How to Save Your Estate Plan

Too often what seems like a great estate plan fails to achieve its goals. Sometimes the execution is wrong. Other times the owner failed to take one or more key steps. One often-overlooked step is to ensure that the estate prevails in any audit by the IRS or state tax authorities.

Estate tax returns are audited at a far higher rate than 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.

More importantly, an estate audit can address issues beyond the estate tax return or even recent transactions. An estate tax auditor often examines income and gift tax returns from past years, even if the statute of limitations for those has expired. An adjustment in a prior income or gift tax return can follow through to an adjustment in the estate tax. The dollar amount at stake can be quite high, especially if penalties and interest are added.

The issues that consume most of an auditor’s time and interest are well-known to professionals. We will review those issues, and then explain the steps that help an estate withstand an audit with few or no changes.

Valuations. Estate and gift taxes are based on the value of property. Auditors review the values placed on property on both the estate tax return and prior gift tax returns. An easy way for the auditor to increase revenue is to assert that property is undervalued. The estate has to accept the new value or incur the time and expense of challenging it.

Any asset for which there is not a price in a public market is subject to challenge. The IRS has a panel of appraisers to review assets and challenge the estate’s values. Real estate and privately-held business interests are frequent IRS targets. Art, antiques, and collectibles also draw reviews.

Gift challenges. Estate owners are advised to make gifts of cash and property so the assets and their future appreciation and income are out of the estate. Gifts could be challenged two ways.

Just as with assets in the estate, the auditor might challenge the value placed on a 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 this reduces the value of the business included in the estate without incurring estate or gift taxes. The IRS could review the past gifts and conclude that the stock was undervalued each year. It might argue that instead of giving $12,000 of stock to each child each year, the gifts were worth $20,000. That would mean a higher portion of the lifetime exemption was used and gift taxes might have been underpaid. To avoid adverse results, the estate would have to establish the value of the stock for each year a gift was made.

The second challenge is that there was no real gift. A gift has no Estate Planning effects unless the owner gives all beneficial interests in the property. Some people try to give property without legally surrendering control. They want to be able to retrieve the property if circumstances change, or they want to have some continuing say in its disposition. The IRS loves to see that. If the owner retains partial control or some of the benefits of ownership, 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 does not tell the children, continues to make full use of the property, and pays all the bills. This is not an effective gift. The property is included in the estate.

Another common example: A business owner gives or “sells” the business to her children. But she retains a consulting contract or other arrangement that requires the business to pay her most of its income each year for life. This likely will be considered an ineffective transfer, because the parent retains most of the income for life, especially if there also is evidence that the parent continued to make most of the significant business decisions.

Life insurance. Benefits from life insurance are included in the estate if the insured holds any beneficial interest in the policy at death or up to three years before death. An auditor will examine these issues closely.

If there is an irrevocable 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. Those benefits likely will be included in the estate.

Missing property. An auditor looks for missing pieces. When an estate has a million dollar home, the IRS expects complementary furnishings and other assets. If those are not on the estate tax return, the auditor might physically inspect the home. The auditor also will review the homeowner’s insurance policy for the stated value of the contents and for riders covering valuable property such as art, antiques, furs, collectibles, and jewelry.

Past income tax returns also might be examined for consistency. If property taxes for a boat are deducted and the boat is not listed on the estate tax return, the estate must provide proof of its sale. Other documents that might be reviewed for clues to hidden assets include checkbooks, credit card statements, and other records of purchases, repairs, or storage of valuable assets.

Those are the main issues an auditor will examine and some of the techniques that will be used. A wise estate owner will be aware of the potential for these actions and take the following steps.

File gift tax returns. In most cases the IRS has three years to challenge a gift tax return, but there is no time limit when a gift tax return was not filed. An estate could be forced to defend the details of gifts made years or decades earlier if no gift tax return was filed.

A shrewd estate owner will file a gift tax return whenever a substantial gift is made, even if no gift tax is due. File a return even when gifts qualify for the annual gift tax exclusion if any of the gifts are not cash and their value can be questioned. A gift tax return should be filed routinely for gifts of business interests, real estate, collectibles, and similar assets.

Use quality appraisals. A back-of-the-envelope estimate will not hold up in an audit. Assets without public prices should be appraised by someone who does qualified tax appraisals, is experienced with IRS standards, and independent from the owner. A broker or realtor appraisal of real estate, for example, probably is not sufficient. The owner should review the appraiser’s training and experience. There should be a written appraisal document with an extensive explanation of how the value was determined, and the report should be kept on file. The exact format and length will depend on the type of property involved.

Make real gifts. Only give away property that is not needed to maintain the standard of living. That makes it easier to give all the ownership rights. Side deals, understandings, and the like concerning ownership disqualify the gifts. Another good rule is to make gifts early and regularly. Auditors are suspicious of gifts made shortly before death, especially if there was no prior history of giving. Remember that life insurance must be given at least three years before death to keep benefits out of the estate.

Keep great records. The IRS’s favorite estates are those in which all the information was in the owner’s head or in records only the owner understood. The IRS has a field day challenging gifts, valuations, and business structures and forcing the estate to prove it wrong. Keep personal financial statements and past income and gift tax returns. Let the executor know where the files are that show the history of each asset. Keep written valuations of non-public assets. If there are any complicated deals or structures, be sure there are memos explaining them.