Recurring Proposal For Estate Beneficiary’s Basis In An Asset

There is an ongoing proposal in estate taxation to require the use of carryover basis by an inheriting beneficiary.

I am not a fan.

There is no need to go into the grand cosmology of the proposal. My retort is simple: it will fail often enough to be an unviable substitute for the current system.

You might be surprised how difficult it can be sometimes to obtain routine tax reports. I have backed into a social security 1099 more times than I care to count.

And that 1099 is at best a few months old.

Let’s talk stocks.

Question: what should you do if you do not know your basis in a stock?

In the old days – when tax CPAs used to carve numbers into rock with a chisel – the rule of thumb was to use 50% of selling price as cost. There was some elegance to it: you and the IRS shared equally in any gain.

This issue lost much of its steam when Congress required brokers to track stock basis for their customers in 2011. Mutual funds came under the same rule the following year.

There is still some steam, though. One client comes immediately to mind.

How did it happen?

Easy: someone gifted him stock years ago.

So?  Find out when the stock was gifted and do a historical price search.

The family member who gifted the stock is deceased.

So? Does your client remember - approximately - when the gift happened?

When he was a boy.

All right, already. How much difference can it make?

The stock was Apple.

Then you have the following vapid observation:

Someone should have provided him with that information years ago.

The planet is crammed with should haves. Take a number and sit down, pal.

Do you know the default IRS position when you cannot prove your basis in a stock?

The IRS assumes zero basis. Your proceeds are 100% gain.

I can see the IRS position (it is not their responsibility to track your cost or basis), but that number is no better than the 50% many of us learned when we entered the profession.

You have something similar with real estate.

 Let’s look at the Smith case.

Sherman Darrell Smith (Smith) recently went before the Tax Court on a pro se basis.

COMMENT: We have spoken of pro se many times. It is commonly described as going to Tax Court without an attorney, but that is incorrect. It means going to Tax Court represented by someone not recognized to practice before the Tax Court. How does one become recognized? By passing an exam. Why would someone not take the exam? Perhaps Tax Court is but a fragment of their practice and the effort and cost to be expended thereon is inordinate for the benefits to be received. The practitioner can still represent you, but you would nonetheless be considered pro se.

Smith’s brother bought real property in 2002. There appears to have been a mortgage. His brother may or may not have lived there.

Apparently, this family follows an oral history tradition.

In 2011 Smith took over the mortgage.

The brother may or may not have continued to live there.

Several years later Smith’s brother conveyed an ownership interest to Smith.

The brother transferred a tenancy in common.

So?

A tenancy in common is when two or more people own a single property.

Thanks, Mr. Obvious. Again: so?

Ownership does not need to be equal.

Explain, Mr. O.

One cannot assume that the real estate was owned 50:50. It probably was but saying that there was a tenancy in common does not automatically mean the brothers owned the property equally.

Shouldn’t there be something in writing about this?

You now see the problem with an oral history tradition.

Can this get any worse?

Puhleeeze.

The property was first rented in 2017.

COMMENT: I suspect every accountant that has been through at least one tax course has heard the following:

The basis for depreciation when an asset is placed in service (meaning used for business or at least in a for-profit activity) is the lower of the property’s adjusted basis or fair market value at the time of conversion.

One could go on Zillow or similar websites and obtain an estimate of what the property is worth. One would compare that to basis and use the lower number for purposes of depreciation.

Here is the Court:

Petitioner used real estate valuation sources available in 2024 to estimate the rental property’s fair market value at the time of conversion.”

Sounds like the Court did not like Smith researching Zillow in 2024 for a number from 2017. Smith should have done this in 2017.

If only he had used someone who prepares taxes routinely: an accountant, maybe.

Let’s continue:

But even if we were to accept his estimate …, his claim to the deduction would fail because of the lack of proof on the rental property’s basis.”

The tenancy in common kneecapped the basis issue.

Zillow from 2024 kneecapped the fair market value issue.

