Form 706: the not-so-simple estate tax return.

Knowing the risks of estate tax work may save you from a costly malpractice claim.

The old adage that nothing is certain in life except for death and taxes may be the motto for CPAs who choose to do estate tax work. But life's certainties can bring the uncertainties of potential lawsuits if practitioners fail to exercise care when engaged to file form 706, the U.S. Estate (and Generation-Skipping Transfer) tax return--a simple form that can give CPAs a load of problems.

It's no surprise that tax work is an area that puts CPAs at greater risk for lawsuits, but estate tax work results in a disproportionately high rate of malpractice claims. In our company, approximately 12% of all tax claims come from estate tax work. This statistic is particularly alarming when compared with the high number of individual tax returns filed each year: The U.S. Department of Treasury reported that more than 110 million form 1040s were filed in 1994, compared with only 40,000 form 706s.

Of the total dollars CAMICO paid to claims, 13% went to estate tax claims--the fourth highest in severity. CAMICO statistics showed that individual income tax claims had the third highest severity, averaging $66,000 a claim. Financial statement compilation-related claims averaged $158,000 a claim, and audit-related claims averaged $348,000 each, logged second and first place in severity. The estate and individual income tax claims have been disproportionately costly considering they arise from individuals rather than businesses, where big ticket audit and compilation claims originate.

The frequency and severity of estate tax claims provide good reasons to pause before including estate tax work in your scope of services. Although it can be very lucrative, it is important to proceed with caution.

While form 706 itself seems relatively simple to prepare, its nuances make it extremely complex. There are several areas that have an especially high potential for error. Following are some red flags CPAs should look out for when preparing estate tax returns.

DON'T MISS THAT DATE

The form 706 deadline is nine months after the date of death. Estate executors can obtain a six-month extension (form 4768) for filing the form, but the tax is still due at the end of nine months unless an application to extend the payment is made on form 4768. There is a standard penalty if the executor does not meet the filing deadline or makes late payments: 5% per month of the amount of tax due for the late filing penalty and 0.5% per month of the tax due for late payments. Remember also other returns, such as a final-year individual income tax return or an estate income tax return.

It's possible to miss deadlines because of miscommunication. Since attorneys and CPAs often work together on one estate, important deadlines can be missed if it is unclear which party is responsible for filing the appropriate extension or return. Engagement letters easily clarify the CPA's responsibilities. Not only does the engagement letter put both the attorney and the client on notice that there is unresolved business, such as filing deadlines, it serves as an excellent written defense against any claim resulting from missed return filings the CPA was not engaged to prepare.

There may be legitimate reasons for delayed filings, such as disagreements over the value of a very large asset. CPAs should advise clients to deposit enough money before the filing deadline to cover the expected tax. Because both the late payment and late filing penalties are calculated based on the tax unpaid at the payment deadline, both penalties are avoided if the tax payments exceed the expected tax. For example, if the CPA estimates the total tax due is $100,000, and tax payments at the payment deadline equal $90,000, the penalty will apply only to the $10,000 unpaid portion.

THE QUANDARIES OF QTIPS

While penalties for late filings can be stiff, mistakes in determining the tax due can be equally disastrous. A missed qualified terminable interest property election could cost both the CPA and the client dearly. QTIP elections qualify for the estate tax marital deduction when a surviving spouse receives only a terminable interest. However, to receive QTIP treatment, the qualified terminable interest must be reported correctly on form 706.

When an individual dies, the QTIP election allows deferral of estate taxes until the death of the surviving spouse. The IRS currently accepts the QTIP election if everything on the form shows the election was intended. However, missed QTIP elections are a common cause for claims against CPAs. When a CPA in one case failed to make a QTIP election, the resulting tax was nearly $50,000. Nothing could be done to remedy the error, and the client's only recourse was to sue the CPA.

If, however, the surviving spouse dies shortly after the first spouse, the QTIP election will not offer the lowest tax rate. One of the QTIP's few disadvantages is that the QTIP property is included in the second-to-die spouse's taxable estate of the second spouse to die, and that estate will then be taxed at a higher marginal rate. CPAs always should use the six-month estate tax return filing extension to keep this tax savings tool available.

CHOOSE PLANNING TECHNIQUES CAREFULLY

Deciding when an estate's assets should be taxed is critical. Gift taxes and generation-skipping transfer taxes (GSTTs) are some of the alternatives to ensure an estate is taxed at the most advantageous time; however, they are extremely complex.

