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Preventing an IRS Audit of an Estate Tax Return
By
Professor Elaine Hightower Gagliardi (U. of Montana Law School)
Professor J. Martin Burke (same)
Professor Michael Friel (U. of Florida Law School)
All estate tax returns are mathematically verified, classified for audit potential, and checked that all required documents are attached. Selected returns are assigned by estate tax managers to estate tax auditors for audit. Certain estate characteristics, coined “audit triggers" by estate planners, increase the likelihood of managers and auditors selecting estate tax returns for examination. At least ten issues, ranging from simply dying rich to special use valuation for a farm or closely-held business, can trigger an estate tax audit.
An estate tax audit differs markedly from an income tax audit. One difference is that income tax returns are batched and run through a computer for audit selection, whereas estate tax returns are individually examined and assessed for audit potential by trained IRS employees. Another difference is that income tax audits are conducted by Tax Auditors (junior grade of examiner requiring only a college degree), whereas estate tax audits are conducted by Estate Tax Auditors (one of the highest grades of IRS examiners, requiring either a law degree or CPA).
1. Classification of Estate Tax Returns
All estate tax returns are filed with one of the regional service centers, determined by the decedent's domicile. At the service center, estate tax returns are initially screened for mathematical and clerical errors. If the estate tax return contains a computational error which resulted in an overpayment of estate taxes, the IRS will refund the excess. If the estate underpaid the taxes due to a miscalculation, the IRS will issue a summary assessment notice of the amount due. (See Chapter 72 for a discussion of taxpayer's rights upon being issued a summary assessment.)
After returns are verified for mathematical accuracy, estate tax returns are classified by experienced IRS employees called "classifiers" for "audit worthiness." A classifier is an IRS employee who has been exposed to many estate tax returns and has what the IRS deems a "sense" of which returns deserve further examination. In addition to this "sense," items which may increase the likelihood of an audit include:
(1) obvious errors on return;
(2) incomplete information or missing documentation;
(3) controversial valuations; and
(4) evidence that valuation of substantial assets was estimated.
If a return is not selected for examination, it will be sent to the service center Returns Files Unit and an “Estate Tax Closing Letter” will be issued. In the alternative, if a return is selected for audit, it will be forwarded to the district level for a further determination of "audit worthiness." Most audits are performed at one of the district offices, each of which accounts to a particular service center.
2. District Level Processing of Returns
Once a return is forwarded to the district level, a qualified IRS employee will preliminarily screen the estate tax return to determine if additional data or information will be needed before a final decision can be made to either accept or examine the return. This function is known as “perfection of the return” and is not considered part of an official "audit." Estate representatives can be contacted for purposes of perfecting the return without being advised that an audit is taking place. Nevertheless, this type of contact should indicate to the estate representative that the return is being processed at the district level.
After a return is preliminarily screened, returns are routed to the district estate tax manager who will make a second determination of overall "audit worthiness." If a return is deemed unworthy of an audit, the return is routed back to the service center and marked "survey before assignment" and an Estate Tax Closing Letter is issued. Returns that are deemed audit worthy are assigned to auditors who can also decide not to audit the return. If an auditor deems a return unworthy of audit, the return is closed out and marked "surveyed after assignment", and an Estate Tax Closing Letter is issued. However, auditors are unlikely to disagree often with both their estate tax manager and classifier, and it is likely that most estate returns which are assigned do, in fact, undergo audit.
Estate tax managers and auditors are instructed to only audit returns which contain at least one issue which is likely to result in a material change in tax liability. Therefore, when managers and auditors manually inspect an estate tax return for its "audit worthiness", they scrutinize the return for select estate characteristics which have the highest likelihood of resulting in a material change in tax liability. Estate tax planners have identified ten estate characteristics (below) which typically trigger an audit. Generally, "audit triggers" involve areas with the following characteristics: highly subjective valuations (vulnerable to IRS argument as to valuation method); strict requirements (vulnerable to noncompliance charges); and poor recordkeeping (vulnerable to lack of proof allegations).
