Taxes

hidden-details-in-financial-statement-footnotes

Getting to the Bottom of Hidden Details in Financial Statement Footnotes
Getting to the Bottom of Hidden Details in Financial Statement Footnotes 1600 941 smolinlupinco

You only get part of the big picture if you only look at the numbers. Reading comprehensive footnote disclosures gives valuable insight into your company’s operations. These disclosures are located at the bottom of financial statements that have been reviewed and audited.

Key details often get overlooked because most individuals just scan these notes instead of thoroughly reading them. Curious about what risk factors you may find within these disclosures? Below are just a few examples to look out for in your statements.  

Transactions between related parties

There are occasions when companies give or receive preferential treatment to or from related parties. This arrangement should be disclosed in the footnotes because of the potential risk associated with these relationships. 

A great example is if a bookstore rents retail space from the owner’s brother at a rate well below market pricing. This price break saves the store approximately $95,000 in rent annually. However, the bookstore isn’t disclosing the existence of this favorable party-related deal, which inflates its appearance as a profitable shop on its financial statements. 

One day, the brother sells his share of the building to a commercial investor, who then increases the rent to a more reasonable market rate. This sudden increase could put the bookstore into financial uncertainty. Its stakeholders, who had no idea of the previous party-related arrangement, are now blindsided and could face substantial losses.  

Changes in accounting rules and procedures

Financial statement footnotes also disclose changes to accounting principles and justification for these modifications. You will also find out what effect these adjustments had on the statements above. Keep in mind that a manager may be dishonest and use these changes to manipulate the reported results. This could occur when reporting depreciation, for example. However, there are legitimate reasons for changing accounting methods, such as when regulators impose modifications. 

Liabilities that are contingent and unreported

Disclosure footnotes often share details regarding specific risks that could impact a company’s finances but are not reflected on a balance sheet. Examples of such liabilities include:

  • IRS audits
  • Lawsuits
  • Environmental claims

You can also learn about a company’s loan agreement details, leases, contingent liabilities, and warranties within a financial statement’s footnotes.

Events with long-term impacts

Stakeholders want to be fully informed of any business struggles ahead, such as new regulatory requirements taking effect in the coming year or a company losing a major client. Disclosure footnotes share these significant event details when there’s a likely material impact on business value or future earnings. 

Always strive for transparency

Today’s marketplace is filled with uncertainty, causing stakeholders like investors and lenders to demand more supporting documentation and disclosures to answer their questions. They want to make informed decisions, so it’s vital to work with experienced accountants to draft clear and concise footnotes and answer stakeholders’ concerns. 

You can also work with our team to review your concerns regarding disclosures made by possible merger and acquisition targets or your publicly-traded competitors. 

© 2022

prepare-for-1099-k-filing-threshold-decrease

Businesses Must Prepare for the 1099-K Filing Threshold Decrease in 2022
Businesses Must Prepare for the 1099-K Filing Threshold Decrease in 2022 1600 941 smolinlupinco

When issuing reporting forms for 2022, businesses may be submitting additional worker information due to recent reporting range changes. At the start of this year, the income threshold for filing Form 1099-K (Payment Card and Third-Party Network Transactions) was significantly decreased, increasing the likelihood that larger numbers of businesses and workers may receive this document, including those who conduct personal transactions.

The history behind the change

The IRS requires banks and online payment networks like PSEs (payment settlement entities) and TPSOs (third-party settlement organizations) to report payments related to business or trade. Form 1099-K acts as the vehicle for this reporting requirement and typically affects companies like Paypal, CashApp, and Venmo, along with gig economy businesses like DoorDash and Uber.

In 2021, The American Rescue Plan Act reduced this reporting requirement minimum from $20,000 of reportable payments made over 200 transactions or more to just $600. While this amount is akin to other 1099 forms, this will be the first time gig economy workers receive these forms and will give the IRS a more accurate view of the revenue within these market spaces.  

