The Consistent Basis Rule

 

I was talking to two brothers last week who are in a partnership with their two sisters. The partnership in turn owns undeveloped land, which it sold last year. The topic of the call was the partnership’s basis in the land, considering that land ownership had been divided in two and the partnership sold the property after the death of the two original owners. Oh, and there was a trust in there, just to add flavor to the stew.

Let’s talk about an issue concerning the basis of property inherited from an estate.

Normally basis means the same as cost, but not always. Say for example that you purchased a cabin in western North Carolina 25 years ago. You paid $250 grand for it. You have made no significant improvements to the cabin. At this moment your basis is your cost, which is $250 grand.

Let’s add something: you die. The cabin is worth $750 grand.

The basis in the cabin resets to $750 grand. That means – if your beneficiaries sell it right away – there should be no – or minimal – gain or loss from the sale. This is a case where basis does not equal cost, and practitioners refer to it as the “mark to market,” or just “mark” rule, for inherited assets.

There are, by the way, some assets that do not mark. A key one is retirement assets, such as 401(k)s and IRAs.

A possible first mark for the siblings’ land was in the 1980s.

A possible second mark was in the aughts.

And since the property was divided in half, a given half might not gone through both marks.

There is something in estate tax called the estate tax exemption. This is a threshold, and only decedents’ estates above that threshold are subject to tax. The threshold for 2024 is $13.6 million per person and is twice that if one is married.

That amount is scheduled to come down in 2026 unless Congress changes the law. I figure that the new amount will be about $7 million. And twice that, of course, if one is married.

COMMENT: I am a tax CPA, but I am not losing sleep over personal estate taxes.

However, the exemption thresholds have not always been so high. Here are selected thresholds early in my career: 

		Estate Tax
Year		Exclusion
1986		500,000
1987- 1997		600,000
1998		625,000

I would argue that those levels were ridiculously low, as just about anyone who was savings-minded could have been exposed to the estate tax. That is – to me, at least – absurd on its face.

One of our possible marks was in the 1980s, meaning that we could be dealing with that $500,000 or $600,000 estate threshold.

So what?

Look at the following gibberish from the tax Code. It is a bit obscure, even for tax practitioners.

Prop Reg 1.1014-10(c):

               (3) After-discovered or omitted property.

(i)  Return under section 6018 filed. In the event property described in paragraph (b)(1) of this section is discovered after the estate tax return under section 6018 has been filed or otherwise is omitted from that return (after-discovered or omitted property), the final value of that property is determined under section (c)(3)(i)(A) or (B) of this section.

(A) Reporting prior to expiration of period of limitation on assessment. The final value of the after-discovered or omitted property is determined in accordance with paragraph (c)(1) or (2) of this section if the executor, prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, files with the IRS an initial or supplemental estate tax return under section 6018 reporting the property.

(B) No reporting prior to expiration of period of limitation on assessment. If the executor does not report the after-discovered or omitted property on an initial or supplemental Federal estate tax return filed prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, the final value of that unreported property is zero. See Example 3 of paragraph (e) of this section.

(ii) No return under section 6018 filed. If no return described in section 6018 has been filed, and if the inclusion in the decedent's gross estate of the after-discovered or omitted property would have generated or increased the estate's tax liability under chapter 11, the final value, for purposes of section 1014(f), of all property described in paragraph (b) of this section is zero until the final value is determined under paragraph (c)(1) or (2) of this section. Specifically, if the executor files a return pursuant to section 6018(a) or (b) that includes this property or the IRS determines a value for the property, the final value of all property described in paragraph (b) of this section includible in the gross estate then is determined under paragraph (c)(1) or (2) of this section.

This word spill is referred to as the consistent basis rule.

An easy example is leaving an asset (intentionally or not) off the estate tax return.

Now there is a binary question:

Would have including the asset in the estate have caused – or increased – the estate tax?

If No, then no harm, no foul.

If Yes, then the rule starts to hurt.

Let’s remain with an easy example: you were already above the estate exemption threshold, so every additional dollar would have been subject to estate tax.

What is your basis as a beneficiary in that inherited property?

Zero. It would be zero. There is no mark as the asset was not reported on an estate tax return otherwise required to be filed.

