Transferring business interests or other assets to loved ones can be a fraught transaction. If you don't properly document and disclose the transfer, the IRS could demand unpaid gift taxes, penalties, and interest from you years later. Here's what you need to know to avoid such negative possibilities.
In general, the IRS has three years to either:
However, the three-year statute of limitations period doesn't start until you "adequately disclose" the transfer to the IRS. If you don't adequately disclose a transfer, the IRS could come after you for unpaid gift taxes, plus penalties and interest, years — even decades — later.
To avoid this situation, your gift tax return must satisfy federal tax regulations' adequate disclosure requirements. Even if you treat a transfer as a nongift (such as the transfer of an asset in exchange for full and adequate consideration), you may want to report it on a gift tax return to prevent the IRS from later arguing that you made a taxable gift.
Important: If you decide not to disclose a sale transaction on a gift tax return, document the transaction properly. You and your buyer should retain copies of this documentation indefinitely.
To adequately disclose a transfer, file a gift tax return for the year the transfer is completed. The return should describe the transferred property, any consideration you received for it and the identity of, and relationship between, you and each transferee. Also attach a detailed description of the method used to value the transferred property or a qualified appraisal. If applicable, include a statement describing any position taken that's contrary to proposed, temporary or final tax regulations or revenue rulings published at the time of the transfer.
If you've transferred property to a trust, include the trust's tax identification number and a brief description of its terms (or a copy of the trust instrument) on the gift tax return. Additional information may be required for certain transactions between related parties, such as grantor retained annuity trusts, qualified personal residence trusts, and transfers of interests in corporations or partnerships.
For transfers reported on a gift tax return as nongifts, describe the methods used to value the property or furnish an appraisal. You'll also need to explain why the transfers aren't gifts.
Often, strict compliance with tax regulations is required. However, a recent U.S. Tax Court ruling (Schlapfer v. Commissioner) held that substantial compliance with the adequate disclosure regulations is sufficient so long as it's detailed enough to alert the IRS to the nature of the transaction. With adequate detail, the IRS will presumably be able to make a reasonably informed decision about whether to select a return for audit.
The ruling in Schlapfer should provide some comfort to taxpayers who have neglected to cover all the bases when disclosing gifts. However, to avoid an IRS challenge and potential litigation, it's advisable to follow the regulations as closely as possible.
If your estate plan involves transferring assets, there's a risk that a nongift transfer could at some point be characterized as a partial gift. To preserve your plan and minimize tax exposure, report any gift or transfer on a gift tax return that satisfies the adequate disclosure requirements. It's also critical to file the return in a timely manner. Contact us for help.
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