People give gifts for a variety of reasons, including tax planning, but letting the IRS know about the gift is not a natural follow-up to giving gifts. Most people don’t file a gift tax return if they believe they do not owe gift tax. While gifts to any individual of $15,000 or less in a year do not incur a gift tax, reporting all gifts to the IRS, particularly non-cash gifts, can be a great thing. Why? It starts the statute of limitations clock ticking – the IRS has three years to challenge the value, or they have to accept that value the taxpayer provides for both gift and estate tax purposes.
As long as there is no reporting – adequate disclosure – the IRS has the right to examine the value of the gift, and can impose interest and penalties if they determine that a taxable gift was made and was not reported. This can be when the person giving the gift passes away, and the estate tax becomes an issue for that person’s estate. Why? Because the gift tax and the estate tax are inter-related. All taxable gifts made during life are part of the calculation of the taxable estate.
The tax code imposes a tax on transfers of property by gift. A gift is deemed to have occurred any time a taxpayer transfers property for less than it is worth, usually the fair market value of the property. If a taxpayer gifts property for less than it is worth, then the difference in the value of the gift and any amounts the taxpayer receives in return is treated as an indirect gift. This indirect gift can occur any time there is a transfer, except for a business transaction that is in the ‘ordinary course of business.’ While gifts of cash can easily be valued, the gift of property, or a partial interest in property, can be hard to value. As the years go by, the information about the gift can be harder to come by, and the IRS can apply the information they gather, and which may not be accurate.
For example, Tom and Jerry buy a house from grandma, who is moving to Florida. She only needs $200,000 to buy a condo, but the house is really worth $350,000. Tom and Jerry pay the $200,000, but they are also receiving a $150,000 ‘gift.’ As the years go by, Tom adds a sun room and renovates the kitchen, and the neighborhood improves. When grandma passes away 10 years later, the house is worth $700,000. Tom, Jerry, and the IRS are going to try to estimate how much the ‘gift’ was really worth at the time Tom and Jerry bought the house.
For a grandma with a business to pass along, the ‘gift’ can be even harder to value. Small businesses owned by families are often built on sweat-equity, may have lots of good will, and poor record-keeping. Instead of buying a house, Tom and Jerry buy grandma’s cookie business. Grandma figures she really only owned the mixer and the oven, and sells the business off for $20,000, and a little bit of income each month to help her with expenses. Tom and Jerry use grandma’s secret cookie recipes to build a cookie empire. Without filing a gift tax return, when grandma passes away, the IRS has the right to figure out what those secret cookie recipes were worth, how much ‘good will’ is in grandma’s smiling face on each bag of cookies, and what the income stream to grandma was worth.
Grandma may resist bringing herself to the attention of the IRS, but she may get her oven mitts burned, along with Tom’s and Jerry’s, by not reporting the gift, and having tax due, interest to pay, and delinquency penalties, and no adequate disclosure to start the statute of limitations running. Instead, grandma gives the IRS the ability to come in and value that cookie business any time after the transfer.
Adequate disclosure is more than just letting the IRS know you made a gift. The Treasury Regulations have detailed instructions on what qualifies as adequate disclosure. Generally, the person making the gift must provide:
- a description of the property transferred and anything received in return;
- the identity of, and relationship between, the person giving the gift and each person who receives a gift;
- if the property is transferred into a trust for a person’s benefit, you must provide the trust’s identification number and a description of the trust’s terms;
- a detailed description of how the transferred property was valued, including the method used (this may be a qualified appraisal with its own specific requirements); and
- a statement describing any tax position the taxpayer is making that contradicts any regulation or IRS position.
Adequate disclosure of all gifts, following the IRS guidelines, is the best way to stop an IRS audit from starting. What do you do if the IRS comes sniffing around grandma’s cookies when she passes away?
First, argue that there is the transfer in the ordinary course of business. This has to be a sale as if negotiated with an unrelated person who has all the facts about the business. The best evidence is in the transaction documents, any appraisals of grandma’s cookie recipes, and good records throughout the years of what the business was actually worth. The IRS will closely examine transaction among family members. If these transfers are consistently reported on income tax returns, they should serve as adequately disclosure for gift and estate tax purposes.
Second, even if the sale was among related family members, argue that there was a sale for fair market value. Again, the transaction documents, contemporary financial statements and appraisals are key to proving the value.
But remember – adequate disclosure remains the best way to keep the IRS’s mitts off the cookies.
For further information about gifts and gift tax returns, please contact me.
 For 2017.