Despite the change already being signed into law, some congressional members have attempted to pass bills that would restore the previous minimum threshold of $20,000 and 200 transactions. However, there are no guarantees of passage.

According to Congress and the IRS, underreporting these earnings has been an issue for some time. Part of the problem could be that taxpayers aren’t aware that these additional sources of income from working as a Lyft driver or Etsy seller are taxable in the first place.   

While many taxpayers will likely be unaware of these changes until they receive their Forms 1099-K in early January of 2023, businesses should prepare now to minimize their tax liabilities regarding reportable payments. 

Next steps you can take now

Any reportable activities, including gig work, should be reviewed by taxpayers. Ensure any payments received are accurately documented. Any payments resulting from business or trade must be accurately reported to ensure employees can adequately withhold and pay any owed taxes. 

If you earn income through activities related to the gig economy or receive payments through a company like Paypal, consider increasing your tax withholding. You might also consider making additional or estimated tax payments to avoid potential tax penalties.  

Keep personal payments separate and record deductions

It is essential that taxpayers who receive taxable gross receipts through a PSE record their income and personal expenses separately. For example, suppose you send someone an electronic gift card using money from a PayPal account that also receives payments from your Etsy business. PSEs can’t tell the difference between personal transactions and those related to your business, so it’s best to maintain different accounts for each of these purposes.  

Remember, taxpayers who haven’t previously reported all of their gig work income likely didn’t track their deductions either. Now is the time to begin this process so one can minimize the amount of taxable income the IRS recognizes because of the gross receipts amount reported on Form 1099-K. It’s not uncommon for the agency to treat all reported gross receipts as income and require substantiation of all deductions a taxpayer claims. The deductions you can take will vary depending on the type of work you perform.

© 2022

corporate-estimated-tax-how-to-calculate-it

Corporate Estimated Tax: How to Calculate It
Corporate Estimated Tax: How to Calculate It 1600 941 smolinlupinco

June 15th is the next deadline to make quarterly tax payments. If you’re a business or individual who must pay, now is an excellent time to review the way corporate federal estimated payment calculations work. Your goal is to minimize your business’s estimated tax liability without getting dinged with an underpayment penalty. 

Four ways to calculate

To avoid an estimated tax penalty, corporations must pay an installment based on the lowest amount calculated by one of the below four methods: 

Preceding year method

Corporations can circumvent underpayment penalties on owed estimated tax by paying 25% of their preceding year’s tax according to the four payment due dates on their return. In 2022, some corporations are limited to only using this method for calculating their first payments if their taxable income was $1 million or more in any of the previous tax years. Also, if your corporation’s previous tax return covered less than twelve months or you filed a return that didn’t have any tax liability, you won’t be eligible to use this method. 

Current year method

Your corporation can pay 25% of the current year’s tax to avoid an estimated tax underpayment penalty. Just make sure to make these payments according to the installment schedule on your return. For example, if you didn’t file a return at all, you’ll pay 25% of this year’s tax. The installment due dates typically fall on the 15th of April, June, and September of the current year and January 15th of the next. 

Seasonal income method

Corporations with taxable income that follows recurring seasonal patterns can annualize their income by assuming earnings for the current year will follow the same pattern as previous years. A mathematical formulation is used to test a corporation’s eligibility for this method by establishing their seasonally patterned income. If you believe your company qualifies to use this method, you’ll want to ask for qualified assistance to ensure that it does.

Annualized income method

When using the annualized tax method, quarterly installments are made based on the computation of taxable income for the months in the tax year ending before the installment is due. This is achieved by assuming that any earnings received will be at the same rate throughout the year. 

Additionally, corporations aren’t limited to one method for the entire tax year and can switch among the four as needed. 

If you have questions about how your estimated tax bill can be reduced, contact us to set up a review of your corporate tax situation. 

