- If the value of the asset on death was more than the tax basis (what was paid to purchase the asset, plus any improvements, less depreciation, etc.) then the asset will get receive a new income tax basis increased from the initial basis to the fair value at death.
- If the value of the asset on death was less than the tax basis, then the asset will receive a lower income tax basis, reduced from the initial basis to the fair value at death.
- An estate may elect to value all assets at a date six months following the date of death if the overall valuation at that date results in a lower estate tax. Thus, the step-up or step- down in each assets tax basis may be determined at this later date, known as the alternate valuation date or (“AVD”). Some assets may receive a step-up in basis, others a step-down, and each assets value might differ under the AVD then it would have been had a date of death value been used.
- The estates determination of income tax basis for estate tax purposes was, prior to the Act, not binding for income tax purposes on the beneficiaries receiving those assets.
- Executors should exercise caution because the Form 8971 tax return requires new information reporting to comply with the newly enacted basis consistency requirements. The penalties for failing to comply are severe.
- Income tax return filed by anyone who inherited property from a decedent or a revocable trust formed by a decedent, may include new reporting requirements mandating more disclosures concerning gain or loss on the sale or exchange of property acquired from a decedent. These rules will be designed to confirm the compliance with the new rules regarding income tax basis.
- Where will beneficiaries obtain that information? From the executors. So transmitting appropriate information to beneficiaries will be yet another issue executors will have to address. How can and should this new administrative burden be handled?
- The IRS refused requests to create a process to allow an estate beneficiary to challenge the value reported by the executor on Form 8971. The IRS concluded that a beneficiary’s rights with regard to the estate tax valuation of property are governed by applicable state law and that would be the avenue a dissatisfied beneficiary would have to pursue.
- The unexpected and almost surreal imposition of a reporting requirements on beneficiaries that make further transfers of property they themselves received from an estate gives new meaning (and worry) to the phrase “traps for the unwary.”
Basis Consistency Rules: New Proposed Regs Add to Complexity for Executors
The process of determining the value of estate assets, and filing the required estate tax return, have been made even more complicated by law changes that mandate consistency in the reporting of the income tax basis in assets. These rules really make it more important for personal representatives of estates affected to hire professional advisers to complete and file an estate tax return, to document the income tax basis for the estate in each asset, and to inform beneficiaries of their income tax basis in asset received. Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41; Sec. 2004 (the “Act”). While guidance on the application and interpretation of these rules has been provided by the IRS, many complications and issues remain. Temporary Regulations (TD 9757) were issued and Proposed Regulations were issued on March 2, 2016. REG-127923-15.
The new basis reporting rules are effective after July 31, 2015.
Prior to the Act there was no requirement of reporting estate values to a beneficiary. When someone died their assets tax basis (the amount on which gain or loss on sale is determined) would be changed:
Example: Parent bequeaths a rental property to son and son later sells it. Parent’s executor valued the house at the date of Parent’s death at $2 million. Son, a month later, sells the rental property for $2.5 million and reports the income tax basis at $1.5 million paying no capital gains tax. That may have been permissible under prior law, it is no longer acceptable.
What is the Value of an Estate Asset
An estate is required to report the date of death (or alternate valuation date) values of a decedent’s assets. The paradigm for determining that value is the price a willing buyer and willing seller would negotiate. But, as everyone is aware, for non-marketable assets, there is a range of amounts that often exist for the valuation of non-marketable assets. The assumptions involved in determining the value of an interest in real estate or a non-controlling business are significant. Which comparable business or real estate assets should be used? What adjustments should be made to the values of these other assets to make them representative of the asset in the current estate being valued? What is the correct salary adjustment to reflect an arm’s- length wage for the principal? What is the correct capitalization rate? What valuation methodologies are used? What the reasonable and acceptable range of values and underlying assumptions are appropriate?
Given the uncertainty in values, in the past some beneficiaries may have reported their interest in an inherited asset at a different value then what the estate used. Since there was no mandate for the estate to provide valuation data to the beneficiary, there may have been little choice to the beneficiary but to come up with his or her own value for the asset inherited.
