11 minute read
Why Your Gift Tax Return Requires Adequate Disclosure
By C. P. Schumann, CPA, CVA, MAFF
If an individual transfers business interests or assets to another, and the transfer is “adequately disclosed,” the Internal Revenue Service (IRS) has three years to challenge the valuation of the asset or to claim that the transfer was actually a gift or a partial gift. If the transfer is deemed to be not “adequately disclosed,” the IRS can seek unpaid gift taxes, plus penalties and interest, even decades after the transfer. Thus, it is imperative to understand the byzantine disclosure requirements; and, in certain situations, it might be prudent to report a transfer on a gift tax return simply to commence the limitations period.
This topic is particularly pertinent now, as the IRS is expecting that a huge number of gifts will be made before the 2026 drop in the estate tax exception. This anticipated gift rush, on top of past gift booms, pose a significant problem for the IRS: How to screen and audit a huge number of gifts, in the three-year window. In response, IRS lawyers have made public statements to the effect that they will handle the problem by nit-picking. Of course, statements by IRS employees do not represent the official position of the Service. Still, this does point to a practical solution.
The 2001 revision to the statute “Exceptions to General Period of Limitations on Assessment and Collection” provides that the three-year time period does not start until a detailed list of conditions is met. Nitpicking would logically consist of looking for facts leading to one of the exceptions, and then claiming gift-related discounts were overstated. Anyone snagged through such means in four, five, or many more years could face quite an inflated assessment, even if the initial deficiency was fairly small. This might be a good time to check that the statute’s shopping list is covered.
The statute provides a long list of exceptions. With respect to valuation, the method used to determine fair market value and its related detail may be satisfied by submitting an appraisal by a qualified, unrelated appraiser that includes the information considered, including financial data sufficiently detailed so that another person can replicate the process, and many other specific items. This essentially is the content of a qualified appraisal. To avoid creating an easy IRS challenge, the shopping list should be faithfully covered in the documentation accompanying the gift tax return. If a gift is adequately disclosed on a Form 709 Gift Tax Return, then generally the IRS cannot effectively change the gifts after the three-year statute of limitations has expired. However, if the IRS finds that a gift is not adequately disclosed, the statute of limitations is extended, and the gifts can be reviewed at any time.
What Does “Adequate” Really Mean?
According to the rules under Internal Revenue Code Section 6501, a transfer will be adequately disclosed on a return if it is reported in a way adequate to apprise the IRS of the nature of the gift and the basis for the value reported. To be considered adequately disclosed by the IRS, each return should provide the following information:
1. Sufficient description of the transferred property and any consideration received by the transferor (person making the gift), which should also include:
a. Identification of number of stock shares or percentage(s) of interests transferred;
b. All nine digits of the entity’s Employer Identification Number (EIN);
c. Full (unabbreviated) entity name, including: Inc., LLP, LP, LLC;
d. Identification of the type of interest transferred: general, limited, limited liability, assignee; and
e. Information about whether the transferee provided any consideration (money or other assets in exchange).
2. The identity of, and relationship between, the transferor and each transferee (person receiving the gift).
3. Detailed description of the method used to determine the fair market value (FMV) of the property transferred, including:
a. Any discount claimed in valuing any assets owned by the entity being gifted;
b. For entities whose value is determined based on the Net Asset Value Method, disclosure of the FMV of 100% of the entity and how it was valued;
c. Description of the methodologies (including comparable sales) used to discount the value;
d. Any restrictions on the transferred property that were used to determine FMV, including formation documents, shareholder agreements and by-laws; and
e. Explanation of the different discount regimes or the basis for using such discounts.
4. A statement describing any position taken that is contrary to any proposed, temporary, or final U.S. Treasury regulations or revenue rulings published at the time of the transfer.
Adequate Disclosure Items Related to the Valuation Report
• The date of the appraisal
• The date of the transfer
• The purpose of the appraisal
• A description of the property
• A description of the appraisal process employed, including the valuation method(s) used
• A description of any hypothetical conditions considered
• The information considered in determining the value, including all financial information in sufficient detail to allow the reader to replicate the appraisal analysis and valuation
• The appraisal procedures followed, and the reasons that support the analysis, opinions, and conclusions
• The valuation method utilized, the rationale for the procedure used in determining the fair market value of that asset transferred
• The specific basis for the valuation, such as specific comparable sales or transactions, sales of similar interests, asset based approaches, merger-acquisition transactions, etc.
Adequate Disclosure and the IRS’s Strategy of More Information Reporting
Historically, the IRS has taken a very restrictive view of what constitutes adequate disclosure on a federal gift tax return. For example, in a 2015 IRS Field Advice memo, a gift of a partnership interest was found to not be adequately disclosed on a Form 709 Gift Tax Return because the partnership’s EIN was missing just one digit.
Relatedly, for many years, the IRS has taken steps to increase the information reporting burden on taxpayers. Notice 200783, making an identified abusive trust arrangement a listed transaction, requires taxpayers to disclose substantial information regarding these transactions. Notice 201666 requires taxpayers involved in certain microcaptive insurance arrangements to disclose substantial information regarding these “transactions of interest.” Recently, the IRS issued new instructions to Schedules UTP, Uncertain Tax Position Statement; K-2, Partners’ Distributive Share Items — International [or Shareholders’ Pro Rata Share Items — International]; and K-3, Partner’s [or Shareholder’s] Share of Income, Deductions, Credits, etc. — International, that require substantially more information than has been acceptable in the past (Schedule UTP) and substantially more information than may be available to the taxpayer (Schedules K-2 and K-3). And Field Attorney Advice (FAA) 20214101F requires substantially more information to support a research credit refund claim than has been acceptable in the past.
