Many practitioners do not have to deal with estate and gift tax audits often and may need information about the process. What is the auditor looking for? What documentation is needed? How best to meet the requirements or what to do if the taxpayer does not agree with the auditor? This article provides a series of suggestions for tax advisers and taxpayers about how to avoid estate and gift tax audits and how to deal with them when served with an IRS notice.

1. Why Does It Take So Long?

A major complaint from practitioners is the time it takes to close an audit and to get a closing letter. The initial delay is not the examiner’s fault. When estate or gift tax returns are filed, they go to the Cincinnati Service Center, where they are processed, given a document locater number and prepared for classification. The Estate and Gift Tax staff reviews each return and select those most appropriate for audit. Others are held for a period of up to six months. If not selected during that time, they are accepted as returned. This does not mean that all of the values are accepted, only that the return was not selected for audit (and is unlikely ever to be audited). IRS Policy Statement P-8-49 indicates that once a closing letter has been issued, that case will not be reopened unless the grounds are substantial and the potential effect on the tax liability is material. This audit selection process takes approximately six months.

Selected returns go to a field office, where they are reviewed for audit potential. As workload permits, they are assigned to an examiner, who also makes a determination about audit potential. An auditor should contact the taxpayer (or his or her representative) within 45 days of assignment. The initial letter will request copies of documents to support the information reported in the return (such as income tax returns, business income tax records, appraisals, personal checks or verifications of claims), as well as support for legal positions that may have been taken. Ideally, the auditor should respond promptly to letters or telephone calls, have a face-to-face meeting if appropriate, and meet agreed-on deadlines. The taxpayer and his or her representative should do the same.

The goal is to complete an audit, if possible, within 18 months of filing. There is a three-year statute of limitations on estate tax returns that cannot be extended, so if additional tax must be assessed, it will be done during that period. If additional assets are located or if a mistake was discovered in the original return, amended returns or refund claims can be filed during this three-year period. Refund claims after this time can be made up to two years after payment was made but are limited to the amount of the payment.

2. Be Respectful

A critical rule is to respect the auditor. Almost all are attorneys and are well experienced. It is fine to disagree, but the tax adviser should consider the examiner’s point and ask to review his or her support. If the auditor is truly wrong or impossible to get along with, the tax practitioner should request a conference with the manager. That is an appropriate way to get a second look at the matter and may result in an agreement. Being argumentative or refusing to supply relevant information may just make the auditor more persistent. Besides delaying the audit and making the examiner more tenacious, estate tax attorneys have long memories and will remember any lack of cooperation for the next audit. IRS Estate and Gift Tax has downsized, leaving fewer attorneys and a nationwide audit system. This means that returns filed in one state may be audited in another, and there may not be a local auditor or manager.

3. The Selection Process

Estate and gift tax returns are individually reviewed and are selected for unusual items, such as large family claims, charitable deductions not supported in the testamentary documents, questionable marital provisions, large deductions, missing documents or support, prior gift tax returns not reflected in the estate tax return, math errors and large discounts. Returns with special elections (e.g., qualified domestic trusts, Sec. 2032A special valuation or Sec. 6166 installment-payment elections that may require liens) are guaranteed to be reviewed. The Service is trying to adjust the audit rate to the declining number of returns and to audit the “best” returns nationwide. This may mean a decrease of audit coverage in some parts of the country and an increase in others. Nine months after filing, one can call the estate tax unit at the Service Center to find out where the return is or if it has been accepted as filed. If a closing letter is lost, that is also the opportunity to request another letter or to ask about things like mistakes on letters or assessment problems. The toll-free number is (866) 699-4083. This source can also help with questions about amended returns, extensions of time to file or pay, installment cases and account balances.

4. FLP and LLC Controversies

One target of audits is family limited partnerships (FLPs) and limited liability companies (LLCs). These entities are often used by clients who did not understand the ramifications or who demanded continued control, resulting in the IRS using Sec. 2036 to include the full value of the asset in the estate at date-of-death value. Clients who use this approach should have a good business background, be able to handle a complicated personal financial situation and understand and be willing to follow the rules of a business entity. FLPs and LLCs should be used only by advisers that knowingly consider the risks and are prepared to provide their clients with regular reviews to ensure that the business purpose is preserved. This limits the argument to the discounts taken; clearly, this is where most controversies arise.

While a taxpayer is allowed to make a bad business decision, when family members are involved, the Service will closely scrutinize it. For audit purposes, the amount of discount is the trigger (especially if the FLP assets are securities, cash or otherwise liquid). There is just not enough information on an estate or gift tax return for the initial IRS review to determine whether an audit is appropriate. One should expect, at the very least, to be asked to routinely provide a copy of all agreements and the relevant appraisals.

