The Modified Carryover Basis Rules of I.R.C. ยง 1022: Current Implications for Fiduciaries
by Kent N. Schneider1
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) garnered attention in the popular press primarily for repealing the estate tax and generation-skipping tax for decedents dying after 2009. These changes to the transfer tax system were accompanied by the simultaneous repeal of the stepped up basis rules found in I.R.C. § 1014. Although the effective date for repealing I.R.C. § 1014 and replacing it with newly-enacted I.R.C. § 1022 is not imminent, the consequences of these changes increase the importance of current recordkeeping practices. This article will explain how the new modified carryover basis rules will affect wealthy taxpayers in general, and fiduciaries in particular.
I. Background
Under current law, a taxpayer's income tax basis in property acquired from a decedent is stepped up to the property's fair market value on the date of death.2 In addition, the heir's holding period in inherited property is considered to be long term, regardless of the decedent's actual holding period.3 These rules have several important consequences. First, if the property acquired from the decedent had increased in value during the decedent's lifetime, the unrealized gain permanently escaped income taxation. Conversely, if the property had declined in value, the unrealized loss was not recognized either by the decedent or his heir. Finally, since the decedent's income tax basis generally is ignored when determining the heir's basis in the inherited property, and since the decedent's date of acquisition is irrelevant to the heir, the typical taxpayer need not maintain basis information for assets he does not intend to dispose of during his lifetime.
Example 1
: T dies in 2002 owning only two assets: land purchased in 1980 and shares in Dotcom, Inc. purchased in 1998. T paid $1,000,000 for each of these assets. On T's date of death, the land was valued at $10,000,000, and the stock was worth only $200,000.
The basis of the land in the hands of T's heir is now $10,000,000. Neither T nor his heir will pay income tax on T's unrealized gain of $9,000,000.
T's heir takes the Dotcom, Inc. stock with a basis "stepped down" to $200,000. As with the unrealized gain on the land, T's unrealized loss of $800,000 is never recognized by either T or his heir.
Note that for both the land and the stock, T's cost basis in the property transferred at death was not used. Thus, even if T had not maintained adequate records regarding his basis in these assets, the income tax consequences would have been the same.
II. The New Modified Carryover Basis Rules
In contrast to the stepped up basis rules that have been in effect for decades, I.R.C. § 1022 mandates that "property acquired from a decedent dying after . . . 2009" is to be treated the same as if acquired by gift.4 Consequently, the basis of inherited property generally will be the lesser of the decedent's basis or the property's "fair market value . . . at the date of . . . death."5 Since the decedent's basis will become a major factor in determining the income tax basis to the heirs, the adequacy of the decedent's recordkeeping is now an issue of even greater importance.
A. Eligible Property
To be eligible for a basis increase, the property must be owned, or treated as being owned, "by the decedent at the time of death,"6 including:
• Acquisition "by bequest, devise, or inheritance,"7
• Acquisition "by the decedent's estate from the decedent,"8
• "[P]roperty transferred by decedent to a qualified § 645 revocable trust,9
• Property transferred by the decedent in trust where the decedent retained the "power to alter, amend, or terminate the trust,"10
• Property passing by reason of death to "joint tenants with right of survivorship or tenants by the entire[ties],"11 and
• "[T]he surviving spouse's one-half" interest in "property held by the . . . surviving spouse" and decedent as community property.12
For jointly-owned property, the portion of the property eligible for basis increase depends upon whether the surviving joint owner is the decedent's spouse. If property was owned jointly by the decedent and surviving spouse, either as tenants by the entireties or as joint tenants with right of survivorship, one-half of the property is eligible for a basis increase.
13 In contrast, if the property was owned jointly by the decedent and someone other than the decedent's spouse, then only that portion of the jointly-held property purchased by the decedent is eligible property.
