Iceberg ahead! Navigating the murky waters of gift-tax-return preparation.

Amid the declarations of victory and chest thumping that accompanied enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, it was easy to miss some of the legislation's finer points. For example, although the legislation reduces the estate and generation-skipping transfer (GST) taxes gradually through 2009 and repeals them completely in 2010 for that year alone, it does not eliminate the gift tax. This raises numerous compliance issues and compounds the uncertainties CPAs face when they prepare gift tax returns and allocate GST exemption. This article highlights some of these concerns and the points practitioners could overlook when they prepare gift tax returns.

DETERMINING PRIOR GIFTS

The first step in preparing a gift tax return is the simplest and most important. CPAs must ask the client if he or she has ever filed such a return and should obtain copies. It's also important to ask if the client made other gifts that should have been, but were not, reported on a gift tax return. Practitioners should not accept the client's offhanded "no" for an answer, but instead should speak to his or her attorney and previous accountant and confirm in writing any assurances they give. This information will determine how much, if any, unified credit and GST exemption the client has left. (See glossary of key terms on page 79.)

If a client makes and reports current-year gifts that use up her unified credit and to which she allocates some of her GST exemption, and the CPA later discovers prior taxable gifts already had exhausted the credit or exemption, the client will owe taxes, interest and penalties. If she paid gift taxes for transfers made before 2002, the increased gift tax exemption ($1 million as of January 1, 2002) will not serve as a credit to "undo" those prior taxable gifts.

DOUBLE TAXATION?

Certain transfers can be subject to both the gift and estate taxes. Simply because a client transfers property and retains an interest in it (usually under IRC section 2036 or 2038), causing all or part of the property to be included in the donor's estate, that does not mean the transfer is not a taxable gift reportable on a tax return. For example, a transfer to a grantor retained annuity trust (GRAT) or a qualified personal residence trust (QPRT) may produce a taxable gift the grantor must report. If the grantor dies before the trust's term expires, the date-of-death value of the trust property is included in her gross estate for estate tax purposes.

In Walton v. Commissioner, 115 TC 589 (2000), the Tax Court held that it is possible to structure a GRAT on a "zeroed out" basis so the value of the grantor's retained annuity exactly equals the value of the property transferred to the trust. This means no taxable gift occurs when the client funds the trust. This ruling, combined with the general inadvisability of paying gift taxes in light of possible permanent estate tax repeal, may increase the popularity of GRATs when doing lifetime estate planning.

Taxable gifts that are included in a donor's gross estate (on line 1 of the estate tax return) are not counted in the tax base twice because IRC section 2001(b) removes such gifts from the decedent's total taxable gifts (line 4) when calculating the estate tax. Such transfers therefore are not subject to double taxation although the donor nonetheless must report them on a gift tax return.

SPLIT GIFTS

When a married taxpayer makes a gift to a third party, his or her spouse may elect to be treated as having made half of that gift. Splitting gifts can help minimize or eliminate the tax consequences a gift might create if only the donor had made it. Although this rule may seem simple, several traps for the unwary CPA could result in an ineffective split and unintended use of the unified credit by one or both spouses.

If one spouse elects to split gifts, the other must do the same. In other words, if a husband elects to split his wife's gifts, she must elect to split her husband's gifts. Married couples may not file a joint gift tax return; if spouses decide to split gifts, the donor spouse in all cases must file a gift tax return reporting the gifts and the consenting spouse must sign it. In most cases the consenting spouse also must file a return reporting the split gifts. The instructions for Form 709, United States Girl (and Generation-Skipping Transfer) Tax Return and Treasury regulations section 25.2513-1(c) describe the circumstances under which only the donor spouse must file a return. Even if the consenting spouse is not required to file a gift tax return, CPAs may find it prudent to recommend the client do so anyway for recordkeeping purposes.

The split gift election applies to all gifts made during the taxable year--the spouses cannot pick and choose which ones to split. Taxpayers cannot split gifts made to them by their spouses. Thus, gifts to a trust with multiple beneficiaries, including the spouse, can be split only to the extent it is possible to determine at the time of the gift the third-party beneficiaries' interest and separate it from the spouse's interest.

If the gift to the trust is subject to Crummey withdrawal rights, the spouses may split the amount beneficiaries other than the donee spouse can withdraw. The amount the donee spouse can withdraw cannot be split. The spouses cannot split any "future interest" portion of the gift (the portion not subject to Crummey withdrawal rights) if the trust is a "spray" trust since it isn't possible to determine the third-party beneficiaries' interest. A discretionary spray trust is one that authorizes--but does not require--the trustee to distribute income and principal to other trust beneficiaries at the trustee's discretion.

