Journal of Financial Planning: February 2016
Randy Gardner Vincent, J.D., LL.M., CPA, CFP® is a professor of wealth management at the University of Missouri and a practicing estate planning attorney with more than 30 years of experience.
Leslie Daff, J.D., is a state bar certified specialist in estate planning, trust, and probate law, and the founder of Estate Plan Inc.
After taking office, President Obama repeatedly asked Congress to enact a “consistency of basis” rule that would require an heir’s income tax basis in property received from a decedent to equal the property’s value for estate tax purposes. With the passage of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (STA) in late July, 2015, Congress granted the President’s request.
For advisers working with recently deceased clients whose estates are large enough to require the filing of an estate tax return, this recent legislative development requires immediate action if significant penalties are to be avoided.
For executors, trustees, and beneficiaries, the key elements of the new law are:
- An addition to the stepped-up basis, IRC Section 1014(f) requires beneficiaries to use the finally determined estate tax value for a property as the income tax basis of the property acquired from the decedent (the consistency of basis rule);
- Newly-enacted Section 6035 (quoted in full in the sidebar on page 36) requires executors to submit statements containing property value information to the IRS and each recipient of property from the estate within 30 days after the filing of the estate tax return; and
- Penalties apply for failing to consistently report basis (a 20 percent understatement penalty) and for not submitting the new information statement (up to 10 percent of the aggregate items required to be reported).
In other words, if an executor reports a $1 million value of property on a decedent’s estate tax return and later claims a $1.5 million basis for the property on an income tax return, resulting in a $100,000 tax understatement, the executor is liable for a $20,000 (20 percent of $100,000) understatement penalty. If the executor intentionally fails to report the value of the property on a Section 6035 statement, the penalty could be as high as $100,000 (10 percent of $1 million).
Furthermore, with the Congressional overturn of the Supreme Court’s decision in United States v. Home Concrete and Supply LLC (see the table below describing other noteworthy changes in the STA), the IRS has six years to audit for overstatements of basis on income tax returns.
These rules are effective for estate tax returns filed after July 31, 2015. If the estate tax return was extended, the new rules could apply to decedents who died up to 15 months earlier (after April 30, 2014). On August 21, 2015, the IRS released Notice 2015-57, which does not relieve these estates from submitting the information statement, but does extend the 30 days after filing the estate tax return due date to February 29, 2016.
Some practitioners are taking the position that if a return was filed merely to elect portability, the new rules do not apply. However, given the IRS’s authority (see IRC Section 6035(b) in the sidebar) to issue regulations relating to “the application of this section to property with regard to which no estate tax return is required to be filed,” this position may be premature.
Understanding the Consistency of Basis Rule
Although the roots of the consistency of basis issue reach as far back as 1954, two recent cases have brought the issue into the spotlight. In Janis v. Commissioner of Internal Revenue, the discounted value of an art gallery was claimed on the estate tax return, while the co-executors and beneficiaries attempted to claim a higher basis for income tax purposes based on appraisals and the stepped-up basis rule when they sold the gallery. The Circuit Court applied a duty of consistency to deny the higher income-tax basis to the beneficiaries.
In Van Alen v. Commissioner of Internal Revenue, the beneficiaries took advantage of the special-use valuation rules for real estate on their estate tax return, but attempted to use the higher best-use valuation as their basis on an income tax return. The Tax Court held the beneficiaries were barred from using the higher valuation because of the agreement they signed to claim the estate tax reduction. Essentially, the judicial principles underlying the holdings of these two cases have been codified with the new legislation.
To reduce or avoid estate tax, families and their advisers have developed an array of valuation discount techniques based on minority ownership, marketability restrictions, the death of a key person, built-in gains, family discord, buy-sell agreement language, and a host of other factors that would influence a hypothetical buyer. The new law prevents taxpayers from taking advantage of these valuation discounting techniques for estate tax while later using appraisals to claim a higher income-tax basis when the property is sold.
Section 6035 Implementation Issues
In the typical high net worth estate, property is held through an individual or joint trust. After a grantor’s death, the trust is split into a marital trust—a survivor’s trust or qualified terminable interest property (QTIP) trust, or both—and a bypass trust. Or, if the surviving spouse has predeceased or the decedent was single, into sub-trusts for the children. Procedurally, the advisers make a Section 645 election and create an administrative trust. In the preparation of the Form 706 estate tax return, value allocations are made to these trusts, but property-specific allocations may not be made until months after the estate tax return has been filed.
The 30-day rule described in Section 6035(a)(3)(A) in the sidebar will change this practice. The allocation of properties to the various trusts will have to occur within 30 days of the filing of the Form 706 on a beneficiary-by-beneficiary basis.
It is likely practitioners will: perform more detailed income tax/estate tax trade-off projections; extend the Form 706 filing date more frequently; delay the Form 706 filing until they can simultaneously submit the Section 6035 information statement; and need to charge more for the Form 706 tax return and the related Section 6035 statement preparation.
The detailed itemization of properties allocated to each beneficiary (or beneficiary’s trust) may raise privacy issues and potentially lead to more family discord lawsuits.
Another issue raised by Section 6035 is the relevance of the values disclosed in the required information statements. The values will seldom correspond to the actual income tax bases of the assets. The IRS will not be able to enter the date-of-death information into a database and connect it to a later-filed income tax return. The basis later reported on a beneficiary’s income tax return will be different for many reasons.
To illustrate, consider the following situation: Jack owns property jointly with his wife, Jill. The property was purchased for $200,000, but has a value of $1 million. If the property is joint tenant with right of survivorship property, Jack will report $500,000 of value on his estate tax return and in the Section 6035 filing. If Jill sells the property, she will claim an income tax basis of $600,000 (Jack’s $500,000 plus Jill’s basis of half the $200,000). The basis she claims on her income tax return will not correspond with what was reported to the IRS on the Section 6035 statement. If the property was community property, when Jill sells the property, she will claim an income tax basis of $1 million, because of the double step-up for community property—again not the $500,000 reported on the Form 706 and Section 6035 statement.
Even if Jack owned the $1 million property alone and the property passes at his death to a child, subsequent improvements to the property made by the child, increasing the child’s income tax basis in the property, will result in an inconsistency between what is reported on the child’s income tax return and what was reported to the IRS on the estate tax return and Section 6035 statement.
Under Section 6035(b), the Secretary can issue “regulations relating to … situations in which the surviving joint tenant or other recipient may have better information than the executor regarding the basis or fair market value of the property.” In other words, anticipate the government requiring the disclosure of the bases adjustments in these examples.
Editor’s note: Although this information is current as of January 11, the IRS could release new guidelines on this topic at any time. Should there be new information from the IRS, the online version of this column will be updated accordingly at FPAJournal.org.