Here is the Court:

Petitioner has failed to establish that the depreciation deduction here in dispute was calculated by taking into account the lesser of (1) the rental property’s fair market value or (2) his basis in the rental property.”

And …

That being so, he is not entitled to the depreciation deduction shown on his untimely 2018 federal tax return.”

Again, we can agree that zero is inarguably wrong.

But such is tax law.

And yes, the Court mentioned that Smith failed to timely file his 2018 tax return, which is how this mess started.

Here is the Court:

Given the many items agreed to between the parties, we suspect that if the return had been timely filed, then this case would not have materialized.”

Let’s go back to my diatribe.

How many years from purchase to Tax Court?

Fifteen years.

Let’s return to the estate tax proposal.

Allow for:

• Years if not decades
• Deaths of relevant parties
• Failure to create or maintain records, either by the parties in interest or by municipalities tasked with such matters
• Soap opera fact patterns

And there is why I object to cost carryover to a beneficiary.

Because I have to work with this. My classroom days are over.

And because – sooner or later – the IRS will bring this number back to zero. You know they will. It is chiseled in stone.

And that zero is zero improvement over the system we have now.

Our case this time was Smith v Commissioner, T.C. Memo 2025-24.

Can You Have Income From Life Insurance?

 

I was looking at a recent case wondering: why did this even get to court?

Let’s talk about life insurance.

The tax consequences of life insurance are mostly straightforward:

(1) Receiving life insurance proceeds (that is, someone dies) is generally not an income-taxable event.

(2) Permanent insurance accumulates reserves (that is, cash value) inside the policy. The accumulation is generally not an income-taxable event.

(3) Borrowing against the cash value of a (permanent) insurance policy is generally not an income-taxable event.

Did you notice the word “generally?” This is tax, and almost everything has an exception, if not also an exception to the exception.

Let’s talk about an exception having to do with permanent life insurance.

Let’s time travel back to 1980. Believe it or not, the prime interest rate reached 21.5% late that year. It was one of the issues that brought Ronald Reagan into the White House.

Some clever people at life insurance companies thought they found a way to leverage those rates to help them market insurance:

(1)  Peg the accumulation of cash value to that interest rate somehow.

(2)  Hyperdrive the buildup of cash value by overfunding the policy, meaning that one pays in more than needed to cover the actual life insurance risk. The excess would spill over into cash value, which of course would earn that crazy interest rate.

(3)  Remind customers that they could borrow against the cash value. Money makes money, and they could borrow that money tax-free. Sweet.

(4)  Educate customers that – if one were to die with loans against the policy – there generally would be no income tax consequence. There may be a smaller insurance check (because the insurance is diverted to pay off the loan), but the customer had the use of the cash while alive. All in all, not a bad result – except for the dying thing, of course.

You know who also reads these ads?

The IRS.

And Congress.

Neither were amused by this. The insurance whiz kids were using insurance to mimic a tax shelter.

Congress introduced “modified endowment contracts” into the tax Code. The acronym is pronounced “meck.”

The definition of a MEC can be confusing, so let’s try an example:

(1)  You are age 48 and in good health.

(2)  You buy $4,000,000 of permanent life insurance.  

(3)  You anticipate working seven more years.

(4)  You ask the insurance company what your annual premiums would be to pay off the policy over your seven-year window.

(5)  The company gives you that number.

(6)  You put more than that into the policy over the first seven years.

I used seven years intentionally, as a MEC has something called a “7 pay test.” Congress did not want insurance to morph into an investment, which one could do by stuffing extra dollars into the policy. To combat that, Congress introduced a mathematical hurdle, and the number seven is baked into that hurdle.     

If you have a MEC, then the following bad things happen:

(1) Any distributions or loans on the policy will be immediately taxable to the extent of accumulated earnings in the policy.

(2) That taxable amount will also be subject to a 10% penalty if one is younger than age 59 ½.

Congress is not saying you cannot MEC. What it is saying is that you will have to pay income tax when you take monies (distribution, loan, whatever) out of that MEC.

Let’s get back to normal, vanilla life insurance.

