So What If You Do Not File A Gift Tax Return?

Let’s talk a little federal estate and gift tax.

It is unlikely that you or I will ever be subject to the federal estate tax, as the filing exemption is $5,430,000 for decedents passing away in 2015. If I was approaching that level of net worth, I would reduce my practice to part-time and begin spending my kid’s inheritance.

Let’s say that you and I are very successful and will be subject to the federal estate tax. What should we know about it?

The first thing is the $5,430,000 exemption we mentioned. If you are married, your spouse receives the same exemption amount, resulting in almost $11 million that you and your spouse can accumulate before there is any federal tax.

The second thing is that the federal estate tax is unified with the federal gift tax. That means that – at death - you have to add all your reportable lifetime gifts to your net worth (at death) to determine whether an estate return is required. As an easy example, say that you gift $5,400,000 over your lifetime, and you pass away single and with a net worth of $1 million.

·        If you just looked at the $ 1 million, you would say you have no need to file. That would be incorrect, however.

·        You have to add your lifetime gifts and your net worth at death. In this example, that would be $6,400,000 ($5,400,000 plus $1,000,000). Your estate would have to file a federal estate tax return.

Q: How would the IRS know about your lifetime gifts? 

A: Because you are required to file a gift tax return if you make a gift large enough to be considered “reportable.”

Q: What is large enough?

A: Right now, that would be more than $14,000 per person. If you gifted $20,000 to your best friend, for example, you would have a reportable gift.

Q: Does that mean I have a gift tax?

A: Nah. It just means that you start using up some of the $5,430,000 lifetime exemption.

Q: Does that mean that gifts under $14,000 can be ignored?

A: Not quite. It depends on the gift.

Q: Do you tax people take a course on hedging your answers?

A: Hey, that’s not…, well …. yes. 

Many advisors will separate a straightforward gift (like a check for $20,000) from something not so straightforward (like an interest in a limited partnership) valued at $20,000. 

The reason has to do with discounts. For example, let’s say I put $2 million in a limited partnership. I then give 100 people a 1% interest in the partnership. Would you pay $20,000 for a 1% interest?

Let me add one more thing: any distribution of money would require a majority vote. Therefore, if you wanted to take money out, you would have to get the approval of enough other partners that they – combined with your 1% - represented at least 51%. 

Would you pay $20,000 for that?

I wouldn’t.  Life would be easier to simply stash the money in a mutual fund. I could then access it without having to round up 50 other people and obtain their vote. The only way I would even think about it would require a discount. A big discount.

That discount is referred to as a minority discount. 

Let’s go a different direction: what if you just sold that interest instead of rounding-up 50 other partners?

Then the buyer would have to round-up 50 other partners. If I were the buyer, I would not pay you full price for that thing. Again, mutual fund = easier. You are going to have to offer a discount.

That discount is referred to as a liquidity discount.

Normal practice is to claim both control and liquidity discounts when gifting non-straightforward assets such as limited partnership interests or stock in the family company. 

Let’s use a 15% minority discount, a 15% liquidity discount and a gift before any discount of $20,000. The gift after the discount would be $14,000 ($20,000 * (15% + 15%)). No gift tax return is required unless the gift is more than $14,000, right?

Well, yes, but consider the calculus in getting to that $14,000. If the IRS disagreed, perhaps by arguing that the discounts should have been 10% +10%, then the gift would have been more than $14,000 and should have been reported.

Q: This is getting complicated. Why not skip a return altogether unless the gift is clearly more than $14,000?

A: Why? Because if you prepare the return correctly, there is a statute of limitations on the gift. If you file a return and describe that gift in considerable detail, the IRS has 3 years to audit the gift tax return. If the 3 years pass, that gift – and that discounted value – is locked in. The IRS cannot touch it.

Do not report the gift, or do not report it in sufficient detail, and there is NO statute of limitations.

Q: If I am dead, who cares?

A: Let’s return to the estate tax return. The gift is being added-back to your estate. Without the statute of limitations, the IRS can reopen the gift and revalue it, even if the gift was made a decade or two earlier. That is what NO statute of limitations means.

Q: Is this a bogeyman story told just to frighten the children?

A: Let’s take a look at Office of Chief Counsel Memorandum 20152201F.

NOTE: This type of document is internal to the IRS. A revenue agent is examining a return and has a question. The question is technical enough to make it to the National Office. An IRS attorney there responds to the agent’s question.