If you are in an estate tax situation, the consistent basis rule makes clear the importance of identifying and reporting all assets of your estate. This becomes even more important when your estate is not yet at – but is approaching – the level where a return is required.

At $13.6 million per person, that situation is not going to affect many CPAs.

When the law changes again in a couple of years, it may affect some, but again not too many, CPAs.

But what if Congress returns the estate exemption to something ridiculous – perhaps levels like we saw in the 80s and 90s?

Well, the consistent basis rule could start to bite.

What are the odds?

Well, this past week I was discussing the basis of real estate inherited in the 1980s.

What are the odds?

"I Never Heard Of The Alternative Minimum Tax"

 

I am looking at a case that involves the alternative minimum tax.

While it still exists, much of the steam has thankfully been taken out of the AMT. It started off as Congressional reaction to a handful of ultrawealthy families paying little to no income taxes decades ago. Congress’s response was to require a second tax calculation, disallowing certain things – such as exemptions for your dependents.

Yes, you read that correctly, you large-family tax scofflaw.

Now, it wouldn’t be so bad if this thing had been scaled to only reach the wealthy and ultrawealthy, but that is not what Congress did. Congress instead gave you a spot, and then you were on your own. For 2017 that spot was approximately $84 grand in income for marrieds filing jointly.

I used to see the AMT as often as a Gibson’s employee sees donuts.

Thankfully the Tax Cut and Jobs Act of 2017 did a couple of things to defang the AMT:

(1) It increased the exemption (that is, the spot) for everyone. Marrieds now have an exemption of approximately $115,000, for example.

(2)  More importantly, it adjusted a previous rule that phased-out the exemption as one’s income increased. For example, marrieds in 2017 would start phasing-out when their income reached approximately $160,000. Now it is over $1 million, which makes a lot more sense it if was truly targeted at the wealthy.

Why the absurdly low previous income thresholds for the AMT, especially since it was supposed to target the “rich?” Think of it as Congressional addiction to paper crack – the paper being your dollar bills.

The tax law is a little saner until 2026, when the TCJA goes “poof.” Much prior tax law will then resurrect – including the previous version AMT.

Robert Colton and Alina Mazwin (R&A) filed a joint return for 2016.

The IRS did its computer matching and sent them a notice. There was $125,000 reported by JP Morgan Chase Bank. The IRS wanted taxes on it.

R&A explained to the IRS that the $125,000 was a legal settlement, and that half of it went to Mr Colton’s ex-spouse.

The IRS said OK, but we want taxes on the $62,500.

Let’s take an aside here. You may have heard that lawsuit settlements are not taxable. That is only partially true. The lawsuit has to involve physical injury (think a car crash, for example) to be tax-free.

It appears that Mr Colton’s settlement was of the non-car crash variety, meaning that it was taxable.

R&A then amended their 2016 return, picking up the $62,500 but also claiming a miscellaneous itemized deduction of $80,075 for attorney fees.

Hah! They might even get a tax refund out of this, right? Take that, IRS.

Except …

Guess what is not deductible for the AMT.

Yep, that miscellaneous itemized deduction.

So – for AMT purposes – their income went up by the $62,500 but there was no deduction for the related legal fee.

How much income did R&A have before the IRS contacted them?

About $40 grand.

Yep, the AMT had been bent so far beyond recognition that it trapped someone amending a return to show perhaps $100 grand in income.

Folks, that income level does not go you invited to the cool parties on Martha’s Vineyard.

Let me share a line from the case:

Petitioners stated in their petition that ‘[they] never heard of [the] alternative minimum tax.”

I get it. I consider it unconscionable that an average person has to hire someone like me to prepare their taxes.  

Our case this time for the home gamers was Colton and Mazwin v Commissioner, T.C. Memo 2021-44.

Divorced Parents And A Dependent Child

 It is one of my least favorite issues in tax practice.

Who is entitled to a dependent?

Granted, there is no longer a dependency exemption available, but there are other tax items, such as the child tax credit, that require a dependent.

The issue can go off-the-rails if the parents are (a) divorced and (b) combative.

It occurs when both parents claim the same child for the same year.

One of the parents is going to lose the dependency, of course, but how the Code determines which one may surprise you.

The Code wants to know which is the custodial parent – that is, which parent did the child live with for the majority of the year. Granted, in some cases the answer may be razor close, but most of the time there is a clear answer.

