Introduction
How you plan and address the avalanche of 2012 gifts, the filing of 2012 gift tax returns in 2013 for those 2012 gifts, and the eventual audit many of these gifts will undoubtedly be subjected to, should all be influenced by how you will handle the Appeals of those audits. Starting with the potential end game scenario may prove valuable at each of the earlier stages of these gifts and related compliance and audit issues.
2012 will likely prove the most active year in the history of the gift tax. With the threat of a reduction in the annual gift tax exemption from $5.12 million to a much lower $1 million, and with discounts, grantor trusts, perpetual GST allocations all being proposed for legislative restriction or repeal, more wealthy taxpayers will make substantial transfers in 2012 than ever before. Large numbers of large dollar transfers will likely result in burgeoning IRS audit activity. But the large dollars being transferred will result in many of those audits going up to the Appeals Division as taxpayers and the IRS endeavor to settle what will undoubtedly be large assessments. The following checklists will highlight some of the steps practitioners will face, and some of the technical issues that 2012 gifts will likely raise.
2012 Issues to be Alert For
√ Inattention to Formalities: The Wandry case has resulted in some practitioners minimizing the importance of many gift planning details and instead relying on the backstop of a defined value clause to solve any gift tax problems. Wandry v. Comr., 2012-88. Simply put some practitioners may have thought that they did not need to be concerned about the quality of the appraisal, or whether other formalities were adhered to, as they may have done in prior years. Since many interpret the Wandry case as having given broad license to the use of defined value clauses, they may have reassessed the downside of a 2012 gift as more modest than perhaps should have been done. If the IRS revalued a gift at $4 million that the taxpayer had valued at $2 million the excess of 50% of the assets given would revert perhaps back to the donor or a non-taxable receptacle like a QTIP trust. Should returns and gift plans be audited that took this view, potentially every phase of the gift and underlying documentation may prove problematic.
√ Step Transaction Doctrine: The sheer time pressure to complete many 2012 gifts will result in missed steps, the lack of “aging” different phases of the plan, the completion of components that in the past may have been spread over several tax years into a single tax year, and more. These may all raise the specter of the IRS applying the step transaction doctrine to compress many transactions into a more costly tax result.
√ Reciprocal Trust Doctrine: This has been much talked about in the literature addressing 2012 planning, but that doesn’t assure problems won’t be common. If each spouse sets up an inter-vivos trust for the benefit of the other spouse and descendants, the IRS may view the trusts have not appreciably having changed each spouses’ economic position and attempt to uncross the trusts applying the “reciprocal trust doctrine.” While this is typically an estate tax challenge that will cause estate inclusion, it may also arise as an attack to unwind a donative transfer during a gift tax audit. Practitioners will have to evaluate the circumstances, and most importantly the terms of the trust agreements, and identify meaningful differences.
√ Gift Splitting Issues: If one spouse has title to the assets transferred by gift to a trust, the other non-donor spouse may join in splitting that gift. Gift splitting will be especially critical if absent the election to split gifts the transfer exceeds the transferor spouse’s remaining exemption. However, if the non-transferring spouse who would elect to gift split is also a beneficiary of the trust, gift splitting will not be permitted. As trusts become more complex, and more powers and fiduciary positions are added, it may not be obvious how or in what manner a spouse might be a beneficiary.
√ Economic Substance Challenges: In the 2012 frenzy to take advantage of the $5.12 million gift exemption some taxpayers will undoubtedly transfer more assets than might be appropriate. If insufficient assets are retained to fund the taxpayer’s living expenses for the future, the IRS may attack the transaction as not having economic validity, and inferring that there had to be an implied agreement between the donor and the trustees to make distributions or the transfer could not be made. Practitioners facing these challenges may have to develop budgets and financial forecasts for the donor/taxpayer to justify the transaction if this was not done at inception.