5. Issues to Expect

If a client’s return is selected for audit, what will the auditor want to know? Many of the issues can be anticipated from previous court decisions:

• Review of the decedent’s background, lifestyle, gifts and assets; see Est. of Harper, TC Memo 2002–121; Est. of Abraham, TC Memo 2004–39, aff’d, 408 F3d 26 (1st Cir. 2005); and Est. of Rosen, TC Memo 2006–115.
• Information about donor’s health, intent and entity operation. Clients or family members may be interviewed; see Est. of Rosen and Est. of Abraham.
• Information about any meetings with the client(s) and the reason for the entity; see Est. of Rosen and Est. of Bongard, 144 TC 95 (2005).
• Were documents timely created and filed? See Knight, 115 TC 506 (2000).
• Did clients take distributions from the entity to make gifts? See Est. of Rosen and Turner, 382 F3d 367 (3rd Cir. 2004).
• Was there an entity business plan and an independent way to pay expenses? See Est. of Harper; Turner; Est. of Schauerhamer, TC Memo 1997–242; and Est. of Reichardt, 114 TC 144 (2000).
• If funded with a liquid asset, did this change? Did management change? See Est. of Reichardt and Est. of Hillgren, TC Memo 2004–46.
• Were transactions done in correct order (formation, contribution, gift)? See Est. of Shepherd, 115 TC 376 (2000), aff’d 283 F3d 1258 (11th Cir. 2002); and Senda, TC Memo 2004–160, aff’d, 433 F3d 1044 (8th Cir. 2006).
• Did the manager understand his or her function and fiduciary obligation, or were there unequal distributions? Were FLP assets or distributions used for the donor’s living expenses?

  See Est. of Rosen; Est. of Bigelow, TC Memo 2005-65; and Est. of Korby, TC Memos 2005-102 and 2005–103.

• Were business responsibilities taken seriously (e.g., accountings, decisions recorded, returns filed, contemporary documentation avoiding post- or year-end accounting adjustments)? See Est. of Rosen, Est. of Bigelow and Est. of Reichardt.
• Was a legitimate, nontax reason documented? See Est. of Rosen.
• Were so many personal items put into the FLP (home, vacation place) that the donor could not pay bills? See Est. of Rosen and Turner.
• Are personal assets “rented” from the partnership? See Est. of Reichardt; Est. of Rosen; and Est. of Disbrow, TC Memo 2006–34.
• Were estate tax or death-related expenses paid from the FLP? Was it dissolved soon after death? See Est. of Disbrow and Est. of Rosen.
• Did the agreement provide for extraordinary powers or unilateral rights for the manager? See Est. of Abraham and Est. of Korby.

Appraisals: An appraisal needs to be done for any gift and at death. The appraisal will receive special scrutiny. The tax adviser should review it for the following information:

• Are the property, date and math correct in the appraisal, and are they internally consistent?
• Is the appraisal by a qualified and independent appraiser? Notice 2006–96 has new requirements and a potential penalty for appraisers.
• Does it discuss terms of all agreements or refer to previous sales or redemptions?
• Does it show any buy-sell or right of first refusal’s effect on marketability discount?
• Does the discount represent the risk involved in the enterprise or realistic restrictions on it?

Appeals: FLPs and LLCs are a nationally coordinated issue in Appeals; Appeals settlement is monitored and approved by a national coordinator, Mary Lou Edelstein. In October 2006, the Service published UIL 2031.01-00, Appeals Settlement Guidelines for Family Limited Partnerships and Family Limited Liability Corporations (PDF), which gives the government’s position and settlement guidelines. While much of the specific guidance to Appeals officers is redacted, it is still a useful document. It has been reported that Appeals settlements may be less generous than settlements considered at the audit level, depending on whether new decisions have come down. Clients should understand that valuation is an art, not a science, and it is expensive in time and money to have dueling valuation experts. IRS attorneys are using more precise methods, internal-valuation engineers and valuation specialists, as well as outside critiques and appraisals. Part of the valuation calculation is the willing-seller test: Would clients actually sell their interests for the discounted value they have claimed?

Administering an FLP or LLC is not an event; it is a process. Clients and advisers must pay attention to and follow the business requirements and consider the income tax ramifications. It is not inexpensive; it can cost an average of $150,000 for setup, annual recordkeeping and consultations with attorneys, CPAs and valuation experts. It should have a business purpose other than tax savings and should make economic sense even without the tax savings. Sec. 2036 does not apply if there was a bona-fide sale. Court cases are continuously refining how value is determined, but if an active business is involved, there is a risk element that may be appropriately reflected in a discount. If members purchase their interests for a reasonable price and also pay attention to the business recordkeeping and follow business rules, they have a good chance of having the entity respected.

6. Penalties

Recent emphasis has been put on the assessment of appropriate penalties by Service personnel. The applicability of an accuracy-related penalty was discussed in the IRS Appeals Discount Settlement Guidelines, which indicated that penalties must be considered on their own merits and that it is never appropriate to “trade” any amount of an appropriate penalty for a taxpayer’s concession of the underlying issue. An IRS Counsel comment indicated that more cases were not being settled at the audit or appeals levels, because penalties were not being abated. A frank discussion with clients that advocate an aggressive position is in order; if the Service’s position is significantly different, there is a realistic possibility of penalties being proposed.

7. What If No Agreement Is Reached?

The estate and gift tax auditor will come up with a report; if the taxpayer does not agree, a meeting with the manager can be requested. If an agreement is still not reached, Estate and Gift will send a 30-day letter, which gives the taxpayer the option to agree or to request a conference with Appeals staff. If the taxpayer has not responded after 30 days, a statutory notice of tax assessment will be issued, which gives the taxpayer 90 days from the notice date to take action. The taxpayer can file a Tax Court petition to protest the deficiency without paying the tax. Most likely, there will be an opportunity to meet with Appeals prior to going to court. If there is no timely response, the tax will be assessed. The remaining option requires the estate or taxpayer to pay the tax and sue for a refund in district court.

This article was written by Lorraine F. New, New PLLC, Birmingham, MI (not affiliated with Baker Tilly International), for The Tax Adviser. Her views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.