The Code anticipates that the custodial parent will claim the child.

What if the noncustodial parent provides most of the child’s support?

The Code (for the most part) does not care.

How does the noncustodial parent get to claim the child?

If the parents get along, then there is no issue. Everyone follows the rules and there is no tax controversy.

If the parents do not get along and both claim the same child, the IRS is going to get involved. It will want to know: who is the custodial parent?

But the divorce decree says ….

You might be surprised how little the IRS cares about that divorce decree.

What it is interested in is whether a certain form was filed with the noncustodial parent’s return: Form 8332.

This form has to be signed by the custodial parent. If the parents do not get along, you can see the problem.

What happens if the noncustodial parent does not attach this form and both parents claim the child?

Let’s take a look at the DeMar case.

The divorce decree said that Mr Demar (Dad) was to claim the son in odd-numbered years. Dad claimed the son for 2015.

Mrs DeMar (Mom) also claimed the son.

The IRS came in. There (of course) was no Form 8332. The IRS could care less what that divorce decree had to say, so off to Tax Court they went.

Dad is going to lose this all day every day, except ….

Would you believe that – before the Tax Court hearing – Mom signed Form 8332?  

That doesn’t happen much.

There is a proposed Regulation on this point:

A noncustodial parent may submit a copy of the written declaration to the IRS during an examination to substantiate a claim to a dependency exemption for the child.

Did that save Dad?

Let’s keep reading:

A copy of a written declaration attached to an amended return, or provided during an examination, will not meet the requirement of this paragraph … if the custodial parent … has not filed an amended return to remove that claim to a dependency exemption for the child.

So one can file the 8832 late but one also has to prove that the other parent amended his/her return to remove the dependency for the child.

Guess what?

Mom did not amend her return.

Dad lost.

The IRS did not care about that divorce decree and the odd-numbered year.

I get it. The IRS has no intention of playing family court, so it established mechanical rules for the dependency. The average person focuses on the divorce decree – understandably – but the IRS does not.  Procedure is everything in this area.

Our case this time was DeMar v Commissioner T.C. Memo 2019-91.

Remember The Port

One thing about this blog is that it likely reflects what’s happening here at Intergalactic Command.

Here goes: it is unlikely that you will need an extensive and expensive estate tax plan, unless you (a) have unique family issues, such as a special needs child, or (b) have a tractor-trailer load of money.

Pass away in 2018 and you will not have a federal estate tax until you get to $11.2 million.

OBSERVATION: This amount increased under the new tax bill.

Folks, that excludes almost everybody.

I suppose you could live in a state with a state estate tax, like Illinois. If you do, here is some tax advice: move.

So how do you get into the federal estate tax?

It is easy enough in concept.  

Here goes:

                          Net FMV of assets you die with

                                           Plus

                    Reportable gifts made over your lifetime

BTW, notice that assets you die with and assets you gifted away are added together. The IRS is going to tax you whether you kept stuff or gave it away. The nerd term for this is “unified” tax.

There are tricks and traps to “assets you die with,” but, for the most part, it means what it says. The “net” means you get to deduct your liabilities from your assets. The “FMV” means fair market value. Take a car for example. You might get its FMV from Kelly Blue Book.

What does “reportable gifts” mean?

Let walk around the block on this. Let’s say you made a gift to a family member in 2017. Do you have to report it?

Depends on the amount. For 2017 the annual gift tax exclusion was $14,000. This means that you could gift anyone on the planet $14,000 and the government did not need to know. If you were married, then your spouse and you could double-up, meaning that together you could gift $28,000 without the government needing to know.

Let’s say that you are single. You gifted someone $50,000 in 2017. What have you got?

Easy enough: $50,000 – 14,000 = $36,000 is reportable. Yep, you went over the limit. You have to file a gift tax return.

Mind you, it is very unlikely that you will have any gift tax due on that return.

Why not?

Let’s circle back to the formula:

                             

                          Net FMV of assets you die with

                                           Plus

                    Reportable gifts made over your lifetime

You haven’t died yet, so the first line is zero.

But you still have the second line.

Remember that you can die in 2018 with $11.2 million and not be taxed.

