Audits of Estate Tax Returns and Protecting the Fiduciary Client Presented to the Estate and Financial Planning Council of Central New Jersey Frank Agostino, Esq. Lawrence A. Sannicandro, Esq. April 20, 2017 1 Overview I. Introduction and Overview II. Preparing the Estate Tax Return III. Examination of Estate Tax Returns IV. Strategies to Limit the Liability of Fiduciaries and Transferees V. Gifts and Bequests from Non-U.S. Donors and Decedents 2
Introduction and Overview 3 Introduction and Overview a. Unlike other returns, which are subject to a “lottery”, ALL estate tax returns will be individually reviewed to determine audit potential and identify the key issues for any examination. b. Estate and Gift Tax Auditors return more tax dollars per capita than any other subdivision of tax. Therefore, audits in estate and gift are emphasized. 4
Introduction and Overview c. Estate and Gift Tax Auditors are specially trained in estate and gift tax matters. d. Estate tax audits – require a special strategy e. Timing: Estate tax return audits are usually initiated within nine months of the filing of the return. f. Timeline: Absent special circumstances (i.e., someone filing a reward application two years after the estate tax return is filed), estate tax audits are usually concluded no later than 18 months after filing. 5 Introduction and Overview g. Characters in the cast: i. Personal representative, executor, or administrator; ii. Estate and gift tax auditor; iii. Office of Appeals (independent of exam; helps resolve issues w/o litigation); iv. Criminal Investigation (CI) (the law-enforcement division of the IRS); v. Taxpayer Advocate Service (independent of exam; helps ensure rights are understood and respected); and iii. Chief Counsel and Division Counsel (attorneys who provide technical guidance and litigate cases, respectively). 6
Prepare Estate Tax Returns With the Audit in Mind 7 Prepare the Estate Tax Return With the Audit in Sight • Anticipate Your Audience at the Outset – “Begin with the end in sight.” • Practice Tip 1: Use reputable appraisal firms • Practice Tip 2: Ensure adequate documentation for the audit by attaching required documents to the return and storing necessary information in a safe place. • Practice Tip 3: Assume all relevant evidence will be reviewed by the auditor and a judge 8
Prepare the Estate Tax Return With the Audit in Sight • Practice Tip 4: Know what the IRS knows: – Request account transcripts – account, W&I, gift, and related entity – Order past gift tax returns from the IRS (Form 4506) – Copy of predeceased spouse’s estate tax return (Form 4506) – Last three years of income tax returns and bank statements – Make requests under the Freedom of Information Act (“FOIA”) – Westlaw searches (i.e., adverse judgment search to determine liabilities and liabilities) – Accurint (for information on businesses, real estate, etc. – Transunion TLOxp (“TLO”) (for information on credit, bankruptcies, foreclosures, liens, judgments, assets, professional licenses, etc.) – Google searches 9 Prepare the Estate Tax Return With the Audit in Sight • Practice Tip 5: Perfect the return by including: – Certified copy of Will; – Certified copy of death certificate; – Forms 712, Life Insurance Statement; – Copy of trust instruments; – Copy of power of appointment instruments; – Appraisals on real estate; – Appraisals on art (required for art objects with a value greater than $3,000); – Financial data on non-public entities; – Copies of Forms 709, United States Gift (and Generation-Skipping Transfer Tax Return – Last full year’s Federal income tax return in some States • (e.g., New Jersey) 10
Prepare the Estate Tax Return With the Audit in Sight • Practice Tip 6: Anticipate common audit issues: – Adjusted taxable gifts and gift tax paid; – Real estate (fractional interest, arm’s-length sale); – Accrued interest and dividends included; – Are you properly reporting assets transferred to a revocable trust; – Closely held businesses (sales price in formational documents, reasonable and appropriate discounts, reliable appraisal); – Life insurance (ILITs, Form 712); – Fractional interest discounts; – FLPs (indirect gift, section 2036 issues, reasonableness of discounts); – Powers of appointment – Annuities; – Expenses incurred during administration; and – Was portability properly elected? 11 Examination of Estate Tax Returns 12