In one case, a CPA and a tax attorney advised a client to make taxable gifts totalling $1 million (after the annual exclusion) to her grandchildren. The CPA and the attorney felt the gifts would be an estate planning tool that would effectively use the taxpayer's $1 million GSTT exemption. However, neither the attorney nor the CPA informed the client about the three-year rule.

If a taxpayer makes gifts that exceed both the annual exclusion and the taxpayer's remaining unified credit, the taxpayer must pay gift tax. Under the three-year rule, any gift tax paid within three years of the taxpayer's death is included in the estate.

The gifts produced a total gift tax of $345,800. The total tax owed with the gift tax return equalled $153,000 after applying the $192,800 unified credit. Approximately one year later, the taxpayer died before the $153,000 tax had been paid; therefore, the taxpayer's gross estate included the unpaid gift tax. The estate also claimed the maximum marital deduction. The IRS ruled that because the gift tax liability was unpaid at the date of death, the marital deduction would be reduced by the unpaid amount. Thus, the estate had a tax liability even though all the property was passed to the surviving spouse. The surviving spouse then sued the CPA.

The consequences of this previous case could not have been predicted. Everyone has a $1 million GSTT exemption. When a taxpayer makes a gift subject to GSTT, he or she can allocate a portion of the exemption to that gift. Similarly, when the taxpayer dies and leaves gifts that are subject to GSTT, the executor can allocate any remaining exemption to the gifts so that the entire exemption is exhausted.

A decedent's estate tax return must report all gifts made during life. When examining estate tax returns, the IRS frequently will verify that the gifts were properly valued at the time they were made. For example, the IRS could subsequently determine that a $200,000 made during life and was subject to GSTT should have been valued at $300,000.

The revaluation will certainly increase the estate tax the heirs must pay (because the estate will be subject to higher graduated rates). In addition, if the statute of limitations on the gift tax return has not lapsed, disastrous results can occur. The gift revaluation will cause additional gift and GSTT tax. Because the GSTT exemption is automatically applied to certain lifetime gifts, the amount of GSTT that can be applied at death will be reduced. Therefore, the GSTT exemption allocation that was made as part of the estate tax return will be invalid. Bypass, marital and other trusts previously exempt from GSTT now could be subject to it. If the statute on the gift tax return has closed, the regulations are less clear about the gift revaluations's effect on the GSTT exemption remaining at death. However, this example demonstrates that gift, estate and GSTT taxes are all interrelated and that mistakes in gift tax valuation can easily affect the estate tax and GSTT.

EVEN MORE POTENTIAL HAZARDS

Although gift and generation-skipping taxes, QTIPs and late filings are among the most common liability risks to CPAs, there are many other subtleties to estate tax law. Here are areas to consider to minimize your risk:

* Deductions for administrative expenses. When the estate elects to claim administration expenses on the estate's income tax return, the amount of property treated as "passing" to the surviving spouse can be reduced. Thus, the election can reduce the marital deduction and subject the estate to estate tax.

* Will and trust interpretation. Frequently, a will or trust contains provisions either addressing or affecting estate tax or GSTT. Marital deduction formula interpretation can be very complex. If a will or trust provision is misinterpreted and the estate or its beneficiaries incurs needless estate tax or GSTT, the beneficiaries have a cause of action against the CPA.

* Income in respect of a decedent (IRD). This generally includes interests in qualified plans, such as individual retirement accounts. Incorrect treatment of these items can cause premature income taxation of the IRD amounts.

* Post-mortem estate planning. Even after a death, estate planning opportunities can help lower estate tax. One of the most powerful tools is the disclaimer, which can virtually correct erroneous provisions of a decedent's will, such as those that cause excessive estate tax or GSTT.

* Valuation discounts. Assets included in the gross estate subject to various discounts are a prime source of IRS attack. If the discount is too conservative, the CPA can be exposed to beneficiary suits. If the discount is too excessive, an IRS audit could subject the beneficiaries to pay additional estate tax after it has been distributed.

Estate tax engagements should be backed by basic loss prevention measures, such as

* Engagement letters. Provide a detailed record of your responsibilities and what you will be doing. Send the letter to the client and the attorney.

* Documentation. Keep dated records of all interactions with the client and his or her attorney. Record all important decisions and follow up with a letter of explanation to the client. Note any deadlines.

