Draft Form 706 Requires Disclosure of Lifetime Sales to Trusts
On August 16, 2006, the IRS released a new draft Form 706. The draft form adds a new category of lifetime transfers that is required to be disclosed on an estate tax return. Specifically, line 12(e) of part 4 of the draft form asks an executor whether a decedent at any time during his or her lifetime transferred or sold an interest in a partnership, a limited liability company or a closely-held corporation to a trust that was in existence at the decedent’s death and that was (1) created by the decedent during his or her lifetime or (2) created by someone other than the decedent under which the decedent possessed any power, beneficial interest or trusteeship. If the answer to this question is yes, the executor is required to provide the EIN of the entity in which the interest was transferred. (see below)
As a result of new line 12(e), certain gratuitous transfers to trusts that are reportable on a gift tax return will need to be reported for a second time on the transferor’s estate tax return. More significantly, certain sales to trusts for which no gift tax return was filed will need to be disclosed on the seller’s estate tax return. For example, an individual’s sale of a partnership interest to his or her grantor trust for fair market value will need to be reported on the individual’s estate tax return, regardless of whether the sale was required to be reported on a gift tax return.
Some practitioners generally advise clients to report sales to grantor trusts on gift tax returns (or on statements attached to gift tax returns), particularly if the assets that are sold are difficult to value. Reporting a sale to a grantor trust starts the running of the statute of limitations (generally three years from the time the return is filed) on IRS challenges to valuation and other issues related to the sale. If a sale to a grantor trust is not reported and the IRS subsequently learns of the sale and determines that the sales price understates the true value of the transferred property, a deficiency may be asserted, along with interest and, in some cases, penalties, regardless of when the sale occurred.
If new line 12(e) is finalized, practitioners who do not currently advise clients to report sales of interests in partnerships, LLCs or closely-held corporations to grantor trusts on gift tax returns may wish to consider doing so. Reporting these sales will help to close the statute of limitations on IRS challenges more quickly and may even reduce the risk of such challenges. If a sale is reported on one of the more than 99 percent of gift tax returns that are not audited and the transferor dies more than three years after the gift tax return is filed, the IRS will generally be precluded from raising valuation or other issues related to the sale on an audit of the transferor’s estate tax return. (see below) Furthermore, in the event that the IRS does successfully challenge a sale disclosed on a gift tax return, it may be possible to make adjustments to a client’s estate plan that would not be possible if the challenge arose after his or her death.
Without providing further instructions, the form instructs executors to “provide the EIN number to this transferred/sold sold item.” It is unclear what, if any, additional details about the transfer to the trust need to be supplied.
In 2005, approximately 0.8% of gift tax returns filed with the IRS were audited. Approximately 8% of estate tax returns were audited. See Treasury Inspector General for Tax Administration, Trends in Compliance Activities Through Fiscal Year 2005, Figures 45 and 46.