3. "Top Ten" Audit Triggers
The ten key triggering factors in the opinion of a number of estate tax specialists are listed as the following:
a. Large Gross Estate. The most important predictor in triggering an estate tax audit is the size of the estate. As the size of the gross estate increases, fewer returns are filed but a larger percentage of returns are audited.
b. Substantial Real Estate Holdings. Substantial real estate holdings displayed on Schedules A, E, F, G or H may increase the chance of an audit. Because real estate is usually the major asset in an estate and a unique asset; valuation methods utilized by the estate are closely scrutinized by the IRS and vulnerable to change. The IRS has issued rulings containing guidelines on valuing real estate (see Chapter 56), but these guidelines are only broad ranges to work within. The larger the real property amount, the better the chances for adjustment on audit, especially for industrial, commercial or agricultural real estate.
c. Closely-Held Stock. A closely-held business is difficult to value and distribute fairly among heirs. Estate planners spend a lot of time advising clients, from a non-tax perspective, about leaving voting stock to heirs who will run the business, nonvoting "income" stock to surviving spouses and heirs not involved in the business, and allocating other assets. Since there is no precise way to value closely-held stock, controversy often arises over corporate intangible assets such as: goodwill, the value of the decedent to the business, customer lists, other forms of intellectual property (patents, trademarks, copyrights), and the business' short and long-term future prospects. Therefore, proposed adjustments on Schedule B for closely-held stock are very probable, and estate tax auditors are aware that this is a natural area for their attention. For a detailed discussion of valuing closely-held stock, see Chapter 43.
d. Life Insurance Excluded from Estate. Life insurance on the decedent's life is not includable in the estate unless the proceeds are payable to the estate or the decedent held "incidents of ownership" in the policy. Form 706, General Information Section, Question 8A specifically asks the estate representative if there was any insurance on the decedent's life that is not included on the return as part of the gross estate. Estate tax auditors specifically reference the affirmative answer of this question and all required Forms 712 (Life Insurance Statements) to investigate whether the decedent had an incident of ownership in any life insurance policies. Incidents of ownership – e.g., right of insured or estate to its economic benefits, power to change the beneficiary, power to surrender or cancel the policy, power to assign the policy or to revoke an assignment, power to pledge the policy for a loan, power to obtain from the insurer a loan against the surrender value of the policy, or a reversionary interest – include many tenuous rights and powers. Decedents may have thought that they had disposed of their entire interest, but because of the above incidents of ownership, they may be held to own the policy. Auditors are instructed to scrutinize insurance forms for such ineffective transfers of insurance.
e. Jointly-Held Property. Current tax law presumes that the first non-spousal co-owner to die supplied all the consideration necessary for jointly-held property; therefore, the full fair market value of the property must be included in the decedent's estate, unless the estate can establish the value of consideration furnished by other joint tenants. Because it is difficult for many estates to affirmatively establish joint tenants' contributions due to poor recordkeeping, commingling of funds and other reasons, this is a natural area for the IRS to make an adjustment. For a detailed discussion of jointly-held property, see Chapter 7.
f. Miscellaneous Personal Property. Sole proprietorships are often as difficult to value as closely-held corporations and are viewed as prime areas for possible adjustment. In addition, estate tax auditors are concerned with missing items generally presumed to be owned by a decedent based on his or her occupation or status. (For example, if the decedent was a dentist who owned his own practice, the standard dental office equipment could be worth a small fortune.) Auditors are instructed to scrutinize Schedule F for missing items and for devalued items.
g. Transfers Within Three Years of Death. Gifts made within three years of death will generally not be included in the decedent's gross estate with an exception for life insurance, transfers with a retained life estate, transfers taking effect at death and revocable transfers (see Chapter 5).
h. The Marital Deduction. So many estates claim this deduction that it is the most important mechanism by which an estate's tax bill is reduced. Therefore, the IRS strictly scrutinizes the estate tax return and ancillary documents to see whether the property qualifies for the marital deduction. The rules for qualification with respect to both the form of disposition and the language used must be precisely met. A mistake in drafting could subject the estate to substantial estate tax liability. For a detailed discussion of the marital deduction, see Chapter 13.
i. Alternate Valuation. When an estate elects to value all property six months after the date of death, the "alternate" date, it is usually because the value of securities has decreased and the estate wants to decrease the estate tax burden. The auditor wants to assure that the strict requirements for alternate valuation have been satisfied.
j. Special Use Valuation. Family farms and other types of business real property can be valued at below the fair market value as long as the property continues to be used by family members for the same purpose after the decedent's death. Since the value of the property is made artificially low, auditors make sure that the requirements for the special treatment have been met. See Chapter 20 for further discussion of special use valuation.