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Whenever you transfer property to another person — especially a family member — consider filing a gift tax return, even if it’s not technically required. Why? Because a timely filed gift tax return that meets the IRS’s “adequate disclosure” requirements starts the clock on the statute of limitations.

An Unexpected Tax Bill

Generally, the IRS has three years to challenge the value of a transaction for gift tax purposes or to assert that a nongift was, in fact, a partial gift. But unless the transaction was adequately disclosed, there’s no time limit for reviewing it and assessing additional gift tax. That means the IRS can collect unpaid gift taxes — plus penalties and interest — years or even decades later.

There’s a reluctance to file gift tax returns disclosing nongift transactions for fear of drawing the IRS’s attention. However, a carefully prepared gift tax return can be the best insurance against unpleasant tax surprises down the road.

Let’s take a look at a fictional example: Fred, the sole owner of a closely held business, decides to sell 10% interests in the business to each of his four children. He estimates that the business is worth $10 million and, after applying a 25% minority interest discount, values each child’s interest at $750,000. He transfers a 10% interest to each child in exchange for a $750,000 promissory note. Let’s assume that Fred has already used up his lifetime gift and estate tax exemption.

Because Fred transfers the interests in exchange for what he believes is full and adequate consideration, he doesn’t file a gift tax return. Fast-forward 10 years: The IRS determines that the actual value of the business at the time of the transfers was $15 million, so that each child’s interest was actually worth $1,125,000. The IRS assesses gift tax on $1.5 million — the difference between the value of the interests and the consideration paid. Assuming that the gift tax rate in the year of transfer was 40%, Fred receives a $600,000 gift tax bill plus penalties and 10 years of interest.

What’s Adequate Disclosure?

If Fred had filed a timely gift tax return, meeting the adequate disclosure requirements, the IRS would have had only three years in which to challenge his valuation. To meet these requirements a return must include:

• A description of the transferred property and any consideration received,
• The identity of, and relationship between, the transferor and each transferee,
• The trust’s tax identification number and a brief description of its terms (or a copy of the trust instrument) if property is transferred to a trust,
• Either a detailed description of the method used to value the transferred property or a qualified appraisal (see “Benefits of an independent appraisal” below),
• A statement describing any position taken that’s contrary to any proposed, temporary or final tax regulations or revenue rulings published at the time of the transfer, and
• An explanation as to why transfers reported as nongifts aren’t gifts.

Additional requirements apply to transfers of interests in a corporation, partnership (including a limited liability company) or trust to a member of the transferor’s family. In addition to the above, adequate disclosure requires:

• A description of the transactions, including a description of the transferred and retained interests and the methods used to value each,
• The identity of, and relationship between, the transferor, transferee, all other persons participating in the transactions, and all parties related to the transferor holding an equity interest in any entity involved in the transaction, and
• A detailed description (including all actuarial factors and discount rates used) of the method used to determine the amount of the gift (if any), including, for equity interests that aren’t actively traded, the financial and other data used to determine value.

Financial data generally includes balance sheets and statements of net earnings, operating results, and dividends paid for each of the preceding five years.

Gain Peace of Mind

If you transfer valuable business interests or other property to family members or others — either as gifts or as exchanges for valuable consideration — be sure to file a timely gift tax return that satisfies the adequate disclosure requirements. Doing so can help you support your valuation of the property (particularly if it’s accompanied by a qualified independent appraisal), start the clock on the statute of limitations, and avoid unpleasant tax surprises years or even decades down the road.

Benefits of an Independent Appraisal

• A detailed description of the method used to determine the property’s fair market value, including financial data, transfer restrictions considered and a description of any blockage, minority interest, fractional interest or marketability discounts claimed, or
• An appraisal of the property (including certain required information) by an independent, qualified appraiser. “Independent” means that the appraiser isn’t the transferor, the transferee, or a relative or employee of either.

Obtaining an independent appraisal offers significant benefits, particularly for difficult-to-value property, such as interests in closely held businesses. An appraisal by a qualified appraiser helps ensure that the gift tax return contains all valuation information necessary to satisfy the adequate disclosure rules. Plus, if the appraisal is conducted at or near the time of the transfer, it will go a long way toward persuading the IRS that the original valuation of the property was accurate.

© 2018