Let’s talk about Robert Doggart.

Doggart had two life insurance contracts with Prudential Insurance. He took out loans against the two policies, using their cash value as collateral.

Yep. Happens every day.

In 2017 he stopped paying premiums.

This might work if the earnings on the cash value can cover the premiums, at least for a while. Most of the time that does not happen, and the policy soon burns out.

Doggart’s policies burned out.

But there was a tax problem. Doggart had borrowed against the policies. The insurance company now had loans with no collateral, and those loans were uncollectible.   

You know there is a 1099 form for this.

Doggart did not report these 1099s in his 2017 income. The IRS easily caught this via computer matching.

Doggart argued that he did not have income. He had not received any cash, for example.

The Court reminded him that he received cash when he took out the loans.

Doggart then argued that income – if income there be - should have been reported in the year he took out the loans.

The Court reminded him that loans are not considered income, as one is obligated to repay. Good thing, too, as any other answer would immediately shut down the mortgage industry.  

The Court found that Doggart had income.

The outcome was never in doubt.

But why did Doggart allow the policies to lapse in 2017?

Because Doggart was in prison.

Our case this time was Doggart v Commissioner, T.C. Summary Opinion 2023-25.

New Life Expectancy Tables For Your Retirement Account

On November 7, 2019 the IRS issued Proposed Regulations revising life expectancy tables used to calculate minimum required distributions from retirement plans, such as IRAs.

That strikes me as a good thing. The tables have not been revised since 2002.

There are three tables that one might use, depending upon one’s situation. Let’s go over them:

The Uniform Lifetime Table

This is the old reliable and the one most of us are likely to use.

 Joint Life and Last Survivor Expectancy Table

This is more specialized. This table is for a married couple where the age difference between the spouses is greater than 10 years.

The Single Life Expectancy Table

Do not be confused: this table has nothing to do with someone being single. This is the table for inherited retirement accounts.

Let’s take a look at a five-year period for the Uniform Lifetime Table:

Age	Old	New	Difference
71	26.5	28.2	1.7
72	25.6	27.3	1.7
73	24.7	26.4	1.7
74	23.8	25.5	1.7
75	22.9	24.6	1.7

If you had a million dollars in the account, the difference in your required minimum distribution at age 71 would be $2,275.

It is not overwhelming, but let’s remember that the difference is for every remaining year of one’s life.

As an aside, I recently came across an interesting statistic. Did you know that 4 out of 5 Americans receiving retirement distributions are taking more than the minimum amount? For those – the vast majority of recipients – this revision to the life expectancy tables will have no impact.

Let’s spend a moment talking about the third table - the Single Life Expectancy Table. You may know this topic as a “stretch” IRA.

A stretch IRA is not a unique or different kind of IRA. All it means is that the owner died, and the account has passed to a beneficiary. Since minimum distributions are based on life expectancy, this raises an interesting question: whose life expectancy?

COMMENT: There is a difference on whether a spouse or a non-spouse inherits. It also matters whether the decedent reached age 70 ½ or not. It is a thicket of rules and exceptions. For the following discussion, let us presume a non-spouse inherits and the decedent was over age 70 ½.

An easy way to solve this issue would be to continue the same life expectancy table as the original owner of the account. The problem here is that – if the beneficiary is young enough – one would run out of table.

So let’s reset the table. We will use the beneficiary’s life expectancy.

And there you have the Single Life Expectancy Table.

As well as the opportunity for a stretch. How? By using someone much younger than the deceased. Grandkids, for example.

Say that a 35-year old inherits an account. What is the difference between the old and new life expectancy tables?

                                Old             48.5

                                New            50.5

Hey, it’s better than nothing and – again – it repeats every year.

There is an odd thing about using this table, if you have ever worked with a stretch IRA. For a regular IRA – e.g., you taking distributions from your own IRA – you look at the table to get a factor for your age in the distribution year. You then divide that factor into the December 31 IRA balance for the year preceding the distribution year to arrive at the required minimum amount.

