Editor: Alexander J. Brosseau, CPA
Many taxpayers are responding to the favorable gift and estate tax environment and making more gifts. While it may take some finesse to report the most complicated transactions on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, you do not have to be a gift tax specialist to be aware of 10 common return preparation mistakes.
1. GST consequences of unreported gifts
One of the most perilous issues on Form 709 arises from missed generation-skipping transfer (GST) tax elections. If a taxpayer makes a gift to a trust and fails to affirmatively elect whether to allocate GST exemption to the transfer on a timely filed Form 709, the automatic allocation rules under Sec. 2632(c) apply. The automatic allocation rules are complicated, and the result may not be what the taxpayer intended.
For example, assume a taxpayer establishes a life insurance trust and contributes less than the annual exclusion each year for 20 years. The trust is intended to skip generations (i.e., pass to grandchildren or more remote descendants), but no gift tax returns were filed, and no GST election was made for the trust. The taxpayer dies and the life insurance pays out to the trust. Assuming the application of Sec. 2632(c) does not automatically allocate GST exemption to the trust, the trust will have a GST event when either distributions are made to skip persons or there are no longer any skip person beneficiaries of the trust. A late allocation of GST exemption could be made to exempt the trust, but the cost generally would be the use of an increased exemption amount, due to increases in the trust values since the initial gift. Tax preparers should consider the impact of any gifts made during the year, even if they are below the annual exclusion threshold.
2. Annual exclusion claimed on gifts of illiquid assets
To qualify for the gift tax annual exclusion, a gift must be of a present interest. This means that it must convey an unrestricted right to the immediate use, possession, and enjoyment of property or the income therefrom. This facts-and-circumstances test essentially requires the donee to be able to convert the property to cash. Case law (see, e.g., Price, T.C. Memo. 2010-2) has scrutinized transfers of illiquid assets like partnership interests. The courts have denied the annual exclusion when the partnership agreement effectively barred transfers to third parties, prevented partners from withdrawing their capital accounts, and did not require income distributions to limited partners. When taxpayers gift an illiquid asset, care should be taken to determine whether the asset qualifies for the annual exclusion.
3. Annual exclusions — read the withdrawal right provisions
As noted above, a gift will not qualify for the gift tax annual exclusion unless it is of a present interest. To qualify transfers to trusts for the gift tax annual exclusion, trust agreements commonly employ a Crummey withdrawal right, which allows a beneficiary the right to withdraw a specified dollar amount for a specified period (see Crummey, 397 F.2d 82 (9th Cir. 1968)). Crummey withdrawal language varies according to the drafting attorney, so it is important to carefully read the trust provisions to understand the amount of the withdrawal right. Some agreements provide beneficiaries the right to withdraw the lesser of the transferred amount or the annual exclusion amount (or twice that amount if the donor is married at the time of the gift). Others stipulate that the donor can adjust the withdrawal amount, vary which beneficiaries receive the right, or specify the amount of the withdrawal in the Crummey notice. The beneficiary must actually receive notice (generally in writing) of the right to withdraw trust property for the transfer to qualify for the annual exclusion. As a best practice, tax preparers should request copies of the Crummey letters to support the amount and availability of exclusions taken on Form 709.
4. GST annual exclusion — timing matters
For a gift to trust to qualify for the GST annual exclusion under Sec. 2642(c), the trust must be a direct skip trust where (1) no portion of the trust can be for the benefit of any person other than the sole beneficiary; (2) the trust is includible in the beneficiary's estate if the trust does not terminate before the individual dies; and (3) the transfer absorbs the gift tax annual exclusion. The gift tax annual exclusion is applied chronologically, and so tax preparers must be aware of transfer dates to calculate the proper exclusions.
Example 1: A grandmother makes a cash gift to a trust for the benefit of her three grandchildren in April 2021. The trust has withdrawal rights that allow the grandchildren to each withdraw $15,000 of the gift. The gift absorbs the gift tax annual exclusion for each grandchild but not the GST annual exclusion because the trust does not meet prong 1 above. Then, in July 2021, the grandmother gifts $15,000 to a trust for one of the grandchildren that meets prongs 1 and 2 above. Despite the fact that the gift to the trust in July would otherwise qualify for the GST annual exclusion, the annual exclusion with respect to that grandchild was used for the April transfer; thus, no GST annual exclusion is available for the gift to the trust in July.
