Why Your Gift Tax Return Requires Adequate Disclosure

At first glance, federal gift tax returns (IRS Form 709) may seem straightforward, but they can potentially cause several headaches if not prepared properly.

The Internal Revenue Service (IRS) states that in the case of gift tax returns, the statute of limitations (the time frame in which the IRS can review a taxpayer’s gifts) is three years from the return’s due date (including extensions) or the date that the return is actually filed. In order to trigger the statute and prevent government review after the 3-year limitation, the taxpayer must file the gift tax return and check that all gifts are adequately disclosed.

If a gift is adequately disclosed on a Form 709, 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.

Adequate disclosure rules

Even if you believe your gift tax returns are filed correctly, it’s probably best to check again. Although a return can arguably identify a lot of information, it is more important that the information is considered “adequate.”

So 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:
   1. Identification of number of stock shares or percentage(s) of interests transferred
   2. All nine digits of the entity’s Employer Identification Number (EIN)
   3. Full (unabbreviated) entity name, including: Inc., LLP, LP, LLC
   4. Identification of the type of interest transferred > general, limited, limited liability, assignee
   5. Include 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 property transferred, including:
   1. The non-discounted FMV of the transferred property
   2. Financial data used to determine the value, including copies of tax returns; financial statements
   3. Any discount claimed in valuing the gifted interests in the entity, including ownership
   4. Any discount claimed in valuing any assets owned by the entity
   5. If the entity value is determined based on the net asset value, then need to include FMV of 100% of the entity
   6. Description of the methodologies (including comparable sales) used to discount the value
   7. Any restrictions on the transferred property that were used to determine FMV, including formation documents, shareholder agreements and by-laws
   8. Explanation of the different discount regimes or the basis for utilizing 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.

How the IRS interprets the rules

Several taxpayers have learned the hard way about what it means to adequately disclose their gifts. For example, in a recent matter from the Office of Chief Counsel, the IRS held that a taxpayer’s disclosure on a gift tax return was inadequate, which kept the statute of limitations from running. The taxpayer had originally gifted units in a limited partnership and a limited liability partnership that held farmland to his daughter.

The IRS concentrated on the following facts before concluding that the gift description was not adequate:

• There was one number missing from the EIN.

The IRS commented that when missing one number, there are 70 different EIN possibilities. An EIN is generally nine digits, however there were only eight numbers listed on the taxpayer’s Form 709.

• The entity name was abbreviated and the type of interest was left out.

In this case, the IRS noted that they needed to know if the partnership was a LLP, LP, LLC, or some other entity form. They were unsure if any general partner, limited partner, or limited liability interests were transferred. Without the designations, a taxpayer could wrongly imply that the entity was a traditional partnership.

• The valuation determination was incomplete.

The taxpayer provided an underlying appraisal of the entity’s real estate, but didn’t provide information about the value of the transferred entity. In addition, no entity financial data was provided and there was no statement regarding the 100% value of the entity, even though the entity’s value was based upon net assets. The taxpayer should have included five years of tax returns filed with financial statements and descriptions of any discounts.

With this taxpayer’s mistakes in mind, it is important to keep all data detailed and precise to help avoid future challenges from the IRS. Contact me or another member of Kaufman Rossin’s estate and trust team to help you properly prepare your federal gift tax return.