Finally, if spouses elect to split gifts, each is treated as the transferor of half of the gift for GST purposes. This means each is free to allocate (or not allocate) a portion of the GST exemption to the gift. If the gift is to a generation-skipping transfer trust (as defined by IRC section 2632(c)(3)(B)), the nondonor spouse will be deemed to have allocated the unused portion of his or her GST exemption to the trust to the extent necessary to ensure the trust is GST-exempt. Nondonor spouses who don't want the automatic allocation rules to apply to their half of a gift to a GST trust must elect out of the rules on a timely filed gift tax return.

REPORTING CHARITABLE GIFTS

Before August 6, 1997, donors were required to report all gifts to charity in excess of the annual exclusion. The Taxpayer Relief Act of 1997 changed this rule. Charitable gifts made after August 5, 1997 that qualify for the IRC section 2522 gift tax charitable deduction must be reported only when the gift is less than the donor's entire interest (for example, a split interest gift, such as to a charitable remainder trust).

If, however, a donor makes a transfer that requires a gift tax return, then he must report all gifts for the calendar year on the return, including nontaxable ones and those that wouldn't have required a return had they been the donor's only gifts. Thus, if a donor files a return to report noncharitable gifts and made donations to charities in that same calendar year, she must report all charitable gifts. CPAs will find clients often balk at reporting gifts to charity on a gift tax return, even though they will disclose the same information on their income tax returns. To many it seems redundant to list such transfers when they have no tax consequences; the requirement is widely ignored by taxpayers without any apparent consequences. Still, the technical requirement exists and practitioners should recommend compliance.

ADEQUATE DISCLOSURE

The IRS cannot revalue--for gift and estate tax purposes--transfers made after December 31, 1996 which the taxpayer has "adequately disclosed" on a gift tax return after the limitations period on the gifts (generally three years after the filing date) has run. This is true even if no gift tax was assessed or paid on those gifts. Because the statute of limitations will not run on inadequately disclosed gifts made in 1997 and after, its very important for CPAs to make sure donors report gifts in a way that adequately informs the IRS of their nature and how the donor determined the reported values. Treasury regulations sections 301.6501(c)-1(f)(2)(i) through (v) list the information a donor must disclose on a gift tax return to meet this requirement.

If a donor files a gift tax return and does not satisfy the adequate disclosure rules (or doesn't disclose the gift at all), she can still trigger the statute of limitations in a later year by filing an amended return. Revenue procedure 2000-34 (2000-34 IRB 186) provides CPAs with guidance on submitting the required information. The donor must file the amended return with the same IRS service center where she filed the prior-year gift tax return. The top of the first page of the return must include these words: "Amended Form 709 for gift(s) made in (year), in accordance with Revenue Procedure 2000-34."

Because the statute of limitations will not run on inadequately disclosed gifts, this means the IRS can adjust the gift's value to determine (1) "prior taxable gifts" and the current gift tax liability and (2) "adjusted taxable gifts" and the estate tax liability. A readjustment in value could result in the IRS's imposing a gift tax (because an upward adjustment results in the taxpayer's using more unified credit, leaving less for later gifts, after the taxpayer has already made them) or an increased estate tax (because adjusted taxable gifts are higher than anticipated). The IRS can revalue gifts made before 1997 to determine the tax on a later gift or the donor's estate tax unless a gift tax had been assessed or paid for the year the gifts were made. However, the IRS cannot assess additional tax for the year of a pre-1997 gift if the taxpayer had filed a gift tax return and the statute of limitations on it has expired.

The regulations require the donor to submit either a "qualified appraisal" or a detailed description of the method used to determine the fair market value of the transferred property. These requirements are found in Treasury regulations section 301.6501(c)-1(f)(3), which outlines the types of information taxpayers must include to satisfy the description of value requirement in the absence of a qualified appraisal. Some of these data may be difficult or impossible for the donor to obtain (especially for gifts of closely held business interests or interests in entities that own other entities). In these cases the donor either must obtain a qualified appraisal or run the risk the gift is not adequately disclosed and the statute of limitations does not run. For donors who don't want to incur the additional expense of obtaining a qualified appraisal, it's critical for CPAs to stress the need to provide the valuation information the regulations require and explain the consequences of failing to do so.

VALUING LIFE INSURANCE

Clients often establish irrevocable trusts to hold life insurance policies. Rather than have the trust purchase new policies, the client transfers existing policies. For whole life insurance, the gift tax value equals the policy's "interpolated terminal reserve value" plus any premiums the donor paid before making the gift that cover the period extending past the gift date. (See example 4 in Treasury regulations section 25.2512-6(a)). Thus, if the donor pays the premium annually and transfers the policy to the trust nine months later, 25% of the premium is added to the interpolated terminal reserve amount to determine the policy's value for gift tax purposes.