© 2022

partners-may-need-to-report-more-income-tax-return

Partners: You May Need to Report More Income on Your Tax Return Than You Received in Cash
Partners: You May Need to Report More Income on Your Tax Return Than You Received in Cash 1600 941 smolinlupinco

If you’re a business partner, you may find yourself confused during tax season. In any given year that you receive a distribution of your partnership income, you could be taxed for more than you actually received.

How is this possible? It’s because of how U.S. taxation is set up to tax partners and their partnerships. Because these entities are subject to income tax like C-corps, you get taxed on your partnership’s earnings whether distributed or not. In situations where losses are suffered, that too is passed on to you, even though you may be unable to use your share of this loss to offset other income.

Passing through your share to partners

Partnerships aren’t subject to income tax, but the IRS treats them as a separate entity for the purposes of income and gains, deductions, losses, and credits. Because of this, partners can pass through their share of these items. 

Filing an information return

Your partnership will submit a Schedule K of Form 1065 to separately identify important tax items, such as income, credits, deductions, etc. This is done so that you and other partners can apply any tax reporting rules or limitations to these items based on your role within the entity. These items may include interest expense on investment debts, any charitable contributions made, and capital gains and losses.

Options for avoiding double taxation

There are basis and distribution rules in place to help you avoid getting taxed twice. Your initial basis in your partnership, which depends upon how your interest was acquired, is increased by your share of taxable income from your partnership. 

If your share’s income gets paid in cash, you won’t owe tax on that cash if you have sufficient basis. Under this circumstance, you can simply reduce your basis by the amount of that distribution. However, if the opposite occurs and the cash amount exceeds your basis, then you have to pay a capital gains tax on that excess.

Example 

Two partners contribute $15,000 to create a partnership. In the first year, their partnership has $90,000 in taxable income and no cash distribution gets made to these partners. Each reports $45,000 of taxable income which is on their K-1 documentation from the partnership. Remember, they each had a starting basis of $15,000 but this increases by $45,000 to create a new basis amount of $60,000. In year two, they had no taxable income because their partnership broke even. As a result, when their $45,000 each gets distributed, it will be tax-free. However, they now must reduce their basis in their partnership from $60,000 to $15,000 to avoid taxation on the excess. 

Additional rules and limits to consider

The above overview is just a basic example of why partners may pay more taxes on distributed shares of their partnerships than actually received. Keep in mind there are still other rules that could impact your tax situation, such as additional special rules that govern non-cash distributions to partners, securities distributions, and those stemming from liquidations. There are also specific events that may also require basis adjustments of your share as a partner. 

To better understand how your partnership distributions could affect your tax return, contact us directly to learn more. 

© 2022

effects-of-inflation-on-financial-statements

The Effects of Inflation on Your Financial Statements
The Effects of Inflation on Your Financial Statements 1600 941 smolinlupinco

The continuing trend of rising inflation has investors and business owners on high alert. The U.S. The Bureau of Labor Statistics has also tracked the steady rise in consumer pricing, which has seen an 8.3% increase over the last year. Its findings are based on the Consumer Price Index (CPI), which measures changes in cost for items the public relies on for daily living needs, such as fuels, clothing, food, medical services, home costs, and more. This latest calculation is just slightly less than the previous 12-month increase of 8.5%, a number that topped the highest increase ever recorded back in December of 1981.

The producer price index (PPI) has also risen 11% over the past 12 months, furthering anxiety for consumers and financial experts. This is still a lower figure than the previous 11.2% increase for the last measured period in March, another record-breaking rise for wholesale inflation. PPI measures inflation rates before consumers feel the pinch in their wallets. 

Primary impacts

If you’re a business owner, inflation could directly affect costs and hurt consumer demand for goods and services deemed discretionary. You might experience decreases in profits unless you can pass these losses to your customers through strategic pricing models. Still, it’s not just your gross margins you need to worry about. Below are seven additional areas of concern from today’s inflationary trends that could impact your financial statements.  