14
Although a broad range of property is eligible for basis increase, certain types of property cannot benefit from basis adjustments, including: property given to the decedent three years prior to death by someone other than the decedent's spouse,15
(i) [S]tock or securities of a foreign personal holding company,16
(ii) [S]tock of a DISC [domestic international sales corporation] or former DISC,17
(iii) [S]tock of a foreign investment company,18 or
(iv) [S]tock of a passive foreign investment company unless such company is a qualified electing fund (as defined in [I.R.C.] section 1295)19
"[I]ncome in respect of decedent."20
B. Tax Consequences
As with gifted property, the modified carryover basis rules will cause the decedent's unrealized gains on appreciated property to be postponed until the heir disposes of the inherited property in a taxable transaction. At that time, the decedent's gain will be recognized by the heir.
In contrast, when an individual dies owning property that has declined in value, the decedent's unrealized loss generally will not be recognized. This, of course, is the same detrimental result that occurs under the current "stepped up basis" rules. Fortunately, I.R.C. § 1022 provides "basis increase" rules that will mitigate this effect for smaller estates.
Example 2: Assume the same facts as in Example 1, except that T dies in 2010. At the time of death, T owns only two assets: land purchased in 1980 and shares in Dotcom, Inc. purchased in 1998. T paid $1,000,000 for each of these assets. On T's date of death, the land was valued at $10,000,000, and the stock was worth only $200,000.
The modified carryover basis rules will give T's heir a basis of $1,000,000 in the land. Thus, T's unrealized gain of $9,000,000 is postponed, but not avoided.
In contrast, T's heir takes the Dotcom, Inc. stock with a basis equal to the lesser of T's cost basis of $1,000,000 or the property's fair market value on the date of death of $200,000. Thus, the basic carryover basis rules will prevent T's unrealized loss from being recognized. Fortunately, as described below, modifications to the carryover basis rules can mitigate this harsh result.
Note that for both the land and the stock, T's cost basis in the property transferred at death was referenced. Thus, if T had not maintained adequate records regarding his basis in these assets, the income tax consequences would have been worse. In the worst case scenario, T's basis in the land and stock would be presumed to be zero, resulting in a significant loss of tax benefits.
Although less advantageous than the current rules that step up the basis of appreciated property to fair market value, the modified carryover basis rules will give taxpayers some relief when inheriting property that has been declined in value. This is accomplished through one or more basis increase provisions.
C. $1.3 Million Basis Increase
I.R.C. § 1022(b) permits the basis of eligible property to be increased up to $1.3 million, plus the sum of the decedent's unused capital loss carryovers, net operating loss carryovers, and the decedent's unrealized losses on property owned on the date of death.21 The basis increase amount is allocated among the eligible property. However, no asset's basis can be adjusted above fair market value.22 As a result, for smaller estates, the heirs will receive a basis that is stepped up from carryover basis to fair market value. If an estate is valued at $1.3 million or less, then the result is the same as under the current rules. Even if no basis records exist and all assets in the estate are presumed to have a zero basis, the $1.3 million basis increase rule will give the heirs a basis equal to the inherited property's date-of-death valuation. For larger estates, however, carryover basis records will be crucial.
Example 3: Assume the same facts as in Example 2. At the time of death, T owns only two assets: land purchased in 1980 and shares in Dotcom, Inc. purchased in 1998. T paid $1,000,000 for each of these assets. On T's date of death, the land was valued at $10,000,000, and the stock was worth only $200,000. T leaves his entire estate to his daughter.
As in Example 2, T's heir takes the Dotcom, Inc. stock with a basis of $200,000. Thus, the carryover basis rules, in many cases, will prevent T's unrealized loss from being recognized.
