What Happens in an Estate Tax Audit

Most estate tax returns are processed and accepted without an examination. The ones that are examined tend to share something: a large or unusual value position, a closely held business, discounted entity interests, significant lifetime gifts, or a return that simply looks incomplete.

If the IRS opens an exam on a Form 706, it does not mean anyone did anything wrong. It means the IRS wants to test the numbers. Your job is to make sure the numbers can stand up.

Who does the examining

Estate and gift tax returns are examined by the IRS's Estate and Gift Tax program. IRM 4.25.1, Estate and Gift Tax Examinations, sets out how examiners work these cases: reviewing transcripts, verifying the statute of limitations, obtaining related returns such as historical Forms 709, deciding the scope of the exam, and documenting each issue.

Not every selected return gets a full audit. IRM 4.25.1 provides for surveying returns, which means closing them without examination, and for limited scope examinations that focus on one or two issues. A limited scope exam on a single appraisal is a very different experience from a full review of every schedule.

The statute of limitations

The IRS generally has three years after the Form 706 is filed to assess additional estate tax under IRC 6501(a). Examiners are required to verify and protect that date early, and IRM 4.25.1.2.1.1 addresses the estate tax statute specifically.

That period stretches to six years under IRC 6501(e)(2) if the return omits items from the gross estate exceeding 25 percent of the gross estate stated on the return. There is a relief valve: an item disclosed on the return or an attached statement in a manner adequate to apprise the IRS of its nature and amount is not counted as omitted.

Here estate tax differs from income and gift tax. For most taxes, the IRS and the taxpayer can agree in writing to extend the assessment period. IRC 6501(c)(4) excludes the estate tax imposed by chapter 11 from that rule, and Treas. Reg. 301.6501(c)-1(d) says the same. The estate tax period cannot be extended by consent.

That changes the dynamics of a long exam. As the three-year date approaches, an examiner who has not finished cannot simply ask for more time. The IRS's practical choice is to issue a notice of deficiency on the issues it has developed. Executors should know the date and keep the examiner's timeline in mind when deciding how quickly to respond and what to concede.

What the first contact looks like

An estate exam usually starts with a letter to the executor, and to any representative authorized on Form 2848, identifying the return and the examiner. It typically comes with an Information Document Request, or IDR. IRM 4.25.1.7.4.3 governs how examiners use IDRs.

Typical requests include:

• The will, any trusts, and probate filings.
• Appraisals for real estate and business interests, with the appraisers' qualifications.
• Brokerage and bank statements around the date of death.
• Partnership agreements, operating agreements and corporate records for closely held entities.
• Records of lifetime gifts and any Forms 709 filed.
• Support for deductions: debts, mortgages, administration expenses, claims against the estate.
• Insurance policies and Form 712 statements.

Respond completely and on time. A partial response invites follow-up IDRs and a longer exam.

Valuation is the main event

Estate tax is a tax on value. The standard is fair market value under Treas. Reg. 20.2031-1(b): the price at which property would change hands between a willing buyer and a willing seller, neither under compulsion and both having reasonable knowledge of the relevant facts.

Examiners frequently refer appraisals to IRS engineers or appraisal reviewers inside the agency for review. Disputes tend to center on:

• Real estate, especially unique or waterfront property where comparables are thin.
• Closely held businesses and the valuation method used.
• Discounts for lack of control and lack of marketability on entity interests.
• Assets with no ready market: art, collectibles, notes, and royalty interests.

The quality of the original appraisal is the biggest factor in how these disputes go. A thorough appraisal from a qualified appraiser that explains its methodology is hard to dislodge. A thin one is an invitation. The guide to estate valuation disputes goes deeper.

Lifetime gifts come back into play

The estate tax is computed on the taxable estate plus adjusted taxable gifts. Examiners pull the decedent's Forms 709 and look for gifts that should have been reported and were not.

A gift that was never reported on a Form 709 has no statute of limitations for gift tax under IRC 6501(c)(9), and it can be revalued in the estate's computation. A gift that was adequately disclosed on a timely return, with the gift tax statute expired, generally cannot be revalued. The guide to adequate disclosure and the gift tax statute explains why that matters so much.

Closing an agreed case

If the estate and the examiner reach agreement, the executor signs Form 890, the waiver of restrictions on assessment for estate and gift tax. IRM 4.25.1 sets internal timeframes for closing agreed and no-change cases. The additional tax and interest are then assessed and due.

After closing, the estate's account transcript will reflect the exam closure. That transcript, or a requested closing letter, is the estate's proof that the IRS is done. See estate tax closing letters and account transcripts.

When you do not agree

If the case is unagreed, the examiner issues a 30-day letter with a report of the proposed adjustments. The estate can file a written protest and ask for review by the IRS Independent Office of Appeals. IRM 4.25.13 covers Appeals, mediation and settlement procedures in estate and gift cases.

Appeals considers the hazards of litigation, which is often where valuation cases settle. Both sides know a court could land anywhere between the two appraisals.

If Appeals does not resolve it, the IRS issues a notice of deficiency, and the estate has 90 days to petition the U.S. Tax Court. Miss that window and the tax is assessed.

How to make the exam go better

Executors cannot control whether a return is selected. They can control a lot about how the exam goes.

• Organize before the first meeting. Index the documents by schedule. An examiner who can find things quickly spends less time looking for problems.
• Answer the question asked. Respond to each IDR item specifically. Volunteering unrelated material rarely helps.
• Bring the appraiser in early. If the IRS reviewer has questions about method or comparables, the appraiser who did the work is the best person to answer them.
• Keep the estate liquid enough. Hold a reserve for a possible deficiency rather than distributing everything during the exam.

Penalties

Examiners consider penalties as part of every exam. In estate cases, that usually means the accuracy-related penalty under IRC 6662, including the substantial and gross valuation misstatement penalties under IRC 6662(g) and (h). Reasonable cause and good faith, including reliance on a qualified appraisal, are defenses. See estate tax penalties and reasonable cause.

Paying an increased tax

An exam can produce a bill the estate cannot pay quickly, especially if the assets are real estate or a business. An estate that elected section 6166 installment payments on a timely return may be able to defer the deficiency attributable to the closely held business. Others can request an extension under IRC 6161.

The executor should also watch personal exposure. Distributions made before the exam closes can create liability under the federal priority statute if the estate cannot pay what the audit produces.

If the IRS has opened an exam on an estate tax return, call (813) 229-7100. Let's talk.