Last year was a unique year for estate planners. The estate, gift and generation-skipping transfer (GST) tax exemptions were at $5,120,000, which were (at that time) the highest levels in history. These record exemptions were scheduled to expire at midnight on December 31, 2012 and revert back to gift and estate tax exemptions of $1,000,000 and a GST tax exemption approximately of $1,400,000. The gridlock in Congress deflated the confidence of many practitioners and clients that legislation extending the record exemptions would be enacted prior to the end of 2012. Therefore, opportunistic taxpayers rushed to make gifts during 2012, partly out of fear that the high exemptions could be lost. As a result, a record number of 2012 gift tax returns are expected to be filed in 2013. These returns are due by April 15, 2013, although the due date can be automatically extended by 6 months if the appropriate form is filed with the IRS on or before April 15, 2013.
The importance of accurately reporting a gift on a 2012 gift tax return cannot be understated. The failure to properly report a gift on the return can derail the benefits of what was otherwise a great plan. For example, the failure to properly make a split-gift election can cause significant gift tax to the donor. In addition, the failure to properly allocate GST exemption can expose transferred assets to GST tax or future estate tax. Here are a few tips to help you avoid some of the most common (and costly) mistakes when preparing your 2012 gift tax return(s):
1. Election to split gifts. Code § 2513 generally provides that a gift made by one spouse to a donee (other than his or her spouse) can be treated as made one-half by each of the donor and the donor’s spouse if the both spouses consent to split the gift. This consent must be signified on the first gift tax return reporting the transfer that is filed with the IRS. The non-donor spouse indicates his or her consent by signing the donor’s gift tax return on Line 18 of Part 1. The failure of the non-donor spouse to sign Line 18 can result in the IRS treating the entire gift as being made by the donor. For example, a $7,000,000 gift by a donor in 2012 which was intended to use $3,500,000 of gift tax exemption of each of the donor and the donor’s spouse would instead be treated as a $7,000,000 gift by the donor if the split-gift election is not properly made. Consequently, the donor would be liable for gift tax at the rate of 35% on the excess of $7,000,000 over the donor’s remaining gift tax exemption.
A split-gift election must be made as to all gifts made during the calendar year. The donor’s spouse cannot pick and choose which gifts made by the donor will be split. Therefore, it is important to analyze whether the donor and the donor’s spouse will be in a better position by splitting all of the gifts or not splitting any gifts at all.
Last year was also the year of the spousal lifetime access trust (SLAT). A SLAT is basically a trust created for the benefit of a spouse and descendants. Treasury Regulation § 25.2513-1(b)(4) generally provides that, in circumstances such as a SLAT where a gift is made to a spouse and third parties, the donee spouse may consent to split only the portion of the gift made to third parties, provided the interest of the third parties is ascertainable at the time of the gift and, therefore, severable from the interest of the donee spouse. SLATs are often drafted so that the spouse and remaining beneficiaries are merely discretionary beneficiaries, which means that the value of the interests of the third parties is not ascertainable. Accordingly, gifts to a SLAT generally cannot be split by the donor’s spouse. The inability to make the split gift election for a gift to the SLAT may impact the gift tax ultimately payable by the donor. However, this does not prohibit the donor’s spouse from splitting the remaining gifts made by the donor.
2. Allocation of GST Exemption. Gifts that are direct skips or indirect skips are reported on Part 2 or Part 3, respectively, of the gift tax return. A direct skip is a transfer to a donee who is more than one generation below the donor. Direct skips are immediately subject to GST tax. An indirect skip is a transfer to a trust that, although not immediately subject to GST tax, could have a generation-skipping transfer at some point in the future. A donor’s GST exemption is automatically allocated to a direct skip while a donor’s GST exemption may or may not be automatically allocated to an indirect skip. Although it is generally easy to decipher which gifts should be reported on Part 2 as direct skips, it can be more difficult to determine which gifts should be reported on Part 3 as indirect skips.
Code § 2632(c) defines “indirect skip” as a transfer of property (other than a direct skip) subject to gift tax that is made to a “GST Trust”. A GST Trust is defined as any trust that could have a generation-skipping transfer with respect to the transferor in the future, unless the trust falls into one of the six enumerated exceptions listed in Code § 2632(c)(3)(B). Therefore, it is important to analyze the terms of the donee trust to determine whether a generation-skipping transfer (i.e., direct skip, taxable distribution or taxable termination) could occur from the trust at some point in the future after the initial gift is made. If it is possible for a generation-skipping transfer to occur from the trust in the future, the gift should be reported on Part 3 of the return even if the donee trust does not qualify as a “GST Trust” under Code § 2632(c)(3)(B).
A taxpayer’s GST exemption will be automatically allocated to an indirect skip to a GST Trust. These automatic allocation rules were enacted in 2001 as a safety net for donors who inadvertently failed to properly allocate GST exemption to a transfer to a GST trust reported on a gift tax return and also to cause the allocation of GST exemption to annual exclusion gifts made to certain trusts for which a gift tax return may not have been filed. However, taxpayers and preparers would be well advised not to rely solely on these automatic allocation provisions.
Column C of Part 3 of the return provides a donor with the following three elections (the “2632(c) election”) regarding the allocation of GST exemption to indirect skips:
1. Donor may elect not to have the automatic allocation rules of Code § 2632(c) apply to the current transfer made to the donee trust;
2. Donor may elect not to have the automatic allocation rules apply to both the current transfer and all future transfers to the donee trust; or
3. Donor may elect to treat any trust as a GST trust for purposes of Code § 2632(c), which means that the donor’s GST exemption will be automatically allocated to all transfers to the donee trust.
