On Sept. 16, 2024, the Department of the Treasury finalized regulations (final regs) related to the basis consistency requirements under Internal Revenue Code Sections 1014(f) and 6035. This comes 8 1/2 years after it issued proposed regulations, which drew concerns and requests for clarifications from estate administration practitioners. The outcome is worth the wait, as the final regs resolve many of the outstanding questions and perceived overstepping of its authority in some of the more controversial proposed provisions.
Background of Basis Consistency
As the basis consistency rules are, in effect, an anti-abuse provision, it’s helpful to understand what the perceived abuse was. For estate tax purposes, property included in a decedent’s gross estate is valued at fair market value as of the date of death (or alternate valuation date if that election can be and is made). While some deductions and credits might reduce or eliminate the estate tax liability, the higher the value for estate tax purposes, the higher the estate tax liability. However, transfer taxes aren’t the only taxes impacted by the FMV of the decedent’s property. Broadly generalizing IRC Section 1014, the basis of property acquired from the decedent’s gross estate is the FMV as of the date of death (or, again, the alternate valuation date). Therefore, the higher that value is, the lower the income tax liability when there’s a recognition event because of the higher basis. So, with hard-to-value assets with a range of reasonable value, from a tax perspective, the estate tax system incentivizes reporting a lower value and the income tax system at a higher value.
These opposing incentives have been around for decades. While there was no explicit statutory requirement that the same value be reported for estate and income tax purposes, the law (both regulatory and jurisprudence) wasn’t silent on the issue. Treasury Regulations Section 1.1014-1(a) provides that “the purpose of section 1014 is, in general, to provide a basis for property acquired from a decedent that is equal to the value placed upon such property for purposes of the federal estate tax.” Further, the courts have held that in reporting values for estate tax and income tax purposes, there’s a “duty of consistency [that] not only reflects basic fairness, but also shows a proper regard for the administration of justice and the dignity of the law. The law should not be such a idiot that it cannot prevent a taxpayer from changing the historical facts from year to year in order to escape a fair share of the burdens of maintaining our government.” Janis v. Comm’r, 461 F.3d 1080, 1085 (9th Cir. 2006) (quoting Estate of Ashman v. Comm’r, 231 F.3d 541, 544 (9th Cir. 2000)). Under this doctrine, a taxpayer who either reported the value for estate tax purposes or is in a similar economic position as that taxpayer can’t change the value to their advantage for income tax purposes.
Despite the existing law, the Obama administration targeted this perceived abuse by calling for a statutory change in each of its annual tax proposals. The proposal was based on the idea that the executor was best positioned to determine the value. Therefore, the executor of larger estates (defined as those that were required to file an estate tax return) to report to a party acquiring property from a decedent’s gross estate and that the beneficiary be bound by that value. After about six years of the Obama administration proposing this change, Congress added Internal Revenue Code Sections 1014(f) and 6035 as part of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015. The provisions were included as a revenue raiser as this change was projected to raise $1.5 billion in new revenue over 10 years, a large sum given there was no evidence of such rampant abuse.
Problematic Proposed Regulations
With Sections 1014(f) and 6035 taking effect in July 2015, the IRS had to quickly create a reporting form, instructions and regulations. The IRS released the reporting form (Form 8971 and its accompanying Schedule A with instructions in January 2016—Schedule A is what the beneficiary receives listing property and its basis, while Form 8971 is sent to the IRS certifying the Schedule As were provided and providing copies of those schedules. In March 2016, the IRS released proposed regs. For a more comprehensive and contemporaneous analysis of these proposed regulations, see (James I. Dougherty and Eric Fischer, Treasury Releases Proposed Regulations on Basis Consistency).
The proposed regs made clear that if there was no court-appointed executor, then it was the statutory executor under IRC Section 2203 who should make the filing and explicitly stated that estate tax returns that were being filed for portability purposes didn’t create a Form 8971 filing obligation The proposed regs listed certain property that didn’t need to be reported as part of this reporting regime, such as cash, income in respect of a decedent, certain tangible items or items already sold before distribution, but didn’t exclude or even mention other types of property that wouldn’t receive a basis adjustment such as property subject to Section 1014(e).
While some parts of the proposed regs raised requests for further clarification, some provisions drew outright criticism from practitioners. One such provision was the “zero-basis rule,” under which the proposed regs stated that if property wasn’t reported on the estate tax return despite being part of the gross estate, then the acquiring beneficiary had zero basis in that property. Another provision was a subsequent reporting requirement imposed on beneficiaries that would require them to file basis reporting forms if they gifted the inherited property. Despite the proposed regs, even the Obama administration tacitly acknowledged that the 2015 statute didn’t grant the IRS this authority by asking Congress to create consistent basis reporting for gifts.
