Audits of Estate Tax Returns and Protecting the Fiduciary Client. Presented to the Estate and Financial Planning Council of Central New Jersey

Transcription

1 Audits of Estate Tax Returns and Protecting the Fiduciary Client Presented to the Estate and Financial Planning Council of Central New Jersey Frank Agostino, Esq. Lawrence A. Sannicandro, Esq. April 20, Overview I. Introduction and Overview II. III. IV. Preparing the Estate Tax Return Examination of Estate Tax Returns Strategies to Limit the Liability of Fiduciaries and Transferees V. Gifts and Bequests from Non-U.S. Donors and Decedents 2

2 Introduction and Overview 3 Introduction and Overview a. Unlike other returns, which are subject to a lottery, ALL estate tax returns will be individually reviewed to determine audit potential and identify the key issues for any examination. b. Estate and Gift Tax Auditors return more tax dollars per capita than any other subdivision of tax. Therefore, audits in estate and gift are emphasized. 4

3 Introduction and Overview c. Estate and Gift Tax Auditors are specially trained in estate and gift tax matters. d. Estate tax audits require a special strategy e. Timing: Estate tax return audits are usually initiated within nine months of the filing of the return. f. Timeline: Absent special circumstances (i.e., someone filing a reward application two years after the estate tax return is filed), estate tax audits are usually concluded no later than 18 months after filing. 5 Introduction and Overview g. Characters in the cast: i. Personal representative, executor, or administrator; ii. Estate and gift tax auditor; iii. Office of Appeals (independent of exam; helps resolve issues w/o litigation); iv. Criminal Investigation (CI) (the law-enforcement division of the IRS); v. Taxpayer Advocate Service (independent of exam; helps ensure rights are understood and respected); and iii. Chief Counsel and Division Counsel (attorneys who provide technical guidance and litigate cases, respectively). 6

4 Prepare Estate Tax Returns With the Audit in Mind 7 Prepare the Estate Tax Return With the Audit in Sight Anticipate Your Audience at the Outset Begin with the end in sight. Practice Tip 1: Use reputable appraisal firms Practice Tip 2: Ensure adequate documentation for the audit by attaching required documents to the return and storing necessary information in a safe place. Practice Tip 3: Assume all relevant evidence will be reviewed by the auditor and a judge 8

5 Prepare the Estate Tax Return With the Audit in Sight Practice Tip 4: Know what the IRS knows: Request account transcripts account, W&I, gift, and related entity Order past gift tax returns from the IRS (Form 4506) Copy of predeceased spouse s estate tax return (Form 4506) Last three years of income tax returns and bank statements Make requests under the Freedom of Information Act ( FOIA ) Westlaw searches (i.e., adverse judgment search to determine liabilities and liabilities) Accurint (for information on businesses, real estate, etc. Transunion TLOxp ( TLO ) (for information on credit, bankruptcies, foreclosures, liens, judgments, assets, professional licenses, etc.) Google searches 9 Prepare the Estate Tax Return With the Audit in Sight Practice Tip 5: Perfect the return by including: Certified copy of Will; Certified copy of death certificate; Forms 712, Life Insurance Statement; Copy of trust instruments; Copy of power of appointment instruments; Appraisals on real estate; Appraisals on art (required for art objects with a value greater than $3,000); Financial data on non-public entities; Copies of Forms 709, United States Gift (and Generation-Skipping Transfer Tax Return Last full year s Federal income tax return in some States (e.g., New Jersey) 10

6 Prepare the Estate Tax Return With the Audit in Sight Practice Tip 6: Anticipate common audit issues: Adjusted taxable gifts and gift tax paid; Real estate (fractional interest, arm s-length sale); Accrued interest and dividends included; Are you properly reporting assets transferred to a revocable trust; Closely held businesses (sales price in formational documents, reasonable and appropriate discounts, reliable appraisal); Life insurance (ILITs, Form 712); Fractional interest discounts; FLPs (indirect gift, section 2036 issues, reasonableness of discounts); Powers of appointment Annuities; Expenses incurred during administration; and Was portability properly elected? 11 Examination of Estate Tax Returns 12

