The IRS receives a vast amount of information, which can make it challenging for them to act on all the information they possess. However, taxpayers have the ability to alert the IRS to potential tax issues and wait for the IRS’s response. The IRS generally cannot ignore information it has received.
For example, in the context of the research tax credit, several courts have said that the IRS cannot conduct a multi-year audit and then assert that it did not have enough information disclosed to it to support a refund claim for the very same research tax credit. The Harper v. United States, No. 19-55933 (9th Cir. Feb. 25, 2021) case is an example of this.
This begs the question as to whether the taxpayer can disclose information and wait to see if the IRS acts on the information before the three-year period expires for the IRS to assess the tax. The answer is sometimes “yes,” taxpayers can do just that.
But what about disclosure of information that isn’t exactly right, but should be sufficient to alert the IRS to the issue?
This brings us to Schlapfer v. Commissioner, T.C. Memo. 2023-65. In Schlapfer, the court addresses whether filing a gift tax return for the wrong year starts the three-year time limit for the IRS to assess tax. More specifically, the court addresses whether a taxpayer who discloses gifts via the IRS’s voluntarily offshore compliance program and later withdraws from that program, prevents the IRS from coming back years later to assess the gift tax.
Facts & Procedural History
The taxpayer is a Swiss-born businessman with ties to both the United States and Switzerland. He became a U.S. citizen in 2008.
He was the policyholder of a Swiss life insurance policy issued in 2006, funded by stock and cash from an entity that he was the 100% owner of. The entity was a Panamanian entity.
In 2006, the taxpayer apparently tried to assign ownership of the insurance policy to his mother, aunt, and uncle. He had to follow up with the insurance company to finalize the assignment in 2007. This resulted in the entity being transferred to these family members as it was owned by the life insurance policy.
In 2013, the taxpayer submitted a disclosure packet to the IRS as part of its Offshore Voluntary Disclosure Program (“OVDP”). The packet included a gift tax return for 2006, informing the IRS that he had made gifts of the entity stock to his relatives.
The Form 709 gift tax return included the following language:
A PROTECTIVE FILING IS BEING SUBMITTED. ON JULY 6, 2006, TAXPAYER MADE A GIFT OF CONTROLLED FOREIGN COMPANY STOCK VALUED AT $6,056,686.PER U.S. TREASURY REGULATION 25.2501-1(B), THE TAXPAYER IS NOT SUBJECT TO U.S. GIFT TAX AS HE DID NOT INTEND TO RESIDE PERMANENTLY IN THE UNITED STATES UNTIL CITIZENSHIP WAS OBTAINED IN 2008.
The IRS examined the OVDP claim. The IRS eventually concluded that the gifts were made in 2007, not 2006, and that the taxpayer had failed to file a gift tax return for 2007, thereby not adequately disclosing the gift to commence the period of limitations on assessment.
The taxpayer contended that the assignments were requested in 2006, and, due to a scrivener’s error, he had to follow up in 2007 to make the assignments. The IRS gave the taxpayer the choice to opt out of or be removed from the OVDP. He withdrew.
The IRS then prepared a substitute for return Form 709 and issued a notice of deficiency in October 2019. Litigation ensued in the U.S. Tax Court. The IRS filed for summary judgment, and the taxpayer filed a cross-motion for summary judgment.
About the U.S. Gift Tax
Before getting into the IRS’s procedural rules, we should pause to consider the gift tax.
The U.S. gift tax is a tax imposed on the transfer of property by gift. It is a separate tax from the estate tax, but both taxes are part of the unified gift and estate tax system. The gift tax is paid by the donor (the person making the gift) rather than the recipient of the gift.
The gift tax rate is 18-40% of the value of the gift.
The gift tax applies to the transfer of property by gift if the value of the gift exceeds the annual exclusion amount. The annual exclusion in 2023 is $17,000 per individual. This means you can give up to $17,000 per year to an individual without incurring any gift tax or needing to report the gift.
Once this annual exclusion amount is exceeded, one generally uses up their lifetime exemption. This is almost $13 million per donor in 2023.
And there are certain transfers that do not count as gifts, such as transfers between spouses. Transfers at death also are not taxable–such as transfers of businesses using buy-sell agreements.
These rules are the same for gifts to U.S. persons and by U.S. persons to foreign persons. The only significant difference is that there is a limit on gifts to foreign spouses (but qualified domestic trusts or QDOTs and other tax planning options can avoid this limitation).
The gift is to be reported on Form 709, which is due no later than April 15th of the year following the gift.