The insurance company should provide the interpolated terminal reserve value as of the date the policy is transferred to the trust on Form 712, Life Insurance Statement, which CPAs should attach to the gift tax return. Don't rely on verbal assurances by the insurance agent or the agent's in-force ledger regarding the policy's value. Incorrectly valuing a policy for gift tax purposes will result in an incorrect allocation of the generation-skipping transfer exemption to the trust. Although the 2001 act's automatic GST exemption allocation rules (discussed below) should operate to ensure the trust is GST-exempt, incorrect gift values will make it impossible for accountants to determine the donor's remaining GST exemption.

ALLOCATING THE GST EXEMPTION

If an outright gift to a skip person qualifies for the annual exclusion, the GST tax does not apply to that gift. A donor therefore does not use any GST exemption for outright annual exclusion gifts to skip people. However, a gift to a trust that qualifies for the gift tax annual exclusion (for example, because it is subject to Crummey withdrawal powers) generally is not automatically exempt from GST tax. The only exception is for annual exclusion gifts to certain trusts described in IRC section 2642(c)(2). A donor therefore must allocate GST exemption to a gift to a trust even if the gift tax annual exclusion completely covers it. Gifts to GST trusts after December 31, 2000 automatically consume part of the donor's unused exemption to the extent necessary to make the inclusion ratio zero, unless the donor elects not to apply these rules. A trust's inclusion ratio reflects how much GST exemption has been allocated to the trust. A ratio of one means no GST exemption has been allocated to the trust. A zero inclusion ratio means the trust is completely GST-exempt.

If a donor makes an annual exclusion gift to a GST trust and the automatic allocation rules apply, she nonetheless may want to file a gift tax return reporting it and attach a "Notice of Allocation" to create a permanent record of its value, start the statute of limitations running and track how much of her GST exemption remains.

A donor cannot allocate GST exemption to an inter vivos transfer (a transfer the donor makes during his lifetime) if the property would be included in his or her spouse's gross estate (other than under IRC section 2035) if the donor died immediately after the transfer. The period during which the donor is prohibited from allocating GST exemption to the transferred property is called the "estate tax inclusion period" (ETIP).

A donor therefore cannot allocate GST exemption to a grantor retained annuity trust or qualified personal residence trust--where the trust property is included in her gross estate if she dies before her retained interest in the trust terminates--until the estate tax inclusion period ends (when the grantor dies, a generation-skipping transfer occurs with respect to the property, or the grantor's retained interest in the trust expires). A GST exemption allocation on a gift tax return before the ETIP ends is not effective until the ETIP terminates and cannot be revoked.

CPAs should report the gift portion of a transfer subject to an ETIP on a timely filed gift tax return. Under the new rules in the 2001 act, generation-skipping transfer exemption will be allocated automatically to the GST portion of gifts for ETIPs that end for reasons other than the donor's death. A donor nonetheless may want to file a gift tax return when the ETIP ends to maintain an accurate record of her remaining GST exemption and the amount allocated at the close of the ETIP. If the ETIP ends due to the donor's death, the estate should report the transfer on the estate tax return. The transfer's value for GST purposes will equal the fair market value of the property at the close of the ETIP.

REPORTING BASIS

A donor's basis in gifted property "carries over" to the donee. The basis is stepped up only to the extent of any gift taxes paid on the gift. Although the instructions for form 709 indicate donors must report the basis of gifted property on the return, there is no statutory or regulatory requirement to do so. The regulations provide that to trigger the statute of limitations on a gift, it must be adequately disclosed. As described earlier, this happens only if it is "reported in a manner adequate to apprise the IRS of the nature of the gift and the basis for the value so reported." The safe harbor criteria of the regulations make no mention of reporting basis. Case law supports the conclusion that a gift tax return may be "complete" without including basis information. See Zellerbach Paper Co. v. Helvering, 293 US 172, 180 (1934) (and the cases referred to therein); McCaskill v. Commissioner, 77 TC 689, 696-97 (1981).

Because it's often difficult or impossible to determine the basis of property a client has given away, CPAs should omit such information from a gift tax return unless both client and accountant are confident the information is accurate. Providing incorrect or incomplete basis information could create income tax problems for the donee upon a later sale. For example, the IRS could argue that legal principles prevent the donee from taking a position about the basis of gifted property different from the one on the gift tax return.

