject to gift tax and have the clients acknowledge that all relevant transactions were disclosed.
Is the Gift Complete: A transfer is not taxable (reportable) as a gift until complete. So practitioners should take some reasonable steps to assure that a transfer is in fact a completed gift before reporting it. To be complete, the donor must transfer beneficial interest in the assets to the recipient (donee). What does this require? What documents are used? The donor must give up “control” over the asset. An area of frequent issue with this is when the client gifts an FLP but borrows money back on a regular basis, or extracts most of the earnings as compensation without regards to the fair value of any work effort. In these cases has control been given up? To be complete the gift must be beyond donor’s recall. This might require an analysis as to whether each of the steps necessary to transfer the asset to the donee trust have been consummated, the terms of the trust and any governing documents, etc. Accountants preparing gift tax returns might need to consult with the client’s attorney to ascertain the legal status of the transactions involved. In some instances the transaction will be intentionally structured so that the gift transfer is intentionally “incomplete” in order to avoid a gift. For example, transfers to some trusts (e.g., asset protection trusts that don’t seek estate tax savings) might intentionally be incomplete. The determination as to whether a gift is incomplete can be more complex than the determination as to whether the gift is complete. A client can assure that the gift is incomplete by transferor retaining both a testamentary special power of appointment and also the right to veto any distribution proposed by the trustee. The IRS ruled in CCA 201208026 that a transfer to a trust was complete for Federal gift tax purposes where the donors retained a testamentary (exercisable at death) special power of appointment but named someone else as trustee who had the authority prior to the donors’ deaths to distribute all of the income and corpus of the trust to persons other than the donors or to distribute it to charity. These issues can be quite complex and clients may not understand the scope of the practitioner’s effort that may be necessary to ascertain the proper reporting position.
- Gifts Under Powers of Attorney: These represent another potential landmine for practitioners preparing gift tax returns. If the gifts were made by an agent, the IRS may raise issues of estate inclusion for gifts made under a power of attorney under IRC Section 2038 for federal estate tax purposes. The IRS may argue that the gifts made under a power of attorney which did not give explicit authority to the agent to make such gifts are invalid under state law and therefore revocable by the principal/decedent or a guardian ad litem appointed for such individual. Since these gifts are revocable until the individual dies, they are includible in the individual's estate. Practitioners should attach a complete copy of the power of attorney that was relied upon in making gifts. If the language is not expressly clear perhaps a memorandum of law or perhaps even an opinion as to the basis of the power of attorney document supporting gifts should be obtained. If the practitioner completing the gift tax return is an accountant, it may be advisable to involve the client’s estate planning attorney (perhaps the attorney that prepared the power of attorney under which gifts were made) to evaluate the situation.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.
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