New Consistent Basis Reporting Regulations Provide Clarity and Some Big Surprises

When a person dies, the income tax basis of property included in the person’s gross estate changes to its fair market value (FMV) at the date of death (or the alternative valuation date six months later if that is elected).  This provision is generally beneficial in two respects:  1) property generally increases in value over time, so the increase in basis eliminates the inherent capital gain for income tax purposes, and 2) cost records for property owned by the decedent are often unavailable.  However, property that is considered “income in respect of a decedent or IRD” has a basis of zero and does not receive a new basis at death. Examples of IRD property include traditional IRAs, qualified retirement plans, and earned or accrued income that was not received as of the date of death.

Some taxpayers have taken aggressive tax positions in order to reduce their income taxes, arguing that the FMV of the property they inherited was actually greater than the FMV used in the decedent’s estate tax return.  In response, on July 31, 2015, Congress enacted a basis consistency law and granted the IRS sweeping powers to carry out the intent of the law.  On March 4, 2016, the IRS published temporary and proposed regulations.

The executor of the estate must report the FMV of the property to the IRS on Form 8971 and to any person acquiring ownership in the property on Schedule A to Form 8971.  The report must be furnished the earlier of:  1) 30 days after the estate tax return due date (including extensions), or 2) 30 days after the filing of the estate tax return.  Any adjustment to the FMV must also be reported within 30 days of the adjustment.  Penalties apply to late or incomplete reporting, and also to any understatement of income tax from using a tax basis greater that the FMV as finally determined for the estate tax return.  The IRS has extended the due date to March 31, 2016 for all Forms 8971 that were due before then.

For the vast majority of estates, these reporting rules will not apply.  Reporting is required only if an estate tax return (Form 706) is required to be filed because the decedent’s gross estate (which includes prior taxable gifts) exceeds the basic exclusion amount, which is $5,450,000 in 2016.  Form 8971 is not required in the following situations:

·       Form 706 is filed only to make the portability election.

·       Form 706 is filed for the sole purpose of making an allocation or an election for purposes of the generation-skipping transfer tax.

·       A protective Form 706 is filed for an estate having a FMV of less than the basic exclusion amount in order to start the statute of limitations (SOL) against a potential IRS audit.

If Form 8971 is required to be filed, not every item included on the estate tax return has to be reported on Schedule A.  Exemptions are:

·       Cash and equivalents.

·       IRD assets.

·       Tangible personal property having a total value of $3,000 or less.

·       Property sold by the estate at a gain or loss.

Some big surprises in the regulations just published:

·       If the executor of the estate has not determined which specific property each beneficiary will receive, then each beneficiary must receive a report of all of the estate’s property that could be used to satisfy the beneficiary’s interest.  This requirement is sure to cause controversy among the beneficiaries when they see the size of the estate and the types of property that are available to them!  Most of the time the executor will not make distributions out of an estate until after receiving a “closing letter (or its current IRS equivalent)” to protect against any personal liability for additional estate tax from an IRS audit.

·       A so-called “zero basis rule” is introduced by the IRS, and seems contrary to well established tax law.  The IRS states that if property is discovered to have been left off of the estate tax return, and would have increased the estate tax if included, its income tax basis is zero no matter the FMV.  If the SOL has not expired on the estate tax return, then the executor can amend the return and add the overlooked asset and restore the tax basis.  If the SOL has expired, the basis is zero.

·       The zero basis rule also applies to an estate tax return that should have been filed but was not.  The basis of property is zero until the estate tax return is filed and final values are determined.  This means that assets sold, depreciated, etc. before then may have overstated basis deductions and tax penalties could result.  Thus a big exposure exists for estates having hard-to-value assets (e.g. a business interest) claiming valuation discounts, and where the gross estate FMV is less than the basic exclusion amount and no estate tax return is filed.  The IRS has a big incentive to challenge the valuation discounts to cause a requirement to file an estate tax return.  In this situation it will be prudent to file a protective estate tax return if increasing the asset’s value would cause or increase estate tax.

·       The new tax law requires basis consistency reporting of executors.  The IRS has now exercised its legislative authority to create a whole new category of people subject to the reporting requirements:  beneficiaries!  Heirs of an estate who in turn gift or otherwise transfer (other than by sale) property received from the estate to a related person or entity, must report the basis of the transferred property to both the IRS and the transferee by filing a Form 8971 within 30 days of the transfer.  There appears to be no time limit on this exposure to report, so in theory the requirement could apply to a transfer made many decades after the inheritance!

·       Some estate plans leave property to one beneficiary for a period of time (e.g. his or her lifetime) after which the property passes to another person (the contingent beneficiary).  The proposed regulations require that a supplemental basis report be provided when the property passes to the contingent beneficiary.  Since this can be many years into the future, one commentator has asked, “Will executors now have lifetime duties?”

Update:

On March 23, 2016, the IRS issued Notice 2016-27 which further extends the due date from March 31, 2016 to June 30, 2016.