1. Goodwill. Companies using GAAP to estimate the fair value of acquired goodwill should use valuation techniques that remain consistent from period to period. However, one should also recognize that as inflation increases, revisions to these assumptions may be necessary to maintain accurate estimations. For example, it’s common practice during inflationary periods for market participants to use higher discount rates. They might also anticipate revised cash flows due to rising costs, modifications to product pricing, and changing consumer behaviors in this market climate. 

2. Debts. As the Federal Reserve attempts to control inflation by raising interest rates, companies with variable-rate loans could see their interest costs rise as well. As of May, the Fed imposed a 0.5% increase in its target federal funds rate and might increase this rate again throughout the remainder of 2022.

If you’re one of the businesses affected by this increase, it might be wise to convert your variable-rate loans to fixed loans or seek approval for additional credit to secure a fixed-rate loan before any future increases by the Fed. Companies in this predicament could also explore restructuring their debt. Depending on the approach used, you may be able to report it as one of the following under the U.S. Generally Accepted Accounting Principles (GAAP):

  • Extinguishment of debt 
  • Modification
  • Troubled debt restructuring

3. Inventory. GAAP measures inventory at the lower of either net realizable value or cost and market value. There are several methods businesses rely on to determine their inventory cost:

  • Average cost
  • First-in, First-out (FIFO)
  • Last-in, First-out (LIFO)

Your profits and ending inventory valuation are directly impacted by your chosen method. Additionally, you might also experience a trickle-down effect on your tax liability.  

4. Investments. It’s well known that one source of volatility in public markets is inflation. Realized or unrealized gains and losses can occur when your company’s investments undergo market value changes–directly affecting any liabilities and deferred tax assets under GAAP. 

Companies may opt to modify their investment strategy out of concern for this inflationary impact, though doing so could potentially demand disclosures of the changes in financial statement footnotes. New accounting methods may even be necessary when taking this approach. 

5. Overhead costs. Escalation clauses related to CPI or other measures for addressing inflation could be in your long-term lease, thus increasing rent overheads. The same is possible for vendor contracts and contracts with other service providers.

6. Foreign currency. Foreign exchange rates aren’t impervious to inflation. When exchange rates fluctuate, businesses that accept, bank, and/or convert these currencies will adapt to ensure the rates used are appropriate for that point in time. 

7. Going concern disclosures. Business management must determine if there is substantial doubt about their company continuing as a going concern. Every reporting period, evaluations take place to review a company’s ability to meet its obligations within the 12-month period after its financial statement issuance. 

Skyrocketing inflation frequently devastates unprepared businesses. Without adequate countermeasures to inflationary effects, doubt arises about the company’s long-term viability.

We’re here to help

Inflation can have widespread impacts on a company’s financial statements. Reach out to us for assistance in anticipating the possible effects on your business’s financials and developing lasting solutions to mitigate these risks. 

© 2022

tax-issues-changing-to-s-corporation-from-c-corporation

Tax Issues Caused By Changing to an S-Corporation from a C-Corporation
Tax Issues Caused By Changing to an S-Corporation from a C-Corporation 1600 941 smolinlupinco

For some small businesses, switching to an S-corporation entity structure from a C-Corp can reduce federal employment taxes. Despite the financial savings your company can enjoy while operating under this new classification, there are some additional taxation liabilities to keep in mind before making this change. 

To better understand how your business could be impacted by converting to an S Corp formation, check out this quick overview of the issues you might face: 

Passive Income 

S-corporations may be liable for tax related to any passive income that exceeds a 25% threshold of their gross receipts and revenue and profits carried over from their former C-Corp status. This classification includes income such as:

  • Dividends
  • Royalties
  • Profitable stock sales

You could lose your S-Corporation classification if your company owes this tax for three consecutive years or more. This scenario is avoidable by distributing profits and earnings your business accumulated and letting shareholders pay their share of the owed taxes. If this isn’t an option, you may consider avoiding this tax by capping how much passive income can be earned. 

