Planning an estate and implementing the plan don’t end the job. To meet your goals, take another step and ensure that the estate will prevail in an audit.
Few people realize that the audit rate on estate tax returns is far higher than the rate on income tax returns. The greater an estate’s value, the more likely it is to be audited. An estate tax return can be 10 or 20 times more likely to be audited than an income tax return, depending on the individual’s wealth.
An estate audit often addresses issues beyond the estate. It is not unusual for an estate tax auditor to conclude that prior income or gift tax returns need to be restated. Add penalties and interest, and the stakes in an estate audit can be quite high.
Keep the potential for an audit in mind during the planning process. There are issues that make an aggressive estate tax audit more likely, and steps you can take to avoid adverse results from an audit.
Valuations. The top targets for the IRS are returns on which the value placed on property can be questioned. The estate and gift tax is based on the value of assets. The IRS increases tax revenue each time it successfully argues that the value of one or more items listed on the tax return is too low.
When a large portion of an estate’s value is in real estate or a nonpublicly-traded business, the IRS takes notice. Art, antiques, and collectibles also can draw the IRS’s interest. For all these items, there is no public market price. The value is subjective unless the property is sold to a willing, independent buyer.
The IRS has appraisers to challenge the value placed by the taxpayer’s appraiser. The auditor will examine how the value was determined by the estate and decide if the result should be challenged.
Gift challenges. An effective and frequently-used estate tax strategy is to make gifts of property. If property is out of the estate, it is not taxed. There might be gift taxes, or they might be avoided because of the annual and lifetime exemptions. In either case, the future appreciation is out of the estate.
The IRS challenges gifts in two ways.
One challenge is to the value placed on the gift. Suppose a corporation owner each year gives his children stock with a value that does not exceed the annual gift tax exclusion. Over time he is getting the value of the business out of his estate without owing estate or gift taxes.
In this case, the IRS might challenge the value placed on the stock each year. It might argue that instead of giving $10,000 of stock to each child each year, he gave away $20,000 of stock. The owner’s estate and children would have to establish the value of the stock for each year a gift was made.
The second challenge is that a gift was not made. To make a legal gift, the owner might give away all beneficial interests in the property. Often, a wealthy individual will purport to give away property without legally giving up control. The IRS loves to see that. If the owner retains even partial control or some of the benefits of ownership, the IRS will say that the entire value of the property is included in the estate.
For example, an individual has his lawyer change the deed to a house or vacation house so his children are listed as the owners. But the owner continues to make full use of the property and pays all the bills. Perhaps the children aren’t even told the title was transferred to them.
Another common example: A business owner gives or “sells” the business to his children. But he retains a consulting contract or other arrangement that requires the business to pay him most of its income each year for life. The IRS will say that there was no gift or sale, because there was a side deal to pay the parent most of the income for life. Often, there is evidence that the parent continues to make most of the significant business decisions, indicating that he retained control.
Life insurance. If the insured retains any beneficial interest in a policy, the life insurance proceeds are included in his estate. To effectively give away a life insurance policy, not only must the gift be complete but the gift must be made more than three years before death.
An auditor will closely examine life insurance arrangements. If there is a life insurance trust, the documents will be reviewed for any forbidden powers. For example, if the insured retains the right to change the beneficiary, the policy proceeds might be included in the estate. If a business owned life insurance, the arrangement will be examined to see if the insurance benefits can be included in the estate. Many estates overlook group term policies offered through the deceased’s employer. The benefits should be included in the estate.
Missing property. The IRS expects that people who own assets of a certain value also will own certain other valuable assets. For example, if someone owns a million dollar house, the IRS expects the furnishings to be worth a significant amount. If a lesser amount is listed on the tax return, the auditor will want proof that really is how the house was furnished. The auditor will get a copy of the homeowners’ insurance to check the stated value of the contents. The auditor also will look for riders covering other valuable property, such as art, antiques, furs, collectibles, and jewelry.
Past income tax returns also might be examined. If property taxes for a boat are deducted, the boat better be listed on the estate tax return or proof of sale produced. If the auditor believes the personal assets are understated, he might even review the checkbook, credit card statements, and other records for evidence of purchases, repairs, or storage of valuable assets.
Here are some steps that will protect your estate and heirs from an adverse estate tax audit.
File gift tax returns. When a gift tax return is filed, the IRS normally has three years to challenge the return. If no return is filed, there is no statute of limitations. Don’t file a return, and your heirs might be forced to defend the value placed on gifts made 20 years earlier.
After making gifts, file a gift tax return. File a return even if the gift qualifies for the annual gift tax exclusion, especially when the value of a gift can be questioned. You might not need to file a return for gifts of cash or publicly-traded property that are well-documented. But for business interests, real estate, collectibles, and similar assets, file a return to get the statute of limitations running.
Get quality appraisals. Be sure all your appraisals are done by someone who does qualified tax appraisals and is experienced with IRS appraisals. The appraisal document should have an extensive explanation of how the value was determined. The exact format and length will depend on the type of property valued. When hiring an appraiser, pretend you are an IRS auditor. Question the appraiser’s training and experience in detail. Don’t have any broker or realtor appraise the real estate.
Remember the three-year rule. Life insurance and business interests that were owned within three years of death generally are included in the estate. If you want the assets out of your estate, sever all ties from them.
Keep great records. The IRS’s favorite estates are those in which the owner knew everything about every item of property, but all the information was in his head. When he dies, the IRS has a field day finding all the assets and including them in the estate. It is up to the estate to prove that the assets should be excluded. Keep personal financial statements and past income and gift tax returns. Let your executor know where the files are that show the history of each asset.