TERMINABLE INTEREST GIFTS TO SPOUSES

A donor is entitled to an unlimited marital deduction for gifts to his or her spouse. This deduction does not apply to a gift of a "terminable interest" unless the donor elects to treat the interest as "qualified terminable interest property" (QTIP). A terminable interest is one that will terminate or fail because time passes or a contingency occurs (for example, a life estate is a terminable interest). The deduction for lifetime gifts of QTIP property applies only if the transaction satisfies IRC section 2523(f)(2)--the donee spouse must have a qualifying income interest for life and the donor spouse must elect QTIP treatment. No person, including the donee spouse, can have the power to appoint the QTIP property to anyone other than the donee spouse during his or her lifetime. The lifetime QTIP election is irrevocable and must be made on a timely filed gift tax return. Failure to follow this rule will result in a taxable gift to the donee spouse.

The spouse's subsequent disposition of all or part of qualified terminable interest property can have significant unintended gift tax consequences under IRC section 2519. If the spouse gives or sells any part of his or her income interest in the QTIP property, he or she is treated as having gifted the entire QTIP property, except for the income interest. The gift tax consequences of the spouse's disposition of his or her income interest in the QTIP property are determined separately under IRC section 2511.

If the spouse is treated as having transferred the entire QTIP property under section 2519, he or she may recover from the transferee the gift tax attributable to the value of the interest in the QTIP property other than the income interest. Any reimbursement is treated as consideration paid to the spouse and is deducted from the value of the gift. The spouse's failure to exercise this right of recovery may be a "gift" to the donee.

KEEP THE SHIP AFLOAT

Gift-tax-return preparation is not as easy as it might initially appear. As did the Titanic, CPAs face many hidden icebergs. Proper return preparation requires communication with the client, careful recordkeeping and knowledge of the technical reporting requirements. Ensuring that gifts are adequately disclosed and properly substantiated and valued will protect both the practitioner and client from unanticipated, and sometimes unpleasant, tax consequences.

EXECUTIVE SUMMARY

* THE 2001 ACT DID NOT ELIMINATE THE GIFT TAX. That means CPAs and their clients still face compliance issues when preparing and filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to report gifts. An important first step in this process is confirming the client's prior-gift history.

* WHEN A MARRIED TAXPAYER MAKES A GIFT TO a third party, his or her spouse may elect to be treated as having made half of it. If one spouse elects to split gifts, the other must do the same. The donor spouse must file a gift tax return reporting the gift and the consenting spouse must sign it.

* IT'S IMPORTANT FOR TAXPAYERS TO ADEQUATELY disclose gifts on a timely filed return so the three-year statute of limitations can begin to run. Failure to satisfy these requirements means the statute of limitations does not begin to run until the taxpayer does so. The IRS cannot revalue adequately disposed gifts.

* GIFTS OF LIFE INSURANCE CAN BE PARTICULARLY troublesome to value for gift tax purposes. For whole life insurance policies, the gift tax value is the policy's interpolated terminal reserve value plus any premiums the owner had paid that covered the period after the date of the gift. The insurance company should provide the value in writing on form 712.

* THE DONOR'S BASIS IN PROPERTY CARRIES OVER to the donee. The basis is stepped up only to the extent of any gift taxes paid. CPAs should omit basis information from form 709 unless both client and accountant are confident the information is accurate.

Glossary of Key Terms

Crummey withdrawal rights. Gifts to a trust usually don't qualify for the gift tax annual exclusion. Instead, the law treats them as taxable gifts that use up part of the donor's unified credit. A Crummey withdrawal right (named after the court case that first established it) gives a trust beneficiary the right to withdraw all or part of the donor's gift to a trust for a limited period of time (usually 30 to 60 days). The portion of the donor's gift the beneficiary may withdraw thus qualifies for the annual gift tax exclusion--even if he or she doesn't exercise the right.

GST exemption. Every individual may make up to $1.1 million in generation-skipping transfers (transfers to skip persons) without paying the GST tax. The exemption is scheduled to increase over time, rising to $3.5 million by 2009.

Skip person. This is a donee who is more than one generation below the donor. For example, a grandchild is a skip person for his or her grandparent. A donee's status as a skip person is determined either by family relationship or by the donee's age relative to the donor. Special rules apply to determine whether a trust is a skip person (see IRC section 2613(a)(2)).

Unified credit. This credit, also referred to as the applicable credit amount, effectively exempts the first $1 million of a donor's taxable gifts from the gift tax. Any taxable gifts in excess of the unified credit are subject to tax, beginning at a 41% rate up to a maximum of 50%. The current gift tax rate schedule is found in IRC section 2001 (c). Reporting Gifts

Reporting Gifts

In 2001 Americans filed 304,000 gift tax returns and paid nearly $4 billion in gift taxes. This amount represented only 0.2% of total tax collections for the year.

Source: Internal Revenue Service, www.irs.gov.

AMY K. KANYUK, Esq., is an attorney with McDonald & Kanyuk, PLLC, in Concord, New Hampshire. Her e-mail address is [e-mail].