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.

Penalties For Cash Reporting Failures

 

It would be a vast understatement to say that the plucky Rebellion had software issues this busy season.

We saw (some of) it coming … given the merger and all. Short of Excel and Word, there was little overlap between our softwares - that is, our preparation software, research software, time reporting, invoicing and receipt, monitoring the accounting practice and whatnot.

We are still working through the shock.

And I see a Tax Cout decision issued about a week ago concerning software.

I can tell you before reading it how the Court will decide:

Software – unless involving matters exceeding the minds of mortal men – will not save one from penalties. If one purchases and installs software, one is under obligation to learn and master it.

My thoughts?

I am divided. An ordinary taxpayer does not – should not - need my services. Reach a certain point though, and a tax professional becomes as necessary as a primary physician or a dentist.

Still, the Code has become increasingly complex since I came out of school. The very computerization that has allowed professionals to streamline and systematize their work has simultaneously allowed the Congressional tax committees to draft and score increasing complex and near-unworkable changes to the Code. Far too many of these changes can potentially reach ordinary taxpayers. That taxpayer would probably not know that he/she wandered into a minefield. He/she would learn of it when the penalty notice arrived, however. The IRS (and too often the courts) presume that you have a graduate degree in taxation – ignorance of the law is no excuse and all that flourish. They do not care that you don’t.

Dealers Auto Auction of Southwest LLC (Dealers) was an Arizona company selling vehicles through auction houses. It frequently received cash in the ordinary conduct of its business. Not surprisingly, the cash from a sale would often exceed $10,000.

There is a Code section involved here:

          Section 6050I

(a)  Cash receipts of more than $10,000

Any person

(1)  Who is engaged in a trade or business, and

(2)  Who in the course of such trade or business, receives more than $10,000 in cash in 1 transaction (or 2 or more related transactions),

shall make the return described in subsection (b) with respect to such transaction (or related transactions) at such time as the Secretary may by Regulations prescribe.

Once Sec 6050I is triggered, the company files Form 8300 with the IRS. It is an information return (no taxes go with it), but there are penalties for failure to file the return.

Not surprisingly, it has its own rules and subrules.

You know the Forms 8300 were an issue for Dealers.

They bought software (AuctionMaster) to deal with it.

They bought the software after flubbing the 2014 Form 8300 filings. The IRS assessed penalties of over $21 grand, and Dealers realized that buying software was cheaper than paying penalties.

And … the IRS was back in 2016.

Why?

Dealers filed 116 Forms 8300. The IRS argued that Dealers should have filed 382.

The IRS wanted over $118 grand in penalties.

Yipes!

Here is the Court:

Dealers Auto was not immediately aware of its failures. Instead, it was not until the Commissioner began the examination that Dealers Auto became aware of its noncompliance.”

Dealers was blindsided.

It took immediate steps:

·       It contacted the software provider and learned that improved aggregation features were available starting in 2017 (the year following the audit year).

·       Dealers quizzed the auditor on the subtleties of Form 8300 and its filing requirements.

·       Dealers changed its procedures and internal control for filing 8300s.

·       Dealers changed to electronic filing of the 8300s. They let the software cook.

No way the IRS was going to retract that $118 grand-plus assessment, though.

Dealers appealed the penalty. It wanted abatement for reasonable cause.

COMMENT: So would I, frankly.

Dealers’ argument was straightforward: we relied on software, and the software malfunction was outside of our control.

The IRS responded: there was no malfunction. You never mastered the software. If you had, you would have realized that it was not functioning as you thought.

Harsh, methinks. Probably honest, though.

Here is the Court:

Dealers Auto failed to establish that there was a software failure.”

The instructions for the software suggest that the software prepared Forms 8300 for printing, but Dealers Auto asserts that the software files the forms on the user’s behalf.”

Even assuming Dealers Auto met its burden to show a failure beyond the filer’s control, the record does not support a finding that Dealers Auto acted reasonably before or after the failure. For example, Dealers Auto did not establish that it was correctly using the software or that data was being entered correctly into the system.”

Dealers Auto argues that it reasonably believed the software was working as intended because it was generating some information returns. But the record shows that Dealers Auto software prepared only 116 Forms 8300 in 2016. The record also shows that Dealers Auto was required to file at least 212 Forms 8300 in 2014.”