Tax Loss Carry Forwards

Suppose your C-Corp had experienced operating losses before switching and didn’t apply it to reduce taxable income. In that case, it can’t then be applied to your S-Corp as an offset to its income or get passed along to your shareholders. This is why you should first determine whether it’s worth forfeiting these tax savings for those you’ll enjoy as a company with an S status. 

LIFO Inventories 

If your C-Corp uses the LIFO inventory method, plan on paying taxes on that benefit if you convert to an S-Corp. While you can spread this cost over a four-year period, carefully consider if the possible gains you will receive as an S status are worth this additional expense. 

Built-in Gains Tax

When converting to a C-Corporation from an S, you will have to pay a built-in federal gains tax on your appreciated assets and profits for this changeover. This applies if you have recognized gains within the first five years of becoming an S-Corporation. While this may not be ideal, if your decision to switch will ultimately have improved tax benefits despite this taxation, you may opt to continue with your plans.

These potential factors that could impact your decision to change your corporation status from C to S are the most common, but not the only ones you should consider. You also have to keep in mind that any shareholder-employees you have under an S-Corp structure won’t have the same tax-free benefits as before, and those who have outstanding loans could complicate things further. 

There are several options companies have at their disposal to mitigate or completely eliminate some of the tax issues mentioned above. Avoiding some of the unnecessary pitfalls related to these solutions is also important and doable with the right planning. Ultimately, much depends on how you run your company and any special circumstances that might be at play. Contact us to discuss the effect of these and other potential problems, along with possible strategies for dealing with them.

important-2022-q2-tax-deadlines-for-businesses-and-employers

Important 2022 Q2 Tax Deadlines for Businesses and Employers
Important 2022 Q2 Tax Deadlines for Businesses and Employers 1600 941 smolinlupinco

Businesses and other employers should take note of these key tax-related deadlines for the second quarter of 2022. 

April 18

  • Calendar-year corporations must use Form 1120 file a 2021 income tax return or use Form 7004 to file for an automatic six-month extension. Any tax due must be paid.
  • Corporations must pay the first installment of their estimated 2022 income taxes.
  • Individuals must use Form 1040 or Form 1040-SR to file their 2021 income tax return or use Form 4868 to file for an automatic six-month extension.
  • Individuals who don’t pay income tax through withholding must use Form 1040-ES to calculate and pay the first installment of their 2022 estimated taxes.

May 2

  • Employers must use Form 941 to report income tax withholding and FICA taxes for the first quarter of 2022. Any tax due must be paid.

May 10

  • If you deposited on time and fully paid all of the associated taxes due, employers must use Form 941 to report income tax withholding and FICA taxes for the first quarter of 2022.

June 15 

  • Corporations must pay the second installment of their 2022 estimated income taxes.

This list isn’t all-inclusive, and it’s worth keeping in mind that there may be other additional deadlines that apply to you. To learn more about filing requirements and ensure that you’re meeting all applicable tax deadlines, contact us.

© 2022

tax-deadline-april-18th-file-for-extension

The Tax Deadline Is April 18th: If You Aren’t Ready, File for an Extension
The Tax Deadline Is April 18th: If You Aren’t Ready, File for an Extension 1600 941 smolinlupinco

This year’s tax filing deadline is rapidly approaching—if you don’t have time to gather your tax information and file by April 18th, you can use Form 4868 to file for an extension.

An extension allows you to avoid incurring “failure-to-file” penalties and will give you until October 17 to file. However, you’re still required to pay your taxes by April 18th. If you haven’t paid whatever tax you estimate is owed by that date, you’ll incur steep penalties.

Tax deadline penalties: Failure to pay vs. failure to file

Failing to pay and failing to file incur separate penalties. 

