The Gift Tax and the Tax Gap

There is ample evidence that the nation’s gift tax revenue is ravaged by taxpayer noncompliance, thereby enlarging the overall federal tax gap. In a nutshell, taxpayers often make gifts that exceed the gift tax annual exclusion, yet they fail to report this information to the IRS, and the agency lacks the resources and ability to identify those derelictions. The result is that the nation’s coffers suffer. To level the information playing field between taxpayers and the IRS, this analysis champions two simple reform measures that could narrow the tax gap, yielding billions of dollars in additional tax revenue without raising taxes.

I. Introduction

Over the past several decades, there has been intense scrutiny of the nation’s tax gap — the difference between what taxpayers owe in tax and what they actually pay.¹ Indeed, politicians often seek to close the tax gap as a way to raise revenue without having to raise taxes,² and a large percentage of the IRS budget is dedicated to coaxing taxpayers to be tax compliant.³ When it comes to closing the tax gap, the public and the IRS have focused mostly, if not entirely, on the income tax. And that makes sense: The vast majority of forfeited tax revenue is in this realm — almost a staggering half-trillion dollars annually.⁴ However, there are also many taxpayers who are derelict in complying with their filing and payment obligations insofar as the nation’s gift tax is concerned; thus, billions of dollars of revenue are needlessly slipping through the cracks.⁵

This article examines the gift tax and the corrosive effects that noncompliance in this realm likely has on the overall tax gap. After exploring the nature of the problem, its magnitude, and reasons for its severity, I propose two simple reform measures Congress can readily institute that would largely put an end to this practice and simultaneously result in the collection of much-needed revenue — without raising taxes.

II. Nature of the Problem

After enacting the estate tax in 1916, Congress enacted the gift tax in 1924.⁶ Why? To protect the estate tax base from taxpayers eroding it vis-à-vis lifetime gifts.⁷ Thus, whenever a taxpayer makes a gratuitous transfer of property, the nation’s gift tax is supposed to apply.⁸

Despite its application, usually no gift tax is due because the taxpayer’s unified credit against the gift tax (now $13.61 million) shelters the transfer from immediate taxation.⁹ To illustrate, if a grandmother transfers $10 million into a trust established for her grandson’s benefit, the gift tax is applicable. However, the grandmother’s lifetime exclusion would protect her from having to pay an immediate gift tax.

Regardless of the absence of any tax being due, taxpayers are supposed to file a gift tax return (Form 709, “United States Gift (and Generation-Skipping Transfer) Tax Return”) whenever they make a taxable gift.¹⁰ In general, a taxable gift is any amount given to a single person in a year in excess of the gift tax annual exclusion (now $18,000).¹¹ Those tax returns are due on the same date that taxpayers file their income tax returns.¹²

However, if taxpayers are derelict in their gift tax return filing responsibilities, there is no penalty associated with their actions. That is because the failure-to-file penalty applies only if a tax is due and owing.¹³ Thus, no failure-to-file penalty is due unless the aggregate amount of gifts that a taxpayer has made exceeds the taxpayer’s lifetime exclusion amount (as previously pointed out, $13.61 million; for a widow or widower — because of the portability of the exemption — that may be as high as $27.22 million).¹⁴ The absence of any penalty applying is problematic insofar as it simultaneously erodes the estate and generation-skipping transfer tax bases, resulting in the corresponding “leakage” of tax revenue.

Think the situation is less dire than the above paragraph purports it to be? Reconsider the example in which the taxpayer’s grandson received $10 million. Suppose that the taxpayer (the grandmother) dies 20 years later and designates her daughter (the mother of the grandson) as executor of her estate. Consider two likely scenarios:

• Scenario 1: The daughter might be unaware of the earlier gift and thus fail to report it.

• Scenario 2: Given the amount of time that has elapsed, the daughter might selectively “forget” that the gift was ever made.

Regardless of which scenario is accurate, the outcome is the same: The daughter would not report the earlier $10 million gift on Form 706. Regarding the second scenario, suppose that the same facts unfolded but Friendly National Bank was instead named as executor; in that situation, there is little doubt that the financial institution would know nothing regarding the earlier gift made by the decedent to her grandson, and thus it would fail to report it on Form 706.