This is going poorly.

What do I see?

I see a small business that was surprised in 2014. It responded with technology, but its familiarity with technology appears limited. It got surprised again. Normally that would indicate recidivism, but I don’t think that is what happened here. I think Dealers had only so many resources to throw at a problem. In addition, they may not have realized the extent of the problem if they were quizzing the IRS auditor on the ins and outs.

What did the Court see?

While it is not necessary to show that Dealers Auto made every data entry correctly, the record offers the Court no insight as to Dealer Auto’s installation, training, or use of the software.”

Here it comes:

Dealers Auto failed to establish that it has reasonable cause for its failure to file information returns for 2016.”

What disappoints me about cases like this is the failure to reward a taxpayer’s effort. Dealers tried. It bought software. It was filing, albeit not as much as it was supposed to. Should it have expended more money and resources on the matter? Clearly, but then I should have played in the NFL and retired as a Hall of Famer. The IRS is punishing Dealers like a scofflaw who did not care, made things up and never intended to follow the rules. To me, applying the same penalties to both situations is abusive.

Our case this time was Dealers Auto Auction of Southwest LLC v Commissioner, T.C. Memo 2025-38.

The Importance of Marking A Return As “Final”

I have worked tax controversy for many years now. I have seen the system work well; I have seen the system work poorly. I would say – with some generosity – that the system has been on the downslope for several years now.

It may be as simple as a tax notice.

It may be – even more simply – failing to indicate that a particular tax filing is a “Final.” Perhaps the business has been sold or closed. Maybe the company discontinued a line of business and will no longer have that specific filing. Maybe the company is reorganizing to another state and will not have the origin state’s filing anymore. There can be a host of reasons for a final.

I am looking at one involving Albertina Camaclang doing business as “Europa Guest Home,” which we will abbreviate as “EGH.”

EGH was a small residential care facility in California. She sold the business in 2002. She however never marked “final” on her Form 941, which is the form to report (and remit) federal withholding and social security payroll taxes.

Sixteen years later (16, you read that correctly) there was a dispute. The IRS said they mailed a notice to EGH informing that they had never received Forms 941 for 2008.

COMMENT: Six years after the sale.

EGH said it never received the IRS notice.

And the IRS could not produce a copy of the letter nor proof that it was mailed.

But the IRS did kindly prepare Forms 941 showing unpaid liabilities of over $600 thousand. These are referred to a “substitutes for return” or “SFRs.” It is generally preferable to file a return rather than allow the IRS to prepare an SFR. The IRS is not concerned with deductions, for one thing. We are not told what EGH’s annual 941 liability was back in the day, a useful bit of information as we weigh the $600 grand.

The IRS filed liens.

COMMENT: Yep, predictable.

Off to Tax Court.

We are now in 2019. EGH hired a tax lawyer. The lawyer requested a Collection Due Process or Equivalent Hearing. EGH’s defense was straightforward: the business was sold long before 2008.

Go to 2020, and a settlement officer (SO) was assigned to the case.

And there was this:

The settlement officer learned of a parallel criminal investigation into petitioner, which delayed further work into the case. On February 15, 2023, the IRS lifted the suspension, and the settlement officer resumed work on the matter.”

OK then.

The SO wanted to schedule a conference with EGH on March 24, 2023. The SO also wanted paperwork to substantiate the sale of the business as well as original tax returns (meaning the 941s) for 2008.

COMMENT: Easiest tax returns ever: zero all the way down.

EGH requested access to its administrative file. This delayed the conference to June 5, 2023.

Which the IRS wanted later to reschedule. How about July 13^th?

EGH responded on July 19^th, explaining that it had received the notice that very day.

Back to rescheduling.

Mind you, EGH still had not provided documentation on the sale of the business.

COMMENT: I would have led with that documentation. I cannot help but wonder if something was afoot, which is how IRS CID had gotten involved.

The attorney finally provided the SO with a grant deed showing sale of the real estate.

COMMENT: What about the business located on that real estate, counselor?

The SO wanted to know why EGH filed Forms 941 for 2004 and 2005 if it was sold in 2002.

COMMENT: So do I.

The attorney argued that the IRS prepared these returns fraudulently.

COMMENT: Interesting persuasion skills being flashed there.

In the alternative, the attorney argued that the accountant was an idiot and incorrectly filed another entity’s return as EGH.

