Accounting and Tax Issues in Probate - Part II, Prepare for a Tax Audit Now, Not Later
INTRODUCTION: Let me begin by explaining why this is necessary. The best time to prepare for an estate tax audit is before you file the return. There are a number of outstanding sources available to help you do the job correctly. The AICPA provides a fiduciary tax organizer for Form 1041. It helps you gather together all of the information you will need to file the return correctly. The AICPA also offers an estate and trust income return checklist for Form 1041 that covers virtually every possible topic in seven pages. It has a mini-checklist only two pages long for those with shorter attention spans. Finally, the AICPA offers an IRS examination guide intended for use in office and field income tax examinations. It offers helpful hints about what might be looked at during an examination. PROPER PREPARATION: The key to avoiding or successfully surviving an audit is proper preparation. Be sure to include copies of all relevant documents and other information necessary to support the information reflected on the return. If you did not prepare the return but are now facing the audit, gather the information as quickly as possible so you have it for submission to the examiner. If you are not able to provide back up documentation when you meet the examiner for the first time, the examiner may feel the documentation did not exist when the return was filed or was not properly reviewed prior to the filing of the return. CHECKLIST FOR FORM 706 ESTATE TAX RETURN: The AICPA has a detailed estate (and GST) tax return preparation and review checklist for Form 706 and an estate tax return organizer to help you gather the required information. It also has a paper entitled "Estate Tax Work Paper Procedures and Organization" which is very helpful. Don't try to reinvent the wheel when materials have already been invented to help you do your job better and more efficiently. INCLUDE DOCUMENTATION: If the decedent had a Will or Trust, be sure to include it with the return. Failure to do so will virtually guarantee an audit, unless the decedent died intestate. Be sure to provide copies of appraisals for real property and closely held businesses. If a discount for lack of marketability or minority interest is being claimed, be sure the appraisal justifies the discount. Provide statements from banks and investment companies reflecting the date of death values of all holdings. The same rule applies to retirement accounts and IRAs. If the decedent had life insurance, provide copies of the Forms 112 and/or 712 for all policies. If the insurance proceeds are not includible in the estate, provide a detailed explanation for this exclusion. If the estate includes mineral interests, be sure to include run statements or other verification of the amount paid during the preceding and following six months and the methodology used in computing the value of the property interest. For automobiles, an NADA print out for the year and make of automobile will normally suffice. KEEP WORKING PAPERS: When you are preparing the return, be sure to prepare detailed work papers with copies of all supporting documentation and the computations you used in arriving at the figures on the return, and be sure you can tie these work papers back into the return. Professional looking and accurate work papers will go a long way toward deflecting an auditor's curiosity. WHAT IF YOU DON'T HAVE SUPPORTING DOCUMENTATION? If substantiating documentation is not available for any entry on the return, explain in detail "how" you arrived at the figure used. Do not leave any questions unanswered. Provide a detailed index with a description of each attachment and the entry on the return to which it applies. Organize the return in a logical, easy to follow sequence. WHAT ABOUT LIFETIME GIFTS? If the decedent made lifetime gifts, be sure you know about them and reflect the gifts on Form 706. Often the trustee or personal representative will not know about prior Form 709 Gift Tax Returns. If the estate is such that gifts were likely made, dig deeper and ask everyone who might have any knowledge of any prior filed gift tax returns. Also, be sure to properly allocate the GST exemption and to allow for any subsequent adjustments in value that might occur during the audit. COMMON MISTAKES: While there is nothing you can do to avoid an audit, there are certain actions you can take which will almost guarantee one. These include failing to reconcile your numbers. If the tax return does not compute, an examiner is going to ask you why not. Another common mistake is failing to adequately and correctly describe assets. Carefully check all legal descriptions, account numbers, dates of valuation, etc. Yet another common problem is incomplete or erroneously completed schedules. This is where work papers can be invaluable. Use your work papers to build the return before you transfer a single number to paper. Failure to provide adequate and complete documentation for all items claimed is a major faux pas. Make sure you have something attached to the return to justify each and every entry. Finally, if in doubt about whether to claim a deduction, discount or the like, do not do it unless you can support it with adequate legal and factual justification. Hot button items like valuation discounts generate a disproportionate number of audits. Don't file the return unless you have adequate justification and substantiation in your file should the auditor come knocking.