The donor (now deceased) made two gifts to his daughter. There were some problems with the gift tax return, however:

1.  The taxpayer did not give the legal names of the partnerships.
2. The taxpayer gave an incorrect identification number for one partnership.
3. The taxpayer gifted partnership interests, requiring a valuation. The taxpayer got an appraisal on the land, but did not get a valuation on the partnership containing the land. 
4. Failure to get a valuation on the partnership also meant the taxpayer failed to document any discounts claimed on the partnership interest.

What was the IRS conclusion?

The Service may assess gift tax based upon those transfers at any time.”

The IRS concluded there was no statute of limitations. No surprise there. Granted, if there is enough money involved the estate has no choice but to pursue the matter. It however would have been easier – and a lot cheaper - to prepare the gift tax return correctly to start with.

Q: What is my takeaway from all this?

A: If you are gifting anything other than cash or publicly-traded stock, play it safe and file a gift tax return. Ignore the $14,000 limit. 

Using An Annuity To Teach Tax

I intend someday to return to college and teach tax. It would be an adjunct position, as I have no intention of taking up another full-time job after this. One tax CPA career is enough.

I have previously taught accounting but not tax. There is some order to accounting: debits and credits, recording transactions and reconciling accounts. Tax and accounting may be siblings, but the tax Code does not purport to show anyone’s net income according to “generally accepted accounting principles.” It may, mind you, but that would be a coincidence.

Sometimes there are jagged edges to tax accounting. Have Johnson & Johnson issue financial statements pursuant to the tax Code and they would likely find themselves in front of the SEC.   

Let's say you are taking your first tax course. The syllabus includes:

·        What is income?

·        What is deductible?

·        Why doesn’t the answer make sense?

I am looking at Tobias v Commissioner. I give the taxpayers credit, as they were thinking outside the box. They knew they hadn’t made any money, irrespective of what the IRS said.

Edward Tobias was an attorney and kept an inactive CPA license. His wife was a school administrator. They had bought a variable annuity in 2003 for almost $230,000. In order to free up the cash, they sold stock at a loss of approximately $158,000. They put another $346,000 into the annuity over the years.

Fast forward to 2010. They withdrew $525,000 to buy and improve a residence. At that point in time, the deferred income (that is, the inside buildup) in the annuity policy was approximately $186,000. They insurance company sent them a Form 1099 for $186,000.

But they left the $186,000 off their 2010 tax return. They did attach an explanation, however:

The … account was funded with after-tax funds and all withdrawals have been made prior to annuitization. Accordingly, any potential gains should be applied to the prior capital loss carryforward, which is approximately $148,000. Additionally, this account has not recouped losses incurred in prior years and has incurred substantial withdrawal penalties; the calculation made by … is incorrect and is contested.”

You know the IRS was going to match this up.

The Tobias’ had a remaining capital loss of $148,000 from stock they sold to buy the annuity. In addition they had already put approximately $576,000 into the annuity, an amount less than the withdrawal. They were just getting their money back, even without taking that capital loss into consideration. 

The IRS on the other hand said they had $186,000 in income. The IRS also wanted an early distribution penalty of almost $19,000.

Who is right?

When the Tobias’ withdrew $525,000, they took deferred income with it. This is the “income first” rule of Code Section 72(e), and the rule has been there a long time. It says that – upon taking money from an annuity – the inside income is the first thing to come out. Like the fable of the frog and scorpion, that is what annuities do.

What about the $148,000 capital loss? A capital loss has a separate set of rules. Capital losses offset capital gains dollar-for-dollar. Past that they offset non-capital-gain income up to $3,000 per year. Annuity income however is not capital gain income, so we are stuck at $3,000.

But the economics were interrelated, argued the Tobias’. They sold the stock to buy the annuity. The loss on that should offset the income from the annuity, right?

No, not right.

When these transactions hit the tax return, each took on its own tax attribute. One attribute went to house Gryffindor, another to house Hufflepuff. They are all in Hogwarts, but they have been separated by the tax Sorting Hat. You cannot just mix them together - unless the Code says you can mix them together. Unfortunately, the Code does not say that.

So you have the odd result that the Tobias’ owed tax and penalty on more money than they made from the deal.

The answer makes sense to a tax guy.

It may just be a bit hard to teach.

Does A Charitable Remainder Trust Have To Be Charitable?

Over the years I have been able to work with very wealthy people. That level of wealth allows the tax attorneys and CPAs to bring out their toys. Granted, there may not be as many toys as when I came out of school, but the toys can still be impressive.