And here is an understated sentence:

While discussing these discrepancies, there was a ‘breakdown’ in communication between petitioner’s counsel and the settlement officer.”

To be a fly on the wall.

On August 29, 2023, a new settlement officer ….

I will interrupt here. I have practiced procedure for decades. I have never – barring illness or something like that – replaced an SO midstream. I am getting the impression that the most interesting parts of the story were not written down.

On August 29, 2023, the new SO reached out to explain why the IRS had filed SFRs and liens to back them up.

COMMENT: Self-serving, but OK.

The new SO requested new signed returns reporting zero liability filed by September 5,2023.

COMMENT: I would file them that very afternoon and end this nightmare.

On August 30, 2023, the IRS sent a letter acknowledging receipt of the returns. The IRS also enclosed Form 12257 Summary Notice of Determination and Waiver of Judicial Review.

EGH declined to sign the 12257.

The SO said fine. The IRS would nonetheless issue a notice of determination indicating a zero balance.

The IRS closed the file on September 1, 2023.

The IRS released the liens on October 27,2023.

The Tax Court closed the case.

COMMENT: I do not understand the reluctance to sign the 12257. Granted, one would lose certain procedural rights (such as the right to appeal), but EGH got everything it wanted: tax reduced to zero, interest and penalties likewise reduced to zero, liens released. What was left to fight over?

On October 6, 2023, EGH filed with the Tax Court for a review of the notice of determination.

COMMENT: Why? Let me keep reading…. EGH wanted reimbursement of approximately $50,000 for its litigation costs.

Folks, it does not work this way. The Tax Court had already decided and closed the case. EGH now wanted the Tax Court to resurrect the matter (the word is “vacate.”). Please stop already.

Would you believe that the Tax Court agreed to vacate?

EGH got its day. It now had to prove certain things – including being the prevailing party – to obtain reimbursement of its litigation costs.

EGH had pushed too far.

Remember: EGH had delayed at every turn. 

Here is the Court:

Petitioner is not the prevailing party. Accordingly, we need not consider whether petitioner unreasonably protracted proceedings or claimed ‘reasonable costs.’ Petitioner is not entitled to administrative or litigation costs.”

Our case this time was Albertina Camaclang d.b.a Europa Guest Home, Docket No. 15761-23L, filed April 23, 2025.

Valuing a Questionable Business

 

Starting with a 46-page case soon after finishing tax season may not have been my best idea.

Still, the case is a hoot.

Here is the Court:

Backstabbing, infidelity, and blackmail – not the first words that come to mind in relation to a baby products company.”

We are talking about Kaleb Pierce and his (ex) wife Ms. Bosco.

Early on Pierce sought to make money any way he could. At age 16 he purchased an ice cream truck, for example. He met Bosco and they married in 2000. Several children soon followed.

That ice cream truck was not going to suffice. He switched to selling timeshares. He then switched to painting houses.

In 2005 they had another child. Bosco had an idea relating to nursing newborns, and Pierce had his next business idea. He reached out to Chinese manufacturers to make wristbands for nursing mothers. He set up a website, attended tradeshows and whatnot.

His idea was not an initial success.

But there was someone at the tradeshow who was successful. Pierce wanted to partner with them, but they were not interested, Pierce then decided to duplicate their company and run them out of business.

The model was easy enough: he would manufacture the product in China, undercut the existing retail price and then reduce that already-undercut price to zero by use of promotional codes. Where is the money, you ask? He would charge a shipping fee. Considering that the price was already reduced to zero, he figured he could press his thumb on the shipping fee as his profit point.

He was right, but not fully. In the early days, the products were sometimes shipped to customers showing the actual shipping cost. Those customers were not amused.

But Pierce could make money.

And the model was simple: appropriate someone’s product, create a website to pitch it, have the product manufactured cheaply, make money hand over fist. Mind you, the products were all directed at nursing mothers, so the window to market and sell was limited. He had to strike hard and fast. He also had to keep introducing new products, as he continually needed something on which to hang a shipping charge.

The company was called Mothers Lounge (ML). ML sold each product through a different subsidiary. This separation of business was vital to give the appearance that the companies were unrelated. Even so, many customers found that the same company was selling the products. They requested that different orders be shipped together, which ML could not do, of course. ML had reached a point where 97% of its revenues came from that free- just-pay-shipping model.

