|JAY A. SOLED, JD, LLM, is assistant professor of accounting and information systems at Rutgers, The State University of New Jersey, Newark. His e-mail address is firstname.lastname@example.org.|
The Taxpayer Relief Act of 1997 actually does provide some relief to hard-pressed taxpayers. It introduced some major technical and administrative changes to the U.S. transfer tax system, including a gradual increase in the unified credit that eventually will enable each taxpayer to shield up to $1 million from estate and gift taxes. It also introduced a $1.3 million exclusion for certain qualified family-owned businesses. (The IRS Restructuring and Reform Act of 1998 made this exclusion a deduction.) Few of these changes, however, are as significant to taxpayers and their CPAs as the new rules for filing gift tax returns.
SOME RELEVANT BACKGROUND
Taxpayers who make transfers that fall within the scope of the annual exclusion or within the medical and education expense exclusions are not obligated to file gift tax returns. The annual exclusion includes present interest gifts, gifts that vest immediately, that do not exceed $10,000 per beneficiary. In contrast, taxpayers who make transfers that fall outside of those exclusions or who make split gifts with their spouses are required to file gift tax returns, even when no tax is due (such as when the taxpayer uses his or her unified credit or the transfer qualifies for the gift tax charitable deduction).
When a taxpayer files a gift tax return, the statute of limitations begins and generally runs for three years after the return is filed (six years if the amount of unreported items exceeds 25% of the amount of the reported items).
Once the statute of limitations lapses, a taxpayer usually can use it as protection from an IRS assessment. For example, suppose Alan transferred 100 shares of X stock to his son Edward in 1991 and in 1992 reported the value of the transfer as $100,000 on Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax Return . Once the statute of limitations had lapsed in 1995, the IRS could not challenge Alan's valuation of X stock for purposes of computing his gift tax liability.
The lapse of the statute of limitations was not, however, an impenetrable shield. In Smith v. Commissioner (94 TC 872 ), the Tax Court held that a gift could be revalued for purposes of computing a taxpayers estate tax. This was true even when the statute of limitations had lapsed. Under Smith , the estate of a taxpayer who made gifts during his or her lifetime might have less unified credit available, bear a higher marginal estate tax rate or both.
Suppose Alan had died in 1996 with a taxable estate of $2 million and the IRS could prove the value of X stock was $600,000 (rather than $100,000) at the time of the original transfer. Under those circumstances, the $600,000 value would be used to compute the tax on Alan's estate. This change would affect adjusted taxable gifts, increasing the estate tax liability by $249,000. (See the exhibit for a comparison of the computations.)
The practical implication of Smith was that taxpayers and their executors, as a precautionary measure, had to retain transfer tax records until after the taxpayer died and the estate has received a closing letter from the IRS. The Tax Relief Act of 1997 changed that.
| Gift Tax Facts
Source: Internal Revenue Service, www.irs.ustreas.gov.
NEW LAW UNDER THE ACT
For gifts made after August 5, 1997, the act precludes the IRS from challenging taxpayers valuations of gifted property once the statute of limitations has lapsed. This new rule effectively alleviates the burdensome recordkeeping requirements the Tax Court established in Smith .
Notwithstanding the fact that the act legislatively overturned Smith , it tightened the statute of limitations requirements for gifts made after August 5, 1997. Now, in order for taxpayers to invoke a statute of limitations defense, two conditions must be met:
- Adequate disclosure. Taxpayers must show or disclose the value of the gift on a gift tax return or attach a statement to the return describing the nature of the gift.
- Expiration. The statute of limitations must have expired for purposes of assessing a gift tax.
When both conditions are met, a taxpayer may discard transfer tax records without fear of a subsequent IRS valuation challenge. (More cautious taxpayers may still hold on to their records until the courts elaborate on the meaning of adequate disclosure.) On the other hand, if a gift is not reported or adequately disclosed, the statute of limitations will not begin, allowing the IRS to assess potential gift tax, interest and penalties or to adjust the taxpayer's unused unified credit at any time.
Before the act, if an IRS audit did not result in a gift tax assessment but the IRS proposed the value of the taxpayers transfer to be greater than what the taxpayer had reported, no court had jurisdiction to hear the taxpayers case. This predicament left many taxpayers in a quandary: Should they make additional gifts and, if so, in what amounts? This quandary led taxpayers to avoid strategic gift giving as an estate planning technique for fear of generating gift taxes.
