Audits more likely for recent family business transactions

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By Jennifer Larino
Dolan Media Newswires

Family business owners who worked frantically to offload company shares to the next generation of owners in the months leading up to the New Year can breathe easier now that Congress passed a law to avert anticipated tax rate increases and tax-exempt gift limits. But CPAs and attorneys warn the work isn’t over quite yet.

The “fiscal cliff” compromise Congress approved in early January prevented a combination of tax hikes and spending cuts that were slated to go into effect this year, including changes to a 2010 law covering gift and estate taxes.

Anyone who gave assets away in 2012 was subject to a gift tax up to 35 percent of the value of the gift — with some exceptions. Individuals can give away $13,000 tax-free each year and had a one-time lifetime exemption of $5.12 million in 2012. In 2013, the top gift tax rate was set to return to 55 percent and the lifetime exemption to $1 million.

Ultimately, Congress increased the top rate to 40 percent and the lifetime exemption to $5.25 million for 2013. But not before many business owners transferred ownership to children or other family members at the end of last year to avoid the threat of higher taxes. The result, estate planning professionals say, is a bubble of large, often complex gift tax deals that are triggering red flags with the Internal Revenue Service.

Laura Walker Plunkett, an estate planning specialist with the law firm Stone Pigman, said family business owners who closed on transactions toward the end of last year should be prepared for an IRS audit. Plunkett said IRS audits of gift tax transactions are typically rare. This month, she is representing clients in three separate gift tax audits filed in 2011.

Plunkett said business owners need to make sure they have the proper documents, including a detailed valuation report for their company, completed and filed with the IRS as well as a way to quickly access paperwork months down the line. The longer that takes, the more difficult an audit will be, she said.

“A lot of people have breathed a sigh of relief since the ‘fiscal cliff’ bill passed,” Plunkett said. “I’m already having a little trouble poking clients to tie those loose ends.”

IRS data shows U.S. taxpayers claimed more than $21 billion in taxable gifts in 2011 amid favorable tax rates and exemptions, more than double the amount filed in the previous year. The IRS has been more aggressive in auditing gift tax returns in recent years, for example, employing state records to track down unreported intra-family land transfers.

Still, audited returns were a sliver of the more than 230,000 returns filed in 2011, up from 1,777 in 2010 to 2,623.

Like property deals, Vanessa Claiborne, president of the investment banking services firm Chaffe & Associates in New Orleans, said gift tax returns involving the transfer of large amounts of company shares for family-owned businesses can be an audit target. Chaffe saw a surge in clients looking to appraise the value of their businesses in late 2012.

Taxing the value of a share in a business is less straightforward than taxing a check wrote to charity or a gift of publicly traded stock, she said. Companies such as Chaffe use a number of approaches to calculate that value, from evaluating a business’ cash flow to drawing comparisons to similar firms.

It’s not uncommon for aggressive firms to lowball a valuation to maximize tax benefit, but Claiborne noted the IRS can and does step in to dispute that figure after the gift.

Marguerite “Peggy” Adams, an attorney with Liskow & Lewis, said the closer the size of a gift is to the $5 million exemption, the more likely a company’s valuation will be under a microscope. Many of her business clients closed large transactions last year to take advantage of the lifetime exemption.

“If you’re making very large gifts and you’re very aggressive on the position you take on valuation, that may increase the likelihood you’re going to be audited,” Adams said.

Jennifer Bordes, a tax director with LaPorte CPAs, said “the anticipation is there” that the IRS will increase audits on gift tax claims this year. Many of LaPorte’s clients pulled the trigger on transactions late last year and may have rushed through important paperwork, she said.

Bordes is encouraging clients to gather valuation reports, copies of checks written during the transaction and information on the investment vehicle used to transfer company shares.

“If a valuation report still needs to be completed in the proper form, that should be worked on so when the tax return is due you’re not scrambling to look for all this stuff,” Bordes said. “Get with a CPA or an attorney and find out exactly which documents you need to have,” Bordes said.

While attorneys and CPAs advise clients to move quickly with paperwork, there is some skepticism that the IRS will have the resources to proactively audit given the sheer volume of returns that will be filed in 2012. Claiborne and Adams noted the agency staff is already stretched thin. According to a March 2012 USA Today report, the service had 5,000 fewer employees during tax season than the year before.

“It just doesn’t seem humanly possible,” Claiborne said.

Recent taxpayer-friendly changes could also curb audits. Tax law now permits married couples to take over unused estate tax exemptions upon the death of a spouse. And the outcome of a 2012 court case, known as the Wandry decision, validated a new technique that allows business owners to base a gift of company shares on the amount they have in exemptions rather than the value of one share.

For example, instead of gifting 100 shares worth $5 million, an owner can give an heir $5 million, with the number of shares included under that gift to be determined later. If the IRS later finds a business is worth more than its appraisal value, owners can adjust the number of shares downward to meet their exemptions without having to pay a penalty, Claiborne said.

Plunkett emphasized that business owners who want to use those protections need to start pulling together the necessary documents now.

“Doing it right doesn’t count if you can’t prove it,” Plunkett said.