How did it turn out?

In his own words:

He “never imagined that he was going to be this successful.”

But then ….

Pierce had an extramarital affair.

Someone added a tracker to Pierce’s software that tracked his keystrokes and found out about the affair.

Someone sent a box with a letter demanding $100,000 by the following week or said someone would tell Bosco about the affair.

Pierce told Bosco about the affair first. The news shattered her. She no longer trusted him. She forbade him from attending tradeshows. He responded by sending employees in his place, but it was not the same. His employees were not as … creative … at recognizing … opportunities as Pierce. Eventually he stepped down as CEO to deal with his family.

The business was not the same.

But Pierce and Bosco were still printing money. He did what a nouveau-riche entrepreneur would do: he started estate planning.

It is here that we get back to tax.

They created a trust. The trust in turn created an operating company. Pierce and Bosco each gifted 29.4% ownership to the trust. They also sold a 20.6% interest to the operating company owned by the trust.

The tax lawyers were busy.

There was a gift tax return, which meant that ML needed a valuation.

The IRS selected the gift tax returns (one by each spouse) for audit.

Pierce and Bosco fired their valuation expert and hired another.

That is different, methinks.

The new expert came in with a lower number. Pierce and Bosco told the IRS that – if anything – they had overreported the gift. What was the point of the audit?

The IRS was not buying this. The IRS argued that the two had underreported the gift by almost $5 million. Remember that the gift tax rate is 40%, so this disagreement translated into real money. The IRS also wanted penalties of almost $2 million.

Off to Tax Court they went.

The Court discussed valuation procedures for over twenty pages, the detail of which I will spare us. The Court liked some things about Pierce and Bosco’s valuations (remember they had two) and also liked some things about the IRS valuation. Then you had the unique facts of Mothers Lounge itself, a business which was not really a business but was nonetheless quite profitable. How do you value a business like that, and how do you adjust for the business decline since the blackmail attempt? The IRS argued that ML could return to a more traditional business model. The Court noted that ML could not; it was a different animal altogether.

The decision is a feast for those interested in valuation work. The Court was meticulous in going through the steps, but it was not going to decide a number. Truthfully, it could not: there was too much there.

The Court instead made an interim decision under Rule 155, a Tax Court arcana requiring the two parties to perform – and agree to – calculations consistent with the Court’s reasoning.

And the Court will review those results in a future hearing.

Our case this time was Pierce v Commissioner, T.C. Memo 2025-29.

Shoplifting And Sales Tax

 

I was recently surprised by a question.

It has to do with use tax, and it is not the most riveting issue – even for a tax CPA.

But it did remind me of a recent-enough case from New Jersey involving sales tax.

Sales tax and use tax are flip sides of the same coin. Let’s set up an example.

·      You have a product-intensive business. Maybe you sell vintage collectible baseball and other sports-themed cards.

·      When you buy cards, it is your intention to sell them. That is your business, of course, and those cards are your inventory. You do not pay sales tax when you purchase them, but you would collect and remit sales tax when you finally sell them.  

·      Let’s say that you acquire a particularly appealing card, one that you want for your personal collection. You remove that card from inventory and take it home.

·      If it stops here, the state does not receive any tax on that card. The business did not pay sales tax when it bought the card. It did not resell because you took the card home.

·      To make the system work, you would owe use tax when you take the card. The state gets its money. Granted, there was a change in names: use tax versus sales tax. I suppose you might have to send a personal check for the tax, or perhaps the business could collect and remit on your behalf. Different states, different rules.

There was a New Jersey case to determine whether sales tax should be included in the calculation of “full retail value” when someone shoplifted an Xbox One game console.

Why the nitpicking?

Because New Jersey categorized the crime depending on full retail value. If the value was between $200 and $500, it was a fourth-degree offense. Go over $500, however, and it becomes a third-degree offense.

Kohl’s sold the X Box for $499.99.

Two pennies away.

Yes, the sales tax would take that above $500 and make it third degree.

Which is what the Court decided.

Then – believe it or not – the decision was appealed. The grounds? The full retail value should not include sales tax.

A fourth degree gets someone up to 18 months in prison. A third degree is between 3 and 5 years.

The Appellate Court noted that no New Jersey court had ever looked at this issue.

