How to Prepare High-Net-Worth Clients for IRS Wealth Squad AuditsHow to Prepare High-Net-Worth Clients for IRS Wealth Squad Audits
Five critical actions to take.
At a recent conference, top officials with the Internal Revenue Service announced a renewed audit focus on high-net-worth (HNW) individuals and their related entities going forward. Advisors must be ready to work with their clients to respond to the IRS given the potential comprehensive scope and overwhelming information gathering that the recently announced audits may require. Here’s brief description of what’s expected and ideas for how to advise clients in preparation for a HNW audit. In addition, these ideas are best practices that may provide advantages regardless of whether an audit is initiated. For example, taxpayers will benefit from a detailed understanding of their financial situation to address potential federal and state tax law changes as a result of the November 2020 election.
Groundhog Day for the Wealth Squad
The newly announced IRS examinations will be conducted by the agency’s Global High Wealth Industry Group. The group, known as the “Wealth Squad,” is housed in the IRS division that oversees tax administration activities for large domestic enterprises and foreign businesses with a U.S. tax reporting presence. These enterprises are generally controlled by individuals with assets or earnings in the tens of millions of dollars.
Notably, this type of initiative isn’t new—similar IRS efforts were made around 2013 following criticism about the agency’s lack of enforcement efforts toward HNW individuals. The recent 2020 announcement, for example, followed a U.S. Department of the Treasury inspector general’s report recommending that the IRS increase its focus on certain high-income taxpayers. And as part of the 2020 initiative, IRS enforcement efforts will increasingly rely on improved technology and big data to further refine and improve screening and enforcement efforts.
Advising Clients Who May (or Do) Receive Such Audit Notices
Based on our experience with prior Wealth Squad audits, we expect the IRS to take a holistic approach in developing a complete financial picture of HNW individuals and the entities they control. We expect this approach to focus on both individual income tax returns and the entities in which the individual has a controlling interest or other material connections (including private foundations (PFs)).
At a high level, a Wealth Squad audit will likely be designed to unpack complexity by taking a coordinated approach often reserved for large corporate audits. As a result, individual taxpayers and their accountants may be overwhelmed at the start of such an audit unless they prepare now.
Five Critical Actions
While unique to each audit, there are numerous critical actions that taxpayers can take to proactively prepare. These include:
Develop a thoughtful taxpayer narrative. A taxpayer, assisted by knowledgeable advisors, can positively affect an audit by ensuring that the IRS understands foundational elements of the taxpayer’s business, personal and charitable activity. Proactively preparing clear and updated organizational charts prior to an audit can help taxpayers identify areas in which they may need to obtain more information. Similarly, documenting the overall history of major recent activities can help identify potential audit risk factors and allow a taxpayer to proactively address the items most likely to require thoughtful explanation to the IRS. Consideration to privacy and privilege will also be important with this review.
Compile a complete understanding of the key assets. We expect that the IRS will target assets commonly implicated in complex audits. These include, among other things:
Foreign assets (for example, bank accounts, foreign trusts, foreign business interests, overseas inheritance and associated reporting compliance);
Associated entities (for example, trusts, partnerships, S corporations and C corporations);
Gifting practices; and
PFs.
Foreign assets may require significant lead time to obtain records. Additionally, the IRS announced it had identified over 1,000 PFs that are linked to or interwoven into global high-wealth enterprises. Thus, taxpayers may benefit from proactively compiling a careful record of any transactions that, absent such records and clear explanation, the IRS could challenge as self-dealing.
Identify potentially involved business partners and family members for coordinated preparation. The IRS has the power to summon third parties for information, including demands for business records and testimony. As the agency has wide latitude regarding the issuance of a summons, taxpayers shouldn’t assume that they can control this process during the audit. Additionally, the receipt of an IRS summons may cause some to act unexpectedly. While skilled counsel may be able to work with the IRS to narrow third-party requests, it’s valuable for taxpayers to understand which of their business partners, or family members, may receive requests for information. Confidentiality provisions in business agreements may limit disclosure of certain information unless compelled by the government, and taxpayers should be ready to work with the relevant parties to make more limited disclosures in lieu of official IRS summonses.
Conduct a detailed or high-level pre-audit. Taxpayers may benefit from a pre-audit exercise by existing advisors already familiar with their situation and/or new advisors with fresh eyes for a peer review. The scope of a pre-audit is customized and often includes detailed reviews of tax returns and other financial information to get ahead of any potential questions from the IRS about the face of the returns. This type of review can also identify areas in which additional records may be critical to substantiating the return positions and third-party contact from the IRS may be most likely.
Think preliminarily about a potential audit plan. As we’ve learned from past Wealth Squad audits (as well as typical large corporate audits), the first step typically involves defining the scope of the audit with the IRS through an audit plan that addresses initial expectations and timing. Considerations such as extensions to the statute of limitations, and appropriate deadlines for responses from taxpayers, can have a direct impact on the scope and tenor of the audit. Also, with remote working being a norm at the time of this writing, careful consideration to the negotiated responses is paramount. Preparing clients for these decisions can be useful. Additionally, clients should be ready and able to address expansions of the scope of the audit.
Sophisticated Process
Overall, audits of HNW individuals are typically complex and require a sophisticated understanding of various interrelated areas of tax law. To this end, the IRS has indicated that it plans to utilize: (1) increased data analytics, (2) improved cooperation among IRS divisions, and (3) the agency’s broad legal powers to summon information from individuals, with a side goal of improving the accuracy and effectiveness of future audits.
Each of the items above should help advisors HNW clients better prepare for these IRS enforcement improvements—preparation that could produce ancillary benefits in planning for business activity following the 2020 election.