Point is: you look at the table every year.

The stretch does not do that.

You look at the table one time. Say you inherit at age 34.  Your required minimum distribution begins the following year (I am making an assumption here, but let’s roll with it), when you are age 35. The factor is 48.5. When you are age 36, you subtract one from the factor (48.5 – 1.0 = 47.5) and use that new number for purposes of the calculation. The following year you again subtract one (47.5 – 1.0 = 46.5), and so on.

Under the Proposed Regulation you are to refer to the (new) Single Life Expectancy Table for that first year, take the new factor and then subtract as many “ones” as necessary to get to the beneficiary’s current age. It is confusing, methinks.

There are public comment procedures for Proposed Regulations, so there is a possibility the IRS will change something before the Regulations go final. Final will be year 2021.

So for 2020 we will use the existing tables, and for 2021 we will be using the new tables.

An Engineer Draws A Tax Penalty

We have spoken in the past about clients I would not accept: one with an earned income credit, for example. The tax Code requires me to go all social worker, obtaining and reviewing documents to have reasonable confidence that there is a child and said child lives in given household. There are penalties if I do not.

Not happening.

Did you know that I can be penalized for not signing a tax return as a paid professional? Yep, it is in Section 6694 for the home gamers.

I saw a penalty recently under Section 6701. That one is a rare bird.

The 6701 penalty can reach someone who is not a preparer but who “aids,” “assists” or “advises” with respect to information, knowing that it will be used in a material tax situation.

Here is an example: you gift majority control of your (previously) wholly-owned business to your kids. This would require a valuation, which in turn requires a valuation expert. That expert is probably not preparing the gift tax return, but the preparer of the gift tax return is relying – and heavily – on his/her work.

The penalty is $1,000 for each incident. Pray that you are not advising a corporation, as then it goes to $10,000 per incident.

The IRS recently trotted out Section 6701 in Chief Counsel Advice (CCA) 201805001. Think of a CCA as an IRS attorney advising an IRS employee on what to do.

The situation here involved a “tax-consultant engineer” who analyzed a taxpayer’s assets to determine the classification of property for depreciation purposes.

In the trade, we call this type of work “cost segregation.”

If you have enough money tied-up in certain types of depreciable assets, a “cost seg” may be a very good idea.

What drives the cost seg is an abnormally-long tax life for commercial property: usually 39 years.  It is a tax fiction, divorced from any economic analysis to build or not build or from a bank decision to lend or not lend.

The grail is to “carve out” some of that 39-year property into something that can be depreciated faster. There is room. The parking lot and landscaping, for example, can be depreciated over 15 years. Upgraded wiring to run equipment can be depreciated with the equipment. The additional plumbing at a dentist’s office? Yep, that gets faster depreciation.

But it probably requires a cost seg. Realistically, an accountant can do only so much. A cost seg really needs an engineer.

The engineer in this CCA must have left the plot, as the IRS was nearly out-of-its-mind over his classification into five-year property. The word they used was “egregious.”

Unfortunately, we are not told what he “egregiously” misclassified.

We are however told that he is getting the Section 6701 chop.

What is the math on this penalty?

Well, his misclassification affected five years of individual returns. The penalty would be 5 times $1,000 or $5,000 for each individual client. Hopefully this was a one-off, as $5 grand should be enough to get his attention.

Can you imagine if it had been a corporation? 

What Does It Mean To Rely On A Tax Pro?

You may know that permanent life insurance can create a tax trap.

This happens when the insurance policy builds up cash value. Nice thing about cash value is that you can borrow against it. If the cash value grows exponentially, you can borrow against it to fund your lifestyle, all the while not paying any income tax.

There is always a "but."

The "but" is when the policy terminates. If you die, then there is no tax problem. Many tax practitioners however consider death to be extreme tax planning, so let's consider what happens should the policy terminate while you are still alive. 