From a revenue perspective, the failure to report the grandmother’s gift is severe. To illustrate, assume that the grandmother’s estate passed entirely to her grandson. Assume further that at the time of the grandmother’s death, her estate was valued at $50 million, the then-lifetime exclusion amount and GSTT exemption amounts were each $20 million, and the estate tax and GSTT rates were both 40 percent.

Had the earlier gift been properly reported, there would have been $10 million remaining for the lifetime exclusion and GSTT exemption amounts ($20 million exemption - $10 million expended on the prior gift). The total transfer tax due and owing thus would have been $25.6 million, equal to (1) an estate tax of $16 million (0.4 * ($50 million - $10 million (remaining lifetime exemption))), plus (2) a GSTT of $9.6 million (0.4 * ($50 million - $10 million (remaining GSTT exemption) - $16 million (estate tax due and owing))).

Without the earlier gift being reported and the failure to report it on the grandmother’s estate tax return, the total transfer tax due and owing would instead be $19.2 million, equal to (1) an estate tax of $12 million (0.4 * ($50 million - $20 million (putative unused lifetime exemption))), plus (2) a GSTT of $7.2 million (0.4 * ($50 million - $20 million (putative unused GSTT exemption) - $12 million (estate tax due and owing))).

The $6.4 million of lost revenue ($25.6 million due had the taxpayer been forthright in her reporting practices versus the $19.2 million paid because of the taxpayer’s reporting derelictions) from the failure of the taxpayer to report a single gift signifies the nature of the problem and signals to Congress the need to take immediate action.

III. Magnitude of the Problem

Quantification of the tax gap insofar as the gift tax is concerned is an important step in discerning not only what resources should be allocated to address it but also whether legislative reforms are in order. To date, there appears to be no specific measure of the tax gap pertaining specifically to the gift tax. However, affiliated case studies and anecdotal evidence confirm that there is a significant problem; further, in the related estate tax realm, where studies have been conducted, revenue loss numbers demonstrate that a continued blind eye is not in the nation’s financial interest.

When the IRS has examined taxpayers’ forthrightness in reporting their taxable gifts, the results have been pitiful. In one case, for example, the IRS analyzed public real estate records and discovered that 60 to 90 percent of taxpayers who transferred a real estate title to a relative failed to file a gift tax return.¹⁵ In another case, a series of IRS gift tax audits revealed that “more than 80 percent of the 1,651 tax returns reporting gifts of $1 million or more . . . understated the value of the gift. . . . The average understatement was about $303,000 on which about $167,000 in additional gift taxes was due.”¹⁶

Deceit in the gift tax realm is apparently commonplace. Apart from the two case studies noted above, consider that a former president — Donald Trump — and his family have historically ignored their gift tax reporting and return filing obligations. Such practices were exposed in a comprehensive article prepared by three New York Times journalists. They chronicled how Trump’s parents transferred millions of dollars to Trump and his siblings and never reported for tax purposes a single dime of those transfers — and were never held accountable for their derelictions.¹⁷

The noncompliance phenomenon rages in the estate tax realm, as well. Several estate tax studies prepared by the academic community attest to that fact, with one study finding the voluntary compliance rate to be a paltry 23.4 percent (admittedly, another study placed the voluntary compliance rate at more than 90 percent, and yet another study placed it at less than 87 percent).¹⁸

The Treasury Department has conducted its own tax gap studies that report lackluster compliance in the estate tax realm, affirming the findings of those academic studies. For 2014-2016, Treasury found the voluntary compliance rate to be 79 percent; for 2011-2013, it was 82 percent; and for 2008-2010, it was 80 percent.¹⁹

Taken together, the IRS case studies, anecdotal evidence, and the majority of the studies produced by both academics and Treasury indicate significant tax revenue hemorrhaging out of the system, with no end in sight.

IV. Reasons for Filing Noncompliance

There is no single reason for the lackluster rate of gift tax return filing noncompliance, which has exacerbated the tax gap. To the contrary, there are many reasons, including:

• the absence of third-party tax information reporting;

• the absence of meaningful penalties;

• difficulties associated with detection;

• difficulties associated with recordkeeping;

• the complexity of the transfer tax system; and

• taxpayers’ mindsets.

Consider how those contribute to the problem.

