Donors' remorse could lead to some questionable legal self-help--a.k.a. tax fraud--lawyers say.
Many wealthy people got pitches from their estate planning lawyers last year encouraging them to make taxable gifts. It seemed like a good idea at the time. Lifetime gifts are an important estate-planning tool. Not only do they leave less for the government to tax later, but if the assets increase in value after you have passed them along, the appreciation is tax-free.
Even people in a position to shift substantial wealth to family tend to be reluctant to make gifts so large that they will incur gift tax. Still, for much of 2010, it seemed like a wise financial strategy to do just that. With both the gift tax and the estate tax automatically scheduled to increase to 55% in 2011, the 35% gift-tax rate on gifts of more than $1 million in 2010 looked like a bargain.
If, due to procrastination or lack of interest, you ignored what lawyers then dubbed a unique "opportunity," you avoided a quandary that’s consuming a lot of airtime this week at the Heckerling Institute on Estate Planning, the annual Super Bowl on the subject sponsored by University of Miami School of Law. The lawyers meeting here in Orlando are in the awkward position of trying to figure out what clients who followed their advice can now do to reverse those 2010 taxable gifts.
Their collective chagrin stems from the sweeping tax overhaul President Obama signed Dec. 17. Under this law the amount that anyone can transfer tax-free during life went up this year from $1 million to $5 million ($10 million for married couples). So by simply waiting until 2011 to make gifts, it might have been possible to avoid gift tax altogether.
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What’s more, under the new law the tax on transfers that exceed the limit stayed at 35%, instead of going up to 55%, so paying tax in 2010 wasn’t a good deal for this reason either. The new rules don’t affect what’s called the annual exclusion: You can still give as much as $13,000 a year ($26,000 for spouses) to as many people as you like without it counting against the lifetime limit.
The problem arises for wealthy folks who were far more generous than that, and followed their lawyers’ advice to purposely incur gift tax in 2010. Compounding what could be a nasty case of donors’ remorse is the looming deadline of April 15 to file the tax return reporting the gift and pay the associated tax.
So now what? Unfortunately fixing the problem isn’t nearly as easy as returning a gaudy holiday gift that just isn’t you.
The process for turning down a gift or an inheritance (usually done for tax reasons) is called a disclaimer and strict rules apply. People who disclaim are generally treated as if they had died before the person making the gift. The asset then passes to the person who would be next in line, either under a will or trust or according to state law.
For lifetime gifts, most lawyers assume an outright gift (as opposed to one made to a trust) will simply revert back to the donor. It’s harder to achieve that result with disclaimers of gifts to trusts because of impediments posed by state law, the terms of the trust or both.
But an even bigger problem with using disclaimers as first aid for 2010 gifts involves the very strict rules that surround the disclaimer process. You must disclaim within nine months of receiving the gift. And more significantly, in order for a disclaimer to be valid, the gift recipient generally may not have accepted an interest in the asset or any of its benefits.
These rules might not be a problem for people who transferred illiquid assets, such as shares in a family limited partnership. But what happens in the more common scenario where people have given shares of publicly traded stock or cash, and the gift recipient has already taken steps that would make the disclaimer invalid?
Taking title to an asset or depositing a check in your account is probably OK, says Carol A. Harrington, a lawyer with McDermott, Will & Emery in Chicago. But receiving interest or dividends might not be. Given all the special circumstances that applied in 2010, Congress could have made the rules more lenient for these gifts, but didn’t, Harrington notes.
You’re also out of luck if the gift recipients have sold the assets or otherwise already enjoyed your largess. For example, Beth Shapiro Kaufman, a former Internal Revenue Service lawyer (she wrote the disclaimer regulations) now in private practice at Caplin & Drysdale in Washington, D.C., got a call from a client who made a $1 million cash gift last year to each child. Turned out the kids had already spent most of the money. No chance of a disclaimer.
Assuming the assets haven’t been dissipated but the facts suggest that a disclaimer is no longer possible, what can you do? Those who go by the book might seek a private letter ruling from the IRS asking for mercy. But stiff IRS filing fees and lawyers’ bills can make this a painful process.
Simply giving back the gift might seem like the path of least resistance. But legally the person returning the gift is in turn making a gift of her own, which requires her to use her own gift tax exemption and report the gift on a gift tax return, even if no tax is due. Nor does this solve the problem of the original donor owing gift tax on April 15.
Lest you be tempted to blame the lawyers, expect them to be ready with disclaimers of their own. Their advice was good when they gave it, and no one can predict the vicissitudes of Congress.
Dennis I. Belcher, a lawyer with McGuireWoods in Richmond, Va., and a panelist at the conference, says the unexpected congressional action might support an argument for undoing the gift based on a separate legal doctrine called rescission. State law on the subject varies. Success would require the donor to show that there was an error of judgment based on predictions of what tax rates would be, rather than a mistake of material fact, Belcher says.
Many other lawyers attending the conference expressed skepticism about whether this argument would fly. It would be a bad precedent that could be used in other situations to defend aggressive tax strategies, they say.
Given the dearth of viable options, conference attendees and speakers mused that their clients might instead resort to a coping device that lawyers normally frown upon: legal self-help. What does that mean here? "It’s tempting for people to rewrite history," explains Ellen K. Harrison, a lawyer with Pillsbury Winthrop Shaw Pittman in Washington, D.C. "Especially where there is no third-party record, those gifts are going to disappear."
Clearly this is a situation that calls for clarification or leniency from the IRS. Without it, self-help for 2010 gifts could turn out to be a euphemism for tax fraud.
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009). An update to the book, on how the new tax law affects your estate plan, can be downloaded from estateplanningsmarts.com.