Common Gift Tax Return Errors: The Ultimate Guide to Form 709

A potpourri of frequent omissions and mistakes

Oct 11, 2024

This is a continuation of the series on preparing Form 709. For the first article in this series and a series index, click here. While many of the articles in this series are behind a paywall, this has been provided as a free guide with links to broader explanatory articles and videos. NOTE THAT THIS ARTICLE IS PROVIDED FOR EDUCATIONAL USE ONLY FOR AN INTENDED AUDIENCE OF TAX AND ESTATE PLANNING PROFESSIONALS, AND IS NOT INTENDED TO (1) SUBSTITUTE FOR LEGAL OR TAX ADVICE OR (2) SERVE AS A SELF-HELP GUIDE FOR INDIVIDUALS REQUIRED TO FILE FORM 709.

Intro

As we approach October 15, gift tax returns are often included in the set of returns for which an extension is permitted. However, gift tax returns are not for the faint of heart. Not only do we need a high level of technical acumen, but we also need the right tax preparation software and a complete set of supporting documentation.

To assist in last-minute reviews, the following is a list of common Form 709 errors I frequently encounter. Note that this list is not all-inclusive (hence why this article is titled “Common” errors and not “All” errors), so there may be significant items left off this list. But, the errors listed below statistically represent the errors I most often encounter when reviewing federal gift tax returns.

Extension Issues

The 6-month extension for individual income tax filings is obtained by filing Form 4868, which also applies to gift tax returns. However, there is also a separate form for the 6-month gift tax extension – Form 8892.

Frequently, I see preparers rely on the joint extension on Form 4868. However, while I have not seen specific authority addressing this point, I have heard from may CPAs that there is a problem with this extension. If the income tax return is filed before the original due date, then the extension may get cut off for the gift tax return. If the preparer does not then file the Form 8892 (gift tax extension) to separately extend the gift tax return, then the gift tax return may no longer receive an extension after the original due date if the joint extension on Form 4868 is relied upon.

For this reason, especially when there are separate preparers, it may be safe to file Form 8892 in isolation. And, in the rare event gift or GST tax is actually due, payment usually cannot be extended – but the payment voucher for these taxes is found on Form 8892, and not Form 4868.

Note that I have also seen this raised as the income tax filing before the extended due date cutting off the extension for the gift tax return under Form 4868 as well (but not vice versa). I have not seen any technical guidance to this effect either way, but those who wish to be safe may also prefer to file the gift tax return concurrent with, or before, the income tax return is filed.

Split Gift Errors

As we approach the potential sunset of the Tax Cuts and Jobs Act, which could result in a one-half reduction to the inflation-adjusted gift tax basic exclusion amount, it is common for one or both spouses in a married couple to make irrevocable gifts in a calendar year. However, the gift-splitting election may not be as valuable when there are significant taxable gifts. Why?

Under the anti-clawback Treasury Regulations (Treas. Reg. 20.2010-1(c)), the post-sunset applicable credit against estate tax (if the exclusion goes down) will be the greater of (1) the post-sunset amount granted under IRC Section 2010(c)(3), or (2) the amount actually applied to lifetime taxable gifts. This means that the benefit of this formula does not kick in until an individual’s lifetime taxable gifts exceed the bonus basic exclusion amount that could go away at the end of 2025 (probably between $7 and $7.5 million). Even then, the benefit of this formula only creates an estate tax savings of 40 cents for each dollar gifted over the bonus amount.

So, for example, let’s say there were gifts of $9,000,000 for the taxable year by one spouse (that would otherwise qualify for the gift splitting election, meaning no gift to a SLAT). With the gift-splitting election, the exclusion used by each spouse ($4,500,000) would be less than the bonus exclusion amount. But, if no gift splitting election is made, then the donor spouse’s exclusion actually used would exceed the bonus amount – thus gaining the benefit of the anti-clawback formula for federal estate tax purposes (assuming proposed Regulations on use of lifetime exclusion for testamentary transfers are not finalized).

We also need to be sure that gifts qualify for gift-splitting. Generally, a gift-splitting election will cause all gifts to be treated as being made one-half by each spouse – except for gifts to a consenting spouse. Let’s assume a gift is made to a SLAT. Since the consenting spouse is a beneficiary, such a gift generally cannot be split unless the donor can actuarially determine the value of non-spousal gifts to the SLAT. This usually cannot be determined, other than for Crummey withdrawal rights, especially if the consenting spouse’s interest in the SLAT is limited to discretionary distributions of income and principal.

