United States: Treasury's Proposed Zero Basis Rule: Will It Survive?

The so-called step-up in basis at death¹ and the estate tax system have long been closely linked. Generally, property that is acquired or passed from a decedent obtains a new basis at death equal to its then-fair market value.² Meanwhile, since 1954 Congress has provided that nearly all property included in a decedent's gross estate for estate tax purposes is treated as having been acquired from a decedent.³ Thus, property subject to estate tax generally qualifies for a step-up in basis at death.

The close link between the estate tax and the basis step-up at death has meant, in practice, that the outcome of an estate tax audit has significant income tax consequences for recipients of a decedent's property. For example, suppose that a decedent bought a painting for $2 million, which he bequeaths at his death to his friend Stephanie. The decedent's executors report on the estate tax return that the value of the painting at the owner's death was $5 million, but the IRS, on audit, contends that its value at that time was $10 million. The executors ultimately agree to an additional assessment of estate tax based on a value of $7 million. Thus, the estate may pay an additional estate tax, but Stephanie, if she accepts the $7 million value, can report that she has an extra $2 million of basis compared with the estate's initial return position.

Stephanie might instead wish to argue that the IRS's initial valuation was correct, and therefore that her basis for income tax purposes should be $10 million. Thanks to long-standing Treasury regulations and rulings⁴ as well as the duty of taxpayer consistency,⁵ it has always been difficult for the recipient of a decedent's property to disavow the value reported or agreed to by a decedent's executors for estate tax purposes. More recently, apparently in response to proposals for legislation from Treasury,⁶ Congress has gone even further and imposed a statutory mandate of basis consistency. Under new section 1014(f), enacted as part of the Surface Transportation and Veterans Health Care Improvement Act of 2015 (P.L. 114-41), the basis of property acquired from a decedent may not exceed its final value as determined for estate tax purposes, or, if there is no finally determined value (for example, because an estate tax audit is ongoing), its reported value. In short, like it or not, recipients of a decedent's property are now generally bound by the property's estate tax value.

Treasury and the IRS published proposed regulations implementing section 1014(f) not long after it was enacted.⁷ Most provisions in the proposed regulations were as expected, but at least one rule caught practitioners by surprise⁸: Under prop. reg. section 1.1014-10(c)(3), property omitted from the estate tax return receives a basis of zero. For example, if an executor fails to report an item of property on the estate tax return, even inadvertently, and the statute of limitations for assessment of estate tax has expired, the basis of the property will be zero.⁹ Thus, the recipient of the omitted property will be effectively deprived of cost basis and, upon disposing of the property, will be required to treat the entire amount realized as gross income.

The zero-basis rule addresses a serious policy concern. Although it is unclear how often it happens, at least some transfers of property at death surely go untaxed because executors fail to report all items of property that are properly includible in the gross estate. The zero-basis rule would mitigate the loss of estate tax revenue from omissions of property by increasing the income tax costs of omission. Further, to avoid adverse income tax consequences to recipients, executors would often have an additional incentive under the zero-basis rule to identify and report all the property included in the decedent's gross estate. Unfortunately, the zero-basis rule is a flawed solution to the problem of estate tax return omissions. As discussed below, the zero-basis rule would not successfully recoup the estate tax revenue lost from omitted property. The rule would also penalize one class of taxpayers — recipients of decedents' property — for the inaccurate reporting of another class of taxpayers: executors. Thus, the zero-basis rule can induce more accurate estate tax reporting at best indirectly, and in some cases not at all. Finally, the zero-basis rule is vulnerable to attack as an invalid exercise of Treasury's rulemaking authority. It attempts to stretch the language of an income tax provision — potentially past its breaking point — to protect the integrity of the wealth transfer tax system. For those reasons the zero-basis rule should be abandoned. If Treasury believes that it needs additional tools to ensure that all wealth transfers at death are taxed, it should request legislation from Congress and not attempt to graft a wealth transfer tax rule onto section 1014(f).

Section 1014 and the Zero-Basis Rule

Section 1014(a) generally provides that property acquired or passed from a decedent receives a basis equal to its FMV on the date of the decedent's death or the alternate valuation date, if the estate tax alternate valuation date election is made.¹⁰ Section 1014(f) imposes a statutory requirement of consistency between property's estate tax value and its basis under section 1014(a).¹¹ There are two circumstances in which the consistency requirement applies. First, under section 1014(f)(1)(A), the basis of property acquired or passing from a decedent shall not exceed the final value of the property as determined for estate tax purposes. Second, under section 1014(f)(1)(B), if the estate tax value has not been finally determined (for example, because an estate tax audit is pending), the basis may not exceed the value reported by the estate under section 6035.¹² There is no requirement of basis consistency, however, unless the inclusion of property in the decedent's gross estate causes an increase in estate tax.¹³