OK.

The Court reasoned that shoplifting was the purposeful taking of merchandise belonging to a merchant, thereby depriving him/her of the economic benefit from the same. A merchant does not keep the sales tax. Instead, the merchant is an agent, collecting the tax from the customer and remitting it to the state (although there me be a small administrative allowance). Since the merchant would not have kept the sales tax, the Court decided that it should not be considered when calculating full retail value.

The Appellate Court reversed the lower Court’s decision.

Not all states agree with this reasoning. California for example will include sales tax in its full retail value.

Our case this time was State v Burnham, 474 N.J. Super. 226 (App. Div 2022).

Electronic Signatures And The Tax Court

I had a moment of dual disbelief and laughter.

At the expense of the IRS and the Tax Court.

Electronic records, cloud computing and work from home (WFH) have and continue to revolutionize the way we practice and work. I have been working, for example, with a CPA firm sponsoring a very robust WFH policy, as well as outsourcing selected tax functions overseas. Mind you, the infrastructure protecting that data transmission and retention is formidable, but woe to the accountant - especially if over age 40 – learning it for the first time.

Let’s go back to 2020. The Tax Court was rolling-in its new electronic platform – called DAWSON - which in turn was based on PACER, used for dockets in other courts. The Court was embracing electronic records, albeit in fits and starts. For example, the initial launch included only records created by the Court itself. It did not include taxpayer-submitted documents, for example. While the intent to protect taxpayer privacy was clear, it was also clear that some compromise was required. Filings containing confidential information could be sealed. If not otherwise pertinent, any confidential information could be redacted in the filing copy.

DAWSON did allow for electronic filing of the court petition itself.               

This was a big deal.

We have spoken many times about a Notice of Deficiency (NOD) or Statutory Notice of Deficiency (SNOD). This is an IRS notice, and it is also known as the 90-Day Letter. That 90 days may well be cast in concrete, as you have 90 days to file with the Tax Court should you choose to contest the matter. The IRS is very unforgiving here: miss the deadline by one day and it is guaranteed that the IRS will move to toss out your petition.

The electronic filing provides some piece of mind, but accidents still happen.

EXAMPLE: Antawn Jaal Sanders was filing electronically with the Tax Court, but Antawn cut it close. The last day to file was December 12, 2022, and Antawn had started downloading the Court forms onto his Android shortly before 10 p.m. Unable to file from his phone, he switched to his computer at 11:56 p.m. It took him a minute to log in and several to return to where he had been. It was after midnight by the time he started uploading to DAWSON. The IRS of course moved to dismiss his petition, and the Court agreed. Antawn might challenge the IRS, but he was not doing it in Tax Court. After midnight was the next day, meaning his petition was late.

Do you wonder how the taxpayer signs that petition in DAWSON?

If it were a paper file, there would be a handwritten signature.

DAWSON does not allow (for now, at least) for a handwritten signature. What it does do is allow a block-letter facsimile of your signature.

Here is the Court:

The combination of DAWSON username (email address) and password serves as the signature of the individual filing the document.”

The Court says it will accept the facsimile as a signature, so that should be the end of it.

Except when it isn’t.

Robert and Kegan Donlan filed their petition on DAWSON, and they took advantage of the electronic signature.

The IRS immediately filed a Motion to Dismiss, arguing that the Court lacked jurisdiction to hear the case because the petition was not property signed.

The Court bounced the IRS motion, of course.

And I find myself wondering – why did the IRS go there? I suppose it simply had to test the lock, fully expecting it to be locked.

And – here is years of CPA practice speaking – whether it was a new attorney who drew the short straw to look foolish in front of the Court.

Our case this time was Donlan v Commissioner, U.S. Tax Court Docket 16579-24, Feb. 19, 2025.

A Call From Chuck

I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.

Me:              So, what are we going to talk about?”

Chuck:         I worked for Costco for many years.”

Me:              OK.”

Chuck:         I bought their stock all along.”

Me:              Not sure where this is going. Are you diversifying?”

Chuck:         Have you heard of Net Unrealized Appreciation?”

Me:              Sure have, but how does that apply to you?”

That was not my finest moment. I did not immediately register that Chuck had – for many years – bought Costco stock inside of his 401(k).

Take a look at this stock chart: 

Costco stock was at $313 on February 7, 2020. Five years later it is at $1,043.