7 Examinations of Estate Tax Returns Statute of Limitations: Normally, three years. IRC 6501(a) Exceptions for false or fraudulent return or omitted income exceeding 25% of the gross estate. See IRC 6501(c), (e)(2). May not be extended by agreement. Portability Review of the deceased spouse s unused exclusion amount (DSUE) is not subject to the statute of limitations on the first-to-die spouse. This means the Service can examine a predeceased spouse s DSUE on audit of the surviving spouse. See IRC 2010(c)(5)(B). Practice Tip: Save the estate tax return of the first-to-die spouse forever (the IRS only keeps estate tax returns for 75 years). Also, keep complete documentation to substantiate every item on the estate tax return of the first-to-die spouse. 13 Examinations of Estate Tax Returns Returns will be reviewed during classification Commencement: Examinations are usually initiated within 9 months of the filing of the estate tax return Conclusion: Estate tax audits are usually concluded within 18 months of the filing of the estate tax return Use account transcripts to understand events following classification Option 1: The return is not selected for audit (i.e., it is accepted as filed) The Audit Information Management System (AIMS) will be closed using disposal codes 20 (accepted as filed) or 35 (surveyed excess inventory) The return will be stamped Accepted as Filed Letter 627, Estate Tax Closing Letter, will be issued Option 2: The return is selected for audit (i.e., it is being reviewed) Campus Center will send the return to a field office for review 14

8 Examinations of Estate Tax Returns Scope of an Examination Limited Scope Examination The auditor examines 1 to 2 issues; often a correspondence audit Limited Focus Examination The auditor examines all unusual, large, and questionable item Regular Examination The auditor examines all significant issues Project Cases Exam focuses on areas where IRS has identified a potential for abuse 15 The Estate Tax Audit Overview Manage client expectations. Protect the personal representative by filing Forms 56, 4810, and Know what the government knows and more by making FOIA and third-party contact requests. Make a conscious choice as to how to approach the audit (passive v. aggressive). Establish credibility early. Identify the issues to be examined. Anticipate what will be requested in the IDR. Prepare as if your materials will be reviewed by a court. Establish an audit defense: Handling the initial audit interview; Handling requests for information or documents; Handling third-party contacts. Take appropriate countermeasures at every step of the process. Handling the audit itself. 16

9 The Audit Defense: Planning and Preparation a. Manage Client Expectations i. Be straightforward and honest with your client about the audit and its potential range of outcomes. ii. Clearly define the scope of representation. iii. Protect yourself: 1. Plan for the possibility that the client may attempt to blame the professional to escape penalties, especially in fraud cases. 2. Recognize when it may be prudent to bring in outside counsel or refer the case to another. 3. Maintain files and correspondence. 17 The Audit Defense: Planning and Preparation b. Preparation i. Know what the IRS knows. Again, reorder the following: 1. Account Transcripts 2. A FOIA Request 3. Third-party contact sheet from the IRS ii. Fully research and document every potential issue iii. Decide how to approach the representation 1. Passive cooperation and production of requested documents 2. Aggressive representation, asserting all privileges and requiring the auditor to issue summonses. 3. Balance between the two approaches is ideal. iv. Assume that the auditor has read the file and is familiar with the potential issues. 18

10 The Audit Defense: Effectively Representing the Taxpayer c. The initial audit interview i. Where should it take place? 1. Taxpayer s home/business 2. IRS office ii. Should the taxpayer attend? iii. Let the auditor identify the issues! 19 The Audit Defense: Effectively Representing the Taxpayer d. Handling requests for information or documentation i. Turning information over upon request can build trust and good faith. ii. However, there may be times where the taxpayer or taxpayer s representative deems the documents to be irrelevant or privileged, and will not want to produce them. In that case, the IRS may pursue its subpoena power. 1. Do not turn over irrelevant or privileged documents solely on the belief they are harmless. Irrelevant documents may lead to new inquiries and privileged documents may constitute a waiver of privilege. 2. Keep the audit as narrow and streamlined as possible. 20

