After months of comment, speculation and uncertainty among practitioners, the Department of the Treasury issued temporary and proposed regulations for Internal Revenue Code Sections 1014(f) and 6035, which were added to the IRC on July 31, 2015 as part of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015. These new sections, included as “loophole closers” in each of President Obama’s annual budget proposals since taking office, mandate consistent basis reporting between estates and persons acquiring property from a decedent. The perceived abuse is that an estate reports a depressed value for a particular asset (for the purpose of reducing estate tax) while the beneficiary who subsequently disposes of the asset reports that there was a higher date of death value, which would result in a higher step-up in basis under IRC Section 1014(a) (for the purpose of reducing income tax).
To address this perceived abuse, Section 1014(f) generally provides that a taxpayer receiving property from a decedent that received a step-up in basis under Section 1014(a) may not claim a basis in such property exceeding its final value as determined for federal estate tax purposes. Section 6035 imposes a reporting regime to effectuate Section 1014(f) by generally requiring the executor of an estate required to file a federal estate tax return to report basis information to both the IRS and to the beneficiaries of the estate. Congress projects that the new provisions will raise $1.5 billion in new revenue over 10 years, which appears to be an extremely inflated and unrealistic figure given that there’s no evidence to suggest widespread abuse prior to the enactment of the new sections.
For purposes of satisfying the Section 6035 requirement, the Internal Revenue Service issued its final version of Form 8971 and instructions at the end of January. The proposed and temporary regulations issued last week provide useful guidance for the new IRS Form 8971 and the form’s accompanying instructions. The proposed regulations respond to the initial concerns of many commentators and adopt several sensible rules that will ease some of the burden imposed by the new reporting requirement. However, there are still some unresolved questions and instances in which the proposed regulations may go beyond the regulatory authority given to the IRS under Section 1014(f) and Section 6035.
Who’s Required to File Form 8971?
Section 6035(a)(1) provides that the executor of any estate required to file a federal estate tax return under IRC Section 6018(a) and who filed such return after July 31, 2015 must file Form 8971 and provide a copy of the relevant Schedule A to beneficiaries of the estate. Such returns are required to be filed by: (1) the estates of U.S. citizens and estate tax residents with gross estates exceeding the $5.43 million (for 2015) or $5.45 million (for 2016) basic exclusion amount, and (2) the estates of noncitizen nonresidents with U.S. gross estates exceeding the $60,000 basic exclusion amount. The instructions to Form 8971 made clear that the reporting obligation didn’t apply to estates that only filed to make an election for generation-skipping transfer tax purposes, but was silent on whether returns filed to elect portability were subject to the new regime. This silence created concern, given that the portability regulations state that an estate that files a return to elect portability “will be considered… to be required to file a return under section 6018(a).”1 The proposed regulations confirm that the Section 6035 reporting requirement doesn’t apply to estates filing an estate tax return merely for the purpose of electing portability.2
The proposed regulations also include a welcome clarification for the estates of non-citizen non-resident decedents and/or estates that aren’t required to open probate, providing that for purposes of Section 1014(f) and Section 6035, the definition of “executor” under IRC Section 2203 will be used.3 This broader definition will result in the executor being either: (1) the executor appointed by a U.S. court, or (2) if no executor is appointed by a U.S. court, any person in actual or constructive possession of property of the decedent.
Property to Report
Under Section 1014(f)(1), the basis consistency and reporting provisions apply to property included in a decedent’s gross estate; however, under Section 1014(f)(2), there’s an exception for property that doesn’t increase the federal estate tax liability payable by the estate in excess of allowable credits.4 Notwithstanding this exception, the Section 6035 reporting obligation requires all property included in the gross estate to be reported to beneficiaries even if it doesn’t increase the estate tax liability and/or doesn’t receive a basis adjustment under Section 1014(a). This means that most property reported on an estate’s IRS Form 706 or IRS Form 706-NA must appear on Form 8971 and its accompanying Schedule A unless an exception under the proposed regulations applies.
The proposed regulations state there are four exceptions to property reported on an estate tax return that aren’t subject to the reporting requirement, which should ease some of the administrative burden. The following items don’t need to be reported on Form 8971:5
- Cash, other than a coin collection or other coins or bills with numismatic value. This exception makes sense given that there’s no basis adjustment for cash, and it would be difficult to source which cash held at death is distributed to a beneficiary as opposed to cash resulting in the liquidation of assets to satisfy a bequest.
