At the recent Notre Dame Tax and Estate Planning Institute, Lou Harrison of Harrison LLP in Chicago gave some tips to practitioners who are tasked with defending clients against an Internal Revenue Service audit of their estate and gift tax returns. Lou started off by noting that things have changed at the IRS since the COVID-19 pandemic. The IRS is currently transitioning and adding staff (perhaps leaving fewer available agents to handle audits); there are many newly hired agents who may not yet be familiar or experienced with the complexities of the estate and gift tax statutes; and there are agents who are now working from home may not give each audit the same amount of attention as they would give if they were working from the office.
Among the unusual post-Covid events that Lou has also noticed: lost checks submitted with estate and gift tax returns, resulting in penalties assessed against the client (eventually the penalties are removed, but not without effort; a miscalculation of the estate tax due; a misinterpretation of the rules regarding portability; audits at the first spouse’s passing with no estate tax due; increased number of audits of grantor-retained annuity trusts and other idiosyncratic items; and unusual arguments about the level of discounts.
The bottom line isn’t to predict what will be audited, but to understand that these days, any items could be audited, even those noted below. And forewarning clients that an audit is possible will often soften the emotional blow to the client if an audit were to occur.
What’s Being Challenged?
Lou says that the most common IRS challenges continues to be with level of discounts taken for lack of marketability, and overall valuations and elements in a valuation. His network hasn’t seen many audits involving Internal Revenue Code Section 2701 (special valuation rules in the case of transfers of certain interests in corporations and partnerships); qualified personal residence trusts (QPRTs), post-term QPRT lease arrangements, grantor retained annuity trusts and credit shelter trust funding. This doesn’t mean, however, that you shouldn’t be prepared for these types of challenges. All planning should be done with the same level of diligence and scrutiny as always; just don’t lie awake at 2 a.m. worrying that every position and planning that one has done will be reviewed in detail (or at all).
Know Your Agent
Lou recommends that you learn as much about the agent assigned to your audit as you can. Ask around to see if anyone has experience with that particular agent and find out what approach that agent typically takes. Knowledge is power, and due diligence is an important step here.
Three Audit Approaches
Lou outlined three approaches he’s seen practitioners take to audits. The approach you take may depend on what you’ve learned about the agent, or perhaps what you’re most comfortable with.
- Slash and burn. Come in with guns blazing, letting the agent know you’re familiar with the law and the agent shouldn’t waste their time on this. Explain why the law is in your favor.
- Dragnet: Just the Facts. This can work sometimes in a bad facts, complicated case with a lot of documents. This is where one provides the documents being asked, without justifying why the taxpayer’s desired result is the correct one. That is, leaving it to the agent to agree or not agree and perhaps the transaction is too complicated for an ordinary mortal to untangle or want to untangle. But he’s seen this approach used in a case in which the more documents provided without explanation, the more the IRS was interested in unravelling the mystery; the IRS was willing to dig back 10 years to come to a dangerous taxpayer result.
- Respect and honesty. This is Lou’s approach. Agents are lawyers, so respect their intelligence and try to be fair. This approach demonstrates that the taxpayer is acting in good faith. The ambience of the audit isn’t about winning or losing, but conveying to the agent that the goal is to reach a fair and reasonable result or to correctly apply the law, for both sides. Discussions in an audit may be something like: “Here’s what I see as important factors or the relevant law in this case, What do you think?” This approach instills a good working relationship and fair outcomes.
According to Lou, though risk of an audit of the estate and gift return is low, you should prepare your client for that possibility. Also, both the client and their attorney need to be open and honest. If the IRS agent feels the agent is being treated unfairly or that facts or events are being portrayed incorrectly, that could lead to poor audit results and performance.