Recently, the IRS issued guidance reminding taxpayers that gifts of cash or property are required to be reported on an annual gift tax return (Form 709) or the person making the gift faces the risk that the IRS has no statute of limitations on when it can examine the gift and decide whether any unreported gift or inheritance tax is due.
As background, in 2012 Congress made permanent the current estate and gift tax rules, which allow a person either at death or during life, to make gifts of cash or property in an aggregate amount of $5 million ( currently adjusted by inflation to $5.43 million) without paying any gift or estate taxes to the federal government. Any gifts or inheritance passing at death in excess of this amount are subject to a top rate of 40% by the federal government. The gift tax and the estate tax are really the same tax. The gift tax applies to transfers during a person’s life. The estate tax applies for any property transferring at a person’s death, such as by Will or by operation of law. Either way, each person has one $5 million exemption amount that can be applied to either gifts or transfers at death. For example, an individual could make gifts to his or her children totaling $5.43 million without paying any gift taxes. Once the exemption amount is used, any subsequent gift would be subject to a top gift tax rate of 40%. Also, upon that same person’s death, any property held by that individual would give rise to a top federal estate tax of 40%. Alternatively, if that same person had not made any gifts during his lifetime, upon that person’s death the first $5.43 million of cash or property would not be subject to any federal estate tax and any net worth of the deceased person in excess of this amount would be subject to a top federal estate tax rate of 40%.
There are several important exceptions to these rules. First, any individual may gift annually to an unlimited number of person up to $14,000 each. For example, a husband-and-wife with three children could combine their annual gift exclusion amounts, making it $28,000, and transfer this amount to each of their children, making the aggregate gift to the three children $84,000, without any federal gift tax. Second, a spouse may transfer an unlimited amount to his or her spouse, either during lifetime or at death, without triggering any federal gift or estate taxes. This is referred to as the “unlimited marital deduction.” Third, on the death of a spouse, the surviving spouse may inherent any unused exemption amount of the deceased spouse. Finally, gifts to charity are excluded.
Unmarried individuals expecting to have net worth in excess of $5 million, and married couples having combined net worth that is expected to exceed $10 million, need to consider estate and gift taxes when planning for their estates. One strategy to reduce the ultimate amount of estate and gift taxes is for the client to make gifts during the client’s life. The gifted property is removed from the client’s taxable estate since the client no longer owns the property. Any future appreciation associated with that property (for example, stocks, real estate or art work) would not be subject to estate or gift tax to the client because such increase in value occurs after they gift was made. For an asset that is anticipated to appreciate substantially in the future, the gift of that asset effectively avoids any gift or estate tax on that future appreciation in value.
However, the IRS requires that any gift of cash or property (in excess of the annual exclusion amount of $14,000) be reported to the IRS on an annual gift tax return (IRS Form 709) for the year in which the gift is made. The donor is required to file the gift tax return, and include a description of the gifted property, the name of the recipient, and the value of the property at the time the gift was made. The value of the gifted property determines the amount of the $5 million exemption amount that will be used by the gift, For example, a gift of property worth $1 million uses $1 million of the transferor’s exemption amount, ;leaving $4 million of remaining exemption. For this reason, there is a strong motivation to value gifts as low as reasonably possible to preserve the estate and gift tax exemption amount to shield future transfers of property from the tax. Often times, valuation discounts are claimed for transfers for stock or LLC interests in family business with the goal of using less gift tax exemption amount for the gift. The valuation can be challenged by the IRS on audit and if the IRS determines the property had a higher value, a greater amount of the exemption will be used by the gift. Generally the IRS has three years to audit gift tax returns. If no IRS challenge occurs within the three years, the IRS may not later challenge the reported value subject to certain exceptions.
Where a gift is not reported to the IRS or adequately disclosed on the Form 709, there is no time limit on the IRS’ right to initiate an audit of any prior year gifts of cash or property. For unreported gifts, the IRS has the right to examine the gift at any time, including in connection with subsequent year gifts or upon the death of the taxpayer. For this reason, a person takes on a substantial amount of risk by making a gift of property but not properly reported the gift on an annual gift tax return since the IRS may later determine that the value was substantially in excess of what the taxpayer believes the actual value of the property at the time the gift was made, resulting potentially in additional gift and/or estate taxes. In addition, the taxpayer may also be subject to significant civil and potentially criminal penalties. By filing the gift tax return and reporting the gift, the IRS might decide to audit the reported value of the transferred property. In most gift tax return audits, the IRS is verifying that the reported value is properly supported by an appraisal or other documentation, and that the gift tax return was otherwise properly prepared.