Fortunately, due to the $1.3 million basis increase rule, T's unrealized loss can be salvaged. I.R.C. §1022(b) will permit the carryover basis of the stock, $1,000,000, to be increased by $1.3 million, plus the $800,000 loss on the stock. Consequently, T's heir will take the land with a basis of $3,100,000, determined as follows:
| T's carryover basis |
$1,000,000 |
Plus:
$1.3 million basis increase
(plus T's unrealized loss
on the Dotcom stock) |
$2,100,000 |
| Basis to T's heir |
$3,100,000 |
D. $3 Million Basis Increase
In addition to the $1.3 million basis increase available to all heirs, the basis of eligible property distributed to the decedent's surviving spouse can be increased by an additional $3 million.23 To be eligible, the property must be distributed to the surviving spouse via an "outright transfer of property and [be] qualified terminal interest property."24
Example 4: Assume the same facts as in Example 3. At the time of death, T owns only two assets: land purchased in 1980 and shares in Dotcom, Inc. purchased in 1998. T paid $1,000,000 for each of these assets. On T's date of death, the land was valued at $10,000,000, and the stock was worth only $200,000. T leaves his entire estate to his spouse.
As in Examples 2 and 3, T's heir takes the Dotcom, Inc. stock with a pure carryover basis of $200,000.
As for the land, due to the $3 million spousal basis increase and the $1.3 million basis increase, T's heir will take the land with a basis of $6,100,000, determined as follows:
| T's carryover basis |
$1,000,000 |
Plus:
$1.3 million basis increase
(plus T's unrealized loss
on the Dotcom stock) |
$2,100,000 |
$3 million spousal basis
increase |
$3,000,000 |
| Basis to T's spouse |
$6,100,000 |
E. $60,000 Basis Increase
For property inherited from non-resident aliens, the I.R.C. §1022(b) basis increase limit is reduced from $1.3 million to $60,000.25 The $60,000 limit is not increased by any unused losses or unrealized losses of the decedent.26 Nor is the $3 million spousal property basis increase available.27
F. Allocation Rules
For smaller estates, the basis increase rules will permit the basis of all appreciated eligible property to be increased to fair market value on the date of death. However, if the basis increase amount is less than the unrealized appreciation on the eligible property, the basis increase must be allocated among the eligible property. Under these circumstances, the executor has the discretion to allocate the basis increase to the eligible property on an asset-by-asset basis.28 In fact, the reports of the House Ways and Means Committee and the Senate Finance Committee go so far as to suggest that the basis increase could be allocated to a single share of stock. With this flexibility, an executor could maximize future tax benefits by allocating basis to depreciable property and ordinary income property passing by reason of death.
The only restrictions on the executor's discretion are the ceiling rule and fiduciary duty. As previously mentioned, the ceiling rule provides that the basis of an asset cannot be increased above its fair market value on the date of death. This restriction is easily accommodated by using appropriate valuation techniques. On the other hand, an executor's fiduciary obligation to all beneficiaries can present a more complex problem if there are multiple beneficiaries. In such cases, the act of allocating basis to property bequeathed to one beneficiary could be construed as a breach of the executor's fiduciary duty to the other beneficiaries. To prevent such a dilemma, the testator presumably could provide the executor with guidance in the will as to how the basis adjustment, if any, should be allocated. If no such guidance exists, it would be advisable for the executor to obtain the consent of all beneficiaries to a basis allocation scheme prior to implementation.
III. Reporting Requirements
A. Intervivos Transfers
To ensure that donees and heirs obtain the information needed to implement the new modified carryover basis rules, transferors will be subject to strict reporting requirements and penalties for non-compliance.
Although Emily Post would not approve, donors will be required to provide donees with the fair market value of the gifted property, along with the donor's adjusted basis as reported on the donor's gift tax return.29 Donors are subject to a $50 penalty for each failure to provide this information.30
B. Transfers By Reason of Death
For transfers at death of non-cash assets exceeding $1.3 million,31 the executors, administrators, and trustees of revocable trusts must report the following information to the beneficiary and the IRS:
(1) [T]he name and TIN [taxpayer identification number] of the recipient of the property,
(2) [A]n accurate description of such property,
(3) [T]he adjusted basis of such property in the hands of the decedent and its fair market value at the time of death,
(4) [T]he decedent's holding period for such property,
(5) [S]ufficient information to determine whether any gain on the sale of the property would be treated as ordinary income,
(6) [T]he amount of basis increase allocated to the property, . . . and
Any other information prescribed by the Secretary of the Treasury.32
These reporting requirements also are imposed for certain gifts of property received by the decedent within 3 [three] years of death.