11 The Audit Defense: Effectively Representing the Taxpayer d. Handling requests for information or documentation (cont.) i. IRS Subpoena Power 1. The right to summons people to act and documents 2. The IRS may issue summonses or subpoenas for the purpose of ascertaining the correctness of any return, making a return where none has been made, or determining the liability of any person for any internal revenue tax 3. Pursuant to its subpoena power, the IRS may: a. Examine any books, papers, records, or other data that may be relevant or material to such inquiry, and b. Summon the person liable for tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries relating to the business of the person liable for tax or required to perform the act, or any other person the IRS may deem proper to produce such books, papers, records, or other data. e. Limitations i. Attorney-client privilege and potential waivers; ii. Practitioners privilege under I.R.C. ' 7525; iii. Work product privilege; iv. Relevance. 21 The Audit Defense: Effectively Representing the Taxpayer e. Handling Third Party Contacts/Summons i. The auditor may contact third parties for information. 1. By law, the auditor is required to notify the taxpayer of such contact within three days following the contact. 2. It is important to follow up with the third party to ascertain what questions were asked and what information was given. 3. If possible, request to be present at any meeting to preserve privileges. ii. The auditor may issue summonses for documents or unwilling third parties 1. Advise the third party as to any issues or privilege concerns the taxpayer has. 22

12 The Audit Defense: Effectively Representing the Taxpayer f. Settlement Attempts: i. The auditor may be willing to settle based upon a dollar-figure amount, or may be willing to settle on an issue-by-issue basis. ii. Identify the strong vs. weak issues, and the important vs. non-important issues, and decide which are worth conceding to achieve a settlement. iii. Use programs to understand bottom-line impact of conceding issues 23 Concluding the Audit a. When the auditor has reached a decision he or she will discuss his or her findings with the taxpayer. i. If the taxpayer agrees to the changes and resulting computations, the taxpayer can sign a Form 870 & 3614-A. ii. If the taxpayer does not agree: Day letter Day letter 24

13 Exercising Rights Under the 30-Day Letter b. Appeals i. Appeals has the authority to settle based upon hazards of litigation; examining agents do not. ii. In preparing for an Appeals conference, prepare as though the estate were going to trial: 1. Fully research applicable law and present it to the Appeals officer. 2. Bring all supporting documentation that the estate would seek to have considered as exhibits in court. 3. Obtain declarations from relevant third parties. 4. If the case fails to settle at Appeals, the trial prep is then partially accomplished! 25 Exercising Rights Under the 30-Day Letter c. Appeals i. Fast Track Mediation ($100,000 or less) a. May be of limited used in estate tax cases. b. Initiate by filing Form 12269, Agreement to Mediate, the examiner s summary of the issues and tentative tax computations, and the taxpayer s written position. c. Does not apply to compliance coordinated issues. ii. iii. Fast Track Settlement (no dollar limit) a. Initiate by filing Form 14017, Application for Fast Track Settlement, a summary of issues, and the taxpayer s written position. b. Does not apply if issues will take longer than 60 days to resolve Post-Appeals Mediation (no dollar limit) a. Send the appeals officer a request for post-appeals mediation and a written statement detailing the taxpayer s position on the disputed issues. 26

14 d. Litigation Exercising Rights Under the 90-Day Letter i. Recall that the SOL cannot be extended. Thus, the IRS may issue a NOD even though mediation with Appeals is ongoing. ii. If a case is unagreed within 210 days of the SOL expiration date or if the case fails to settle with Appeals, the Service will issue a notice of deficiency (i.e., the 90-day letter). iii. Can petition the United States Tax Court without prepaying the deficiency. iv. Can file a complaint in the United States Court of Federal Claims or the appropriate Federal district Court if the tax is prepaid. v. Bring in an experienced tax litigator early, either during the audit, the Appeals conference, or before beginning litigation. 27 Limiting the Liability of Fiduciaries and Transferees 28

