Piercing the Partition Fiction for Fractional Interest Valuation Schiller Law Group, A Professional Law Corporation Attorneys Orinda California

Form 706 Hot Topics From the Perspective of IRS Estate Tax Attorneys - Results of a Survey

This article was published by
The Continuing Education of the Bar
"Estate Planning and Trust Reporter"
February 2000

Should the preparer of an estate tax return file a "fat" return with extensive attachments or file a bare-bones return and let the IRS raise the issues? Is money well spent on an expensive appraisal for a residence? Is there an unwritten "safe harbor" valuation discount for a 50-percent undivided interest in real property? What issues raise the hackles of the IRS estate tax attorneys? Could it be that failing to attach a will or trust to a return is as likely to trigger an audit as an IRC §6 166 extension request?

Given the importance of these issues to practitioners and their clients, it seemed worthwhile to seek answers from IRS estate tax attorneys themselves. After all, estate tax returns may be the most extensive-and certainly the most expensive-that most clients will ever encounter. When estate tax is payable, the checks are often the largest the personal representative has ever had to sign-in any capacity.

Further, audits are expensive and audit rates remain high even though IRS staffing reductions in recent years have lowered that rate from about 38 percent to a current rate that is closer to 15 percent. (Group managers generally express frustration with the effects of reduced staffing on their workload capacity. It should be noted that, after the survey, the San Francisco Group was expanded by four new attorney hires.)

Between July and September 1999, the author surveyed estate tax attorneys in California employed by the IRS. The IRS divides California among five groups, two in Northern California (San Francisco and San Jose) and three in Southern California (Van Nuys, Los Angeles, and Orange County). At the time of the survey, there were 29 Estate Tax Attorneys in the Northern California groups, including the group managers. Of that total, 14 (48 percent) responded to the survey. Responses from the Southern California groups were significantly more limited. Two of the three group managers responded, but additional responses were discouraged by the Public Affairs Office for that region. Respondents were promised anonymity. The author wishes to extend his appreciation to those who responded, several of whom telephoned to express their appreciation that their views were being sought and would be shared with practitioners.

The first question in the survey asked whether the IRS attorney preferred "fat" estate tax returns, which were defined as ones with appraisals attached. This and all questions in the survey then invited comments. Overwhelmingly (87.5 percent) the respondents expressed a preference for a "fat" return. If important materials are not attached, the estate tax attorneys are more likely to request the missing information and inquire about other matters as well. (One very senior respondent who did not recommend a fat return stated that a fat return is advised when staffing-levels are normal.)

The respondents' comments should be viewed in the context of the initial procedures for handling returns. Returns are filed at the Service Center in either Ogden or Fresno. The Service Center then forwards returns to the appropriate estate tax group for review. On receipt by the group, there is an initial review (or "survey") by the group manager or a senior IRS attorney. Returns may be accepted without further examination at that stage and a closing letter issued. If a return is selected for further review, it will be assigned to an estate tax attorney. That attorney may either recommend acceptance of the return, in which case a closing letter is issued, or begin the field audit.

In the context of this procedure, the potential advantage of a "fat" return from the estate's perspective is that it can reduce or eliminate the possibility of unanswered questions that may cause the return not to be accepted at an early stage. As one respondent stated, "It takes no more time to write a formal opening letter than it does to write a completion letter. If the same return was complete when filed, I might survey the case." Another indicated that it was helpful to include "[a]nything to expedite the process and eliminate taxpayer contacts."

The importance of filing a "fat" return was further confirmed by a survey question that provided a list of 32 "hot issues" concerning estate tax returns and asked the respondents to indicate those they considered "hottest." The respondents identified the failure to attach the will or trust as the third hottest issue and the failure to attach appraisals as the sixth hottest issue. These failures were ranked as more troublesome to IRS attorneys than IRC §6166 installment payment of estate tax for business interests elections, IRC §2057 qualified family-owned business interest (QFOBI) deduction elections, IRC §2032A special use valuation elections, life insurance trust issues, Crummey trust issues, and marital deduction valuation issues.

Of course, wills, trusts, and appraisals may not be the only attachments needed to avoid unanswered questions. Other frequently needed attachments include proof of the contributions of joint tenants who are not spouses; gift tax returns; Forms 712 for life insurance; and a wide variety of documents that may be needed to address special situations.

It is the author's practice to file fat returns, including full appraisals. Whether the complete appraisal is needed or merely the most important pages is a matter of judgment and not covered by the survey. (In gift tax filings, where the IRS asserts a very high standard for adequate disclosure in order to achieve the running of the 3-year statute of limitations for gift tax value, full appraisal attachments should be the rule.)