- Items of income in respect of a decedent, such as individual retirement accounts, which don’t receive a step-up in basis by reason of Section 1014(c). While this will reduce confusion to beneficiaries, it’s interesting that appreciated property acquired by a decedent by gift within a year of death wasn’t also excluded from the reporting requirement, as Section 1014(e) prevents a step-up in basis for such property.
- Items of tangible personal property that don’t require an appraisal under Treasury Regulations Section 20.2031-6(b) (that is, items with a value of less than $3,000).
- Property sold, exchanged or otherwise disposed of (and therefore not distributed to a beneficiary) by the estate in a taxable transaction. While a plain reading of the statutory text naturally leads to this conclusion, it’s comforting that the proposed regulations specifically list this as an exception.
As mentioned above, Section 1014(f)’s consistency rule only applies to property that increases the federal estate tax liability payable by a decedent’s estate in excess of allowable credits. The proposed regulations interpret this provision as excluding from the basis consistency requirement any property that qualifies for the charitable or marital deduction under Sections 2055, 2056 or 2056A.6 This includes all property passing to a surviving spouse that qualifies for the estate tax marital deduction, including outright bequests, beneficiary designations or property passing to a qualified terminable interest property or qualified domestic trust. Because such property doesn’t increase the federal estate tax liability payable by a decedent’s estate, it’s not subject to the general rule of Section 1014(f) and needn’t be included on Form 8971. However, under Section 6035, the executor must still issue a Schedule A to a beneficiary that qualifies for the marital or charitable deduction, but will have to indicate on the Schedule A sent to the beneficiary that each item that qualifies for the deduction doesn’t increase the estate tax liability.
Given the complexities that come with large estates, there are situations in which an estate discovers additional property after filing the estate tax return. The proposed regulations provide potentially harsh results for estates with after-discovered property or property otherwise omitted from an estate tax return. If any such property would have increased the estate’s federal estate tax liability, the proposed regulations dictate two possible results:
- If the executor reports such property on an original or amended federal estate tax return prior to the expiration of the limitations period, a “no harm, no foul” rule applies, and the basis of such property is as finally determined for federal estate tax purposes;7 or
- If the executor fails to report such property prior to the expiration of the limitations period, a zero valuation rule applies, and the beneficiary receiving the asset must pay tax based on a zero basis on the subsequent sale or other taxable disposition of the property.8
In the case of an estate with respect to which after-discovered or omitted property would have changed the status of the estate from one not required to file a federal estate tax return to one required to file a return, the second alternative would result in all property of the estate subject to Section 1014(f) being valued at zero until a return is filed and the value of such property is finally determined for federal estate tax purposes.9
Form 8971 must be filed with the IRS, and all beneficiaries must be provided with the relevant Schedule A, within 30 days of the timely filing of an estate’s federal estate tax return or, if a timely return wasn’t filed, within 30 days of the due date for the estate’s return. However, because of the long delay between the enactment of Sections 1014(f) and 6035 and the IRS’ issuance of proposed regulations and Form 8971, in no event must a Form 8971 be filed prior to March 31, 2016.10 If the value of the property reported on the estate tax return is adjusted, the executor must issue a supplemental report within 30 days of the adjustment.11
As discussed above, in addition to filing Form 8971 with the IRS, the executor of an estate must provide each beneficiary who receives property reported on Form 8971 (including the executor himself if he’s a beneficiary) a copy of Schedule A reporting the property distributable to that beneficiary.12 Executors of estates with beneficiaries that are trusts, estates or business entities rather than individuals must provide a copy of Schedule A to the trustee, executor or entity itself, and not to the beneficiaries of the trust or estate or the owners of the entity.13
The proposed regulations also impose a burdensome reporting requirement on executors and may result in a confusing report being received by beneficiaries. If, as is often the case, the executor can’t determine exactly what property will be distributed to a beneficiary by the due date of the estate’s return, the executor is required to furnish the beneficiary a Schedule A listing all property that could potentially be used to satisfy the beneficiary’s interest.14
The instructions to Form 8971 provide that a beneficiary may be provided Schedule A in person, by e-mail or by U.S. mail to the beneficiary’s last known address or by a private delivery service to the beneficiary’s last known address. If the executor is unable to locate a beneficiary by the reporting deadline, the executor must report on Form 8971 the efforts taken to locate the beneficiary.15 If the executor subsequently locates the beneficiary, he must be provided with Schedule A, and a supplemental Form 8971 must be filed with the IRS within 30 days.
