Effective Risk Mitigation Strategies – Avoiding Estate Tax Return Audits

Estate tax return audits can be expensive and time-consuming. The best way to reduce or avoid costs is to plan ahead.

The focus of this article is specific targets of estate tax return audits and the effective risk mitigation strategies that can be employed during a decedent’s life and in the preparation of an estate tax return to reduce that risk.

There are some basics mistakes and internal inconsistencies that can be easy to avoid and prevent larger headaches in the event of an estate tax audit. The following is a non-inclusive list:

1. Has the estate tax return been filed without all necessary attachments and documents?
2. Does the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, contain inadequate descriptions of reported assets?
3. Have all required questions been answered sufficiently?
4. Have all prior gifts been reported, and gift tax returns attached to the estate tax return?
5. Has the decedent’s last will and testament bequeathed certain specific property which is not properly reported on the Form 706?
6. Has a deduction for real estate taxes been taken on Schedule K of the 706 but no real estate been reported as an asset?
7. Neatness counts! Is the return organized properly with all necessary attachments in good order?

Again, these are just some of the straight-forward mistakes that can needlessly either trigger an audit or create time-consuming issues with an estate-tax examiner. The next group of issues are more technical and complex:

1. Have formation documents been timely created and filed?

The formation of an FLP typically involves the following steps. First, the entity is created under state law by drafting and filing all necessary documents. The entity is then funded with assets. From there, typically the grantor transfers interest in the entity via gifts or sales to their heirs or trusts for their heirs, often at a discount. The entity is then operated according to the agreement. These steps should be taken thoughtfully, following this order and allowing for time in between each step. This process is critical when trying to withstand an IRS challenge during an audit.

2. Have business and accounting requirements been satisfied?

The FLP should be careful to maintain proper accounting books and records. The partners should hold regular meetings and keep detailed minutes. All necessary partnership and gift tax returns should be filed, showing correct ownership, capital accounts, distributions, profits accounts, schedules K-1, etc.

3. Was the FLP funded with personal items of the decedent resulting in their inability to pay for personal expenses?

The grantor should retain substantial assets outside of the FLP. More specifically, following the transfer of a decedent’s assets to an FLP, they must be able to meet their financial obligations without using the transferred funds. If distributions from the FLP are required to meet the basic living expenses of the decedent, IRS would likely assert that all FLP interests are includable in the decedent’s estate. Further, a business plan should exist with a method for the FLP expenses to be paid separate from any personal expenses that might arise.

4. Has a legitimate nontax purpose for the entity been documented?

Tax court decisions have provided several legitimate nontax purposes for the creation of FLPs and LLCs. These include (1) centralized control of family investments, (2) reduced expenses associated with family wealth, (3) educating the next generation regarding management of family investment assets, (4) protecting family assets, (5) consolidating investments with a single investment advisor, and (6) creating a common ownership of assets for efficient management to meet minimum investment requirements. The intent of any created family entity should include most if not all these goals. In addition, during the lifetime of the entity, there should be evidence showing actions were taken to meet these goals.

5. Does the FLP agreement allow for unilateral powers for the manager?

When drafting an FLP agreement primary areas of concern are restrictions on transfer, withdrawal and distributions rights, and management powers. To reduce the likelihood IRS could sustain estate tax inclusion of the interest, the decedent’s control should be limited.

6. Have there been distributions which could negatively impact the discounts?

One of the drivers in establishing an entity discount is a lack of liquidity. In other words, the inability of a partner to benefit from the entities cash flow reduces the value of the partnership interest. If there are frequent distributions (other than perhaps tax distributions), IRS may be successful in reducing a discount on that basis.

7. Was the value of the interest in the estate reported and substantiated through a qualified appraisal?

Knowing it is likely IRS will challenge any discounts taken on family entity interests, it is critical that value be determined via a qualified appraisal. Having the appraisal will make it that much more difficult for IRS to disregard the reported value and challenge the economic factors that give rise to a discount. While having the appraisal in no way guarantees a value will go unchanged on an audit, it does allow for more negotiating power during an audit.

8. Was the entity dissolved shortly have the death of the decedent? Were FLP assets used to pay for death-related expenses?

If an entity is liquidated soon after the decedent’s death, absent some compelling non-tax reason for that liquidation, IRS will likely try to argue the entity was designed only for tax reasons. Generally, it is a good idea for there not to be any transactions with the entity until after any potential audit period is over.

Since these can be more complex matters, there are several different potential issues that can arise with respect to each of the above considerations. There is however one area that commands specific attention because of the focus given to it by IRS: the family limited partnership. Family limited partnerships (FLPs) and limited liability companies (LLCs) are primary targets of IRS estate tax return audits. Specifically, because of the discounts associated with these interests, for years IRS has attacked both the validity and amounts of these discounts, as well as asserted estate tax inclusion of interests gifted during life. While they have not always been successful in challenging these entities, advisors should be aware that IRS is likely to scrutinize such interests reported on an estate tax return. Knowing this, practitioners would be wise to review the relevant case law, which provides many factors to consider and questions to ask when determining if the use of an FLP or LLC will increase the likelihood of triggering an IRS estate tax return audit.

The Takeaway

An estate tax audit may be unavoidable as IRS typically reviews most taxable estates. However, the scope and expense related to that audit can be dramatically reduced. While the above points are only some of the issues that can come up in an examination, taking these considerations into account both during planning and in preparation of the estate tax return can pay off in withstanding IRS challenges.