The author also believes that, in addition to attaching the relevant documents, it is also important to make sure that the examiner will know they are attached and can find them easily. Accordingly, returns should contain a table of contents of attachments. The table of contents also serves as a checklist for ensuring that no attachments are overlooked in the final assembly of the return.

The second question in the survey asked, "Is there any one (or more than one) behavior, presentation, filing practice or other conduct by practitioners that you believe most likely causes audits to arise?" Again, comments were requested. Over 93 percent of IRS respondents identified one or more practitioner actions that trigger audits. Not surprisingly, many of the responses (7 out of 16) mentioned excessive valuation discounts. Unfortunately, there is neither formal nor informal guidance as to how deep a discount may be considered excessive. The practitioner who pursues a seemingly moderate discount has no assurance that the discount will be accepted. Accordingly, practitioners have to balance the desired result, potential IRS objections to even a "moderate and reasonable discount," the cost of audit (plus interest), and the potential for a favorable result in audit, appeal, or the Tax Court.

In this connection, Question 6 of the survey, regarding fractional-interest discounts, sought to determine whether a consensus might exist regarding one-half interests in four types of real property: a single-family residences, commercial rental property, unleased raw land, and farm land. Similar information was not solicited for interests in businesses because of the far greater array of potential interests and issues. As noted in the discussion of Question 6 below, different participants had substantially different views concerning appropriate discount levels, even in the simpler context of real property cotenancies.

According to the participants, behaviors that are likely to trigger an audit are not limited to acts that directly affect the amount of tax liability. Participants cited incomplete returns, lack of appraisals or other important documents, omission of adjusted taxable gifts, handwritten returns, mathematical errors, sloppy returns, bare numbers without backup, and apparent lack of candor.

Clients are legitimately concerned about the cost of an appraisal. Because valuation is the criterion on which estate tax is determined, practitioners often advise that the expense of a top-quality fee appraisal is money well spent. On the other hand, top-quality appraisals are expensive and may not be worth the money, depending on the size of the estate and value and type of property involved.

Question 4 inquired about a hypothetical appraisal for a single-family residence with an assumed value of approximately $800,000. Respondents were asked whether they would be more or less likely to accept the return value, depending on whether the appraisal was performed by a probate referee, a real estate appraiser, or a fee appraiser. This type of property was selected because it is relatively simpler to value than commercial real estate, timberland, or other business property.

Just over 50 percent of the responses expressed preference for a fee appraiser. Several of these replies, as well as others that did not specify a particular type of appraiser, emphasized the importance of references to comparable sales or "evidence." Two responses expressed satisfaction with the HUD form of appraisal, which is less expensive than a full-blown fee report. Respondents were more interested in quality of the appraisal than with type.

In their CPA Foundation Course, Hot Topics of the Federal Estate Tax Return, both Joe Stemach, Senior IRS Estate Tax Attorney, and the author have stated that they feel comfortable using either a HUD form or a real estate broker letter that references comparable sales in the appraisal of residences below the level of major estate homes.

Survey Question 3 inquired, "What course of conduct would you like to see practitioners undertake with estate tax returns to make your job more efficient?" Again, there were numerous references to excessive valuation discounts and inadequately documented returns. In addition, almost half of the IRS attorneys objected to the failure of practitioners to respond promptly to requests for additional documents or information.

Survey Question 8 inquired, "What practice or activity do you see practitioners follow that you believe most significantly harms the credibility of the practitioner in your judgment?"

More than one respondent wondered if there was credibility from any practitioners (and observed that some practitioners may feel similarly toward the IRS). Recognizing this built-in skepticism, conduct that undermines credibility can be divided generally into the following categories:

Some clients and practitioners want to know what range is reasonable for a fractional-interest discount without having to incur large appraisal expenses for an opinion about the consequence of a decedent's ownership of only a fractional share of an item of property. Sometimes they prefer to avoid controversy with the IRS even if there may be some discount "left on the table."

Survey Question 6 asked respondents to state whether there were ranges of fractional-share discounts for 50-percent interests in various types of real property that the respondent would generally find acceptable. This information was requested for single-family residences, commercial rental property, unleased raw land, and farmland. These different types of properties were selected because they present different issues concerning the possibility of partition, the cost of partition, and the income flow pending partition and sale. See Estate of Ellie B. Williams, TC Memo 1998-59; Estate of Bonnie I. Barge, TC Memo 1997-188; IRS Letter Ruling 9336002.

Twelve of the 16 respondents indicated a percentage comfort zone on at least one of the four classifications of real property. See Table 1 (p 100) for the results. Although the percentages varied widely, the average comfort zone discounts reported were:

(Where an individual reported a range, the median of the range was used to average the responses of the various respondents as a group.)