A. Absence of Third-Party Reporting

It is well known that third-party tax information reporting bolsters tax compliance.²⁰ When tax information reporting exists (for example, forms W-2 and 1099), tax compliance flourishes; conversely, when tax information reporting is absent, tax compliance lags.²¹

In the gift tax realm, there is no third-party tax information reporting. Taxpayers who make gifts receive no independent paperwork regarding their gratuitous transfers, and the recipients of taxpayers’ largesse have no reporting obligations, either. From the government’s vantage point, it is completely in the dark; indeed, in terms of tax compliance, there’s a whole lot of finger crossing regarding whether taxpayers will be forthcoming in their tax reporting practices.²²

B. Absence of a Meaningful Tax Penalty Regime

While many taxpayers are tax compliant because they are civic-minded and compliance norms are pervasive,²³ many other taxpayers comply because they fear the risk of stiff penalty imposition. Academics refer to the former circumstance as evidence of the normative theory: Taxpayers act consistent with what they regard as ethical behavior. In contrast, academics refer to the latter circumstance as evidence of the deterrence theory: Taxpayers tend to weigh (1) the risk of audit exposure and the penalties associated with their derelictions against (2) the potential tax savings associated with a specific illicit tax strategy — and if the former outweighs the latter, they will gravitate toward being compliant.²⁴

The normative and deterrence models of tax compliance are not mutually exclusive. Some taxpayers are tax compliant for one reason, the other reason, or a combination of these two reasons. What is clear, however, is that in the absence of any fear of being penalized, more taxpayers will be inclined to be tax noncompliant.

The gift tax has no penalty associated with failing to report a taxable gift unless an actual gift tax is due. And, as noted, when most gifts are made, the taxpayer’s lifetime credit protects those transfers from an actual gift tax being due.²⁵ Thus, a major motivating force to bolster gift tax return filing compliance — deterrence — is absent, and taxpayers largely only have their own consciences to weigh on them if they are noncompliant. And, as is often the case, a taxpayer’s moral compass may prove insufficient to inspire tax compliance.

C. Hard-to-Detect Derelictions

In their tax shenanigans, taxpayers are known to be a cagey group. When it comes to gift giving, taxpayers are renowned for demonstrating their talents. Many foot the bill for expensive trips for their children and grandchildren, pay for their offspring’s graduate school room and board, and underwrite their loved ones’ debts — all under the fanciful notion that they are not making gifts but that these are necessary support payments.²⁶ As a practical reality, the IRS lacks the resources to investigate the nature of all those payments.

At least in the income tax realm, taxpayers who are not forthright in their reporting practices (for example, employers) must be concerned that someone knowledgeable about this information (for example, employees) and anxious to collect a whistleblower reward can report their derelictions to the IRS.²⁷ By contrast, when it comes to derelictions pertaining to the gift tax, there is apt to be no whistleblower activity because the donor and the donee are likely inclined to act collusively rather than being at odds.

D. Inability to Maintain Accurate Records

When it comes to recordkeeping, few taxpayers would receive accolades for their retention and organization abilities. To the contrary, taxpayers are notorious for losing their records, failing to maintain them, or placing them in compromising positions in which they are accidentally destroyed.²⁸

For income-tax-return-related information, the IRS, on its website, generally recommends that taxpayers maintain those records for at least three years.²⁹ However, insofar as the gift tax is concerned, since its application is based on aggregate transfers made during one’s life,³⁰ lifetime retention makes sense, yet for many taxpayers this requirement is either impractical or beyond their abilities to fulfill.

E. Complexity of the Tax System

As the IRS readily acknowledges, the tax gap is not solely attributable to noncompliant taxpayers being nefarious and using every conceivable mechanism to skirt their tax obligations; indeed, the reasons for noncompliance often include the law’s complexity and taxpayers’ inability to comprehend their filing and payment obligations.³¹

Thus, when it comes to the gift tax and its filing and payment obligations, taxpayers often find themselves befuddled. Some think that recipients are taxed on the fair market value of the assets that they receive, while others believe that there is no filing obligation unless an actual gift tax is due. Those are some of the misunderstandings that often lead taxpayers to throw up their hands in frustration and do nothing at all.

F. Taxpayers’ Mindsets

When taxpayers make gifts, a prevailing attitude is that those acts of generosity should be greeted with gratitude. The last thing many taxpayers expect is to be taxed on their generosity — the exact antithesis of the social approbation that they had anticipated. Thwarted expectations, coupled with anger, do not bode well for tax compliance, particularly among those who harbor resentment that their acts of kindness are not socially rewarded. Further, many politicians disparage transfer taxes with such vitriol that at least some of their constituents might consider it part of their civic duty to be noncompliant.³²

V. Reform Measures

In light of rampant taxpayer noncompliance in the gift tax realm, one might think that Congress would have already taken numerous measures to combat taxpayers’ derelictions. This, however, has not proven to be the case.