* Consultation. It is not necessary to turn away estate tax work, but if you are not experienced in filing form 706, you should consult with someone who is.

* A tickler system. It does not matter if your system is sophisticated or if it consists of a simple handwritten calendar. What matters is that the system is used consistently.

* Specialization. Many errors occur simply because the preparer does not do estate tax work often and is not familiar with the subtitles of the laws and regulations. If you are going to do this kind of work, do it frequently enough to gain a solid base of knowledge. Be aware of new regulations and laws and follow current litigation concerning estate taxes. Take courses to update your knowledge.

ONE LAST CHANCE

If you find yourself in trouble with an estate tax engagement, call, confess and comply. Call your insurance carrier and an estate tax expert, confess what your trouble is and comply with their advice. Often they can help you correct the error or at lease minimize the damages. Notify them as soon as you detect a problem--waiting too long could cost you the opportunity to take corrective action.

EXECUTIVE SUMMARY

* PRACTITIONERS WHO FAIL to exercise care when engaged to file form 706, the federal death tax return, increase their chances of suffering costly malpractice claims.

* THERE ARE SEVERAL ASPECTS of estate tax that have an especially high potential for error, such as filing deadlines, the qualified terminal interest property election and gift and generation-skipping taxes.

* THE FORM 706 DEADLINE is nine months after the date of death. Taxpayers can obtain a six-month filing extension, but the tax is still due at the end of nine months unless the taxpayer obtains a six-month payment extension.

* SIMPLE YET POTENTIALLY COSTLY mistakes can be avoided if the CPA uses an engagement letter.

* WHILE LATE FILING PENALTIES can be stiff, mistakes in determining the tax due can be equally disastrous. A missed QTIP election could cost both the CPA and the client dearly.

* GIFT AND GENERATION-SKIPPING transfer taxes are alternatives to ensure an estate is taxed at the most advantageous time, but they are extremely complex.

* IF YOU FIND YOURSELF IN TROUBLE with an estate tax engagement, call your insurance carrier and an estate tax expert, confess what your trouble is and comply with what they advise you to do.

CAMICO'S 1995 Most Frequent Tax-Related Claims

Engagement                  Frequency

Individual                  31%
Corporate                   26%
Estates                     12%
Partnership                 10.3%
All other                   20.7%

Source: CAMICO

CASE STUDY

A QTIP Trust Gone Sour

A software engineer in California designed a device that would allow the transfer of bank funds overseas via satellite. It proved useful among foreign banking institutions and the investor's modest annual income grew substantially.

The engineer subsequently was diagnosed with an incurable form of cancer and her physicians predicted that she had only months to live. Her attorney wisely advised her to include a QTIP trust in her estate plan. This irrevocable trust would allow her second husband access to the interest income on her estate while preserving the principal for her two children from her first marriage. The primary goal of the QTIP trust, however, was to defer estate tax on the trust property until the husband's death.

While the attorney was wise to suggest a QTIP trust, the good advice ended there. In the trust, the attorney had given the trustee a power to distribute trust property to the two children. After the engineer's death, the attorney engaged the CPA to file form 706 and instructed him to make a QTIP election for the trust property. On subsequent audit of form 706, the IRS declared that the trustee's power invalidated the QTIP election. Consequently, the QTIP property did not qualify for the marital deduction. Not only did the husband have to remit the thousands of dollars in estate taxes, he also incurred a penalty for their late payment.

The husband's total loss came to roughly $1 million. The interest he could have earned on the estate until his death was far greater than the tax dollars due.

The husband sued his attorney, who subsequently settled for $800,000 and, in turn, sued the CPA for half of the settlement. Although the CPA was blameless in this costly mishap, he nonetheless was subjected to considerable problems. The CPA said he had never received a copy of the will from the attorney until it was too late for the trustee to disclaim the power of appointment. Additionally, in gathering the information necessary to prepare the form 706 and the QTIP election, he did not find any evidence of the power of appointment. Unfortunately, the CPA did not document his interactions with the attorney, nor did he prepare an engagement letter stating his specific responsibilities. Although his insurance carrier will take the case to court, with little evidence to back him, the CPA's innocence may not be enough.

RIC ROSARIO, CPA, CFE, is loss prevention manager for CAMICO Services, Inc., a subsidiary of CAMICO Mutual Insurance Company. He is a member of the American Institute of CPAs, the California Society of CPAs and the Arizona Society of CPAs.