GIFT TAX RETURNS: FINDING AND FIXING PROBLEMS Celeste C. Lawton Norton Rose Fulbright US LLP January 15, 2016
Introduction Circumstances in which gift tax returns must be filed Common errors found in gift tax returns Duty of advisor to find and fix problems 2
Examples: Circumstances in Which Gift Tax Return Must Be Filed Gift of present interest in an amount greater than the gift tax annual exclusion amount (currently $14,000 per donor, per donee) Gift of future interest regardless of amount of gift Gift to donor s spouse if gift was of a terminable interest (other than a life estate with the spouse s unlimited power to appoint the entire interest in all circumstances) 3
Gift Tax Return Due Date Generally, due no later than April 15 of the year after a gift was made. Due date, not payment date, may be extended 6 months. However, due date may be earlier if the donor died and the donor s estate tax return (with extensions) is due prior to April 15 (or the extended due date of the gift tax return). 4
Gift-Splitting Common Errors Found in Gift Tax Returns Exclusion from GST Tax Deemed Allocation of GST Exemption 5
Gift Splitting Gifts made by one spouse to a third party can be considered for gift tax purposes as being made ½ by donor spouse and ½ by nondonor spouse. Spouses must be married at the time of the gift and neither spouse can remarry during the remainder of the calendar year. Both spouses must be citizens or residents of the US. 6
Errors in Gift Splitting Splitting some gifts but not all gifts Splitting community property gifts Gifts of community property are considered made one-half by each spouse. There is no need to split the gifts. If gifts of community property are erroneously split, both spouses gifts should be reported in Schedule A. 7
Splitting Community Property Gifts: Example Example: Husband makes a gift to Child of $20,000 in community property. Wrong way to complete Schedule A: 8
Splitting Community Property Gifts: Example Correct way to complete Schedule A: 9
Splitting Community Property Gifts: Example Unnecessarily creating extra work to complete Schedule A: 10
Errors in Gift Splitting Splitting gifts not eligible for splitting Examples: Gifts by donor spouse to a third party if nondonor spouse has a general power of appointment over gift Gift to trust of which nondonor spouse is a beneficiary unless portion of gift to third party is ascertainable. Common issue to consider with life insurance trusts! If gift to third party can be ascertained, only the portion of the gift allocable to the third party qualifies for gift-splitting. IRS has held that gifts are not eligible for splitting if nondonor spouse s interest in trust is not limited by ascertainable standard. IRS has held that gifts were eligible for splitting when distributions to nondonor spouse were limited to ascertainable standard and trustee was required to take into account other sources of funds because there was no likelihood that the trustee would actually make a distribution to the nondonor spouse. Facts and circumstances test. 11
Exclusion from GST Tax Not all gifts that qualify for the gift tax annual exclusion will qualify for GST annual exclusion. GST annual exclusion applies to a: Direct skip to an individual; and Direct skip to a trust (i) which has one current beneficiary and (ii) which will be included in the gross estate of such beneficiary (e.g., assets distributed to beneficiary s estate upon termination of trust or beneficiary has a general power of appointment) GST annual exclusion will apply to most 2503(c) trusts GST annual exclusion will not apply to most insurance trusts or other non-2503(c) trusts 12
Deemed Allocation of GST Exemption For gifts made after December 31, 2000, GST exemption will be automatically allocated to certain indirect skips. Indirect skip is any transfer of property (other than a direct skip) to a GST trust. GST trust is defined as any trust that could have a generation-skipping transfer unless one of the six exceptions in 2632(c)(3)(B) of the IRC applies. 13
Deemed Allocation Rules: Fourth Exception Fourth exception: A trust is not a GST trust if the trust is a trust any portion of which would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer. I.R.C. 2632(c)(3)(B)(iv). A trust is not a GST trust if a non-skip person has a power of withdrawal or general power of appointment. Exception to fourth exception: The value of transferred property shall not be considered to be includible in the gross estate of a non-skip person or subject to a right of withdrawal by reasons of such person holding a right to withdraw so much of such property as does not exceed the gift tax annual exclusion amount. A trust does not fail to be a GST trust simply because a non-skip person has the right to withdrawal an amount that does not exceed $14,000 (in 2016). 14
Contingent General Power of Appointment Contingent general power of appointment is a general power of appointment that is granted to a beneficiary only if the inclusion ratio of the trust is greater than zero immediately prior to such beneficiary's death. It is unclear whether the deemed allocation rules apply to a trust that grants a contingent general power of appointment. Circular analysis: Whether the deemed allocation rules apply depends on whether a non-skip person has a general power of appointment but whether the non-skip person has a general power of appointment depends on whether the deemed allocation rules apply. At least one pair of commentators conclude that a trust with a contingent general power of appointment is NOT a GST trust. 15