√ Competency: If the taxpayer did not have sufficient mental capacity to contract (which is a higher degree of capacity than that required to sign a will) the gift transaction will be ineffective. Given the potential impact of state estate tax in decoupled states, and the risk of a lower federal exemption amount, many older taxpayers will have undoubtedly been encouraged to make 2012 transfers. If the practitioners making those transfers did not take the steps to corroborate adequately the donor’s competency, on audit, an historical reconstruction of that evidence will be necessary. If by the time the audit occurs the taxpayer/donor is clearly incompetent, that won’t provide a basis to conclude incompetency at the earlier date when the gift was made, but it will make the demonstration of competency more difficult.
√ Post-Gift Operations: While practitioners handling audits and appeals generally view the documentation completed at the time of the gift as of paramount importance, they should not discount post-gift documentation that may be relevant to the gift tax audit. For example, if post-gift none of the formalities of a family limited partnership were adhered to, that might suggest that the gift of the FLP interest at a prior date was not valid.
Audit Process
√ Exam Letter: The first step in the audit process is for the taxpayer to receive a letter informing him that the IRS has determined to examine the gift tax return. In most cases the return is defended initially by the preparer. While for most returns that might be the CPA, in 2012 in particular it is likely that many estate planning attorneys will file Form 709. While many attorneys are expert in these filings, the scope of clients making 2012 gifts will undoubtedly result in some estate planning attorneys with little or no compliance experience filing returns. CPA practitioners should endeavor to be included in the team that represents the taxpayers from inception. The damage that can be done to a taxpayer’s position from an inexperienced practitioner handling the preparation may be compounded if the same inexperienced practitioner handles the gift tax audit.
√ Response to 30-Day Letter: At the end of the exam the IRS will issue a 30-day letter listing its proposed determination of the audit.
- If the results are not acceptable the taxpayer can file a protest of the results to the IRS Appeals Division. This is the most likely option pursued by most CPA practitioners, but it is not the only option. The Appeals route is chosen by most as it can be far less costly if the matter can be settled at Appeals than if the matter proceeded to trial. However, an error that is sometimes made is to prepare to a lesser degree for an Appeals conference than one would prepare for a trial. That can undermine the case. The protest to Appeals can also prove advantageous because the taxpayer must exhaust his or her administrative remedies in order to shift the burden of proof back to the IRS on the matter. IRC Sec. 7491.
- Instead of pursuing the Appeals route, the taxpayer can request that the IRS issue a 90-day letter. The tax assessment can be paid and the taxpayer can sue for refund of that payment in the Court of Claims or District Court.
- The taxpayer can choose not to pay the tax assessed and instead file a petition to the Tax Court challenging the determination. Some litigators choose from the latter option as a strategy to up the ante to the IRS on the case. However, in many cases the Tax Court will send the matter back to Appeals
Before an approach is selected, CPA practitioners who have not litigated with the IRS in court should consult with attorneys specializing in tax litigation to assess how the unique circumstances of 2012 may affect the decision. The dynamic may well prove different than that of prior years.
√ Gathering Information and Preparing the Case: Even if a Tax Court Petition is filed it will not address the taxpayer’s case in significant detail and many important pro-taxpayer arguments may not even be mentioned. Therefore, regardless of which of the above options is selected, practitioners should begin the preparation of the client’s case.
- This will include a detailed analysis of the case, positions, and arguments. Some practitioners prefer a more limited approach to the Appeals process, but that can be a significant strategic error. Many tax litigators recommend that the Appeals presentations be a precursor of what the taxpayer’s case would be at trial.
- Often it will be necessary to obtain testimony of expert witnesses, additional expert reports and other third party information. A likely issue in many audits will be the valuation of the assets given as gifts in 2012. Thus, practitioners may have to line up the expert who prepared an appraisal report (e.g., underlying real estate appraisal, discount entity appraisal, etc.). It may also prove advantageous to hire an appraiser who was independent of the first appraiser to corroborate the conclusions of the first appraiser’s report. In some instances the new appraiser may not concur with some of the assumptions and/or conclusions of the appraiser whose report was attached to the gift tax return. While costly, it may prove advantageous to have a new independent appraiser complete a new valuation report from scratch. If the new report addresses errors in the prior taxpayer appraisal report (and perhaps errors in any IRS obtained appraisal report) the new appraisal may move the entire case to a quicker resolution. The savings in professional fees might well outweigh the cost of the additional report. Some practitioners have strategically hired the appraiser that the IRS might use at this early stage for a corroborating analysis to preclude the IRS from later hiring its appraiser of choice.