One respondent indicated that his/her discount percentage would apply only if the property is not community property, and that no discount would apply in the community property setting. A practitioner faced with a zero-discount assertion for community property may need to seek review by the group manager or through IRS Appeals. A denial based on family attribution is contrary to a wide body of law, even to the point of sanctions against the Service. See, e.g., Estate of Cervin v Commissioner (5th Cir 1997) 111 F3d 1252, reported in 18 CEB Est Plan R 177 (June 1997) (attorney fees awarded because IRS position against allowing fractional-share discount for real property was unreasonable); Propstra v U.S. (9th Cir 1982) 680 F2d 1248, reported in 4 CEB Est Plan R 52 (Dec. 1982) (discount allowed for community property interest in real property); and Estate of Bright v U.S. (5th Cir 1981) 658 F2d 999, reported in 3 CEB Est Plan R 63 (Feb. 1982) (community property one-half share of a 55-percent block of stock is valued as a 27 1/2-percent block). Several respondents indicated no safe harbor and stated that they require an appraisal to establish the discount amount.

Responses to survey Question 6, asking respondents to state the range of fractional discount "you would generally find acceptable for 1/2 interests in four types of real property"

Readers are cautioned that, although it is possible to calculate an average for the responses, the individual responses, and even some of the ranges for particular IRS attorneys, vary sufficiently that no clear practice emerges. From a practical standpoint, in deciding whether to advise a client to pursue a fractional-interest discount within the general perceived "comfort range," attorneys will be balancing matters of relative staffing levels of the IRS, size of the estate, value of the asset, presence of issues apart from the fractional interest, and the client's willingness to deal with the "luck of the draw."

Survey Question 5 asked, "Do you review estate tax returns on the death of the first spouse in a no-tax estate for the application of fractional interest/lack of marketability/minority interest where no discount is reported on the return?"

This question arises out of the fact that valuation discounts can be a two-edged sword. Clients often desire discounted values as a means to reduce estate tax on the death of an unmarried person, including the death of a surviving spouse. At that time, ownership of fractional interests in property or a minority interest in an entity can achieve substantial estate tax savings. In the context of a "no-tax" estate, however, including the estate of the first spouse to die under a standard formula marital deduction estate plan, discounts are a mixed blessing at best. To the extent that the discount can provide added funding to a credit shelter trust or a GST tax-exempt marital trust, the discount typically produces an eventual benefit in terms of transfer taxes. However, the reductions in values for estate tax purposes also result in reduced basis values for income tax purposes. As a result, the surviving spouse/beneficiary (1) incurs potentially higher capital gains on sale because the basis step-up is reduced by the valuation discounts; and/or (2) receives lower depreciation deductions on improved rental property as a result of the lower basis.

Several estate tax attorneys, primarily in the San Francisco Group, have begun asserting that valuation discounts must be claimed on the estate tax return for the estate of the first spouse to die. Survey responses indicate that this issue is receiving a wider recognition among IRS attorneys, even though they have no jurisdiction concerning income taxes and can only report failures to claim discounts to the income tax section of the IRS. Fifty percent of the responses identified discounts on the death of the first spouse in a "no-tax" estate as an audit issue. One respondent limited the inquiry to estates over $5 million; three respondents indicated the issue would be addressed more widely with greater staffing.

In the context of community property, there are some additional unresolved issues. One involves the so-called duty of consistency and its potential consequences for the survivor's estate, particularly if the heirs of both estates are the same. At least some examiners believe that taxpayers claiming no discounts on the first death should be estopped from claiming discounts at the second death. See Kristine A. Cluck (1995) 105 TC 324 (spouse of heir is bound for income tax purposes by heir's stipulation of value for estate tax purposes). In Mildred Geraldine Letts (1997) 109 TC 290, reported in 19 CEB Est Plan R 84 (Dec. 1997), the duty of consistency was applied to include QTJP election property in a surviving spouse's estate, even though the property had not qualified for the election in the first place. The consistency argument was strengthened by the fact that both estates had the same beneficiaries.

Another unresolved issue involves the Prob C § 100(b) provision that authorizes spouses to agree to a nonprorata division of community property on death. It is a least arguable that such an agreement confers on the deceased spouse's estate the right to have community property allocated in a manner that minimizes or diminishes the valuation-reducing consequences of owning a one-half interest in each specific item of property. The possible effect of such an agreement on fractional-share discounts is unknown.

Practitioners are sometimes concerned that the risk of an audit may be increased by requesting a prompt assessment of estate tax (to apply the nine-month period rather than three years for discharge of the "executor" (which can also include the trustee under a living trust)) under IRC §2204. Survey Question 7 directly asked whether this was the case. All of the IRS attorneys responding to the question agreed that a request for prompt assessment has nothing to do with whether a return is audited. We might note here that an IRC §2204 discharge does not apply to tax deferred under IRC §6166, even if the Service has not assessed estate tax within the nine-month period. IRC §6324A. Further, IRC §2204 protects only the fiduciary as such; it does not protect transferees of a decedent's property.

