The IRS recently published data which leads us to again revisit the issue of why you might want to file a gift tax return, even if filing can be avoided.

1. When must a gift tax return be filed?
This is the easy issue. Here are the basic rules:
(a) You can make a $12,000 annual exclusion gift every year to as many donees as you want. If you are married, then you can make up to a $24,000 annual exclusion gift if your spouse elects to split that gift with you, but you will have to file a gift tax return to report the split gift. If you and your spouse each make separate $12,000 annual exclusion gifts, then no gift tax return is required. The $12,000 annual exclusion amount increases in $1,000 increments with inflation.

(b) Any gifts you make in excess of the $12,000 annual exclusion amount are "taxable gifts" and must be reported on a gift tax return. You have a $1,000,000 lifetime gift tax exemption. This means that even though you must file a gift tax return when you make a taxable gift, no gift tax is owed until your total taxable gifts exceed $1,000,000.

(c) If you make a gift which is a generation-skipping transfer (this is a gift that will skip a generation), then you should file a gift tax return to report the use of some of your $2,000,000 lifetime generation-skipping transfer tax exemption. Thus, even if you make a $12,000 annual exclusion gift, which by itself does not necessitate filing a gift tax return, if the annual exclusion gift is a generation-skipping transfer, then a gift tax return is required. If you do not file a gift tax return, then the law provides for an automatic allocation of your generation-skipping transfer tax exemption to such a gift.

2. Why would you ever want to file a gift tax return if filing could be avoided?
This is a loaded question. Electing to file a gift tax return involves time and expense. It may require appraisals, and worst of all, it could trigger a gift tax audit! So, why would you want to voluntarily file a gift tax return?

The answer is simple. Filing a gift tax return can start the statute of limitations on any determination of deficiency by the IRS. Thus, if a gift tax return is filed making adequate disclosure of the gift, and if the IRS does not send you a notice of deficiency for the gift tax return within three years from the date of filing, the IRS is forever barred from challenging the value of the gift you reported on your gift tax return. If you do not file a gift tax return, then the statute of limitations remains open. The most likely time that the IRS would become aware of your prior gifts would be following your death during an estate tax audit. The IRS could then challenge any gifts you made during your lifetime for which a gift tax return was not filed or for which the statute of limitations had not expired. Note that in order to start the statute of limitations running, a gift tax return must make adequate disclosure of the gift. There are some detailed Treasury Regulations which describe adequate disclosure.

3. Under what circumstances should I consider voluntarily filing a gift tax return?
Typically, there are two types of circumstances in which you should consider voluntarily filing a gift tax return. Here they are:

First, suppose that you make numerous annual exclusion gifts every year of property which is hard to value. We find that many of our clients are making more numerous annual exclusion gifts, since it is possible to prepare trusts for family members which allow annual exclusion gifts to be made for the benefit of some family members who may never actually receive the enjoyment of those gifts. Hard to value property would include limited partnership interests in a family limited partnership, nonvoting interests or other interests in a family LLC, closely held stock, real estate and oil and gas properties as well as undivided interests in real estate and oil and gas properties, and so on.

Second, our clients who want to make substantial transfers of property to lower generations often do so by using some sort of sale or exchange of hard to value property to lower generations. Typically, we try to structure those sales or exchanges as being for fair consideration. Thus, if Mom sells property to Child for fair consideration, no gift tax return needs to be filed to report the sale. However, if the IRS audits the sales transaction and determines that the property was undervalued, then the IRS might assert that Mom made a gift to child of the amount of the undervaluation. Thus, in such a transaction, we often structure the transaction where there is some small gift element present, which allows the client to file a gift tax return and report the transaction. This should start the three year statute of limitations running.

4. Summary of Recent Released IRS Data on Gift and Estate Tax Audits.
We encourage our clients to never play the "audit lottery" game by taking tax return positions based primarily on the likelihood of an audit. However, when deciding whether to voluntarily file a gift tax return, the likelihood of an audit is a consideration.

We are concerned not only about the likelihood of a gift tax audit but also an estate tax audit. If a gift tax return is filed, then we are concerned about the likelihood of a gift tax audit. However, if the gift tax return is not filed, then we are concerned about the likelihood of an estate tax audit, which could subsequently cause a review of the gift for which no gift tax return was filed.

The IRS recently released figures for FY 2006 (October 1, 2005 through September 30, 2006). These figures show a decline in the number of estate and gift tax returns filed as well as a decline in the number of estate and gift tax returns audited.

During this period, 58,000 estate tax returns were filed, down from 66,000 returns filed in 2005. In 2006, there were 256,000 gift tax returns filed, down from 277,000 gift tax returns filed in 2005. The IRS collected $26.7 billion dollars in estate taxes in 2006, compared to $26.3 billion dollars in 2005. Gift tax collections were $1.97 billion dollars, down from $2.04 billion dollars in 2005. All in all, in 2006, the estate tax accounted for only 1.1% of all federal tax revenues, while gift tax collections accounted for only 0.1% of total tax revenue.

Now, how many returns were audited? The IRS revealed that 9.7% of the estate tax returns filed in calendar year 2005 were audited. More revealing, however, is that gross estates under $5 million dollars accounted for 88.3% of all returns filed, and the IRS audited only 7.8% of estate tax returns having gross estates of under $5 million dollars. On the other hand, gross estates over $5 million dollars comprised 11.7% of all estate tax returns filed, and 23.4% of gross estates over $5 million dollars were audited. Focusing on the $5 million dollar and larger gross estates, 13% of the returns examined had no change.

As for gift tax returns, only 0.8% of all gift tax returns filed in 2005 were examined. Of those examined, 20% yielded no change.

Where does this leave you?

If you don't have to file a gift tax return, here are some reasons for not voluntarily doing so:

• You are only making a modest number of annual exclusion gifts, and the property gifted is not difficult to value.
  
• You are fairly young, and the prospect of the gift being reviewed on your estate tax return is many years out.
  
• You don't want to go through the time and expense of filing a gift tax return along with any appraisals that may be necessary.
  
• You don't want to voluntarily trigger a gift tax audit, even though the likelihood of a gift tax audit may be remote.

• You feel good about your gift tax return reporting position, and you believe that a gift tax audit is much less likely than a potential estate tax audit of your gift.
  
• You will be in a better position today in the event of a gift tax audit to support the gift tax values you used rather than leaving it up to your heirs down the road in an estate tax audit.
  
• Based on your age or health, you would just as soon file a gift tax return now as leave the gift issues open for an estate tax audit, which could be sooner than you want.