Estate Planner Mar-Apr 2000
In recent years, the IRS has frowned on several widely used estate planning techniques. But if you always strictly follow the IRS’s approved path, you could end up paying more transfer tax than you should — not all positions taken by the IRS are upheld in court. If you anticipate that some of your transfers will receive heightened scrutiny, you may take additional steps to prevent an audit or reduce the controversy surrounding an audit.
One area under IRS scrutiny is valuation of family entities where discounts for minority interest and lack of marketability are claimed on transfers of business interests to family members. The IRS has focused on examining valuation discounts for these entities. Gifts of interests in closely held businesses are notoriously hard to value because no ready market exists in which interests in them are bought and sold. So, the value of such a business as a whole is often a matter of opinion. In addition, when family members give business interests, they often take discounts that further depress the gifts’ value. These discounts can arouse the IRS’s interest.
Similarly, gifts of interests in family limited partnerships (FLPs) that include fractional interest and marketability discounts are also commonly audited. FLPs reduce estate tax by transferring limited partnership interests to a younger generation. The value of these interests is discounted when the gifts are made to reflect their lack of marketability. The idea is that willing buyers would pay less for these interests because the owner is not easily able to sell the interests to someone else. Generally, limited partnership interests are not traded in any public market and lack a reasonable prospect of being registered for trading in a public market. A discount is also taken to adjust for interests being minority interests that the buyer is not able to exert control over.
Donors of interests in family businesses often limit the gifts to the donor’s $10,000 annual exclusion from gift tax ($20,000 for a married donor whose spouse agrees to split the gift). Even though the donor will not owe gift tax, filing a proper gift tax return is important. Though it may seem counterintuitive, one way to lessen an audit risk is by fully disclosing all relevant facts when filing a gift tax return. Adequate disclosure of the gift prevents the IRS from extending gift tax statute of limitations. Inadequate disclosure allows the IRS to revalue the gifts and assess additional tax. The donor is obliged to file a complete return and report the value of the gifts. While the IRS does not require an appraisal, it can be helpful to have an expert opinion to support your valuation.
The use of Crummey powers commonly used in irrevocable insurance trusts is another example of IRS hostility. The IRS has refused to issue rulings on these powers and has repeatedly challenged them in tax court. But despite these attacks, people still use them.
Crummey powers in trusts allow a donor to apply the $10,000 annual gift tax exclusion that is available only for current gifts to transfer to the trust. Without Crummey powers, if you establish a trust for the benefit of your children and your children lack control over the trust assets, gifts of cash to the trust might not be considered to be of a present interest and would thus fail to qualify for the exclusion. Crummey powers give beneficiaries the right to withdraw cash for 30 days after the deposit so that the gift becomes a present interest. The best way to protect against a challenge to Crummey powers is to comply with all rules and to use them reasonably. It is safer to provide Crummey powers only to those beneficiaries who have a real interest in the trust. Adding remote relatives just to obtain additional annual exclusions will draw IRS attention. And follow all technical rules regarding Crummey powers and IRS-required notices.
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As you will always want to stay within the law when reducing tax, you should seek the assistance of a professional. Be sure to contact us for help in these often complicated matters so you can minimize the likelihood of an IRS audit or adverse audit findings.