- Take a comprehensive approach analyzing all issues to the appropriate degree of depth.
- Prepare a written analysis of the taxpayer’s entire case with a table of contents, timelines and other visual aids to demonstrate the strength of the taxpayer’s position.
- For complex gift transactions, e.g., involving multiple entities, layers of entities, underlying asset and discount appraisals, the rational organization of the files and other records may be essential to the outcome of the case.
- Even though the matter is a gift tax audit, review three years of income tax returns for the taxpayers and any entities involved in the gifts. Be certain you can explain any unusual items that may impact the valuation or completeness of any gift made.
√ Additional Information Requests: Be a Boy Scout – the motto “Be Prepared,” applies to every Appeals case. The critical ingredient to achieving the most favorable results at all levels of audit, including Appeals, is preparation. The client must understand that saving money on preparation could be a dangerous gambit. The professional team must be certain to obtain all the relevant information available. The necessary records and data may extend to much more than what was appended to the gift tax return, even if the return was meticulously prepared with an eye towards meeting the adequate disclosure rules. Obtain any relevant data from the IRS and third party sources, as well as the client.
This may include a number of procedures and steps. Consider a Freedom of Information Act ("FOIA") request. These might disclose useful information such as whether witnesses interviewed by the IRS have taken positions different than that by the IRS. Since the IRS has proposed a gift tax adjustment, consider IRC Sec. 7517 which permits the taxpayer to obtain copies of any documents that the IRS has on the particular case such as valuations, transcript of accounts, an indication of who has worked on each tax return and file. IRC 7602(c) permits a taxpayer to examine a list of witnesses the IRS has spoken to so that the taxpayer can interview them as well in preparing the taxpayer’s case.
√ Forms to File. Form 2848 authorizing the advisors to deal with the IRS should be addressed at the inception of the case. Form 4506 can be filed with the IRS Service Center to request tax returns for each entity and taxpayer involved. If the CPA practitioner has not been the one preparing all entity returns (e.g., a gift was made of an interest in a family LLC that in turn owns minority interests in other limited partnerships or LLCs).
√ Prepare the Case for Presentation: How the practitioner presents the case involved to the appeals office can be important to the ultimate resolution of the matter.
- Your presentation should direct the Appeals officer to the most relevant provisions of each key document and issue. Bear in mind that the Appeals officer will likely be inundated with matters, and making points clear, direct and succinct will make the Appeals officer’s evaluation easier and more efficient, and potentially more favorable for the taxpayer.
- Try to identify any errors in the examining IRS agent’s report. These might be procedural (e.g., determining the statute of limitations) and substantive (e.g., transposition of source data taken from public records, math errors in calculations, etc.). Identification of errors might help convince the Appeals officer of a lesser quality of work by the agent, or possibly even call into question some of the key conclusions of the audit.
- Build a list of taxpayer favorable conclusions to demonstrate to the Appeals officer that there are real risks (hazards) to the IRS if they pursue litigation after the Appeals level. These could be persuasive, especially if you identify significant new issues that the agent had not considered in the preparation of the examination report. This might all serve to encourage the Appeals officer to a settlement favorable to your client.
- Weigh the pros/cons of making strategic concessions when the facts are not favorable to the taxpayer. This can improve the taxpayer’s credibility with the Appeals officer and perhaps move the matter towards resolution. For example if a discount was clearly excessive, re-evaluate the discount and suggest a more reasonable compromise in your report. Conceding on some issues may be sufficient to move the matter to resolution.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.
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