It’s a game changer. The audit process for wealthy families, particularly business owners, has taken on new meaning as the Global High Wealth Industry (GHWI) Group within the IRS begins to hit its stride. Created by the IRS in 2009, the GHWI Group focuses specifically on complex returns, such as those filed by business owners or family offices with complex entity structures and intra-family transactions.
While the IRS historically audited only one return at a time, the GWHI Group is empowered to use an “enterprise” approach to audits, meaning that they can open up the returns for any (and all) related entities, individuals or transactions. Not only are your audits likely to be broader in focus, but also the extent of the information requested and the timeframe for compliance could overwhelm your internal resources. It is critical for family business owners and family offices to understand the nature of these audits and be prepared for these inquiries.
What is the GHWI?
The GHWI is a team of dedicated revenue agents and attorneys focused solely on high-net-worth individuals. While there are no specific triggers for the audit process, the GWHI has identified several areas where they believe revenues are underreported and has staffed up accordingly. Individual returns showing adjusted gross income in excess of $1 million are likely to be flagged for review, as are returns showing transactions or entities in excess of $10 million. The GHWI has a specific focus on partnership transactions, foreign bank transfers, valuations and gift or estate transfers. While the overall risk of audit remains low (between 8% and 20% of returns filed, depending on the income level) and the activities of this group to date have been somewhat limited (mainly because the group has been in the start-up stages), this is changing. The GHWI Group is gaining momentum, and with the huge increase in returns filed by the target taxpayers in conjunction with 2012 planning, a significant percentage of these returns are likely to trigger some type of review or audit.
Early reports indicate that audited taxpayers felt woefully unprepared for the level of scrutiny on their returns. The GHWI effort is part of the Large Business and International division; these audit teams and experts are used to working with compliance and internal audit professionals inside corporations, not individuals or family offices. Even family businesses used to regular tax or accounting audits find they lack the infrastructure or recordkeeping to meet the requests of the GHWI in a timely manner. Further, the GHWI has been staffed specifically with technical experts in international tax matters, valuations, gift and estate transfers and financial derivatives, in addition to larger teams of revenue agents and IRS attorneys. As such, the scrutiny of tax returns and initial information requests can be quite specific.
Information triggers
The IRS has expanded its information sources beyond a review of filed tax returns in an effort to identify more revenue opportunities. Social media outlets, marketing or PR releases on products, and even published reports for shareholders can be another source of information for the revenue authorities. Private foundations are reviewed for fees paid to staff, excess business holdings and related party transactions, all of which must be disclosed on their Form 990s.
More sobering is the IRS focus on real estate transfers. The tax authority believes taxpayers routinely fail to properly report transfers at the appropriate value. The IRS has successfully used a “John Doe” summons to obtain information when the authorities may not know specific names or transactions. While some states have capitulated to these requests, others have tried to limit disclosure, rather unsuccessfully. In a recent federal district court case in California, the judge permitted the IRS to serve a “John Doe” summons on the California State Board of Equalization demanding the names of all residents who transferred property to their children or grandchildren for little or no cost, opening up all such transactions from 2005 to 2010. The IRS has already received information about these intra-family transfers from several states, including Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New York, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, Washington and Wisconsin and begun pursing gift tax inquiries, with fees and penalties, on these transfers. Similar inquiries have been reported with respect to transfers of jewelry and art purchased at galleries or auctions.
Audit process
Anecdotal reports indicate that, while the audit may begin with a narrow inquiry or request to provide supporting documents, including old tax returns already filed with the IRS, the scope can expand rapidly as information is delivered. The IRS may request information like shareholder lists and organizational charts in order to better focus on specific transactions, such as payments of management fees to related entities, or transfers to trusts or intra-family sales, which may not have been accurately reported on all the related individual’s returns.
The response to the information requests is expected within two to three weeks, often overwhelming the ability of the taxpayer to gather the requested information. Meetings with the agents can include their internal experts, requiring the taxpayer to engage attorneys or accountants early in the process. While the average audit usually lasts 12 to 15 months, the GHWI audits appear to be lasting in excess of 24 months, at a significant cost to the taxpayers, in terms of both audit representation and resources expended to comply with information requests.
How should your family prepare for an audit?
• Get organized. While family businesses may retain documents with respect to business operations, dividend payments and valuations, few collect or review gift and income tax returns by shareholders or oversee compliance centrally. Shareholders’ own organizational abilities vary widely. Yet the burden of proof is on the taxpayer to provide information requested in an audit. Many transactions can require substantiation of transfers made years earlier, yet most accountants or attorneys retain records for only five to seven years. Indeed, the IRS can ask for any return, even beyond its own record retention guidelines if it relates to an open transition (such as the allocation of generation-skipping tax to a transfer of shares). Getting organized around your stock ownership and transactions and ensuring compliance across shareholders is vitally important.
For operating businesses, offering an outsourced family office capability to shareholders is a popular alternative, particularly when the business does not have the interest or need for a dedicated in-house staff or there has not been a liquidity event sufficient to offer asset management or other shareholder services. Some type of centralized oversight is critical for families with complex ownership structures. This can ensure compliance and coordination of shareholder activities, as well as the timely retrieval of documentation in the event of an audit.
• Set and follow clear policies and procedures. Family business owners should be clear with shareholders about what information is retained by the business and what information the shareholders must retain. This is especially important if shares or interests are transferred subject to valuation discounts or if the family is using partnerships or LLCs as commingled vehicles. In my work with clients, we create formal electronic records for both business and individual shareholders around transactions or entities. This process can provide the entire family with supporting documentation in the event of an audit inquiry.
• Do a mock audit. Try taking one or two transactions—a recent 2012 gift tax return or an intra-entity fee arrangement—and determine if you have documentation to substantiate the transactions. If management fees were paid, how were the fees determined? Were gift tax returns needed for a transfer of property? What about the valuations—are the documents accessible? Were all installments on intra-family loans paid and accounted for?
Family Limited Partnerships should be closely reviewed, as many families have not kept accurate records to substantiate the validity of the partnership or the surrounding transactions. Even routine documents should be reviewed for accuracy and completeness.
• Think ahead. Any audit will be a drain on company and family resources. If the audit expands across multiple entities, shareholders and transactions, the cost to comply with document requests and reviews can become excessive. A review today of the processes and procedures—perhaps simplifying organizational or governance structures, automating recordkeeping or at least designating a response team—can be a critical measure. If your shareholder list is submitted as part of an audit, what is your duty to notify (or support) other shareholders? Is there an agreement or process among the shareholders to ensure proper reporting of transactions and valuations?
While only a fraction of returns are audited, and fewer by the GHWI, the IRS’s focus on complex returns and wealthy taxpayers has significant implications for owners of closely held businesses and family offices. Understanding the nature of these audits and taking steps today to prepare will ensure fewer interruptions to your core business operations.
Holly Isdale is the founder of Wealthaven, a family business consulting firm specializing in ownership transitions, private trust companies and governance. Wealthaven also operates outsourced family offices (www.wealthaven.com).
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