Recently, two courts have spoken, holding that the IRS’s information reporting efforts violate the Administrative Procedure Act (APA). In Mann Construction, Inc., et al. v. United States, 27 F.4th 1138 (6th Cir. 2022), the Sixth Circuit, reversing a district court, held that before Notice 2007-83 was promulgated and enforced, the IRS was required to comply with the APA rulemaking procedures. In CIC Services, LLC v. Internal Revenue Serv., 592 F. Supp. 3d 677, 683 (E.D. Tenn. 2022), the district court applied Mann Construction and held that the IRS was required to comply with the APA before promulgating Notice 2016-66. The court ordered the IRS to return the documents obtained from the disclosure. See id. at 688. On reconsideration, the Court amended the judgment to remove the requirement that the IRS return the documents obtained from the disclosure during the five years the disclosure requirements of Notice 2016-66 were enforced. CIC Services, LLC v. Internal Revenue Serv., No. 3:17-CV-110, 2022 WL 2078036, at *4 (E.D. Tenn. June 2, 2022).
Schlapfer v. Commissioner, Tax Court Memo 2023-65 (May 22, 2023).
However, the IRS’s highly restrictive view of what constitutes adequate disclosure may soon be changing in light of a recent Tax Court decision: Schlapfer v. Commissioner, Tax Court Memo 2023-65 (May 22, 2023).
Facts: [The following facts are a bit convoluted but stick with me.] The donor was born in Switzerland. He worked as a banker in the United States and Switzerland. He had a United States green card for a while. In 2008, the donor became a United States citizen. In 2006, the donor had purchased a Swiss life insurance policy. As permitted under Swiss law, the donor funded the life insurance policy purchase with stock in a corporation that he owned and also with cash. The ownership of that life insurance policy was then assigned to the donor’s mother, aunt, and uncle. In 2006, Mr. Schlapfer filed a gift tax return that reported a gift of the stock in his company to his mother, aunt, and uncle. He also included in that filing Form 5471 for a foreign corporation that was used to fund the life insurance policy. Mr. Schlapfer took the position on his gift tax return that he was not domiciled in the United States in 2006 because he had not (yet) formed the intention to remain in the United States and, therefore, he was not subject to the United States gift tax. Despite this stated plan, the insurance company initially issued the policy to Mr. Schlapfer as its sole policyholder. It was only in May 2007 that formal ownership of the insurance policy was corrected and put into the names of the donor’s mother, aunt, and uncle.
Disclosure to the IRS: The gift transaction only came to the attention of the IRS in 2013 when Mr. Schlapfer participated in the IRS’s Offshore Voluntary Disclosure Program (the “Program”) because he had not filed United States income tax returns for the years 2004 through 2009. As part of the Program’s compliance rules, Mr. Schlapfer had to furnish copies of his past income and gift tax returns. This led to the IRS’s follow up questions when it asked Mr. Schlapfer to document his gift of the company stock to his mother, aunt, and uncle, and to substantiate his claim that he was not domiciled in the United States in 2006.
Initial Determination in 2016—No Gift in 2006: The IRS examined his 2006 gift tax return and agreed to extend the statute of limitations for a year. Initially, after several months of examination, the IRS concluded that Mr. Schlapfer did not make any gifts in 2006 because the ownership of the insurance policy was ‘wrong,’ the gift was not completed until sometime in 2007.
Tax Court Decision: The Tax Court held that Mr. Schlapfer’s disclosure in his 2006 gift tax return was sufficient to commence the three-year statute of limitations running on that return and thus would time bar any assessment of tax, whether that gift was made in either 2006 or 2007. Schlapfer v. Comm’r of Internal Revenue, T.C.M. (RIA) 2023-065 at *19 (T.C. 2023). The Court explained that “[a] disclosure is adequate if it’s sufficiently detailed to alert the commissioner and his agents as to the nature of the transaction so that the decision as to whether to select the return for audit may be a reasonably informed one.” Id. at *6 (citations and internal quotation marks omitted).
Takeaways from the IRS Decision in Schlapfer v. Commissioner
So, what can we learn from this? If we are in a planning situation, I do not want you to learn anything from this case because—if you are in a planning situation—you should try to comply strictly with the requirements and the regulations, and comply with them in full.
But if you find yourself in a dispute with the IRS and you want to argue that there has been adequate disclosure of the gift and, therefore, that the statute of limitations has run and that it is too late to assess gift tax, we now have a really strong opinion in Tax Court to back us up on the position that strict compliance with the adequate disclosure regulations is not necessary. The disclosure just has to be adequate to provide the IRS with a way to determine whether the gift tax return should be examined.
On January 1, 2026, the estate and gift tax exclusion will be essentially cut in half. Now is the time to start talking to high-networth clients about their transfer plans and making sure that those transfers are adequately disclosed to prevent problems from cropping up unexpectedly many years from now.
