Retirement

Know The Most Misunderstood Part Of Estate Plans: Gift Tax Returns

Gift tax returns could be the most misunderstood, neglected, and overlooked part of estate planning. There are many people who know estate planning quite well but draw blanks when issues about gift tax returns are raised.

The gift tax return is IRS Form 709. You can download it free from www.irs.gov.

The first mistake people make is not knowing when they have to or should file a gift tax return. Even when a gift you made is tax free, you might have to file a return. Plus, there are times when filing a gift tax return is a good idea, though you aren’t required to.

As with the other tax returns, in most cases the IRS can’t take action on an incorrect gift tax return when more than three years have passed since it was filed. There are exceptions for a fraudulent return or when a return is missing information or substantially misstated it. In general, though, the IRS can’t assess additional taxes if it waited more than three years.

But if you don’t file a gift tax return, there’s no statute of limitations. The IRS can raise questions about the transaction five, 10, or 20 years later. It can come after your estate or heirs after you passed away.

After all that time, you or your heirs might not have the evidence needed to show you did everything correctly. The IRS would be able to assess not only a gift tax but also penalties and interest for all the intervening years.

That’s why if there’s any room for disagreement about the value of a gift or whether a transaction was a gift, you should consider filing a gift tax return.

Not many people realize that on Form 709 there’s a section where you can report “non-gift transactions.” You might want to take advantage of this to start the statute of limitations and prevent the IRS from years later recharacterizing your non-gift as a taxable gift.

Consider this strategy when you sell assets to a trust or when you shift assets from one irrevocable trust to another, a maneuver known as decanting a trust. Also consider filing a gift tax return for a non-gift when you take advantage of the generation-skipping transfer tax exemption through a trust.

Another common mistake is not realizing that certain actions are gifts in the eyes of the IRS.

For example, instead of giving an asset to your children you might sell it to them at less than market value. The difference between the selling price and market value is a gift. Forgiving a loan is a gift. So is making a loan at a below-market interest rate.

There are a number of grey areas the IRS traditionally hasn’t enforced but could. Suppose you own or rent a vacation home. You invite some friends to stay with you at no cost. Technically that’s a gift. It’s also a gift to allow relatives to use your property at no cost.

Parents tend to pay some bills for their adult children or allow the children to piggyback on their accounts, such as for cellphones and subscription streaming services.

These all technically are gifts. But no one reports them, and the IRS hasn’t sought to force them to. It’s likely to be an issue only when such gifts are very valuable and you also make significant gifts of money or property to the same person that year.

Gifts to anyone are tax free when the total value of the gifts you made to the person during the year are less than the annual gift tax exclusion, which is $18,000 in 2024. But if the total gifts to a person during the year exceed that amount, the excess could be a taxable gift and you should file Form 709. You also don’t have to report gifts that qualify as unlimited tax free education or medical expense gifts.

A gift tax issue the IRS examines closely is valuation. There’s not much question about the value of a publicly-traded security. But for many other assets, there’s room to question the correct value, and the gift tax is based on an asset’s value at the time of the gift.

You don’t want to wing it or cut corners when reporting the value of a gift of real estate, art, collectibles, a family business, or even used property such as a car or boat.

You should obtain a qualified appraisal of such property, even if you don’t think the value exceeds the annual gift tax exclusion.

IRS regulations define which appraisers are qualified for different types of property. You want to use a professional who is aware of and meets the IRS requirements and will make an appraisal that meets IRS standards.

Another layer of protection when making a significant gift of hard-to-value property that is less than 100% of the property is to use the Wandry clause, named after a Tax Court case.

The documents under which the gift is made state that you are giving a portion of the property worth a specific dollar amount. When you own a family business and are giving a portion to your children, don’t say you are giving 10% of the stock to each child. Say you are giving shares equal to a dollar amount that happens to be 10% of what you believe is the current value of the business. Then, transfer 10% of the shares.

If the IRS later argues the stock was worth more than you said, you can agree to the IRS’s valuation and have the children return the shares that exceed the dollar amount you intended to give. The IRS believes the Tax Court’s Wandry decision is incorrect, but no court has overturned it at this point.

Pay attention to the questions at the top of Form 709, especially the question asking if any valuation discounts were taken on any item listed on Schedule A of the return.

A valuation discount is when the value of the gift is reduced because of factors such as lack of marketability of the property or a minority ownership interest was given. These discounts are common with gifts of business and real estate interests and some gifts made through trusts or family limited partnerships.

Be sure the question is answered in the affirmative if such a discount was taken. But this will increase your audit risk. So, the return needs an attached statement that explains the discount well enough that it might satisfy the IRS and avoid an audit.

It’s important to report gifts on the correct section of Form 709. If an estate planner or accountant doesn’t prepare your return, double check that you completed the correct sections and lines.

Though spouses can make unlimited tax-free gifts to each other there are times when gifts between spouses must be reported. One time is when the gift is defined in the tax code as a “terminable interest,” which your estate planner should explain to you.

Another time is when one spouse is not a U.S. citizen. Gifts to that spouse from the other spouse that exceed a certain amount during the year must be reported on Form 709.

There also can be non-tax reasons to report gifts between spouses.

Suppose a spouse is concerned about potential liabilities from lawsuits and in the couple’s state of residence assets solely owned by one spouse can’t be taken by creditors of the other spouse. One way to help prove that the assets were transferred from one spouse to the other is to file a gift tax return.

Unlike the income tax return, spouses can’t file a joint Form 709 but must file separate gift tax returns. Even when spouses make split gifts (that is, they jointly make a gift), each spouse must file a separate return.

Sometimes you must report charitable gifts on Form 709, though they aren’t subject to estate or gift taxes. A gift tax return must be filed when you transferred less than your full ownership in property to a charity or transferred part of your interest to charity and the rest to another person.

A tricky rule is that when you are required to file Form 709 because of gifts you made to non-charities, then the Form 709 also must include all the charitable gifts you made during the year.

This might seem silly, since charitable gifts aren’t subject to the gift tax. But failing to report the charitable gifts can affect the statute of limitations.

If you underreport the year’s gifts by 25% or more, the statute of limitations is extended from three years to six years. The value of any charitable gifts you don’t report counts toward the 25% underreporting threshold.

Remember that you might be required to file a gift tax return even when no taxes are due.

For example, when gifts to a person exceed the $18,000 annual gift tax exclusion, the excess gift probably is tax free because of the lifetime estate and gift tax credit. But you’ll have to file Form 709. The IRS wants to keep track of how much of the credit was used during your lifetime and isn’t available to be used by your estate. The IRS also might want to examine the valuation you placed on the property.

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