How To Build an Audit Defense for Estate Planning and Gift Taxes

Tax Professionals' Resource
December 11, 2012 — 1,145 views  
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How To Build an Audit Defense for Estate Planning and Gift Taxes

The problem with estate planning and gifting inheritance is that there is never a perfect time to distribute the assets. If funds or property are gifted while a person is alive, then anything over $13,000 a year incurs a tax on it, owed by the gifting party rather than the recipient. If funds or property are transferred after death, then anything a recipient receives can be subject to both inheritance tax as well as income tax in the year the asset is received. There’s no sure-fire way to avoid an IRS audit on returns, but there are ways to make sure that audit doesn’t result in bad findings associated with estate planning.

First, any funds or property gifted while a person is alive that is over $13,000 in a year, either as one gift or as multiple transfers to the same person, should be documented. Additionally, the taxes owed on the amount that exceeds this limit should be paid and kept on file as well. A copy of the payment to the tax agency should be provided to the recipient. Ideally, with both documents then there is no question in an audit that the gift taxes involved were collected and nothing further is due.

Second, inheritance taxes only kick in when funds or assets are transferred to a second party. Fortunately, spouses in an active marriage are not considered second parties for tax purposes. So assets without limit can be moved back and forth between marriage partners. However, when it is time to transfer funds outside of a marriage, then inheritance taxes will be incurred. So, in many cases, people transfer funds to family beneficiaries through gifts annually, staying under the tax limit and documenting each transfer. Such gifts are then tax-free to the recipient, even under income tax rules.

Then, when the first spouse passes away, the second spouse takes over the estate without taxes and continues the gifting. Again, funds and assets can be moved without taxes as long as they stay under the annual limit. Only when the second spouse passes away, any estate transferred can be subject to inheritance tax.

Third, keeping good files and paperwork is critical to audit defense. The worst thing a taxpayer can say to an auditor is that no paperwork exists to prove a figure on a tax return. Auditors love to hear that sort of thing because it means they can then assert the figure is made up and no proof exists for support. That then means the tax agency can nullify the return and demand more taxes as well as interest and late payment penalties. It gets worse from there. However, with clear and detailed paperwork, the auditor is out of luck and has to find something else to report.

Tax Professionals' Resource