What Happens When the IRS Audits Your Estate or Gift Tax Return?
Why estate and gift tax returns draw IRS scrutiny
Estate and gift tax returns — Form 706 and Form 709, respectively — are among the most complex filings in the tax system. They involve large dollar amounts, subjective asset valuations, and intricate planning structures. The IRS devotes significant resources to reviewing these returns, and certain factors reliably increase audit risk.
Returns reporting closely held business interests, real estate, or other hard-to-value assets are frequent audit targets. Valuation discounts — reductions applied to the reported value of business interests or fractional real estate holdings to reflect lack of control or marketability — are among the most scrutinized items on any estate or gift tax return. Aggressive discount percentages, transactions involving family limited partnerships, and large inter-family transfers all tend to draw attention.
How an estate or gift tax audit begins
Most estate and gift tax audits begin with a letter from the IRS indicating that the return has been selected for examination. The letter typically requests documentation supporting reported values, deductions, and claimed exemptions. This initial correspondence sets the tone: the IRS wants to verify the numbers, not necessarily to find fraud.
An IRS estate tax examiner is assigned to the case. Unlike a typical income tax audit, estate and gift tax examiners are specialists. They are trained in valuation methodology, family entity planning, and the technical requirements of estate and gift tax law. They know what to look for, and they know when to bring in an IRS valuation specialist to challenge a reported number.
What the IRS typically challenges
• Valuation of closely held business interests, including the appropriateness and magnitude of minority and marketability discounts
• Valuation of real estate, particularly when no independent qualified appraisal was obtained at the time of the transfer
• Inclusion of assets allegedly transferred before death that the IRS believes were retained by the decedent
• Adequacy of consideration in intra-family sales or installment transactions
• Proper reporting and use of the annual gift tax exclusion and lifetime exemption
The examination process and timeline
Estate and gift tax audits can be lengthy. A straightforward examination may conclude within a year; complex cases involving business valuations or multiple asset classes can stretch considerably longer. The examiner may issue an Information Document Request (IDR) asking for appraisals, financial statements, corporate records, and correspondence related to specific transactions.
If the examiner proposes adjustments — increasing the taxable estate or gift — the taxpayer receives a Notice of Proposed Adjustment. At that point, there is an opportunity to respond with additional documentation, present a counter-appraisal, or negotiate a settlement with IRS Appeals before any tax is formally assessed.
The importance of contemporaneous documentation
The single most effective way to protect an estate or gift tax return from a successful IRS challenge is robust, contemporaneous documentation. Qualified appraisals of non-publicly-traded assets should be obtained at the time of the transfer — not reconstructed after an audit begins. Formalities for family entities must be maintained. The business rationale for any planning structure should be documented clearly and independently of tax savings.
Returns that are carefully prepared, supported by qualified appraisals, and accompanied by a well-reasoned disclosure of any aggressive positions fare significantly better in examination than those that are not.
If your estate or gift tax return has been selected for examination, experienced representation is essential. Our tax controversy attorneys handle IRS estate and gift tax audits from initial contact through resolution. Contact us to discuss your situation.