Not Checking the Box for Claimed Discounts

It is common to make gifts of assets such as closely-held business interests, for which a valuation discount for lack of control and/or lack of marketability may be claimed. However, if such a discount is claimed, there is a box that should be checked on Schedule A, Line A. Further, an explanation of the discount should be attached. (For guidance on the explanation, please see the adequate disclosure regulations under Treas. Reg. 301.6501(c)-1(e)).

Note that this may not just apply for a gift. It may be the case, for example, that assets are sold to a grantor trust for a note, or exchanged with a grantor trust through the exercise of a swap power, and in either case a discount is claimed. In either situation, filing Form 709 to make a non-gift disclosure can start the 3-year limitations period on the discounted value. But, to get the benefit of that discount, the box should be checked to claim the discount.

Claiming Ineligible Annual Exclusions

On Schedule A, Part 4, Line 2, aggregate annual exclusions are listed. However, you should be sure the annual exclusions are available. Frequently, annual exclusions are claimed for gifts to trusts. However, most transfers in trust are gifts of future interests which do not qualify for the annual exclusion. To that end, in order to receive an annual exclusion for a trust gift, a Crummey withdrawal right should be created and reported if a gift tax filing is required.

Improper Crummey Power Reporting

Direct gifts are often reported on Schedule A, Part 1 (for non-skip persons under the GST tax rules) or Schedule A, Part 2 (for skip persons under the GST tax rules). In this vein, note that while Crummey powers represent a direct gift to the power holder, they are often treated as indirect skips for GST tax purposes – especially if structured as hanging Crummey powers. As such, they should be reported on Schedule A, Part 3 as indirect skips – preferably as a separate gift item from the main taxable gift (if any) to the trust under which the Crummey power is created. This also means GST tax exemption should be allocated to the Crummey powers although a gift tax annual exclusion will be claimed.

That being said, some Crummey powers do get treated as direct gifts under the GST tax rules. As a result, a GST tax annual exclusion is available for these gifts. In order to qualify, the Crummey power should be described in IRC Section 2642(c)(2) (for a skip person) or Treas. Reg. 26.2642-1(c)(3). These rules affect the lapse treatment of a Crummey withdrawal right, and provide that an inclusion ratio of zero will be applied to the nontaxable amount (i.e., up to the gift tax annual exclusion) if the lapsed amount is (1) held in a separate subtrust for the sole, lifetime benefit of the Crummey power holder, and (2) will be included in the gross estate of the Crummey power holder. These Crummey powers do get reported on Schedule A, Parts 1 and 2 as if they were direct gifts.

This holds true for spousal withdrawal rights as well. Note that in order to avoid an estate tax inclusion period (ETIP) for a spousal withdrawal right, the GST tax Regulations (under Treas. Reg. 26.2632-1(c)(2)(ii)(B) require us to (1) limit the spousal withdrawal right to $5,000, and (2) limit the exercise period for the withdrawal right (after transfer, not after notice) to no more than 60 days.

It is also not clear under the current state of the law as to whether Crummey notifications are, indeed, required. The IRS used to take this stance, but has not done so in many years. The Tax Court has determined that notifications may not be required in order for a valid present interest to exist. The problem is that many trusts are still written to require notifications, meaning that the risk inherent in not providing them may not be a failure of a present interest but instead a disregard of the trust agreement itself.

Improper 529 Gift Elections

With a gift to a 529 plan, there is an option to spread any contribution to any one donee’s plan over 5 years if the gift is (1) greater than one year’s annual exclusion, but (2) equal to or less than five times the annual exclusion. If this 5-year election is made, the box at the top of Schedule A, on Line B, must be checked and an explanation must be attached.

For each year of this 5-year period, this creates a deemed gift equal to one-fifth of the initial contribution for which the election was made. The year 1 deemed gift is reported as of the date of funding of the 529 plan, and may or may not qualify for the annual exclusion depending on what other gifts were made prior to the 529 gift during the calendar year. (Note that availability of the annual exclusion at the time of the 5-year election does not affect the availability of the election). Note, however, that a 709 must be filed to make this election, but that a 709 is not required for years 2-5 unless (after taking into account the deemed 529 gifts in those years) there are taxable gifts pushing the donor over the reporting threshold.

But, if any gift tax returns are required to be filed for subsequent years during this 5-year election period, the effect of this election should be taken into account. The instructions are not clear on the effective date of each “deemed” annual exclusion gift occurring in years 2-5 of this period (because the instructions state to just list the year and not the date of the deemed gift), but it is safe to assume that such a gift is deemed to occur chronologically before all other gifts during the year. The result is the use of part or all of the annual exclusion for the donee in years 2-5. Thus, if any other gifts are made to the same donee and reported in years 2-5, the effect of this chronologically-superseding deemed gift should be taken into account in, for example, determining the amount of a reported Crummey right and/or claiming the annual exclusion for any other gifts.