All the money you borrowed in excess of the premiums you paid will be income to you. It makes sense if you think of the policy as a savings account. To the extent the balance exceeds whatever you deposited, you have interest income. Doing the same thing inside of a life insurance policy does not change the general rule. What it does do is change the timing: instead of paying taxes annually you will pay only when a triggering event occurs.

Letting the policy lapse is a triggering event.

So you would never let the policy lapse, right?

There is our problem: the policy will require annual premiums to stay in effect. You can write a check for the annual premiums, or you can let the insurance company take it from the cash value. The latter works until you have borrowed all the cash value. With no cash value left, the insurance company will look for you to write a check.

Couple this with the likelihood that this likely will occur many years after you acquired the policy - meaning that you are older and your premiums are more expensive - and you can see the trap in its natural environment.  

The Mallorys purchased a single premium variable life insurance policy in 1987 for $87,500. The policy insured Mr. Mallory, with his wife as the beneficiary. He was allowed to borrow. If he did, he would have to pay interest. The policy allowed him two ways to do this: (1) he could write a check or (2) have the interest added to the loan balance instead.

Mallory borrowed $133,800 over the next 14 years - not including the interest that got charged to the loan.

Not bad.

The "but" came in 2011. The policy burned out, and the insurance company wanted him to write a check for approximately $26,000.

Not a chance said Mallory.

The insurance company explained to him that there would be a tax consequence.

Says you said Mallory.

The policy terminated and the insurance company sent him a 1099 for approximately $150,000.

It was now tax time 2012. The Mallorys went to their tax preparer, who gave them the bad news: a big tax check was due.

Tax preparer became ex-tax preparer.

The Mallorys did not file their 2011 tax return until 2013. They omitted the offending $150,000, but they attached the Form 1099 to their tax return with the following explanation:

Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch -- IRS could not help when called -- Pls send me a corrected 1040 explanation + how much is owed. Thank you."

The IRS in turn replied that they wanted $40,000 in tax, a penalty of approximately $10,000 for filing the return late and another penalty of over $8,000 for omitting the 1099 in the first place.

The Mallorys countered that they had no debt with the insurance company. Whatever they received were just distributions, and they were under no obligation to pay them back.

In addition, since they received no cash from the insurance company in 2011, there could not possibly be any income in 2011.

It was an outside-the-box argument, I grant you. The problem is that their argument conflicted with a small mountain of paperwork accumulated over the years referring to the monies as loans, not to mention the interest on said loan.

They also argued for mitigation of the $8,000 penalty because no one could tell them the taxable portion of the insurance policy.

The Mallorys had contacted the IRS, who gave them the general answer.  It is not routine IRS policy to specifically analyze insurance company 1099s to determine the taxable amount.

They had also called random tax professionals asking for free tax advice.

COMMENT: Think about this for a moment. Let's say you receive a call asking for your thoughts on a tax question. The caller is not a client. Your first thought is likely: why get involved? Let's say that you take the call. You are then asked for advice. How specific can you be? They are not your client, and the risk is high that you do not know all the facts. The most you can tell them - prudently, at least - is the general answer.

This is, by the way, why many practitioners simply do not accept calls like this.                            

The Court did not buy the Mallory's argument. It was not true that the Mallorys were not advised: they were advised by their initial tax preparer - the one they unceremoniously fired. After that point it was a stretch to say that they received advice - as they never hired anyone. A phone call for free tax advice did not strike the Court as a professional relationship providing "reasonable cause" to mitigate the $8,000 penalty. 

The Mallorys lost across the board.

Splitting With The IRS Over Insurance

I am reading a case where the Tax Court just entered a “partial” summary judgement. This means that at least one issue has been decided but the remaining issue or issues are still being litigated.

And I think I see what the attorneys are up to.

We are talking about split-dollar life insurance. 

This had been a rather humdrum area of tax until 2002. The IRS then issued new rules which tipped the apple cart and sent planners scrambling to review – and likely revise – their clients’ split dollar arrangements (SDAs). I know because I had the misfortune of being point man on this issue at a CPA firm. There is a certain wild freedom when the IRS decides to reset an area of tax, with revisions to previous interim Notices, postponed deadlines and clients who considered you crazed.