33 Specifically, the reporting requirements are limited to gifts of appreciated property to the decedent where a gift tax return was required to be filed by the donor.
As with intervivos transfers, a $50 penalty is assessed for each failure to provide the beneficiary with the required information about basis, holding period, and character of property.34 On the other hand, the penalties for failing to provide the same information to the IRS are much more punitive. For transfers at death of non-cash assets exceeding $1.3 million, the penalty is $10,000 for failing to provide the IRS with the required information.35 In addition, fiduciaries are subject to a $500 penalty for failing to report taxable gifts of appreciated property received by the decedent within three years of death.36
IV. Implications for Fiduciaries
Although the effective date for repeal of the estate tax and implementation of the modified carryover basis rules are many years away, it is not too soon to prepare. Better recordkeeping is a must. If taxpayers lack adequate documentation of basis, they should begin tracking down the missing information now, rather than letting the trail get colder. For example, if an investor receives stock shares as part of a tax-free spin-off, it is best to make the basis allocation while the information is readily available. Similarly, donees who receive gifts of non-cash property should ascertain the donor's basis and the property's fair market value on the date of gift, even if the donor is not required to divulge this information. Finally, if a client's estate is likely to be large enough to require allocation of the $1.3 million or $3 million basis increases, the client can prevent future squabbles among beneficiaries by providing the executor, administrator, or trustee with guidance when making the allocation.
Endnotes
1 Kent N. Schneider is a professor of accountancy at East Tennessee State University. He is a member of The Missouri Bar and The Missouri Bar's Taxation Committee. He received his J.D. from the University of Missouri-Columbia, and is a certified public accountant.
2 I.R.C. § 1014(a)(1).
3 I.R.C. § 1223(11).
4 I.R.C. § 1022(a)(1).
5 I.R.C. § 1022(a)(2).
6 I.R.C. § 1022(d)(1)(A).
7 I.R.C. § 1022(e)(1).
8 I.R.C. § 1022(e)(1).
9 I.R.C. § 1022(d)(1)(B)(ii) and § 1022(e)(2)(A).
10 I.R.C. § 1022(e)(2)(B).
11 I.R.C. § 1022(d)(1)(B)(i).
12 I.R.C. § 1022(d)(1)(B)(iv)
13 I.R.C. § 1022(d)(1)(B)(i)(I).
14 I.R.C. § 1022(d)(1)(B)(i)(II).
15 I.R.C. § 1022(d)(1)(C).
16 I.R.C. § 1022(d)(1)(D)(i).
17 I.R.C. § 1022(d)(1)(D)(ii).
18 I.R.C. § 1022(d)(1)(D)(iii).
19 I.R.C. § 1022(d)(1)(D)(iv).
20 I.R.C. § 1022(f).
21 I.R.C. § 1022(b)(2)(C).
22 I.R.C. § 1022(d)(2).
23 I.R.C. § 1022(c)(1) and (c)(2)(B).
24 I.R.C. § 1022(c)(3).
25 I.R.C. § 1022(b)(3)(A).
26 I.R.C. § 1022(b)(3)(B).
27 I.R.C. § 1022(b)(3).
28 I.R.C. § 1022(d)(3)(A).
29 I.R.C. § 6019(b).
30 I.R.C. § 6716(b).
31 I.R.C. § 6018(b)(1).
32 I.R.C. § 6018(c).
33 I.R.C. § 6018(b)(2).
34 I.R.C. § 6716(b).
35 I.R.C. § 6716(a).
36 I.R.C. § 6716(a).
JOURNAL OF THE MISSOURI BAR
Volume 58 - No. 5 - September-October 2002