Note also that if a gift-splitting election is made, the 5-year election does not automatically apply to the consenting spouse. The consenting spouse would have to file a separate 709 if they wish to make the 5-year election with respect to their split contributions to the 529 account.

Leaving Schedule D Blank

Generation-skipping transfer tax (GST tax) can be difficult to understand. Unfortunately, this lack of understanding often leads preparers to leave Schedule D blank. What is Schedule D? It is the part of the 709 on which GST exemption is allocated and reconciled.

If any gifts are reported on Schedule A, Part 2 (as direct skips), then Parts 1 and 3 of Schedule D should be completed to (1) determine the nontaxable amount of the direct skip (up to the annual exclusion), (2) allocate GST exemption to the taxable amount, and/or (3) calculate and report the GST tax due on the direct skip if insufficient GST exemption is allocated.

Likewise, all allocations of GST exemption – whether to a direct skip, or to an indirect skip on Schedule A, Part 3, should be addressed on Schedule D, Part 2. Even if you are electing out of automatic allocation and attaching a Notice of Allocation, the manually-allocated GST exemption should be listed on the appropriate line.

Incorrect GST Exemption Figures

I commonly see errors in either (1) the total GST exemption available under law for the current year, and (2) the amount used in prior years – each of which get reported on Lines 1 and 2, respectively, of Schedule D, Part 2.

A few years ago, I was reviewing a 2020 gift tax return that reported the available GST exemption under law as $1,000,000 – even though this had not been the case since 1998! This showed that the tax preparer’s software was woefully out-of-date. So, if you using tax preparation software for 709s but avoiding paying for updates, make sure you can at least get the starting numbers for GST exemption and available applicable credit correct.

Where automatic allocation is relied upon, it may be the case (for annual exclusion gifts especially) that no gift tax return gets filed in some years. The outcome is the use of GST exemption in non-filing years. However, figures on the amount of GST exemption used in prior years are often directly carried over from prior years’ 709s – resulting in an overstatement of GST tax exemption. Automatically allocated GST exemption from non-filing years must also be subtracted.

Not Including and/or Applying DSUE

If you are preparing Form 709 for a widow, it may be the case that some deceased spousal unused exclusion (DSUE) was preserved from the estate of their most recently-deceased spouse through a portability election. In such a scenario, this DSUE should be reported on Schedule C of Form 709. This amount will increase the applicable credit available against gift tax, to be reported on Part 2, Line 7 on the first page of Form 709. However, it will not increase the available GST exemption because the portability election does not preserve a deceased spouse’s unused GST exemption.

Note also that DSUE gets used first, before the basic exclusion amount, for applicable credit against gift tax on lifetime taxable gifts. As a result, this use should be properly tracked on Schedule C, Part 1 of Form 709. And, while an individual who is widowed multiple times can only use the DSUE of their most recently-deceased spouse, any DSUE used prior to the death of a more recently-deceased spouse still counts in determining their applicable credit against gift tax. These amounts get tracked on Schedule C, Part 2.

GST Election Errors

On Column C of Schedule A, Parts 2 and 3, you will find a box to make certain elections. For Part 2, this is an election out of automatic allocation. For Part 3, this can be an election in or out of automatic allocation, an election to treat a trust as a GST trust, or a termination of a prior election relating to automatic allocation and/or GST trust classification. In either case, this box should be checked for any of these elections.

Checking the box, however, is not enough. For an election out on Schedule A, Part 2, you must complete Schedule D, Part 3 to indicate how much (if any) GST exemption will be allocated to each direct skip gift – the total of which carries over to Schedule D, Part 2, Line 4. For an election out on Schedule A, Part 3, you must include an election statement (which you must put together yourself if your preparation software does not create the statement). And, if you are electing out of automatic allocation on Schedule A, Part 3 but still wish to allocate GST exemption manually, you must include another statement – a Notice of Allocation – to dictate how must GST exemption is being allocated to each indirect skip gift, and the total from this Notice of Allocation should carry over to Schedule D, Part 2, Line 6.

Conclusion

As noted in the introduction, this is not intended to be a complete list. I frequently see issues such as deficient QTIP elections, improper gift descriptions, improper valuation methods (especially for securities accounts), and/or incomplete disclosures. But, these omissions or errors warrant separate discussion. As we move through tax reporting season, however, I hope these guidelines prove useful to you.