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George F. Bearup, J.D. Senior Legal Trust Advisor

September 28, 2023

The “Adequate Disclosure” Rule

Take-Away: While most of us are aware of the three-year statute of limitations when it comes to reporting gifts to the IRS, we tend to gloss over the requirement that the three-year statute of limitations only commences when there has been an adequate disclosure of the gift to the IRS.

Background: The current three-year statute of limitations rule was enacted back in 1997. Specifically, the Tax Code provides that the statute of limitation will not run on a gift unless that gift is disclosed in a return or a statement that is attached to the federal gift tax return in a manner that is adequate to apprise the Secretary of Treasury of the nature of the item of the gift. [IRC 6501(c)(9).] Prior to this 1997 change, the rule was that if the donor filed a gift tax return for a particular year, the statute of limitations would run for that year on all gifts, whether or not the gifts were disclosed. Therefore, the requirements needed to start the three-year statute of limitations are: (i) to have a disclosure in a gift tax return or in a statement that is attached to that return; and (ii) that statement has to be adequate to apprise the IRS of the nature of the item transferred.

Adequate Disclosure: The IRS’s Final Regulations provide guidance on what is necessary to constitute adequate disclosure. The Final Regulations provide that a gift/transfer will be adequately disclosed by the donor/transferor if the donor/transferor discloses:

  • A description of the transferred property;
  • Any consideration received by the donor/transferor;
  • The identity of any relationship between the donor/transferor and each donee/transferee;
  • If the transfer is in trust, the disclosure of the trust’s Tax ID number;
  • A brief description of the trust’s terms if it receives the gift/transfer, or alternatively attach a copy of the entire trust;
  • A detailed description of the method that was used to determine the fair market value of the transferred property or interest, or alternatively attach a qualified appraisal; and
  • Include a statement that describes any position taken in the gift tax return that is contrary to any proposed, temporary, or Final IRS Regulation or Revenue Ruling that is published at the time of the gift/transfer.

Historically, the IRS has taken a very restrictive view of what constitutes adequate disclosure on a federal gift tax return. For example, in a 2015 IRS Field Advice memo, a gift of a partnership interest was found to not be adequately disclosed on a Form 709 Gift Tax Return because the partnership’s employer identification number (EIN) was missing just one digit. However, the IRS’s  highly restrictive view of what constitutes adequate disclosure may soon be changing in light of a recent Tax Court decision.

Schlapfer v. Commissioner, Tax Court Memo 2023-65 (May 22, 2023)

Facts: [The following facts are a bit convoluted, but stick with me.] The donor was born in Switzerland. He worked as a banker in the U.S.A. and Switzerland. He had a U.S. green card for a while. In 2008 the donor became a US citizen. In 2006 the donor bought a Swiss life insurance policy. As permitted under Swiss law, the donor funded the life insurance policy purchase with stock in a corporation that he owned, and also with cash. The ownership of that  life insurance policy was then assigned to the donor’s mother, aunt and uncle. In 2006 a gift tax return was fled in which Mr. Schlapfer reported a gift of the stock in his company to his mother, aunt and uncle. He also included in that filing Form 5471 for a foreign corporation that was used to fund the life insurance policy. Mr. Schlapfer took the position on his gift tax return that he was not domiciled in the US in 2006 because he had not (yet) formed the intention to remain in the US and therefore he was not subject to the U.S. gift tax. Despite this stated plan, the insurance company initially issued the policy to Mr. Schlapfer as its sole policyholder. It was only in May, 2007 that formal ownership of the insurance policy was corrected and into the names of the donor’s mother, aunt, and uncle.

Disclosure to the IRS: This gift transaction only came to the attention of the IRS in 2013 when Mr. Schlapfer participated in the IRS’s Offshore Voluntary Disclosure Program (the Program) because he had not filed U.S. income tax returns for the years 2004 through 2009. Mr. Schlapfer had to furnish as part of the Program’s compliance rules with copies of his past income and gift tax returns. This led to the IRS’s follow up questions when it asked Mr. Schlapfer to document his gift of the company stock to his mother/aunt/uncle and to substantiate his claim that he was not domiciled in the U.S. in 2006.

