When a person makes a gift, frequently what is foremost on their mind is the benefit to the beneficiary. Secondarily, if the gift is part of a broader estate plan, the donor may also consider the potential savings associated with transferring future appreciation out of their taxable estate. Regardless of the objective, many gifts require the filing of a gift tax return. However, if the disclosure of the gift on the gift tax return does not meet specific requirements provided by the IRS, the donor (or his or her estate) may be defending the reported value many years after the original filing.
A Brief Review of the Adequate Disclosure Rules
The IRS typically has three years after a gift tax return is filed to challenge something reported on the return; however, the statute of limitation only applies to items disclosed on the return “in a manner adequate to apprise the Secretary of the nature and amount of such item.” I.R.C. § 6501(e)(2). This broad requirement is typically referred to as the adequate disclosure standard. In an attempt to provide a safe harbor for reporting purposes, the IRS promulgated Treasury Regulations that provide, in painful detail, what the IRS has determined will qualify as an adequate disclosure (the “Adequate Disclosure Regulations”).
In order for a gift to be considered adequately disclosed under the Adequate Disclosure Regulations, the following information must be provided on the gift tax return:
- A description of the transferred property and any consideration received for the transfer. § 301.6501(c)-1(f)(2)(i).
- The identity of the transferor and transferee and their relationship. §301.6501(c)-1(f)(2)(ii).
- If the property is transferred in trust, the trust’s EIN and a copy of the trust agreement or a brief description of the trust terms. §301.6501(c)-1(f)(2)(iii).
- The identification of any position taken in reporting the transfer that is contrary to any Proposed, Temporary or final Treasury Regulations or Revenue Rulings published at the time of the transfer. §301.6501(c)-1(f)(2)(v).
- A description of how the fair market value was determined including (i) an appraisal (meeting certain formal requirements), or (ii) a detailed description of the method used to determine the value (meeting a long list of additional requirements). Reg. §301.6501(c)-1(f)(3); Reg. § 301.6501(c)-1(f)(2)(iv).
In addition to the requirements above, if the transfer is subject to the special valuation rules of Chapter 14 (e.g., GRATs, QPRTs, and transfers of interests invoking §2701) there are additional requirements that must be satisfied. Specifically, in addition to the requirements above, the Adequate Disclosure Regulations require:
- A description of the transactions, including a description of transferred and retained interests and the method (or methods) used to value each. Reg. §301.6501(c)-1(e)(2)(i).
- The identity of, and relationship between, the transferor, transferee, all other persons participating in the transactions, and all parties related to the transferor holding an equity interest in any entity involved in the transactions. Reg. §301.6501(c)-1(e)(2)(ii).
- A detailed description (including all actuarial factors and discount rates used) of the method used to determine the amount of the gift arising from the transfer (or taxable event), including, in the case of an equity interest that is not actively traded, the financial and other data used in determining value. Reg. §301.6501(c)-1(e)(2)(iii).
Compliance with these additional requirements becomes particularly complicated when disclosing a transfer that could implicate §2701 because different interpretations of §2701 can require different information.
To help illustrate the impact of these rules, assume that a parent transferred real property from a failed development to a trust for his daughter in 2010 and reported the transfer on a gift tax return filed on April 15, 2011. Generally speaking, the IRS should have had until April 15, 2014 to challenge the reported value of the real property. Therefore, when the parent died in 2020 (when the value of the property had tripled), the valuation of the property should not have been subject to adjustment. If, however, the gift was not adequately disclosed on the gift tax return, then the valuation can be contested and the IRS will have the benefit of hindsight when establishing the fair market value of the property in 2011 (which, whether admissible or not, can significantly impact settlement negotiations). Additionally, an adjustment focused solely on the 2011 gift may not result in the immediate payment of tax (provided that the donor had sufficient estate tax exemption), while an adjustment as part of an estate tax examination will require the executor to go through the painful process of writing an additional check to the IRS.
Close Only Counts in Horseshoes (the IRS Position)
Many commentators requested that the Adequate Disclosure Regulations include a “substantial compliance” provision or a “good-faith effort” provision; however, the IRS, in the preamble to the Regulations, determined that it would be too difficult to define substantial compliance as part of the regulatory scheme, but “…it is not intended that the absence of any particular item or items would necessarily preclude satisfaction of the regulatory requirements, depending on the nature of the item omitted and the overall adequacy of the information provided.”
This language in the preamble seemed to indicate an informal position that strict adherence to the regulations would not be required; however, guidance from the IRS has not been so kind. IRS Memorandum 20152201F cites a missing digit in an entity’s EIN and the omission of “LP” from an entity’s name as the primary reasons for a disclosure falling short of the adequate disclosure standard and there has yet to be any judicial guidance applying a more liberal interpretation. Therefore, taxpayers should assume strict adherence to the Adequate Disclosure Regulations will be a required to start the statute of limitations.
When it is Not Best to Try and Fail than to Not Try At All
Even if a transfer does not have to be reported on a gift tax return, perhaps because it is a gift qualifying for the annual gift tax exclusion ($15,000 in 2019 and 2020) or a sale to a trust at fair market value treated as a non-gift, it nonetheless may be wise to report such transfer on a gift tax return. Adequately disclosing a non-gift transfer arguably starts the running of the statute of limitation on the valuation and prevents the IRS from later challenging value.
The primary difference between the gift and non-gift adequate disclosure requirements is the lack of the requirement to describe the method used to determine fair market value. Therefore, reporting is still an option even if a formal appraisal is not feasible for the donor, e.g. because of the small value of the transferred asset relative to the cost of a formal appraisal, but there still must be an explanation for why the transaction is not a reportable gift.
It is still unclear whether the courts will apply a more relaxed interpretation of the adequate disclosure requirements or require strict compliance with Adequate Disclosure Regulations. Therefore, the only way to avoid the issue being raised as part of an estate or gift tax examination is to closely monitor gift tax returns and ensure that the return preparer has experience reporting gifts in compliance with the applicable Treasury Regulations. Furthermore, if there is any concern that a previously reported transfer was not adequately disclosed, it may be advisable to file an amended gift tax return, in compliance with the adequate disclosure rules, to begin the three year period. While some practitioners may view this as raising a “red flag” potentially triggering an examination of the return, we have found that it is better to handle an examination when the facts are fresh, there may still be adequate exemption to offset a proposed adjustment, and the IRS does not have another decade (or longer) for hindsight to taint their opinion of fair market value.