Formulaic General Power of Appointment Formulaic general power of appointment is a general power of appointment that is granted only if the estate inclusion would result in a lower aggregate tax than if the property were subject to the GST tax and sometimes only with respect to the portion of the property that would result in a lower tax. May be difficult to determine whether a non-skip person would have a general power of appointment. To determine whether the non-skip person would have a general power of appointment (which would cause the fourth exception to apply), must analyze the non-skip person s estate to compare tax resulting from having general power of appointment versus not having general power of appointment. 16
Hanging Crummey Withdrawal Powers Many insurance trusts give a beneficiary the power to withdraw an amount of the gift not in excess of the annual exclusion amount, but the withdrawal power will lapse at some point in the future. A withdrawal power is a general power of appointment. Therefore, if a withdrawal power lapses as to the greater of $5,000 and 5% of the value of the trust property, the excess portion would be includible in the beneficiary s estate. To avoid estate tax inclusion, many trusts will include a hanging withdrawal power with prevents the excess portion from lapsing until the power can lapse without negative tax consequences. If the beneficiary dies before all of the withdrawal powers have lapsed, the amount hanging would be includible in the beneficiary s estate. 17
Hanging Crummey Withdrawal Powers Example of typical use of hanging Crummey withdrawal power: Donor creates insurance trust which grants each of his four children a power to withdraw an amount equal to the lesser of the child s pro rata share of the gift and the donor s annual exclusion amount. Insurance policy is paid up after premiums of $40,000/year for seven years are paid. Year Amount of gift to trust Each beneficiary s pro rata share of gift Total value of trust after gift Total amount subject to withdrawal per beneficiary Amount which lapses in current year Amount which hangs over to next year 1 $40,000 $10,000 $30,000 $10,000 $5,000 $5,000 2 $40,000 $10,000 $60,000 $15,000 $5,000 $10,000 3 $40,000 $10,000 $90,000 $20,000 $5,000 $15,000 4 $40,000 $10,000 $120,000 $25,000 $6,000 $19,000 5 $40,000 $10,000 $150,000 $29,000 $7,500 $21,500 6 $40,000 $10,000 $180,000 $31,500 $9,000 $22,500 7 $40,000 $10,000 $210,000 $32,500 $10,500 $22,000 8 $0 $0 $210,000 $22,000 $10,500 $11,500 9 $0 $0 $210,000 $11,500 $10,500 $1,000 10 $0 $0 $210,000 $1,000 $1,000 $0 18
Hanging Crummey Withdrawal Powers If a gift is made to a trust containing hanging withdrawal powers, the deemed allocation rules will apply only if the amount hanging (plus the amount of the new gift if withdrawable) is less than the annual exclusion amount. Trust may be a GST trust in one year but not a GST trust in another year. Value of trust property may need to be analyzed at the point of each gift and at the time withdrawal power lapses. Request Form 712s from the insurance company as of each date that a withdrawal power lapses. 19
Duty of Advisor to Find and Fix Problems Duty to find tax related problems Duty to file or amend returns 20
Duty to Find Tax Related Problems Lawyers owe duties to their clients and to the tax system. A lawyer s duty to his client includes acting with reasonable diligence. ABA Model Rules of Professional Conduct Rule 1.3. Reasonable diligence includes such diligence, care of attention as might be expected from a man of ordinary prudence and activity. Black s Law Dictionary. A lawyer s duty to the IRS requires a lawyer to exercise due diligence in preparing or assisting in the preparation of, approving, and filing tax returns. Circular 230 10.22(a)(1). Due diligence is defined as such a measure of prudence as is properly to be expected from and ordinarily exercised by a reasonable and prudent man under the particular circumstances. Black s Law Dictionary. 21
Duty to Find Tax Related Problems Whether a lawyer has a duty to inquire into the client s gifting history in exercising reasonable or due diligence depends on the scope of representation. If the client s remaining estate, gift, or GST exemptions are irrelevant to the scope of the representation, the lawyer may not have a duty to inquire into the client s gifting history. Otherwise, the lawyer may have a duty to determine whether the client has made taxable gifts. If a lawyer has a duty to inquire into a client's gifting history, the lawyer cannot ignore hints that the client may give regarding potential taxable gifts. If a lawyer has been engaged to prepare or to assist in preparing a gift tax return, the lawyer s duty of due diligence suggests that the lawyer should review prior gift tax returns to ensure there are no blatant errors in the returns. 22
Duty to File or Amend Return Circular 230 requires a lawyer who knows that a client has made an error on or an omission from a return to advise the client promptly of the fact of the error or omission and the consequences of the error. ABA Committee on Professional Ethics and Grievances Formal Opinion 314 requires the lawyer to advise the client of the error and advise the client that the error should be corrected. The client does not have a duty to file amended returns. If the client refuses to file an amended return, the lawyer does not have a duty per se to withdraw from the representation. However, a lawyer may not complete a tax return that furthers a prior error that the lawyer knew or reasonably should have known about. 23
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