Initial Determination in 2016- No Gift in 2006: The IRS examined his 2006 gift tax return, and agreed to extend the statute of limitations for a year. Initially, after several months of examination,  the IRS concluded that Mr. Schlapfer did not make any gifts in 2006 because the ownership of the insurance policy was ‘wrong,’ the gift was not completed until sometime in 2007.

Notice of Deficiency in 2019- Taxable Gift in 2007: The IRS later issued a Notice of Deficiency in 2019 with regard to the gift of the life insurance policy in 2007 for $4.0 million in gift tax due. This position was reached because the IRS concluded that Mr. Schlapfer had retained dominion and control over the transferred property, that is was a gift of the insurance policy and not a gift of stock, and that Mr. Schlapfer was domiciled in the U.S. in 2007 when the transfer occurred.

Legal Dispute: In the Tax Court the contested issue boiled down to whether the IRS could maintain its action for a gift tax deficiency for 2007. Whether there were so many defects in the gift transaction as reported on Mr. Schlapfer’s gift tax return that his gift was not adequately disclosed so that the IRS could proceed and assess the federal gift tax, or was there enough information furnished to meet the adequate disclosure requirement to satisfy the three-year statute of limitations. Thus, if the gratuitous transfer had been adequately disclosed on the 2006 gift tax return, then the 2019 Notice of Deficiency would be ‘too late.’

Tax Court Decision:  The Tax Court held that Mr. Schlapfer’s disclosure in his 2006 gift tax return was sufficient to commence the three-year statute of limitations running on that return and thus would  time bar any assessment of tax, whether that gift was made in either 2006 or 2007.“A disclosure’s adequate if it’s sufficiently detailed to alert the commissioner and his agents as to the nature of the transaction so that the decision as to whether to select the return for audit may be a reasonably informed one.”

Information Furnished to the IRS: The Court found that it could consider all of the materials that were submitted by Mr. Schlapfer with his 2006 gift tax return, which included balance sheets and other information on the company. It even considered those materials that were filed as part of the Program with the audit of his 2004 through 2009 income tax returns and his other information reporting. The Court looked at all that information and found there to be adequate disclosure to the IRS.

Substantial Compliance Standard: Perhaps even more important was the Court’s view whether the standard was strict compliance or only substantial compliance of the adequate disclosure requirements. The Court found that only substantial compliance of the Final Regulation’s adequate disclosure requirements were met by Mr. Schlapfer. The Court reached this result by noting that the essence of the adequate disclosure rules was to provide the Commissioner with a viable way to identify gift tax returns that should be examined with a minimum expenditure of resources.

Schlapfer Substantially Complied: The Court then applied the substantial compliance standard and found that Mr. Schlapfer met that standard with his disclosures to the IRS. This was in spite of the confusion in the underlying gift transaction, including: (i) he said that he transferred company interests on the gift tax return, when he actually transferred a life insurance contract; (ii) he said the date of the gift was in 2006, when apparently the policy transferred occurred in 2007 on the insurance company’s records; (iii) at one point Mr. Schlapfer claimed that the donee was his mother, then later he said the policy was given to his mother, aunt, and uncle; and (iv) the method that was used to value the gift of the policy  was embedded in other information furnished later on to the IRS as part of the Program information exchange.  None of these ambiguous disclosures would have satisfied the IRS’s strict compliance approach to adequate disclosure, but they apparently met the Court’s substantial compliance approach to the adequate disclosure rules. Thus, the Court found that there was substantial compliance and adequate disclosure and the deficiency for 2007 was time-barred.

Observation: I wonder what the impact was on the Court’s reasoning when the IRS audited the 2006 gift tax return in 2016 and gave it a ‘pass’ only to return three years later with its Notice of Deficiency?

Conclusion: While every effort should be made to strictly comply with the IRS’s adequate disclosure rules set-forth in its Final Regulations, the Schlapfer conclusion is important. Strict compliance with the adequate disclosure regulations is not necessary- the information provided in or with the federal gift tax return only has to be adequate to provide the IRS with a way to determine whether the gift tax return should be examined.