Example: The estate values a vacation home at $1 million dollars. The home is bequeathed to the decedent’s daughter. She sells the vacation home three months after the decedent died for $1.3 million and reports the income tax basis of the home as $1.3 million. The daughter may not have received valuation information from the estate. Further, if the house was sold so soon after the benefactor’s death, a mere three months, the daughter’s position might reasonably be that the real value at the date of death was the $1.3 million sale price. The daughter will have effectively received a basis step up without the $300,000 differential being reported for estate tax purposes. The basis consistency rules endeavor to mitigate against this, but only for certain larger estates.
The same beneficiary that might have taken a different position on his or her income tax return may now have to challenge the valuation obtained by the executor if he or she disagrees with the outcome. Executors will have to exercise more caution in hiring a qualified appraiser to minimize this risk. The problem with cost saving appraisal steps is that they establish the values to be used on the estate tax return and also for the beneficiaries receiving assets. But shortcuts could expose many involved to penalties (e.g., the 20% understatement penalty on a beneficiary over-reporting basis on a later sale).
Example: Consider the example above. The executor used a price from www.zillow.com for the decedent’s house of $1 million but the heir sold the house shortly after the decedent’s death for $1.3 million. If the heir were stuck using a “cheap” guestimate of the value of the house the executor, or a CPA hired by the executor found on-line, and that resulted in an otherwise avoidable $300,000 capital gains tax to the heir, the heir might well have an issue with the executor and in turn the executor with the CPA. Executors and estate tax return preparers will both have to be more cautious in light of these new rules.
Reporting Requirements Generally
Beneficiaries who receive property that was owned by a decedent will generally have to use as their cost basis in the property for income tax purposes the value of the property as finally determined for estate tax purposes. “Finally determined” means: (1) The value of the asset as shown on Form 706 which is not contested by the IRS within the statute of limitations (an unaudited return result); (2) A value set by the IRS which the executor does not contest on a timely basis; or (3) A court determination. If the property value is not finally determined, as above, for federal estate tax purposes the beneficiary is bound to use the value reported on the new Form 8971. These rules do not preclude otherwise allowable basis adjustments that may occur post-death. For example, if an executor makes a capital improvement to property, that cost may be added to the above basis in determining the actual tax basis to the beneficiary. Prop. Treas. Reg. Sec. 1.1041-(a)(2).
These new basis consistency rules are applicable to property where the inclusion of that property in the decedent’s gross estate increases the estate tax liability. Thus, assets qualifying for an estate tax charitable contribution or marital deduction are excluded from the basis consistency rules because they do not increase estate tax liability.REG-127923-15. The rationale for this remains elusive.
If an estate is required to file Form 706, i.e., a return under IRC Section 6018(a) then the executor has to provide each estate beneficiary and the IRS, a statement identifying the value of each asset reported on Form 706 that is anticipated to be distributed to each beneficiary. Form 8971 must be filed by the earlier of 30 days after the Form 706 is actually filed, or the extended due date on which the Form 706 is required to be filed. The new reporting requirements are applicable to executors and other persons who file after July 31, 2015.
If there are changes to the information reported, the executor may be obligated to make a supplemental filing. The most obvious instance of this requirement is if the values of assets (and hence their tax basis) changes as a result of a final determination (e.g. an IRS audit of the estate). But a supplemental report may be required if there is a change in the beneficiary (e.g., disclaimer but the anticipated beneficiary). Prop. Treas. Reg. Sec. 1.6305-1(e)(2). But will the executor assuredly know when a disclaimer occurs? For example, in a decoupled state a spouse might exercise a non-qualified disclaimer after the 9 month period ends so as to intentionally trigger a taxable transfer to utilize the deceased spouse unused exemption (“DSUE”) of the prior deceased spouse. This can avoid state estate tax on the first spouse’s death, avoid gift tax on the disclaimer in a state with no gift tax, etc. As with so many areas of the law the complexity multiplies as one digs deeper into the practical implications of the requirements.