Arguably, the most problematic provision of the proposed regs was what it meant to acquire property for reporting purposes. Under the proposed regs, a beneficiary was treated as acquiring property if they had, would or might receive property from the gross estate. Given that Form 8971 and Schedule As had to be filed 30 days after the filing of the estate tax return before when many executors would know who’s getting what, this could create confusing reporting.
Impactful Changes
The final regs are twice as long as the proposed regs, given the addition of many examples and answers to specific issues that can commonly arise in estates. Not only were the regs themselves more thorough, but they were also accompanied by a comprehensive preamble.
The most impactful change is a revised reading of what it means to acquire property from a decedent’s gross estate. The proposed regs interpreted “acquired by” to mean someone who may receive property. Thankfully, Treas. Regs. Section 1.6035-1(c)(4) of the final regs states that a “beneficiary acquires such property when, under local law, title vests in the beneficiary or when the beneficiary otherwise has sufficient control over or connection with the property that the beneficiary is able to take action related to the property for which basis is relevant for Federal income tax purposes … a beneficiary’s acquisition of property occurs upon an executor’s or trustee’s distribution of the property. For property passing by contract or by operation of law, the beneficiary’s acquisition of that property generally occurs automatically upon the death of the decedent.”
With this new definition, if an executor knows of property that hasn’t been acquired by a beneficiary by the due date of Form 8971, then the executor must still file Form 8971. But now the executor may either: (1) wait to report it until it’s acquired by a beneficiary, in which case such report is due by Jan. 31 of the year following the acquisition; or (2) as under the proposed regs, report the basis to a beneficiary who might receive that property and provided a beneficiary who had the basis reported to it ultimately acquires it or the estate disposed of it before distribution then no further reporting is required. This will allow estates to avoid providing beneficiaries Schedule As that may cause further confusion or expenses.
Other welcome changes include the elimination of the zero-basis rule and the reduction in applicability for the subsequent reporting rules. Commentators challenged these rules as being outside the regulatory authority granted by the statutes. In the preamble to the final regs, the IRS responded that these proposals are within the regulatory authority granted to the IRS and consistent with the statute, but changes were made for other reasons. Regarding the zero-basis rule, the IRS noted in the preamble that it accepted commentators’ contention that the rule was “onerous, unduly harsh, and unfair” because it was more likely to occur because of inadvertent omission and the omission would be due to the executor making a mistake but this would punish the recipient. In removing this provision, the IRS noted that “existing Federal tax enforcement mechanisms under subtitle F of the Code, including criminal liability, serve to deter willful nonreporting of property on the estate tax return.”
The IRS clearly believes it has the regulatory authority for the subsequent rules because it didn’t eliminate the rule but just restricted the applicability. Despite the IRC provisions imposing the reporting requirement only on executors and not subsequent beneficiaries who make future transfers of inherited property, the preamble contends that without having subsequent reporting, the IRS’ authority to enforce the basis consistency rules would be reduced. Confident in its authority, the IRS noted that the harms of the subsequent reporting outweighed the benefits if the subsequent reporting party was an individual, as there would be substantial penalties on individuals who likely didn’t know or have reason to know of the reporting requirements. The IRS found that requiring trustees to provide subsequent reporting wasn’t too burdensome as they are more aware of tax rules and have a fiduciary duty to provide a beneficiary information such as basis. Therefore, only trustees would still be subject to the subsequent basis reporting regs, and the reporting would be due on Jan. 31 of the year following the transfer of property from the trust. Given that individual trustees will likely be unaware of this requirement, advisors to trustees need to identify trust property subject to the subsequent reporting rule and ensure timely filings are made.
Other Additions
Other additions to the final regs that return preparers should be aware of include:
- Before the reported value becomes final, executors should report and beneficiaries should use the value as reported on the return. If the estate tax value is later adjusted, the beneficiary may be subject to an income tax deficiency and potential penalty, though the penalty may be waived due to reasonable cause, depending on the circumstances;
- A more expansive list of property that doesn’t need to be reported for basis consistency purposes, including life insurance proceeds paid as a lump sum, property subject to IRC Section 1014(e), various cash equivalents such as tax refunds and notes that aren’t forgiven at death;
- An explanation and examples of how property subject to debt should be reported for basis consistency purposes;
- Guidance on applying basis consistency rules when property passes to charity or a spouse but isn’t entirely reduced by an offsetting estate tax deduction;
- Clarification that an estate that’s subject to basis consistency rules but has no property to report on a Schedule A to a beneficiary because it’s all excepted property should still file Form 8971 indicating all property was excepted from reporting; and
- Additional guidance on who’s an executor for basis consistency purposes if there isn’t a court-appointed executor.
Implementation
The additions of IRC Sections 1014(f) and 6035 imposed a substantial reporting requirement, and the proposed regs would’ve added a further burden. The final regs, taken as a whole, somewhat alleviate this issue by providing guidance and rules that more fairly account for the realities of estate administration. As these regs are immediately effective, practitioners must familiarize and implement these new rules quickly for estates and advise trustees of their potential subsequent transfer reporting.