Whether the final value of property has been determined for estate tax purposes within the meaning of section 1014(f)(1)(A) depends on the course of the estate tax audit. If the IRS does not contest the reported value within the statute of limitations for assessment, the finally determined value of the property is its reported value.¹⁴ If the IRS instead specifies a different value, such as by assessing a deficiency, and the estate does not timely contest the IRS value, such as by filing a claim for a refund, the finally determined value is the value specified by the IRS.¹⁵ Finally, the value of property may be determined by a court or settlement agreement with the IRS.¹⁶

The proposed zero-basis rule defines a fourth circumstance, not described in the statute,¹⁷ in which the value of property is considered to have been "determined" for estate tax purposes. Under prop. reg. section 1.1014-10(c)(3), if property is omitted from an estate tax return or an estate tax return is not filed, the final value of property acquired or passing from a decedent is deemed to be zero.¹⁸ Section 1014(a) basis may be restored, however, by amending the estate tax return to report the omitted property, if the period for assessment of estate tax under section 6501 has not lapsed, or by filing an initial estate tax return, if one was not previously filed.¹⁹ If the period for assessment of estate tax has expired, however, the final value of omitted property remains zero, and there is no opportunity to obtain a basis equal to FMV at death under section 1014(a).²⁰

Footnotes

1Because most property tends to appreciate in value, and welladvised taxpayers typically realize losses before death, the fresh basis at death under section 1014(a) is commonly referred to as a basis "step-up."

2Section 1014(a). If an estate tax alternate valuation date election is made under section 2032, the basis of property acquired from a decedent is equal to the fair market value of the property on the alternate valuation date. Id. at section 1014(a)(2).

3Id. at section 1014(b)(9).

4Reg. section 1.1014-3(a); Rev. Rul. 54-97, 1954-1 C.B. 113.

5See, e.g., Janis v. Commissioner, T.C. Memo. 2004-117 (stating that taxpayers who owned an art gallery could not claim a discounted value of their father's art collection for estate tax purposes and then use an undiscounted value for purposes of determining the collection's value as inventory).

6See, e.g., Treasury, "General Explanations of the Administration's Revenue Proposals," at 163 (Feb. 1999). Treasury called for basis consistency legislation even though that was already generally required under existing law.

7Prop. reg. section 1.1014-10(c)(3) (2016).

8See American College of Trust and Estate Counsel, "Comments on Proposed Regulations Under Section 1014(f) and 6035" (May 27, 2016); and American Bar Association, "Comments in Response to Proposed Regulations Regarding Consistency in Income Tax Basis" (June 20, 2016). Another surprising rule in the proposed regulations, a discussion of which is beyond the scope of this article, would require the recipients of a decedent's property to report to the IRS any subsequent transfers of that property.

9If, however, the executor amends the estate tax return to include the omitted property before the statute of limitations runs, the property will receive a step-up in basis. Prop. reg. section 1.1014-10(c)(3)(i)(A).

10Section 1014(a) and (b). In limited cases, basis is determined differently if a special use valuation election is made under section 2032A or if a qualified conservation easement is excluded from the gross estate. Section 1014(a)(3)-(4). Section 1014(c), (d), and (e) carve out exceptions to the step-up in basis, including for income in respect of a decedent under section 1014(c). Id. section 1014(c), (d), and (e).

11Section 1014(f). 12Section 6035 requires that an executor provide Treasury and any beneficiaries with a statement identifying the value of each interest in the decedent's taxable estate. Id. Section 6035(a)(1).

13Id. Section 1014(f)(2). For example, property that qualifies for an estate tax marital or charitable deduction is not subject to the requirement of basis consistency. Prop. reg. section 1.1014-10(b)(2). Property is also not subject to basis consistency if no estate tax is payable after application of all available credits. Prop. reg. section 1.1014- 10(b)(3).

14Section 1014(f)(3)(A); prop. reg. section 1.1014-10(c)(1)(i).

15Section 1014(f)(3)(B); prop. reg. section 1.1014-10(c)(1)(ii).

16Section 1014(f)(3)(C); prop. reg. section 1.1014-10(c)(1)(iii)-(iv).

17Prop. reg. section 1.1014-10(c)(1), which sets forth the general definition of final value, closely tracks the statute. Prop. reg. section 1.1014-10(c)(3) later deems the final value of omitted property to be zero.

18Id. section 1.1014-10(c)(3)(i)(B).

19Id. Prop. reg. section 1.1014-10(c)(3)(i)(A).

20Prop. reg. section 1.1014-10(c)(3)(i)(B).

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Previously published in Tax Notes.

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