For each month (or part of a month) your payment is late, the failure-to-pay penalty is 0.5%. For example, if payment is due on April 18 and you pay on June 25, the penalty is 1.5% (0.5% times 3 months or partial months). The maximum failure-to-pay penalty is 25%.

The failure-to-pay penalty is calculated based on the amount that is shown as due on your return (less credits for amounts paid via estimated payments or withholding), even if your actual tax bill is higher. However, if your actual tax bill turns out to be lower, the penalty will be based on the lower amount.

By contrast, the failure-to-file penalty runs at a higher rate of 5% for each month (or partial month) you fail to file after the deadline. The maximum failure-to-file penalty is 25%. As mentioned above, filing an extension on Form 4868 doesn’t exempt you from failure-to-pay penalties—however, it will prevent you from filing late unless you also miss the extended due date. 

If both the failure-to-file penalty and the 0.5% failure-to-pay penalty apply, the failure-to-file penalty drops to 4.5% per month (or part of a month), so the combined penalty will be 5%. For the first five months, the maximum combined penalty is 25%. After those five months, the failure-to-pay penalty can continue at 0.5% per month for an additional 45 months—an additional total of 22.5%. The combined penalties can thus reach a maximum total of 47.5%.

Another reason the failure-to-file penalty is more severe is that it’s based on the amount you’re required to show on your return, rather than the amount shown as due. (Credit is given for amounts paid via withholding or estimated payments.) 

For example, if your return is filed five months after the due date showing $5,000 owed (after payment credits), the combined penalties will be 25%, which equals $1,250. But if your actual liability is determined to be an additional $1,000, the failure-to-file penalty will also apply to this amount for an additional $225 in penalties (4.5% × 5 = 22.5%).  If no amount is owed, there’s no penalty for late filing.

If a return is filed more than 60 days late, there’s also a minimum failure-to-file penalty. For returns due through 2022, this minimum penalty is the lesser of $435 or the amount of tax required to be shown on the return.

Additional considerations

If returns are filed late due to “reasonable cause” such as death or serious illness in the immediate family, both penalties may be excused by the IRS.

Apart from and in addition to the above penalties, interest is assessed at a fluctuating rate announced by the government. The late filing penalty can also jump to 15% per month in especially abusive situations involving a fraudulent failure to file, with a 75% maximum.

If you have further questions about filing for an extension or possible IRS penalties, contact us.

© 2022

using-crummey-trusts-take-advantage-annual-gift-tax-exclusion

Using Crummey Trusts to Take Advantage of the Annual Gift Tax Exclusion
Using Crummey Trusts to Take Advantage of the Annual Gift Tax Exclusion 1600 941 smolinlupinco

For 2022, the unified gift and estate tax exemption is set at $12.06 million, adjusted for inflation, up from $11.7 million for 2021. For many families, this means estate tax liability won’t be a concern. However, others may still benefit from using the annual gift tax exclusion as an estate planning strategy, especially since future tax law changes may lower the gift and estate tax exemption. 

For this reason, a Crummey trust can still serve as an important part of your estate planning strategy.

Limitations on the annual gift tax exclusion

For 2022, the annual gift tax exclusion allows you to give gifts valued up to $16,000 per recipient without incurring any gift tax. This $16,000 amount is indexed for inflation, but only in $1,000 increments.

For instance, this means that if you have four adult children and six grandchildren, you can gift each of them $16,000 this year (for a total of $160,000) without paying any gift tax. Since this exclusion is per donor, the amount is doubled for married couples.

However, when giving outright gifts, there is always the risk that the money or property could be wasted, especially if you’re giving to a recipient who may be young or irresponsible. 

As an alternative, you can transfer assets to a trust that names your child (or another recipient) as a beneficiary. This setup allows your designated trustee to manage the assets until the recipient reaches a specified age.

But this strategy comes with a catch, because gifts must be a transfer of a “present interest” to qualify for the annual exclusion. In this context, a “present interest” means the recipient has an unrestricted right to the immediate use, possession, or enjoyment of the income or property included in the gift. 