A favorite is the charitable remainder trust.

The concept is simple: you transfer money or other assets to a charity. They in turn agree to pay you an amount for a number of years, which may be the rest of your life. When you pass away, the balance of the trust (the remainder) goes to the charity.

Let’s add some horsepower under the hood:

(1)   You fund the trust with appreciated assets: real estate or stocks, for example. Odds are the trustee will sell the assets, either immediately or over time, to free-up the cash with which to pay your annuity.

Here is the tax gimmick: if you sold the stock or real estate, you would have a big tax bill. The trust sells the stock or real estate and you have … nothing. It’s like a Penn and Teller show!

(2)   Since the trust does not pay tax, more money is left to invest. This could allow larger annual payouts to you, a larger donation at the end, or a combination of the two.

(3)   I exaggerated a bit. While the trust does not pay tax, you will pay tax every year as you receive your payment. Still, you are paying over a period of years, likely a better result than paying immediately in the year of sale.

(4)   You get an immediate tax deduction for the part of the trust that will go to charity. Even if that is decades off, you get a tax deduction today.  

There are some crazy mathematics when working with this type of trust. The answer can vary wildly depending upon age, assumed rates of return (for the invested assets), discount rates (for the passage of time), whether you take an dollar annuity or a percentage annuity, the amount of the annuity and so on.

And then advisors have added bells and whistles over the years. For example, it is possible to put a “limit” on the annual annuity. How? One way is to restrict the annuity to the “income” of the trust. If the income exceeds the annuity, then the annuity is paid in full. If the annuity exceeds the income, then the annuity gets reduced.

Add one more bell and whistle: let’s say that the annuity gets a haircut. Can that reduction accumulate and be carried-over to be paid in the future, or is it forever lost? You can design the trust either way.

A charitable remainder trust with this income limit is referred to as a “NIMCRUT.” Yes, the “NI” stands for net income. Working in this area is like learning a foreign language.

Now, let’s talk about the Estate of Arthur Schaefer. We said the mathematics are crazy, as each piece can move the answer and there seems to be an endless supply of pieces. That “NI” we talked about is itself a piece. Can “NI” blow up our trust?

Mr. Schaefer settled two charitable remainders trusts during his lifetime, one for each son. He made them “NIMCRUTS,” with the provision that any income limitation would carryover and be payable in a later year, if able. Schaefer of course took a tax deduction for the charitable part.

OBSERVATION: These two trusts would also be gifts (to the sons) and trigger a gift tax return.

But he included one more thing: he set the annuity payouts fairly high – 10% for one trust and 11% for the other.

That creates a problem. If you expect the trust to pay out 10% (or 11%) a year, you better invest in stocks that are going to go exponential or you will eventually run out of money. There will be nothing left for the charity. Heck, there may not be anything left for the two sons.

No problem, said the trustee. You see, if the trusts do not have enough income (remember: NIMCRUT), then the 10% or 11% will never be paid. Those trusts can never run out of money. 

Problem, said the IRS. Throwing that NIMCRUT in there is fancy shoes and all, but you cannot take the NIMCRUT limit into account when that is the only way that the charity will ever receive a penny. Maybe Schaefer should have toned-down the 10% or 11% thing a bit and not put so much pressure on the NIMCRUT limit to get these trusts to work.

The matter wound up in Tax Court.

NOTE: Schaefer passed away and it was his estate that was litigating with the IRS. This happened because of the way the estate tax and the gift tax overlap, but we will spare ourselves the tortuous details.

It appears that there was a very sharp tax attorney behind these two trusts, looking at quotes by the Court:

            “We find the text of section 664(e) ambiguous.”

            “The regulations are less clear.”

But there is danger when a tax attorney walks out on a narrow ledge:

“… where a statute is ambiguous, the administrative agency can fill gaps with administrative guidance to which we owe the level of deference appropriate under the circumstances.”

Oh, oh. “Administrative” here means the IRS.

            “… we find the Commissioner’s guidance to be persuasive.”

And so the estate lost, meaning that somewhere in here the charitable donations were lost. Someone was writing the IRS a check.

Charitable remainder trusts are great tax vehicles. I have worked with them to a greater or lesser degree for over two decades, but one has to have some common sense. It is a “charitable” remainder trust. Something has to go to charity. Granted, the mathematics may border on Big Bang Theory, but the overall concept still applies. If it takes a high-powered attorney to parse the tax Code to the Tax Court, the deal may not be for you.