It has appreciated – a lot.

I missed the boat on that one.

The appreciation is unrealized because Chuck has not sold the stock.

The difference between the total value of the Costco stock in his 401(k) and his cost in the stock (that is, the amount he paid over the years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and commonly pronounced (NEW-AHH).

And Chuck has a tax option that I was not expecting. His financial advisor did a good job of spotting it.

Let’s make up a few numbers as we talk about the opportunity here.

Say Chuck has 800 shares. At a price of $1,043, the stock is worth $834,400.

Say his average cost is 20 cents on the dollar: $834,400 times 20% = cost of $166,880.

Chuck also owns stocks other than Costco in his 401(k). We will say those stocks are worth $165,600, bring the total value of his 401(k) to an even $1 million.

Chuck retires. What is the likely thing he will do with that 401(k)?

He will rollover the 401(k) to an IRA with Fidelity, T Rowe, Vanguard, or someone like that.

He may wait or not, but eventually he will start taking distributions from the IRA. If he delays long enough the government will force him via required minimum distributions (RMDs).

How is the money taxed when distributed from the IRA?

It is taxed as ordinary income, meaning one can potentially run through all the ordinary tax rates.

It was not that long ago (1980) that the maximum tax rate was 70%. Granted, one would need a lot of income to climb through the rates and get to 70%. But people did. Can you imagine the government forcing you to take a distribution and then taking seventy cents on the dollar as its cut?

Hey, you say. What about those capital gains in the 401(k)?  Is there no tax pop there?

Think of a 401(k) as Las Vegas. What happens in Las Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.

And that gets us to net unrealized appreciation. Congress saw the possible unfairness of someone owning stock in a regular, ordinary taxable brokerage account rather than a tax-deferred retirement account. The ordinary taxable account can have long-term capital gains. The retirement account cannot.

Back to NEW-AHH.

How much is in that 401(k)?

A million dollars.

How much of that is Costco?

$834,400.

Let’s roll the Costco stock to a taxable brokerage account. Let’s roll the balance ($165,600) to an IRA.

This would normally be financial suicide, as stock going to a taxable account is considered a distribution. Distributions from an IRA are ordinary income. How much is ordinary income tax on $834,400? I can assure you it exceeds my ATM withdrawal limit.

Here is the NUA option:

You pay ordinary tax on your cost - not the value - in that Costco stock.

OK, that knocks it down to tax on $166,880.

It still a lot, but it is substantially less than the general rule.

Does that mean you never pay tax on the appreciation – the $667,520?

Please. Of course you will, eventually. But you now have two potentially huge tax planning options.

First, hold the stock for at least a year and a day and you will pay long-term capital gains (rather than ordinary income tax) rates on the gain.

QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.

What is the second option?

You control when you sell the stock. If you want to sell a bit every year, you can delay paying taxes for years, maybe decades. Contrast this with MRDs, where the government forces you to distribute money from the account.

So why wouldn’t everybody go NUA?

Well, one reason is that (in our example) you pony up cash equal to the tax on the $166,880. I suppose you could sell some of the Costco stock to provide the cash, but that would create another gain triggering another round of tax.

A second reason is your specific tax situation. If you just leave it alone, distributions from a normal retirement account would be taxable as ordinary income. If you NUA, you are paying tax now for the possibility of paying reduced tax in the future. Take two people with differing incomes and taxes and whatnot and you might arrive at two different answers.

Here are high-profile points to remember about net unrealized appreciation:

(1)  There must exist a retirement account at work.

(2)  There must be company stock in that retirement account.

(3)  There is a qualified triggering event. The likely one is that you retired.

(4)  There must be a lump-sum distribution out of that retirement account. At the end of the day, the retirement account must be empty.

(5)  The stock part of the retirement account goes one way (to a taxable account), and the balance goes another way (probably to an IRA).

(6)  The stock must be distributed in kind. Selling the stock and rolling the cash will not work.

BTW taking advantage of NUA does not have to be all or nothing. We used $834,400 as the value of the Costco stock in the above example. You can NUA all of that – or just a portion. Let’s say that you want to NUA $400,000 of the $834,400. Can you do that? Of course you can.

Chuck has a tax decision that I will never have.

Why is that?

CPA firms do not have traded stock.