Folks, if someone has gifted over $11.2 million (mind you, this is over a lifetime), please call or e-mail me. I want to get into that person’s will – I mean, I want to develop a lifelong friendship with a kindred soul.  

What if you fudge the numbers? You know, play down the gifts a bit? Who will know once you are gone, right?

If you are married, there could be a hitch with this.

Let’s take a look at the Estate of Sower case.

Frank Sower passed away in 2012, leaving Minnie as his surviving spouse. He filed an estate tax return, and it showed an unused estate tax exclusion of $1,250,000.         

COMMENT: Beginning in 2010, any unused estate tax exclusion of the first-to-die spouse could carryover to the surviving spouse. For example, the exclusion for 2011 was $5 million. Let’s say that the first-to-die had a taxable estate of $3.6 million. The balance - $1.4 million – could transfer to the surviving spouse.

This was a big improvement in tax practice. Previously tax professionals used trusts – “family” trusts and “marital” trusts, for example - to make sure that estate tax exclusions did not go squandered. One can still use trusts if one wants, but it is not as mandatory as it used to be. The transfer of the unused exclusion to the surviving spouse is called “portability” (“port” to the nerds) and it required (and still requires) the first-to-die to file a federal estate tax return, whether otherwise required, if only to alert the IRS that some of the exclusion is being ported.

There was however a problem with Frank’s estate return: the preparer left out $940,000 of reportable gifts. That in turn meant that the unused exclusion was overstated, as those unreported gifts would have soaked up a chunk of it.

Minnie died in 2013. Her estate showed the unused exemption ported from Frank. It was wrong, but it was there. The same tax preparer must have done her estate return, as once again her reportable gifts were left off.

The IRS audited her estate return and caught the mistake. They wondered whether Frank’s return had the same issue. It did, of course, so the IRS adjusted Frank’s ported exemption.

When the dust settled, Minnie’s estate owed another $788,165.

Ouch. Folks, the estate tax has one of the highest rates in the Code. A lot of effort goes into minimizing this thing. At least Congress has gotten away from having  taxable estates begin at $600,000, as it did in the nineties. Average folk did not consider $600,000 to be “wealthy,” no matter what Congress and the grievance mongers said.

The estate litigated. They argued that the Frank’s estate had a closing letter (think magical letter, but the estate’s letter was non-magical); that the adjustment to the port was an impermissible second review of Frank’s return; that the IRS position improperly overrode the statute of limitations, and so on. The estate lost on all counts.

What do we learn from Sower?

         

(1) It is OK to port.

(2) But the IRS can adjust the port if you get it wrong.

What did we learn from this post?

Remember the port.

The Qualified Small Business Stock Exemption

Let’s say that you are going to start your own company. You talk to me about different ways to organize:

(1) Sole proprietor – you wake up in the morning, get in your car and go out there and shake hands. There is no paperwork to file, unless you want to get a separate tax ID number. You and your proprietorship are alter-egos. If it gets sued, you get sued.

(2) Limited liability company – you stick that proprietorship in a single-member LLC, writing a check to your attorney and secretary of state for the privilege. You gain little to nothing tax-wise, but you may have helped your attorney (and yourself) if you ever get sued.

(3) Form a corporation - a corporation is the old-fashioned way to limit your liability. Once again there is a check to your attorney and secretary of state. Corporations have been out there long before LLCs walked the land.

You then have to make a decision as to the tax flavor of your corporation: 

a.    The “C” corporation – think Krogers, Proctor & Gamble and Macy’s. The C is a default for the big boys – and many non-bigs. There are some goodies here if you are into tax-free reorganizations, spin-offs and fancy whatnot.

Problem is that the C pays its own tax. You as the shareholder then pay tax a second time when you take money out (think a dividend) from the C.  This is not an issue when there are a million shareholders. It may be an issue when it is just you.

b.    The “S” corporation – geared more to the closely-held crowd. The S (normally) does not pay tax. Its income is instead included on your personal tax return. Own 65% of an S and you will pay tax on 65% of its income, along with your own W-2, interest, dividends and other income.

This makes your personal return somewhat a motley, as it will combine personal, investment and business income into one. Don’t be surprised if you are considered big-bucks by the business-illiterate crowd.

The S has been the go-to corporate choice for family-owned corporations since I have been in practice. A key reason is avoiding that double-tax.