To illustrate this point, assume Betty had not yet made any taxable gifts. In 1996, she gave a valuable painting to her son, Andrew. On her gift tax return, Betty reported the value of the painting as $100,000. Upon audit, the IRS valued the painting at $600,000. In the future (ignoring the increasing unified credit under the act), aside from gifts within the annual exclusion, Betty might not make additional gifts, even of rapidly appreciating property. Betty is afraid of being subject to a gift tax adjustment because if the value of the painting is what the IRS claims it to be, she has exhausted her $600,000 unified credit.
To offer taxpayers like Betty greater certainty, the act introduces a new judicial review process. After an IRS audit that results in the IRS claiming the value of transferred property is much greater than what the taxpayer reported, taxpayers may now petition the Tax Court for a declaratory judgment regarding the value of the property in question, even if no gift tax has been assessed. To avail themselves of this judicial opportunity, however, taxpayers must exhaust all available administrative remedies with the IRS (such as filing a protest with the IRS Appeals Division).
FILING STRATEGIES UNDER THE ACT
CPAs should not abandon successful gift tax filing strategies of the past. Whenever the issue of valuation may be disputed, such as transfers involving difficult-to-value assets, including business interests or real estate or when valuation discounts are involved, taxpayers should obtain an appraisal (or two) of the property or an opinion letter from an expert justifying a particular discount. Appraisals done contemporaneously with the gift are easier to do and usually are more accurate than those made years after the transfer. Such appraisals also are far more likely to withstand IRS scrutiny than those made long after the transfer.
In addition to the tried-and-true filing strategies, CPAs should consider some new alternatives as well. Taxpayers now have an added incentive to file gift tax returns that detail their transfers. To meet the adequate disclosure standard, CPAs should file gift tax returns that include
- A description of the transaction, including a description of
transferred and retained interests and the method (or methods) used
to value each.
- The identity (name, address and taxpayer identification number)
of, and relationships among, the transferor, transferee, all other
persons participating in the transaction and all parties related to
the transferor holding an equity interest in any entity involved in
the gift transaction.
- A detailed description (including all actuarial factors and discount rates used) of the method used to determine the amount of the gift resulting from the transfer (or taxable event). In the case of an equity interest that is not actively traded, taxpayers should include financial and other data used to determine value. Financial data generally should include balance sheets and statements of net earnings, operating results and dividends paid for each of the five years immediately before the valuation date.
In the past, many taxpayers who made gifts that fell within the scope of the annual exclusion did not report these gifts because they were not required to do so. Taxpayers who did file gift tax returns offered few details about the nature of the transfers. Under the act, however, taxpayers have an added incentive to file gift tax returns and make full disclosure.
For example, assume Carl owns all 100 shares of outstanding company Y stock worth $2 million. Carl decides he will give one share of that stock to his daughter, Mary. For gift tax reporting purposes, Carl aggressively values the share of company Y stock at $10,000 by applying a 50% minority and marketability discount ($2,000,000/100 × 50%).
Impact of a Change in Taxable Gifts
If the gift had been made before the act was passed, Carl might have chosen not to file a gift tax return because the claimed value of the gift was not in excess of $10,000. If he had filed a return, Carl might not have explained how he determined the value of company Y stock. Under the act, however, the adequate disclosure standard requires that Carl file a gift tax return that reports his transfer of company Y stock along with details of how he determined the per share value. Properly handled, adequate disclosure will curtail the IRS's ability to challenge a taxpayer's valuation estimate long after the statute of limitations expires.
This same disclosure principle applies to other gifts as well: Transfers of any property that involve valuation issues cannot be ignored or camouflaged for purposes of filing gift tax returns. Complete disclosure is now the name of the game. Failure to heed this advice will result in potential transfer tax time bombs.
More specifically, failure to heed this advice could trigger valuation issues at the taxpayer's death. The 1998 act says that for purposes of computing a decedent's taxable estate, the amount of prior taxable gifts is the value finally determined, even if no gift tax was paid or assessed on the gift. Four categories define a gifts final value, including the value
- Reported on the gift tax return (if the IRS does not challenge it before the statute of limitations expires).
- Determined by the IRS (if the taxpayer does not challenge it).
- Determined by a court.
- Agreed upon by the taxpayer and the IRS in a settlement.
It is in the taxpayers obvious best interest to have gifts be valued according to item 1, above.
The act invites new considerations by CPAs about whether a taxpayer should file a gift tax return and what the contents of that return should be. CPAs who fail to be sensitive to these considerations may cause their clients to bear larger than necessary transfer tax burdens.