Nevertheless, as enumerated below, there are two simple measures that Congress could institute that would go a long way toward implementing meaningful reform:

• Reform 1: Require taxpayers who make annual gifts that, in the aggregate, exceed the gift tax annual exclusion (now $18,000) to check off a “yes/no” box on their Form 1040 indicating whether they have made such a transfer. The failure to accurately respond to this question could result in a penalty equal to 10 percent (or some other percentage that Congress decides on) of the amount of the taxable gift.

• Reform 2: Require any gift recipient who received cash or property the value of which, in the aggregate and from any one person during the calendar year, exceeded the gift tax annual exclusion to file Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.” The failure to submit this form would result in a penalty equal to 10 percent (or some other percentage that Congress decides on) of the amount of the taxable gift.

Instituting both reform measures would foster meaningful taxpayer compliance regarding the gift tax because, combined, both reforms would handily address the filing problems described above.

Consider how these two suggested reforms would achieve these objectives:

• Third-party information reporting: A taxpayer’s response on Form 1040 would signal the need for the taxpayer to file Form 709, and the IRS’s receipt of Form 3520 would function as a cross-check mechanism to ensure taxpayer compliance.

• Imposition of a meaningful penalty regime: No longer would a gift tax penalty be predicated on a tax being due and owing. Rather, the failure to properly report a sizable gift (that is, one in excess of the gift tax annual exclusion) would result in possible penalty imposition.

• Easier detection: Under the proposal, the simultaneous donor/donee reporting requirements would certainly help the IRS identify taxpayers who are less than forthright in their reporting practices. Indeed, depending on the circumstances, the parties’ combined failure to report a gift would add a potential conspiratorial criminal element to these dynamics, possibly causing participants to think twice about being noncompliant.

• Accurate recordkeeping: Assuming that many more taxpayers would now file their gift tax returns, they and their heirs could more readily trace their earlier gratuitous transfers.³³

• Simplification: Although the tax system itself would still have complexity, responding to a “yes/no” question on Form 1040 regarding their gift-giving activities should not prove difficult for taxpayers; and, by the same token, reporting the receipt of those gifts on Form 3520 should not prove too onerous.

• Taxpayers’ mindsets: Imposing this dual requirement on taxpayers would put them on annual notice that the code has a meaningful transfer tax system that places a premium on compliance.

Some commentators might argue that these dual reforms would create an administrative burden. However, as noted, it would not be particularly arduous for donors to respond to the Form 1040 query or for donees to complete a revised and revamped Form 3520. The IRS, of course, would need to process those returns. However, processing taxpayers’ Forms 1040 is already standard operating procedure; insofar as Forms 3520 are concerned, the IRS should anticipate the receipt of thousands more of them, but the work associated with processing them pales in comparison with the magnitude of other legislative initiatives (for example, the required paperwork submissions that Congress thrust on the IRS’s shoulders via its enactment of the Affordable Care Act).³⁴

VI. Conclusion

Insofar as metaphors are concerned, the transfer tax system is akin to a three-legged barstool: If any one leg is not functioning correctly, it is at significant risk of toppling over. The gift tax protects the integrity of both the estate tax and GSTT bases. If taxpayers are not gift tax compliant, it bodes ill for the efficient functioning of the estate tax and GSTT.

Today the gift tax realm is rife with noncompliance. Taxpayers routinely make taxable gifts and routinely fail to report them; their derelictions are met with impunity. Something must be done to address this problem.

The two reform measures that this analysis advances — a simple “yes/no” reporting requirement on the part of the donor, and another simple monetary amount/value reporting requirement on the part of the donee — are easily instituted and readily administered.

The exact amount of revenue that these two proposed reform measures together could yield is difficult to pinpoint with any assured accuracy. However, as the reforms would lead to a newly strengthened transfer tax base, it is not unreasonable to suppose that they would garner billions of dollars of additional revenue.

Whereas tax increases are often shunned as anathema, the suggested reform measures should be politically palatable to Democrats and Republicans alike — and any solution that has the potential to generate bipartisan appeal is a true gift, worthy of reporting.