But you can avoid the double tax by taking out all profits through salaries, right?

There is a nerdy issue here, but let’s say you are right.

Who cares then?

You will. When you sell your company.

Think about it. You spend years building a business. You are now age 65. You sell it for crazy money. The corporation pays tax. It distributes whatever cash it has left-over to you.

You pay taxes again.

And you vividly see the tax viciousness of the C corporation.

How many times are you going to flog this horse? Apple is a multinational corporation with a quarter of a trillion dollars in the bank. Your corporate office is your dining room.

The C stinks on the way out.

Except ….

Let’s talk Section 1202, which serves as a relief valve for many C corporation shareholders when they sell.

You are hosed on the first round of tax. That tax is on the corporation and Section 1202 will not touch it.

But it will touch the second round, which is the tax on you personally.

The idea is that a percentage of the gain will be excluded if you meet all the requirements.

What is the percentage?

Nowadays it is 100%. It has bounced around in prior years, however.

That 100% exclusion gets you back to S corporation territory. Sort of.

So what are the requirements?

There are several:

(1) You have to be a noncorporate shareholder. Apple is not invited to this soiree.

(2) You have owned the stock from day one … that is, when stock was issued (with minimal exceptions, such as a gift).

(3) The company can be only so big. Since big is described as $50 million, you can squeeze a good-sized business in there. BTW, this limit applies when you receive the stock, not when you sell it.

(4) The corporation and you consent to have Section 1202 apply.

(5) You have owned the stock for at least 5 years.

(6) Only certain active trades or businesses qualify.

Here are trades or businesses that will not qualify under requirement (5):

(1) A hotel, motel, restaurant or similar company.

(2) A farm.

(3) A bank, financing, leasing or similar company.

(4) Anything where depletion is involved.

(5) A service business, such as health, law, actuarial science or accounting.

A CPA firm cannot qualify as a Section 1202, for example.

Then there is a limit on the excludable gain. The maximum exclusion is the greater of:

(1) $10 million or

(2) 10 times your basis in the stock

Frankly, I do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that Section 1202 has been insufficient to sway many advisors, at least those outside Silicon Valley.

To be fair, however, this Code section has a manic history. It appears and disappears, its percentages change on a whim, and its neck-snapping interaction with the alternative minimum tax have soured many practitioners.  I am one of them.

I can give you a list of reasons why. Here are two:

(1) You and I start the company.

(2) I buy your stock when you retire.

(3) I sell the company.

I get Section 1202 treatment on my original stock but not on the stock I purchased from you.

Here is a second:

(1) You and I start the company.

(2) You and I sell the company for $30 million.

We can exclude $20 million, meaning we are back to ye-old-double-tax with the remaining $10 million.

Heck with that. Make it an S corporation and we get a break on all our stock.

What could make me change my mind?

Lower the C corporation tax rate from 35%.

Trump has mentioned 15%, although that sounds a bit low.

But it would mean that the corporate rate would be meaningfully lower than the individual rate. Remember that an S pays tax at an individual rate. That fact alone would make me consider a C over an S.

Section 1202 would then get my attention.

Ducking Taxes With A Dynasty Trust

Dynasty trust are back in the news. Dynasty trusts are the province of the ultrawealthy, and are not likely to impact you or me much.

However, allow one or two favorable turns of fate and you or I might find ourselves interested in such things. Let’s hope for the best.

What sets up the discussion is three main issues:

(1)  Estate taxes

(2)  Generation-skipping taxes

(3)  The rule against perpetuities

Estate taxes are also called death taxes and apply to your net worth (everything you own less everything you owe) at death. If you own too much, you owe estate tax – short and sweet. Granted, it is getting harder and harder too own too much. The threshold for 2017 is $5.49 million per person, or almost $11 million per married couple.

I would say that – if you have accumulated $11 million – you have done well.

The estate tax intends for every generation to pay tax.

Let’s say that you are worth $15 million. The estate tax will apply. Your assets go to your child. Let’s presume that the assets inherited bounce back to $15 million (remember: there were taxes at your death) and the exemption remains at $5.49 million. The estate tax presumes that your child will pay tax again, repeating a virtuous cycle.

