There's an important-yet unspoken-phenomenon in the world of estate tax: As the number of estate tax filings has been decreasing nationwide since 2001, there's been a corresponding increase in the Internal Revenue Service's audit coverage rate of estate tax returns-from 20 percent to nearly 100 percent. Indeed, at least for the next few years, practitioners should change their assumption from "Federal estate tax returns may be audited," to "These returns will be audited." And of course that means all estate-planning attorneys and accountants should be more careful than ever before, when planning a client's estate.
What makes the IRS' ever-increasing vigilance possible? Well, one implication of the 2008 election results is that we can safely rule out any near-term possibility of an outright repeal of the federal estate
tax. If President Barack Obama holds true to his pre-election tax proposals, the 2009 federal estate tax law will be extended into 2010 and beyond, maintaining the $3.5 million estate tax exemption (possibly indexed for inflation) with a 45 percent estate tax rate for the foreseeable future.
The leap this year to a $3.5 million estate tax exemption from the previous $2 million exemption will be the sharpest single-year increase in the estate tax exemption, both in terms of a dollar amount increase and on a percentage basis, since the modern estate tax was first enacted in 1916. It's been estimated that the $3.5 million exemption will shelter roughly 99.5 percent of all estates from the federal estate tax.
Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the number of estates required to file a federal estate tax return (Form 706) has been steadily declining nationwide. It
went from an annual total of 108,071 returns filed as recently as in 2001, to a mere 38,031 returns filed in all of 2007.
The Facts, and Just the Facts
If the established pattern continues, under which about 45 percent of the total number of federal estate tax returns filed nationwide are taxable, less than 8,000 taxable estate tax returns will be filed in 2010-a drop of approximately 85 percent over a nine-year period.
Yet there's an inverse relationship between the number of estate tax filings and the audit coverage rate. That is to say, as the number of estate tax filings decreases nationwide, there is a corresponding
increase in the audit coverage rate of estate tax returns by the IRS.
In 2001, when 108,071 federal estate tax returns were filed nationwide, there were about 350 attorneys in the IRS Estate and Gift Tax Program auditing federal estate tax returns nationwide.
With a staff of about 350 auditors, there were slightly more than 300 federal estate tax returns filed for every auditor in 2001. IRS estate tax attorneys are informally expected to close about 30 examined
estate tax cases annually with some degree of substantive adjustment. Consequently, about 10 percent of all federal estate tax returns (those that are taxable and those that are not) were being thoroughly audited by the IRS in 2001. By 2005, when the total number of federal estate tax returns had dropped to 45,070, there were only about 129 returns being filed for every auditor. The estate tax audit rate had jumped to 24 percent. These audit rates are dramatically higher than the 1 percent to 2 percent audit rate for individual income tax returns.
Of course, the audit coverage rate for taxable estate tax returns has risen even more dramatically. In 2001, it was 20 percent, because there were about 150 taxable estate tax returns filed for every auditor. By 2005, the audit rate for taxable estate tax returns was over 50 percent. In 2010, the year after the federal estate tax exemption will have risen to $3.5 million, the IRS has projected that 17,500 federal estate tax returns will be filed nationwide. If there are still 270 auditors, the audit rate for taxable returns will be virtually 100 percent.
You've Been Warned
What should tax practitioners take away from these projected trends in the audit coverage rate of federal estate tax returns?
Estate planners will do well by their clients to ask themselves at the earliest planning stage how a proposed transaction is likely to withstand IRS scrutiny. Particular attention should be paid to how hard-to-value assets are reported on an estate tax return. Transactions involving family limited partnerships and other techniques that the IRS considers potentially abusive will continue to trigger closer scrutiny.
In general, tax professionals serve their client's best interests by preparing all tax returns with the assumption that the IRS may audit their work product.
Financial advisors—It's time to up your game. Subscribe to Trusts & Estates. This story originally ran in the February issue of Trusts & Estates, a sister publication.