The Proposed Regulations extend the scope of what is already a very burdensome reporting obligation in yet a further manner that is unanticipated and which will prove elusive to identify. If any portion of the assets a beneficiary inherits from an estate which are subject to Form 8971 reporting are thereafter transferred (e.g., by gift or sale) by that beneficiary to a related transferee member, and that related transferee will determines its income tax basis by based on the beneficiary/transferor’s basis, then that beneficiary/transferor must file a supplemental Statement with both the IRS and the related transferee. The IRS was concerned that opportunities may exist in some circumstances for the recipient of such reporting to circumvent the purpose of the statute (for example, by making a gift of the property to a complex trust for the benefit of the transferor’s family). It appears that these rules apply to a transfer to a grantor trust. So, for example, if physician/daughter inherits assets from father’s estate outright, and she thereafter gifts those assets to a self-settled domestic asset protection trust (“DAPT”) she must issue a new report. What if the daughter’s counsel is not the same counsel as represented the father’s estate. Will her counsel realize which assets these are? What if the assets are stock in a family business and the daughter already held other stock holdings in that business. How can one identify which assets are actually being transferred?Prop. Treas. Reg. Sec. 1.6305-1(f). What if the daughter transfers assets to a non-grantor spousal lifetime access trust (“SLAT”) and thereafter a trust protector turns on grantor trust status?
Who is the Beneficiary
While in most instances the identity of a beneficiary is obvious, there can be situations that are unclear. The Proposed Regulations provide some guidance in this regards. If the beneficiary is a trust or another estate, the for reporting purposes the trustee of the trust or executor of the estate is the beneficiary. With the expanding scope of modern trust drafting, if there is an institutional administrative trustee, an investment trustee and trust protector, would each one suffice for reporting purposes? The regulations remain superficial on this point. If there is a life estate, e.g., in a family vacation home, the life tenant is deemed the beneficiary. Contingent beneficiaries appear to be included within the definition of beneficiary which seems to be an overly broad and perhaps erroneous application of the law that could result in yet further complexity and reporting obligations. Prop. Treas. Reg. Sec.1.6305-1(c)(1).
If the personal representative cannot locate a beneficiary the efforts to do so must be explained on the Form 8971. Prop. Treas. Reg. Sec. 1.6305-1(c)(4). In practical terms might this suggest that an heir search firm will have to be hired to demonstrate a reasonable effort by the executor to identify the beneficiary?
General Implications of New Law
This complex sounding change has important practical ramifications for anyone serving as an executor or personal representative of an estate or a trustee of a revocable trust subject to these new rules. It will also change the income tax reporting for anyone inheriting assets. These rules are appear to be confined to only wealthy taxpayers subject to the estate tax, since they only seem to apply to estates subject to an estate tax. First, some background will be provided, then some of the practical implications considered. Act Sec. 2004 adding new IRC Sec. 1014(f).
Not Applicable to Most Estates
These new rules were anticipated to only apply to estates that had to file a federal estate tax return. The problem with that is that only about 3,000-4,000 returns a year reflect a tax due and the vast majority of federal estate tax returns, Form 706, are filed to secure the portability of the estate tax exemption for the decedent’s surviving spouse. There was considerable uncertainty initially that these so-called “portability returns” would have to file Form 8971 to comply with the complex basis consistency rules. The Proposed Regulations clarify that this is not the case. Estate tax returns for which no estate tax is due and which were filed to secure the portable estate tax exemption, or filed to apply or allocate generation-skipping transfer (“GST”) tax exemption are not subject to the basis consistency filing requirements.
Other exceptions to the reporting requirements are provided for cash (thanks!), certain tangible property valued at under $3,000 discussed below, income in respect of a decedent (“IRD”) such as IRAs and assets that have been sold.