Well, an advisor can break that cycle pretty quickly: have some of the assets go to the grandkids. That skips the estate tax on (at least some of) the assets upon your child’s death.

Congress figured this out too and introduced the generation-skipping tax (GST). Its purpose was straightforward: to tax the assets that skipped tax when your child died. Those assets would otherwise have “skipped” a generation of estate tax.

A favored and common way to transfer assets across multiple generations is through use of a trust. There are more varieties of trusts than there are flavors of  Baskin Robbins ice cream. We however are looking at one trust and one only: the shy and elusive dynasty trust, which has rarely been captured on camera.

Tax archeologists believe that the dynasty trust evolved in response to state liberalization of the rule against perpetuities. Trusts themselves are created under state law, and all 50 states used to prohibit a trust from existing more than 21 years after the death of the last beneficiary who was alive when the trust was created.

To rephrase: the law (1) looked at the beneficiaries born when the trust was created; (2) took the youngest beneficiary; (3) waited until his/her death; and (4) said “All right, boys and girls, you have 21 years to finish this”

The point is that the trust had to eventually wrap up its affairs. It could not be “perpetual.”

In that context, the estate tax – GST tax value meal worked relatively well in identifying and taxing transfers of intergeneration wealth. No matter how complex, trusts simply had to give up the ghost eventually.

However, several states have since either modified or abolished their rule against perpetuities (Alaska and Nevada come to mind). A trust created in one of these jurisdictions can last for … who knows how long.

This has tax implications.

Because the trust is not required to terminate, tax planners can more easily get around the estate and GST combo that worked well enough in an earlier, simpler era.

It is relatively easy to avoid the estate tax issue: the planner simply does not give the beneficiary so much authority that the trust would be pulled into the beneficiary’s estate at death. While a minefield, it is a relatively well-trod minefield.

The GST is a bit more complicated.

I now go where many tax nerds would refuse to go: to give a quick overview of how a dynasty trust and the GST interact. We are venturing to the Mordor of tax practice.

Here goes:

(1)  You have a GST exemption equal to your estate tax exemption. Therefore, if the estate exemption is $5.49 million, your GST exemption is the same amount.

(2)  Meaning you can transfer $5.49 million across as many generations as you like without triggering the GST.

(3)  Rule (2) is not interpreted the way you expect when using a trust.

a.     One would think that trust distributions over $5.49 million to a skip beneficiary would trigger the GST tax.

b.    But not necessarily. The planner instead applies the $5.49 million test at a different point in time. Instead of waiting until the trust actually writes checks to a grandkid or great-grandkid decades from now (that is, the distribution date), the planner measures at the moment the settlor puts money into the trust.

c.     Here is an example. Say your great-grandkid is 15 months old, and you put $5.49 million into a dynasty trust. You next burn your $5.49 million GST exemption on the trust.

d.    We calculate a ratio: GST Exemption Used/Total Gift. Let’s give the ratio a name. We will call it “Jackson.” In our example, Jackson is $5.49 million/$5.49 million or “1.0.”  

e.    We next calculate a second ratio: 1.0 – Jackson. We will call this the “inclusion ratio.” Our inclusion ratio is 1.0 – 1.0 or zero (-0-).

f.      Tax nirvana is an inclusion ratio of zero (-0-).

                                                              i.     The magic to an inclusion ration of zero (-0-) is that future distributions from this trust are exempt from any more GST. That happens because you are multiplying [it doesn’t matter the number] by zero.

                                                            ii.     If the inclusion ratio was 45%, then 45% of future distributions from the trust would be subject to GST.

g.     To press the point, if the trust is worth a quantazillion dollars decades from now but has an inclusion ratio of zero (-0-), it is still exempt from GST.

                                                              i.     There are of course ways to ruin this outcome. One way is to put more money into the trust. The result would be to increase the denominator with no increase in the numerator. The resulting inclusion ratio would not be zero. A tax planner would tell you to NOT DO THAT.

To recap, the change in some states concerning the rule against perpetuities allowed planners to devise near-immortal trusts.

And the estate, gift and GST exemptions have been increasing every year and are now at $5.49 million per person. A married couple can of course double that.

Take the near-immortal trusts, stir in the big-bucks exemption, add a few spices (like family limited partnerships or remainder annuities) and you have a very nice tax tool for keeping wealth within the family across generations.