15 The King s Debtors Dying, The King Shall First Be Paid A personal representative of an estate without enough property to pay all claims of the estate must pay the federal tax claim before other claims. 31 U.S.C Personal representative becomes personally liable for unpaid federal estate tax of the estate and/or unpaid federal income tax of the decedent. See U.S.C. 3713(a), (b). 29 Pay the King First or Be Held Liable If the personal representative pays other creditors before paying the government, the fiduciary may be held personally liable to the extent of the payments that he turned over to creditors other than the government. 31 U.S.C. 3713(b); United States v. Coppola, 85 F.3d 1015, 1020 (2d Cir. 1996); IRM (Mar. 26, 2010). IRS issues a Notice of Liability and sues the fiduciary in the appropriate federal district court Statute of Limitations: 1 year after the liability arises or the expiration of the period of collection (10 years) Can arise many years after the personal representative is discharged 30

16 Strategies to Protect a Fiduciary From Liability File the following forms with the Service: (1) Form 56, Notice Concerning Fiduciary Relationship - File this form twice, once when the fiduciary is appointed and once when the fiduciary is discharged. (2) Form 4810, Request for Prompt Assessment Under Internal Revenue Code Section 6501(d) - Applies to income and gift tax returns. - Shortens SOL from 3 years to 18 months. (3) Form 5495, Request for Discharge From Personal Responsibility Under Internal Revenue Code Section 2204 or IRS has 9 months to respond or else fiduciary is discharged of personal liability. Create reserves for taxes before making final distributions. Require distributees to sign agreements before making final distributions (without reserves) which Agree to indemnify the personal representative from personal liability arising from the distribution; and or Execute refunding bonds and releases requiring distributees to agree to refund such amounts as are required to satisfy the estate s debts, including tax debts. 31 The Importance of Filing Gift Tax Returns - Good Faith Reliance on Gift Tax Returns IRC 2204(d) provides: If the executor in good faith relies on gift tax returns furnished under section 6103(e)(3) for determining the decedent s adjusted taxable gifts, the executor shall be discharged from personal liability with respect to any deficiency of the tax imposed by this chapter which is attributable to adjusted taxable gifts which (1) are made more than 3 years before the date of the decedent s death, and (2) are not shown on such returns. 32

17 Failure to File a Gift Tax Return In 1972 Billionaire Richard Sumner Redstone apparently made a gift to his children but did not file a gift tax return. The IRS, 41 years later, claimed that he owed $1.1 million in taxes, penalties, and interest with respect to the gift. This case involves stock in the family s National Amusements, Inc. received by Redstone s son and daughter after the settlement of an intra-family lawsuit. How could the outcome have been avoided? 33 Potential Strategies File $1 Gift Tax Returns with request for prompt assessment. Disclose the transaction in full, and upon the death of the donor, make a request for a prompt assessment under IRC 6501(d). Because the transaction is adequately disclosed on the gift tax return, even if there is a substantial omission of income, the SOL will not be extended under IRC 6501(e). 34

18 Gifts and Bequests from Non-U.S. Donors and Decedents 35 The IRS s Focus on International Forms Increased scrutiny of transactions between U.S. taxpayers and non-u.s. donors and decedents Common information forms required (but not always filed): Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner (Under Section 6048(b)) Unforgiving penalties can quickly accumulate 36

19 Form 3520, Foreign Trusts & Gifts Grantors or beneficiaries with reportable transactions with foreign persons, trusts or estates must file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. See I.R.C. 679(c), Many reportable transactions; examples include: formation of a foreign trust; transfer of property to a foreign trust; the receipt of any distribution by a U.S. beneficiary; aggregate gifts or bequests from foreign person or estate greater than $100,000; loans to a foreign trust. When to file? Due with tax return for the U.S. grantor or beneficiary (separately filed) Penalties (I.R.C. 6662(j), 6677) 35% of the gross value of the distribution received from or transferred to a foreign trust; 5% per month for the amount of certain foreign gifts, up to 25% Reasonable cause defense available; reviewable in CDP proceedings 37 Form 3520-A, Foreign Trusts U.S. Owner A foreign trust with a U.S. owner must file Form 3520-A, Annual Information of Foreign Trusts With a U.S. Owner. See I.R.C. 679(c), U.S. owner responsible for compliance When to file? 15th day of the 3rd month after the end of the trust's tax year Penalties (I.R.C. 6662(j), 6677) $10,000 per reportable transaction plus a $10,000 continuation penalty Reasonable cause defense available; must show current compliance Able to be reviewed in collection proceeding 38

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