Survey Question 9 provided the respondents with a list of 32 potential audit issues that we believed would include those most likely to interest an examiner. The respondents were asked to rate each issue on a scale from zero to 5, where a rating of 5 indicated the issue was "the hottest of the hot issues -from your perspective." As with other questions, the respondents were invited to comment.

The grand prizewinner in this beauty contest was "Family Limited Partnerships created shortly before death," whichscorched all other issues with a perfect score of 5 across the board. This ranking is not unexpected in light of the various Technical Advice Memoranda (TAMs) issued by the Service on this issue (see IRS Letter Rulings 9719006, 9723009, 9725002, 9730004, 9735003, 9736004, 9751003, 9842003) and the Service's desire to apply the approach from Estate of Elizabeth B. Murphy, TC Memo 1990-472, reported in 12 CEB Est Plan R 34 (Oct. 1990) (no minority-interest discount allowed where decedent made gifts to reduce her block of stock to 49.65 percent less than three weeks before death).

The full ratings are listed in Table 2 (p 102). Some of the results deserve further comment:

Of the ten hottest issues, four were directly related to issues involving asset valuation:

In what may be a surprise to some, issues involving inclusion of nonqualified joint tenancy property in the estate were ranked seventh. This high ranking deserves comment. Generally, unless the surviving joint tenant is a United States citizen spouse, IRC §2040 requires inclusion in the gross estate of the entire joint tenancy asset, except to the extent the surviving joint tenant(s) can establish contribution. In view of the apparent perception of IRS attorneys that such nonqualified joint tenancies raise a substantial possibility of under-reporting, a practitioner filing a return that includes such property should carefully consider attaching evidence of the contributions of the surviving joint tenants. This may avoid an audit that might then spread to a broader range of issues. The IRS interest in this issue provides one more reason for avoiding joint tenancy ownership.

Two statutory elections were ranked in the top ten hottest issues: special use valuation elections under IRC §2032A and installment payment of taxes on business property under IRC §6166. These elections tied for eighth place. These rankings may reflect a perception that estates often cannot satisfy the complex requirements for either election.

Ranking of "Hot Issues" Rated 0 (Unimportant) to 5 (Hottest) by IRS Estate Tax Attorneys

Issues involving the allocation of assets to a bypass trust on the death of the first spouse to die become relevant on the death of the surviving spouse when the executor of the survivor's estate asserts that the bypass trust assets are not included in the survivor's estate. In the context of estate tax returns for the survivor's estate, bypass trust funding tied for eighth place on the list of audit issues.

In view of this ranking, some practitioners may wish to reexamine their procedures concerning trust funding at the death of the first spouse. Although some clients may resist actually changing titles in order to reflect bypass trust ownership, ownership issues may arise later. This is particularly likely to be an issue if there has been significant asset appreciation between the two deaths, as has been the case with many estates due to- the booming bull market for stocks in recent years. Aside from being able to prove title, it is also important to establish that the original funding of the bypass trust did not result in over-funding and therefore did not result in the surviving spouse making a gift. A similar issue concerns the possibility that the surviving spouse may have failed to receive mandatory distributions from the bypass trust.

Although the issue was rated 19th, the matter of Schedule M adjustment language deserves comment here in view of its importance and the ease with which practitioners can address the problem. Whenever an estate plan involves a marital deduction formula clause, Schedule M (pertaining to transfers that qualify for the marital deduction) should provide in some manner that, in the event of audit changes, discovery of other adjusted taxable gifts, other assets, or changes in asset values on examination, the claimed marital deduction will be adjusted in accordance with the formula.

If the return (particularly with a pecuniary bequest formula) merely lists assets without reference to the formula, the Service might determine increased values for estate assets and then argue that the estate is not entitled to an increased marital deduction that is large enough to avoid imposition of tax. This is particularly a risk when the marital deduction transfer is in the form of a QTIP, with the consequence that an affirmative election is required in order to qualify for the deduction. IRC §2056(b)(7)(B)(v).

Accordingly, Schedule M should make clear that the marital deduction is claimed for a formula amount. This can be done with language similar to the following:

The personal representative elects as qualified terminable interest property under IRC Section 2056(b)(7) that specific portion of decedent's property passing to the marital trust under Article of decedent's _ _[Will/Living Trust]_ _ represented by _ _[e.g., a fractional share that is required to reduce the federal estate tax on the decedent's estate to zero based on finally determined estate tax values after taking into consideration all other items deducted on the federal estate tax return, the allowable state death tax credit (to the extent that it does not increase the amount of death taxes payable to any state), exclusions, adjusted taxable gifts, and available unified credit]_ _.

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