Property Not Distributed by Reporting Date
The reality is that in many, perhaps most, estates the fiduciary will not have distributed many estate assets and likely will not know with certainty which assets will be distributed to which beneficiary. The Proposed Regulations mandate that the executor report on each beneficiary’s Schedule A the assets that might be used to satisfy that beneficiary’s bequests. Thus, if there are three children and the distribution of assets has not occurred and is not certain, the executor should list all assets that might be distributed to each child on that child’s Schedule A. If later different distributions are made the executor might determine to file a supplemental return and statement but is not required to. Prop. Treas. Reg. Sec. 1.6305-1(c)(3).
Think of the issues that this can create when brother sees his favorite painting on his Schedule then the executor opts to give it to his sister? Executors and advisers should consider adding a disclaimer to a cover letter accompanying the forms sent to beneficiaries:
“The listing of assets on Form 8971 is a mere guesstimate based on current data as to which assets will be distributed and to whom. The personal representative has not made final determinations and the allocation may change, assets may be sold, and other changes may occur, and if so a supplemental filing will be made as required. There is no intent that a beneficiary indicated draw any conclusion that an asset listed will in fact be distributed to that beneficiary, except to the extent of any partial distribution heretofore. The indication of assets and their distribution is being made at this time to comply with the filing requirements of Form 89721 and not to confirm any legal decisions as to distributions by the personal representative. Therefore, no beneficiary should take any action based on the information disclosed in this filing.”
Later Identified Property
What happens if an asset is discovered after the estate tax return is filed, or even after the period for filing the return has passed? If the property is identified before the time period for assessment has expired, and if it would have generated an estate tax liability if reported, then it is subject to the general basis consistency rules. However, if the property is discovered after the expiration of the period of limitation on assessment, the income tax basis in that property is zero. This rather draconian result seems grossly unfair and penalizes a beneficiary in a situation where the personal representative may have faced a daunting task of identifying assets. Prop. Treas. Reg. Sec. 1.1041-(c)(3). Hopefully, final regulations will reconsider this unreasonable application of the new rules.
Tangible Property Raises Issues
The new basis consistency rules raise practical issues for handling tangible personal property. These assets, regardless of value, often trigger strong emotional reactions from heirs which the reporting may only serve to exacerbate. What if a particular collectible is reported on one beneficiary’s schedule but later distributed elsewhere?
Decedents often make specific bequests of items of tangible personal property. For example, a list may be incorporated by reference into the will (depending on state law and draftsperson custom) or merely be informally left for the personal representative to consider. That list might detail scores of items of artwork, jewelry, furniture, etc. It has been common to report many of these items as one aggregate value which contradicts the intent of the new basis consistency rules.
For smaller value items the executor may give them away to charity or simply discard them.
The Proposed Regulations provide a de minimis rule that effectively negates the need to report items with a value of less than $3,000. While helpful, this rule does not address the interpersonal problems of detailed disclosures, the uncertainty of the value of many of these items, and grouping issues.
The de minimus rule is based on the Proposed Regulations excluding items governed by Treas. Reg. §20.2031-6(b) which provides as follows:
Special rule in cases involving a substantial amount of valuable articles.—Notwithstanding the provisions of paragraph (a) of this section, if there are included among the household and personal effects articles having marked artistic or intrinsic value of a total value in excess of $3,000 (e.g., jewelry, furs, silverware, paintings, etchings, engravings, antiques, books, statuary, vases, oriental rugs, coin or stamp collections), the appraisal of an expert or experts, under oath, shall be filed with the return. The appraisal shall be accompanied by a written statement of the executor containing a declaration that it is made under the penalties of perjury as to the completeness of the itemized list of such property and as to the disinterested character and the qualifications of the appraiser or appraisers.
How are groups of items to be handled? What if one item in a group is to be given each to a different beneficiary?
New consistency in basis reporting is adding new costs, burdens, and responsibilities to executors, and advisers. Failure to handle these requirements properly can trigger severe penalties, result in tax problems, and add to angst among estate beneficiaries. These rules will add to the burdens and costs of estate administration.
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