5. Are they really community property assets?
Gifts of community property are deemed owned one-half by each spouse and should be reported as such on the gift tax return. The determination of community property versus separate property may be unclear for taxpayers who have moved between community-property and separate-property states. Tax preparers need to know the legal status of property transferred and should advise taxpayers to confirm legal title with their attorney.
Example 2: A taxpayer represents that he made a $30,000 gift of community property to his child in 2021. On Form 709 you report a gift by each spouse of $15,000, make no gift-splitting election, and report zero taxable gifts. Upon audit, it is discovered that the gift was the taxpayer's separate property. Consequently, the taxpayer made a gift of $30,000 — $15,000 of which is taxable. This could have been avoided if a gift-splitting election had been made.
If there is any doubt as to the character of the assets, taxpayers may consider electing to gift-split to avoid such unintended consequences.
6. Gift-splitting in the year of divorce or death
Typically, when taxpayers elect to gift-split, every gift is deemed to be made one-half by each spouse. However, in a year in which a spouse dies or the couple divorce, a taxpayer can split gifts with his or her spouse only during the time they were married to each other. For example, assume a married taxpayer makes gifts to his son in March and September. The taxpayer's spouse dies in August. On the taxpayer's gift tax return, only the March gift could be split with the spouse since the taxpayer was not married at the time of the September gift.
7. Gift-splitting contributions to a SLAT
Another gift-splitting complication occurs when a transfer is made to a trust where the spouse is a beneficiary. Lately, this has become more of an issue as taxpayers have been making gifts to spousal lifetime access trusts (SLATs) to take advantage of the temporarily increased applicable exclusion amount. SLATs are designed so that the spouse is a beneficiary, usually with a right to distributions for health, education, maintenance, and support. Under Regs. Sec. 25.2513-1(b)(4), splitting a gift in trust where a spouse is the beneficiary is not allowed when the spouse has an undefined interest in the trust. This does not preclude splitting Crummey power gifts, but it is generally problematic for gifts in excess of the Crummey withdrawal rights.
8. Presentation of GRATs
Grantor retained annuity trusts (GRATs) are reported in an unconventional way on the gift tax return. The term of the GRAT opens an estate tax inclusion period (ETIP), and transfers subject to an ETIP are reported on Schedule A, Computation of Taxable Gifts, Part 1, Gifts Subject Only to Gift Tax, of Form 709 at the time of the transfer. But recall the advice in point 1 above, that it is best practice to make an affirmative election with respect to the allocation of GST exemption.
There is no box to check for the election in Part 1. Even though an allocation of GST exemption will not be effective until the end of the ETIP, a leading practice is to make the election in the year of the initial transfer so that the election is not missed when the GRAT term ends. Additionally, GRATs are subject to the disclosure rules of Regs. Sec. 301.6501(c)-1(e) and need to have additional information provided in the year of the transfer.
9. Reporting and supporting the DSUE
If a taxpayer has a deceased spouse (who died after Dec. 31, 2010), he or she is eligible to use the deceased spousal unused exclusion (DSUE) of the deceased spouse, assuming the DSUE election was made on a timely filed and complete Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. If this is the case, complete the checkbox on Part 1, line 19, of Form 709, along with Schedule C, "Deceased Spousal Unused Exclusion (DSUE) Amount and Restored Exclusion." Taxpayers are required to attach the first four pages of Form 706 filed by the estate of the deceased spouse, any attachments related to the DSUE that were filed with the Form 706, and the calculations of any adjustments to the DSUE amount (e.g., audit reports). The DSUE amount is used first, before the taxpayer's own exemption.
10. Get the statute running — the power of adequate disclosure
To start the statute of limitation, a gift must be adequately disclosed on the gift tax return. Whenever a gift is made with assets that are hard to value (e.g., a partnership interest), tax preparers need to consider the requirements of Regs. Sec. 301.6501(c)-1(e) and/or -1(f). These rules generally require that the gift be described in sufficient detail that the IRS can determine what property was given, the identity of and relationship between the transferor and transferee, details on any trusts involved, and how the value was determined. The volume of information required to be disclosed will generally mean that the transfer cannot be completely described on the face of Schedule A of Form 709. In those cases, tax preparers should consider including a disclosure for the gift so that it meets the adequate-disclosure regulations and starts the statute of limitation for the transfer.
Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or firstname.lastname@example.org.
Contributors are associated with Deloitte Tax LLP unless otherwise noted.
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