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.
The Internal Revenue Service’s recent “zero basis” rule proposal is another reminder that the focus in estate planning has become income tax planning. In this column, we explain several pre-mortem planning strategies, but first we outline the recently proposed post-mortem steps needed to preserve income tax basis.
Form 8971 Reporting
The February 2016 Journal column, “New Disclosures Could Lead to Penalties for Executors and Heirs,” summarized last year’s consistent income tax basis legislation and estate filing requirements. The following updates are noteworthy:
Due date postponed. The IRS has postponed, in Notice 2016-27, the first filing date for Forms 8971 to June 30, 2016.
Form 8971 is required only if Form 706 is required. On March 2, 2016, the IRS issued proposed regulations providing guidance with regard to these filings. One of the favorable provisions in the new regulations provides that Form 8971 is not required if no estate tax return is required. In other words, if the executor files a Form 706 only to make a generation-skipping transfer tax exemption allocation, to make a portability election, or to make a protective filing to avoid a penalty as a result of a later revaluation of assets, Form 8971 is not required.
The “zero basis” rule. In a move that came as a surprise to many estate planners, the IRS takes the position in its proposed regulations that an asset not reported on a Form 706 and later sold by a beneficiary does not receive a stepped-up basis, but rather has a zero basis.
For example: Decedent acquired ABC stock in 1990 for $200,000. At the time of his death in 2016, the ABC stock was valued at $1 million. The decedent’s total estate was $10 million, exceeding the Form 706 filing threshold, but the executor did not file the Form 706. If the decedent’s son later sells the ABC stock, his income tax basis in the stock will be treated as zero, rather than $1 million.
Although the IRS offers ways to avoid this outcome, it is not clear that this harsh result is supported in Congress’ legislation.
The “subsequent transfer” rule. Another surprise in the proposed regulations is the requirement that beneficiaries keep the IRS informed of changes in ownership and property basis following the initial reporting. This obligation could extend for decades following a decedent’s death.
For example: After the decedent’s death, the executor filed a Form 706 and Form 8971, reporting the transfer of a $2 million building to the daughter. Ten years later, the daughter transfers the building to her son. The daughter is required to file a supplemental Form 8971 to the IRS.
These reporting requirements reflect the IRS’s awareness of the shift in emphasis to income tax basis planning. Advisers working with large estates should remain alert for new Form 8971 developments and the potential traps that could result.
Near-Death Strategies to Avoid Loss of Tax Attributes
The strategies discussed next apply to large and small estates before the decedent passes away (pre-mortem planning). When an adviser learns a client is within days or months of passing away, the adviser should scrutinize the client’s investment portfolio for assets that have declined in value and the client’s income tax return for unused capital losses.
Assets that have declined in value. The stepped-up basis rule is not always favorable. If an asset, such as stock or real estate, has declined in value since the decedent purchased the asset, the beneficiaries of the estate will take an income tax basis equal to the property’s value at death, not the decedent’s purchase price.
For example: Father acquired XYZ stock in 2010 for $200,000. He learned his death is imminent. The value of the XYZ stock is currently $160,000. If the father dies today, his son will take an income tax basis in the XYZ stock of $160,000, not $200,000. Income tax basis of $40,000 is lost. If the father was married and left the stock to his spouse, the decline to a $160,000 basis is the same if the stock is community property. If the father lives in a common law state and the stock is jointly owned with his spouse with right of survivorship, the basis decreases to $180,000 ($80,000 value of his half at death, plus the $100,000 basis carried over for his spouse’s half).
Gifting the stock to the child or spouse before death. In the previous example, the father can potentially avoid this loss of basis by gifting the stock to his spouse or child before he dies. This strategy is most effective if he (or the couple) will not be required to file a Form 706, because the strategy requires the reporting of the $160,000 gift ($146,000 if the $14,000 gift tax exclusion is available), and the gift will be added back as a prior gift if the gift is to a child. The income tax benefits still apply. Subject to the dual-basis rule, the father’s income tax basis may carry over to the spouse or child (recipient).
The dual-basis rule provides for the following outcomes: (1) if the recipient eventually sells the stock for less than $160,000, the income tax basis will be $160,000 (“the loss basis”) and the recipient is no better off than if the father had died owning the stock; (2) if the recipient sells the stock for greater than $200,000, a complete recovery of the $200,000 (“the gain basis”) will occur and the recipient will not have experienced a step-down in basis; and (3) if the recipient sells the stock between $160,000 and $200,000, there will be no gain or loss, meaning the recipient partially avoided the loss of basis.
Two of these three outcomes are better than the absolute loss of basis, which would have occurred if the father died owning the stock, and the gift recipient can control the result by timing when the stock is sold.
Selling the stock to the child or spouse before death. The father can also potentially avoid the loss of basis by selling the stock at a loss to his spouse or child before he dies. The income tax loss will be disallowed under the related-party loss rules, and the father’s estate will still hold the $160,000 of proceeds from the sale. However, similar to the gift described above, the potential to recover the income tax basis that would be lost remains. The spouse or child’s (the buyer’s) income tax basis in a related-party loss transaction is also subject to the dual-basis rule.
In other words: (1) if the buyer eventually sells the stock for less than $160,000, the income tax basis will be $160,000 (“the loss basis”) and the buyer is no better off than if the father had died owning the stock; (2) if the buyer sells the stock for greater than $200,000, a complete recovery of the $200,000 (“the gain basis”) will occur and the buyer will not have experienced a step-down in basis; and (3) if the buyer sells the stock between $160,000 and $200,000, there will be no gain or loss, meaning the buyer partially avoided the loss of basis. Two of these three outcomes are better than the absolute loss of basis that would have occurred if the father died owning the stock, and the buyer can control the result by timing when the stock is sold.
Selling the stock to a third party. Another possibility is the father, after reviewing his assets to ensure none will be subject to probate, could sell the assets that have declined in value to third parties. These sales avoid the step-down in basis, but it is an equally unfavorable outcome if the father recognizes capital losses that expire unused at his death because of the $3,000 net loss limitation. If a joint income tax return is filed for the father and his surviving spouse for the year of his death, the situation is not as urgent, as the spouse will be able to take advantage of the losses.
If the father is single and has unused capital loss carryovers or net capital losses in excess of the usable $3,000 from last-minute sales, consider these strategies. He could sell assets that have gains in order to use the losses. This strategy has little overall benefit, because the basis of these gain assets would likely step-up.
A better strategy may be to have the ultimate beneficiaries of the father’s estate transfer gain properties to the father. The father can sell the assets, thereby using his capital losses, and pass the untaxed proceeds to his beneficiaries. This strategy is not subject to the one-year look back rule because the beneficiaries are not receiving back the gifted property. However, the strategy is not effective if the father’s taxable estate exceeds the Form 706 filing threshold.
When it is suggested to a dying client that he or she “get his or her affairs in order,” it is not only preparing estate planning documents. Clients must review the titling of assets, transfer properties that have declined in value, and offset capital losses with gains before death. Follow the steps necessary under IRS’ proposed regulations to retain income tax basis after death.