The 2632(c) election is made by checking column C next to the transfer to which the election applies and attaching a statement to the return describing which election the donor is making. The failure to attach the explanatory statement will confuse matters tremendously. The IRS will not have any way to determine which of the three possible elections the donor intended to make.
Although the 2632(c) election is technically not required, it should be made for every indirect skip when filing a gift tax return. If the donor fails to elect out of the automatic allocation and GST exemption is otherwise automatically allocated under Code § 2632(c) to the 2012 gift, this could result in a waste of the donor’s GST exemption. In contrast, if the automatic allocation rules do not apply to the 2012 gift and donor fails to elect into the automatic allocation (or otherwise make an affirmative allocation of GST exemption), then this could result in unintended GST tax in the future. Finally, if gifts are split by the donor and the donor’s spouse, then each spouse must indicate whether he or she is electing in or out of the automatic allocation rules on his or her respective return.
3. Adequate Disclosure. The IRS generally has three years from the date a gift tax return is filed to challenge a gift or other transfer disclosed on the return. However, this three year period does not begin to run unless the gift is “adequately” disclosed. Treasury Regulation § 301.6501(c)-1(f)(2) provides that a transfer will be treated as adequately disclosed if the return provides the following information:
1. A description of the transferred property and any consideration received by the transferor;
2. The identity and relationship of the transferor and transferee;
3. If the property is transferred in trust, the trust’s tax ID number and a description of the terms of the trust or a copy of the trust;
4. A description of the method used to determine the fair market value of the property transferred or, in lieu thereof, a qualified appraisal; and
5. A statement describing any position that is contrary to any proposed, temporary or final Treasury regulation or revenue ruling.
If a discount (such as a minority interest or lack of marketability discount) is applied in establishing the fair market value of a gift, the amount of the discount and the basis for applying the discount must be described. Therefore, it is important for the donor to obtain a qualified appraisal whenever gifting substantial assets for which a valuation discount is claimed. The tax savings substantiated by the appraisal will far outweigh the upfront cost in obtaining the appraisal. In addition, the donor must affirmatively answer “Yes” to Question A of Schedule A of the gift tax return any time a discount is claimed to notify the IRS that a valuation discount is claimed. The failure to accurately answer Question A may cause the discounted gift to be treated as not being adequately disclosed.
Completed transfers that are not intended to be gifts, such as sales to a family member or trust for the benefit of family members, may also be reported on the gift tax return or in a statement attached to the return in order to start the three year limitations period for the IRS to challenge the transaction. Treasury Regulation § 301.6501(c)-1(f)(4) provides that a non-gift completed transaction will be deemed to be adequately disclosed if the gift tax return includes all of the information listed above for the adequate disclosure of gifts, except that a description of the method used to value the property transferred or a qualified appraisal is not expressly required. Nonetheless, a taxpayer would be well advised to disclose such valuation information. As a rule of thumb, it is generally better to provide the IRS with more information than may be required in order to ensure the limitations period begins when the return is filed.
In addition to satisfying the adequate disclosure requirements, it is just as important to accurately report the gift. For example, for those taxpayers who made formula or defined value gifts in 2012 (perhaps in reliance on Wandry v. Commissioner) it is important to report that the amount transferred is determined pursuant to the formula contained in the transfer documents. A taxpayer should not report that a fixed percentage interest of the property was transferred. Many practitioners believe the taxpayer should attach the transaction documents containing the formula transfer to the return to ensure the adequate disclosure requirements are met and the taxpayer’s intent of making a formula transfer (and not a fixed percentage interest) is clear.
4. Timely Filing. Many individuals believe that merely depositing the return with a mail carrier is sufficient for the return to be treated as filed on the date of deposit. However, Code § 7502 generally provides that the postmark date is determinative, not the date of deposit. Therefore, if a return is deposited with the carrier on April 15th, but not postmarked until April 16th, then the return generally will not be treated as a timely return. The risk that the return will not be postmarked on the day that it is deposited in the mail may be eliminated by the use of registered or certified mail by obtaining a postmarked receipt showing the date of deposit.
A late-filed gift tax return can result in penalties to the taxpayer as well as a loss of GST exemption. GST exemption is allocated to a transfer on the date the transfer was initially made so long as the exemption allocation is made on a timely filed return. In the case of a late filed return, the allocation is deemed to be made on the date that the late return is filed. For example, a donor could have made a gift in 2012 that appreciated in value between the date of the gift and the filing of the return. If the return is timely filed, the amount of GST exemption allocated is based on the value of the contribution on the date it was made. Thus, all appreciation would be exempt. However, if the return is treated as a late filed return, then the taxpayer generally would be required to allocate GST exemption to the appreciated value of the gift as of the date the return is deemed to be filed. Moreover, the IRS may disregard the allocation of GST exemption on a return that is inadvertently filed late if the return does not comply with the requirements for making a late allocation of GST exemption.
A taxpayer or return preparer should never underestimate the importance of filing a complete and accurate gift tax return, even if no gift tax is expected to be due. This especially holds true if the return involves generation-skipping transfers and the allocation of GST exemption. An improper gift tax return can disrupt even the most well planned gifts.