The IRS’s Assessment Period for Gift Taxes
The IRS generally has three years to assess taxes. This means that the IRS has to record the taxes as being due on its books before this time period expires. This is the same three year rule that applies to income taxes.
The time period starts to run when the tax return is filed. Absent a tax return being filed, the time does not start to run and the IRS can assess the tax at any time. This is why it is often advisable to file a tax return, even if the tax return is not entirely correct.
For gift taxes, there are exceptions to this rule that the three-year period does not start running. One such exception is the exception for adequate disclosure:
(9)Gift tax on certain gifts not shown on return
If any gift of property the value of which (or any increase in taxable gifts required under section 2701(d) which) is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b)), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.
Thus, this exception says that if a gift has been adequately disclosed on the gift tax return, or a statement attached to the return, that was filed for the year the transfer occurred, then the ordinary three-year period for assessment commences upon filing of the gift tax return. This is true even if it is later discovered that the gift was incomplete in the year for which the gift tax return was filed.
The court in the current case confirmed that these regulations focus on when the transfer was reported, not when the transfer was completed. So the year of the transfer does not matter for purposes of commencing the period of limitations.
What is Adequate Disclosure?
Disclosure is “adequate” if it is sufficiently detailed to alert the IRS to the nature of the transaction so that the decision as to whether to select the return for audit.
When it comes to gift tax returns, the regulations say that the gift tax return is adequately disclosed if the return provides the following information:
- A description of the transferred property and any consideration received by the transferor;
- The identity of, and the relationship between, the transferor and each transferee;
- If the property is transferred in trust, the trust’s tax identification number and a brief description of the terms of the trust, or in lieu of a brief description of the trust terms, a copy of the trust instrument;
- A detailed description of the method used to determine the fair market value of the property transferred, including any financial data (for example, balance sheets, etc. with explanations of any adjustments) that were utilized in determining the value of the interest, any restrictions on the transferred property that were considered in determining the fair market value of the property, and a description of any discounts, such as discounts for blockage, minority or fractional interests, and lack of marketability, claimed in valuing the property; and
- A statement describing any position taken that is contrary to any proposed, temporary or final treasury regulations or revenue rulings published at the time of the transfer.
In this case, the taxpayer argued that the period to assess gift tax has expired because he adequately disclosed the gift on his 2006 gift tax return. He points to four documents to support this claim: (1) the gift tax return; (2) a protective filing attachment; (3) Schedule F of Form 5471 for his 2006 tax return; and (4) the Offshore Entity Statement.
The IRS argues that the period to assess gift tax did not expire because the taxpayer did not adequately disclose the gift. Specifically, it asserts that (1) the Offshore Entity Statement is not part of the 2006 gift tax return and it should not be considered to determine whether Mr. Schlapfer made an adequate disclosure of the gift; and (2) even if the Offshore Entity Statement is considered, Mr. Schlapfer still failed to adequately disclose the gift because he failed to satisfy all applicable requirements of treasury regulation noted above.
Substantial Compliance is Sufficient
The IRS has frequently rejected the concept of substantial compliance–particularly during audits and in court. This position ends up alienating otherwise compliant taxpayers and sets a bad tone and sets hard rules that, ultimately, provide reasons for others to not voluntarily comply. The IRS is often on the losing end of this position, even though the IRS employees who are working the particular cases do not see it that way.
According to the court, substantial compliance is the correct standard as to whether there is adequate disclosure was made.
The court said that if a requirement is essential to the statute, then strict adherence to all regulatory requirements is necessary to satisfy the statute. However, if a requirement is considered “procedural or directory” and is not crucial to the main purpose or essence of the statute, it may be fulfilled by substantial compliance. In other words, if the requirement is not integral to the fundamental objective of the statute, minor deviations or substantial compliance may be acceptable.
In this case, the court rejected the IRS’s argument that strict compliance was required. It concluded that this substantial compliance was sufficient. The court concluded that the taxpayer substantially complied with each requirement of the regulations for making adequate disclosure.
The IRS often has the upper hand when it comes to taxes and tax procedural rules. This puts taxpayers at a disadvantage. This is not true when it comes to possessing information about transactions. Taxpayers have the upper hand here. This case provides one example of how taxpayers can use this information to their advantage in some cases.
As evidenced by this case, taxpayers should file gift tax returns and provide supporting records to disclose gifts to the IRS, even if there are inaccuracies or uncertainties. By doing so, they start the statute of limitations and prevent the IRS from making assessments years later. Proper disclosure is crucial to protect taxpayers’ interests and establish a clear record of compliance.