To set-up the issue, a classic split dollar arrangement involves an employer buying a life insurance policy on an employee. The insurance is permanent – meaning cash value build-up - and the intent is for the employee to eventually walk away with the policy or for the employee’s estate to receive the death benefits. The only thing the employer wants is a return of the premiums it paid.

Find a policy where the cash value grows faster than the cumulative premiums paid and you have a tax vehicle ready to hit the highway. 

Our case involves the Morrissette family, owners of a large moving company. Grandmom (Clara Morrissette) had a living trust, to which she contributed all her company stock. She was quite concerned about the company remaining in the hands of the family. She had her attorney establish three trusts, one for each son. The sons, trusts and grandmom then entered into an agreement, whereby each son – through his trust – would buy the company stock of a deceased brother. If one brother died, for example, the remaining two would buy his stock. In the jargon, this is called a “cross purchase.”

This takes money, so each trust bought life insurance on the two other brothers.

This too takes money, which grandmom forwarded from her trust.

How much money? About $30 million for single-premium life policies.

Wow.

Obviously the moving company was extremely successful. Also obviously there must have been a life insurance person celebrating like a madman that day.

The only thing grandmom’s trust wanted was to be reimbursed the greater of the policies’ cash value or cumulative premiums paid.

Which gets us to those IRS Regulations from back when.

The IRS had decreed that henceforth SDAs would be divided into two camps:

(1) The employee owns the policy and the employer has a right to the cash value or some other amount.

This works fine until the premiums get expensive. Under this scenario the employee either has income or has a loan. Income of course is taxable, and the IRS insisted that a loan behave like a loan. The employee had to pay interest and the employer had to report interest income, with whatever income tax consequence followed.

And a loan has to be paid back. Many SDAs are set-up with the intent of the employee walking away someday. How will he/she pay back the loan at that time? This is a serious problem for the tax planners. 

(2)  The employer owns the policy and the employee has a right to something – likely the insurance in excess of the cash value or cumulative premiums paid.

The employee has income under this scenario, equal to the value of the insurance he/she is receiving annually. The life insurance companies publish tables, so practitioners can plan for this number.

But this leaves a dangerous possible tax issue: what happens once the cash value exceeds the amount to which the employer is entitled (say cumulative premiums)? Let’s say the cash value goes up by $250,000, and the employer’s share is met. Does the employee have $250,000 in income? There is a lot of lawyering on this point.

The Court decided that the grandmom had the second type – type (2) of SDA, albeit of the “family” and not the “employer” variety. The sons’ trusts had to report income equal the economic benefit of the life insurance, the same as an employee under the classic model.

This doesn’t sound like much, but the IRS was swinging for a type (1) SDA. If the sons’ trusts owned the policies, the next tax question would be the source of the money. The IRS was arguing that the grandmom trust made taxable gifts to the sons. Granted the gift and estate tax exclusion has been raised to over $5 million, but $30 million is more than $5 million and would trigger a hefty gift tax. The IRS was smelling money here.                 

The partial summary was solely on the income tax issue.

The Court will get back to the gift tax issue.

However, having won the income tax issue must make the Morrissette family feel better about winning the gift tax issue. According to the IRS’ own rules, grandmom’s trust owned the policies. What was the gift when the trust will get back all its money? The attorneys can defend from high ground, so to speak.

And there is one more thing.

Grandmom passed away. She was already in her 90s when the sons’ trusts were set up.

She died with the sons’ trusts owing her trust around $30 million.

Which her estate will not collect until the sons pass away or the SDAs are terminated. Who knows when that will be?

And what is a dollar worth X years from now? 

One thing we can agree on is that it not worth a dollar today.

Her estate valued the SDA receivables at approximately $7 million.

And the IRS is coming after her. There is no way the IRS is going to roll-over on those split dollar arrangements reducing her estate by $23 million.

You know the IRS did not think this through back in 2002 when they were writing and rewriting the split dollar rules.