Because of this, a gift made to a trust won’t qualify as a gift of a present interest unless certain provisions are made in the trust language. Instead, it will be considered a gift of a “future interest” and won’t be eligible for the annual gift tax exclusion.

How a Crummey trust can help

A Crummey trust can offer a solution here. Crummey trusts satisfy the rules for gifts of a present interest but don’t require the trustee to distribute the assets to the beneficiary.

In a Crummey trust, periodic contributions of assets can be coordinated with an immediate power that gives the beneficiary the right to withdraw the contribution for a limited time. The expectation of the donor, however, is that the power won’t be exercised. (This cannot be expressly provided for in the trust document.)

These gifts will not be treated as a gift of a present interest due to the beneficiary’s limited withdrawal right, allowing gifts to the trust to qualify for the annual gift tax exclusion. Note that the tax outcome is determined by the existence of the legal power and not the exercise of it.

Additional requirements

To ensure your Crummey trust will hold up under IRS scrutiny, you must give the beneficiary actual notice of the withdrawal right, as well as a reasonable period (typically at least 30 days) to exercise it. 

If you have further questions regarding the use of a Crummey trust, contact us.

© 2022

Defined-Value Gifts Avoid Gift Taxes

How to Use Defined-Value Gifts to Avoid Unexpected Gift Taxes
How to Use Defined-Value Gifts to Avoid Unexpected Gift Taxes 850 500 smolinlupinco

For 2022, U.S. taxpayers may transfer up to $12.06 million by gift or bequest without triggering federal transfer taxes, thanks to the highest gift and estate tax exemption in history. 

However, this historically high exemption may not last forever. Unless Congress chooses to pass further legislation, the exemption amount is currently scheduled to drop to $5 million, adjusted for inflation, in 2026. 

If you’re like many taxpayers, you may be thinking about making a substantial gift to take advantage of the current exemption before it expires. However, many commonly gifted assets like family limited partnerships (FLPs) and closely held businesses can be risky because they are difficult to value. 

To avoid unexpected tax liabilities, you may want to consider a defined-value gift.

Defined-value gifts

To put it simply, a defined-value gift consists of assets that are valued at a specific dollar amount (as opposed to a specified percentage of a business entity, FLP units, or a certain number of stock shares).

Properly structured defined-value gifts are useful because they don’t run the risk of triggering an assessment of gift taxes. In order to properly implement this strategy, the defined-value language in the transfer document must be drafted as a “formula” clause and not as a “savings” clause.

While a savings clause provides for a portion of the gift to be returned to the donor if it is ultimately found to be taxable, a formula clause will transfer a fixed dollar amount that is subject to adjustment in the number of units or shares necessary to equal that dollar amount. This adjustment will be based on the final value determined for those units or shares for federal gift and estate tax purposes.

Using the right language

It’s vitally important to use certain specific, precise language in the transfer documents for defined-value gifts. Otherwise, the gift may be rejected as a defined-value gift by the U.S. Tax Court. 

Take, for example, a recent court case involving an intended defined-value gift of FLP interests. In this case, the Tax court decided to uphold the IRS’s assessment of gift taxes based on percentage interests, despite the donor’s intent to structure the gift as defined-value. 

The Court’s reasoning? The transfer documents had called for the FLP interests to be transferred with a defined fair market value “as determined by a qualified appraiser.” However, the documents made no provision to adjust the number of FLP units if their value was “finally determined for federal gift tax purposes to exceed the amount described.” 

As a result, the court ruled that a defined-value gift had not been achieved.

We can help you make a defined-value gift

As you can see, an effective defined-value gift requires carefully and precisely worded transfer documents. If you plan to make a substantial gift of hard-to-value assets, contact us for assistance. We can work with you to help you avoid unexpected tax consequences from your gift.

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