If all the recent news about a chastened Internal Revenue Service has you tempted to try some creative estate planning, you might want to consider a few things first. Even with its skimpier staff, the IRS still manages to audit about 28% of all estate-tax returns involving $5 million or more--and 9% of those worth $1 million to $5 million. And you should probably double those odds since the IRS gets two swipes at a married couple. Plus, it is the IRS's A-team that audits estates.
Indeed, the stakes are so high in estate returns--catching an underreported dollar yields as much as 55 cents in revenue--that the IRS is concentrating its firepower in this area even while the percentage of personal income-tax returns audited has dropped to a 40-year low. The taxman is especially on the alert for aggressive estate-tax strategies such as family limited partnerships and fancy maneuvers involving charitable donations.
With a family limited partnership (FLP), a parent who is, say, the owner of a business, sets up a partnership and, over time, transfers ownership to the heirs, who are limited partners. The parent becomes the general partner, retaining control over the business. A major attraction here is that it allows the business owner to discount the value of the gifts being made to the heirs on the premise that they don't have control of the asset. The discount reduces any gift-tax liability and gets the valuable asset out of the parent's estate. This strategy produces more fights in tax court than any other, says Alvin Golden, a trust and estates lawyer in Austin, Tex.
If you're going to set up an FLP, it's critical to get a professional appraisal to support whatever valuation you put on the limited partners' discounted shares. Experts say a 10% to 20% discount could slide right by, since the IRS will probably figure it would give away that much in a settlement. Ratcheting the discount up to 60% would catch the auditors' attention, and 80% "would knock their socks off," cautions David Rhine, a CPA and family-wealth planner in Ramapo, N.Y.
Even giving money to charity might put you in the IRS's crosshairs, especially if you use a charitable family limited partnership (CFLP). It will "absolutely" get you audited, says Stephan Leimberg, an estate lawyer who operates www.leimberg.com, a Web site dealing with estate and financial issues. Using the CFLP, you give 99% of a highly appreciated asset--such as a family business or an investment portfolio--to a charity in a way that allows you to retain control. As with all donated property, you avoid triggering capital-gains taxes. But with the CFLP, your children may buy back the asset from the charity later. So what has happened? If you gave the asset to the kids directly, you might have to pay gift tax, and your heirs would be stuck with your low cost basis should they want to sell. By having them purchase the asset from the charity, they get a higher basis. That will reduce their future capital-gains tax liability.
PLAY DEFENSE, TOO. Just because such arrangements irk the IRS doesn't mean you shouldn't use them. If you're facing the top estate-tax rate, you may decide that the benefits are worth the risk. In fact, despite fervent attacks, the IRS has yet to convince courts that FLPs are a tax dodge rather than a legitimate business tool.
In taking the offensive, you should play defense as well. One way is to file gift-tax returns for all cash and noncash gifts--even if you think your gift is worth less than the $10,000 annual limit for tax-free gifts from one person to another. The IRS has only three years to audit you after a complete and proper filing. So you can lessen the chance that years later the agency will insist that all those gifts were worth a lot more and demand back taxes, interest, and penalties.
No matter how you structure your estate, keep three years' worth of bank and brokerage statements where they can easily be found. Your loved ones will need them if the IRS comes calling.
By Carol Marie Cropper