Audits of Gift & Estate Tax Returns
Navigating tax law isn’t always easy. When it comes to gift and estate tax returns, errors or significant valuation understatements can result in a time consuming and costly audit that surprises you with thousands of dollars in unpaid taxes. Additional interest, penalties and legal fees can make the situation even more stressful.
The latest IRS data book was issued in June 2020 and provides some interesting statistics. In 2019, the odds of an estate tax return being audited was just under 7% and for a gift tax return, the chances were slightly less than 1%. However, for taxable estates, especially relatively large estates that include hard-to-value assets, there is a much greater the chance for audit. Estates larger than $10 million had an audit rate of almost 22%. We can imagine the audit rate is even higher for those estates over $100 million that own illiquid assets.
Fortunately, there are ways to reduce the odds of an audit. If you’re informed about why audits occur, you can take the proper steps to avoid audits related to gift and estate tax returns. Furthermore, taking the correct steps now can lead to a better result even if the return is selected for examination.
What Can Trigger a Gift or Estate Tax Audit?
Here are some of the common factors that can lead to gift or estate tax audits:
- Total estate and gift value: Generally speaking, gift and estate tax returns are more likely to be audited when there are taxes owed and the size of the transaction or estate is relatively large.
- Qualified appraisal: If a non-traded asset is involved, a qualified appraisal is required to substantiate the value reported on the return. The initial steps in the IRS process include assessing whether the taxpayer has included a qualified appraisal prepared by a qualified appraiser. The IRS will also assess whether the appraisal meets the Uniform Standards of Professional Appraisal Practice. Moreover, documentation and appraisal reports that don’t meet IRS standards are subject to audit.
- Hard-to-value assets: The IRS commonly challenges the reported value of items that have no public market price, even if such items have been appraised by a qualified appraiser. Assets such as privately-held company stock and interests in family-limited partnerships are subject to a significant level of scrutiny. IRS auditors will examine the methods used by the taxpayer’s appraiser to determine whether they should challenge the value reported for gift or estate tax purposes. The IRS will compare these methods to those contained in the Service’s relevant “Job Aid” handbooks.
- Common areas of scrutiny: The IRS regularly reviews a variety of methods, factors and assumptions, including lack of control and lack of marketability discounts, discount rates applied within income-based approaches, tax affecting, intrafamily notes, tangible asset values, key assumptions and limiting conditions, comparable company selections, normalizing adjustments and executive compensation.
- Tax affecting: A technique used by appraisers to compare the tax implications of a closely-held pass-through entity, such as an S corporation, to a group of publicly traded C corporation guideline companies is to “tax affect” the earnings. The IRS is very likely to audit and challenge valuations containing tax affecting of pass-through entities given the significant impact of this adjustment and the guidance contained in the IRS’ “S Corporation Job Aid.” Working with an appraiser who understands the issues and relevant court decisions is paramount.
- Appraisal errors: Appraisals that contain false or misleading information stick out to the IRS. Mathematical errors are the easiest to spot, though the IRS will also closely examine evidence linked to the appraisal to determine if it’s factual or relevant to the given value.
How Long Do Audits Last?
In most cases, the statute of limitations — the time in which the IRS can conduct and complete an audit — is three years from the filing date. It can take between 12 to 18 months for the IRS to mail an audit notice.
Federal gift tax returns and estate tax returns are initially sent to the national service center for processing. The department staff reviews each return to decide which are most appropriate for auditing. There are typically two attorneys and two valuation specialists working together to review batches of returns. This team ultimately determines which returns should be “flagged” for further review. Because of the volume of returns, staff can hold returns at the service center for up to six months. If they don’t flag the return for auditing during this time, the return will likely never be audited.
The service center then sends flagged returns to a field office for further review. At this point, a local classification process ensues. Delays can occur for many reasons. Examiners typically have a backlog of returns to get through, and the process for each return can take even longer if they contain complex issues that require close examination. Together, these delays can compound enough that the initial audit notice is mailed up to 12 to 18 months after you first file your return.
Considerations for IRS Estate and Gift Tax Audits
Responding to and complying with estate and gift tax audits can be daunting. To set the taxpayer up for success at audit, proper preparation is key.
The best way to prepare for an audit is to assume your gift or estate tax return is going to be audited and to work with your legal, tax and valuation advisors to ensure you’re putting your best foot forward. These advisors will know the key issues of any case and should prepare documents and address issues with the assumption they’ll be reviewed. This is the best way to audit-proof your return or set yourself up for the best possible result at audit.
If the audit ultimately turns on a valuation issue in an appraisal filed as part of the estate/gift tax return, contact your appraiser as soon as possible. The best appraisers are accustomed to audit responses, can help steer you through the process and are well-equipped to prepare a written rebuttal to issues brought by the IRS agent or specialist. You have the right to request details about the IRS’ rationale and data supporting their contention and conclusions. If an IRS engineer has prepared a report used to counter the appraisal attached to your return, ask for a copy of the engineer’s report. That report should be shared with your appraiser for the purposes of preparing the written rebuttal.
The IRS agent will need to cite reasons to their superiors to close out the audit, whether that means a no-change letter or a settled amount. Your job should be to help them by providing specific rationale and relevant market data.
If an agreement can’t be reached with the IRS agent, you have the right to raise the case to their superior for further review. What’s more common is that the taxpayer will allow the Service to close the audit as unagreed, with a notice of deficiency issued. The taxpayer then promptly requests that the case goes to the IRS Independent Office of Appeals (“Appeals”) for resolution. Unlike the IRS examining agents, Appeals is required to consider the hazards of litigation and, therefore, may be more willing to negotiate.
Having an experienced team of legal, tax and appraisal professionals is critical to handling a gift tax or estate tax audit.
Audits: The MPI Advantage
When it comes to illiquid assets, the best way to protect yourself and your clients from being audited or having adverse results at audit is to obtain a valuation from a qualified appraiser that’s rigorously prepared, thoroughly documented and satisfies all relevant appraisal standards and requirements.
With over 80 years of experience in estate and gift tax valuations, Management Plannning Inc. provides valuations that routinely withstand IRS scrutiny. Clients from around the country rely on our dedicated staff of senior professionals for their most sensitive, complex and high-stakes matters. You can also count on us for the proper support should you be audited, and we’re equipped to appear as expert witnesses in U.S. Tax Court and other courts of law if necessary.
Contact us today and tell us how we can help. We look forward to working with you!