Examinations of Estate Tax Returns • Statute of Limitations: – Normally, three years. IRC § 6501(a) – Exceptions for false or fraudulent return or omitted income exceeding 25% of the gross estate. See IRC § 6501(c), (e)(2). – May not be extended by agreement. • Portability – Review of the deceased spouse’s unused exclusion amount (DSUE) is not subject to the statute of limitations on the first-to-die spouse. This means the Service can examine a predeceased spouse’s DSUE on audit of the surviving spouse. See IRC § 2010(c)(5)(B). – Practice Tip: Save the estate tax return of the first-to-die spouse forever (the IRS only keeps estate tax returns for 75 years). Also, keep complete documentation to substantiate every item on the estate tax return of the first-to-die spouse. 13 Examinations of Estate Tax Returns • Returns will be reviewed during classification • Commencement: Examinations are usually initiated within 9 months of the filing of the estate tax return • Conclusion: Estate tax audits are usually concluded within 18 months of the filing of the estate tax return • Use account transcripts to understand events following classification – Option 1: The return is not selected for audit (i.e., it is accepted as filed) • The Audit Information Management System (AIMS) will be closed using disposal codes 20 (accepted as filed) or 35 (surveyed excess inventory) • The return will be stamped “Accepted as Filed” • Letter 627, Estate Tax Closing Letter, will be issued – Option 2: The return is selected for audit (i.e., it is being reviewed) • Campus Center will send the return to a field office for review 14
Examinations of Estate Tax Returns • Scope of an Examination – Limited Scope Examination • The auditor examines 1 to 2 issues; often a correspondence audit – Limited Focus Examination • The auditor examines all unusual, large, and questionable item – Regular Examination • The auditor examines all “significant” issues – Project Cases • Exam focuses on areas where IRS has identified a potential for abuse 15 The Estate Tax Audit – Overview • Manage client expectations. • Protect the personal representative by filing Forms 56, 4810, and 5495. • Know what the government knows and more by making FOIA and third-party contact requests. • Make a conscious choice as to how to approach the audit (passive v. aggressive). • Establish credibility early. • Identify the issues to be examined. • Anticipate what will be requested in the IDR. • Prepare as if your materials will be reviewed by a court. • Establish an audit defense: – Handling the initial audit interview; – Handling requests for information or documents; – Handling third-party contacts. • Take appropriate countermeasures at every step of the process. • Handling the audit itself. 16
The Audit Defense: Planning and Preparation a. Manage Client Expectations i. Be straightforward and honest with your client about the audit and its potential range of outcomes. ii. Clearly define the scope of representation. iii. Protect yourself: 1. Plan for the possibility that the client may attempt to blame the professional to escape penalties, especially in fraud cases. 2. Recognize when it may be prudent to bring in outside counsel or refer the case to another. 3. Maintain files and correspondence. 17 The Audit Defense: Planning and Preparation b. Preparation i. Know what the IRS knows. Again, reorder the following: 1. Account Transcripts 2. A FOIA Request 3. Third-party contact sheet from the IRS ii. Fully research and document every potential issue iii. Decide how to approach the representation 1. Passive cooperation and production of requested documents 2. Aggressive representation, asserting all privileges and requiring the auditor to issue summonses. 3. Balance between the two approaches is ideal. iv. Assume that the auditor has read the file and is familiar with the potential issues. 18
The Audit Defense: Effectively Representing the Taxpayer c. The initial audit interview i. Where should it take place? 1. Taxpayer’s home/business 2. IRS office ii. Should the taxpayer attend? iii. Let the auditor identify the issues! 19 The Audit Defense: Effectively Representing the Taxpayer d. Handling requests for information or documentation i. Turning information over upon request can build trust and good faith. ii. However, there may be times where the taxpayer or taxpayer’s representative deems the documents to be irrelevant or privileged, and will not want to produce them. In that case, the IRS may pursue its subpoena power. 1. Do not turn over irrelevant or privileged documents solely on the belief they are harmless. Irrelevant documents may lead to new inquiries and privileged documents may constitute a waiver of privilege. 2. Keep the audit as narrow and streamlined as possible. 20
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