Sections 6721 and 6722 provide penalties for failure to file Form 8971 and Schedule A. Generally, the penalty for failure to file or provide the required information under Section 6035 is $250 per form or beneficiary statement. If it’s determined that an executor’s failure was due to “intentional disregard,” the penalty is increased to the greater of $500 or 10 percent of the items the executor failed to report. Penalties accrue to a maximum of $3 million. Accordingly, an executor’s failure to comply with the reporting requirements of Section 6035 can result in substantial penalties.
For beneficiaries, Section 6662 provides that accuracy-related penalties on underpayments could result if an estate beneficiary subsequently reports a higher basis on his income tax return than the estate tax value reported on Form 8971. While Section 1014(f) sets a ceiling on the basis that can be reported by a beneficiary, it’s important to note that Section 1014(f) doesn’t impose a floor, meaning that even if the IRS acquiesces to an executor’s valuation for estate tax purposes, it’s not estopped from arguing for a lower basis in a subsequent income tax audit of a beneficiary.
The proposed regulations also present two additional downsides for estate beneficiaries. First, the preamble recognizes and confirms that there’s no method available under federal law for a beneficiary to challenge the basis reported by an executor on Form 8971. Second, the proposed regulations provide that if a beneficiary disposes of an asset and the value of the asset is subsequently adjusted (for example, in an estate tax audit), the beneficiary may not rely on the basis provided on Schedule A and may have a deficiency and underpayment resulting from the difference.16 One can only hope that these harsh results will be addressed by subsequent regulations or rulings.
Signs of Expansion
The President’s budget proposal for fiscal year 2017 included a new plan to further expand the basis consistency provisions of Sections 1014(f) and 6035.17 However, the administration isn’t waiting for an additional statutory change to expand the reporting requirements and seeks to impose an additional reporting requirement under the proposed regulations.
Under the proposed regulations, if a beneficiary of property reported on Form 8971 (including property not subject to the consistency rule) subsequently distributes or transfers such property to a “related transferee” in a transaction in which the related transferee determines its basis in whole or in part based on the value reported on Form 8971, then the beneficiary must file a supplemental Form 8971 with the IRS and provide a Schedule A to the related transferee within 30 days of the transfer.18 For this purpose, a “related transferee” is as defined in Section 2704(c)(2) and includes the beneficiary’s spouse, ancestor (or ancestor’s spouse), descendant (or descendant’s spouse), sibling (or sibling’s spouse), a controlled entity or any trust that’s grantor to the beneficiary. For beneficiaries that are trusts, estates or entities, it remains unclear what, if any, effect the Chapter 14 attribution rules may have on the expanded reporting requirement.
Section 6035(b) provides authority to issue regulations “as necessary to carry out this section,” including: (1) the application of Section 6035 to property with regard to which no estate tax return is required to be filed, and (2) situations in which a surviving joint tenant may have better information than the executor regarding the basis of property. At present, it’s unclear how this regulatory authority is sufficient to support the broad expansion imposed by the proposed regulations’ subsequent reporting rule. In fact, the Administration’s proposal in this year’s Greenbook implies that a statutory change is needed to impose a consistency and reporting requirement for property received by gift under the carry-over basis rule of IRC Section 1015. Further, while an extremely liberal reading could potentially justify such a requirement in limited circumstances, the proposed regulations’ preamble citing Section 6035(b)(2), which grants the authority to issue regulations related to “situations in which the surviving joint tenant or other recipient may have better information than the executor regarding the basis or fair market value of the property,” certainly wouldn’t provide the authority for this expansion. However, unless and until the IRS or the courts limit the subsequent reporting requirement, beneficiaries and their advisors should be aware of the impact of the basis reporting regime on subsequent planning transactions.
Create Best Practices
As discussed above, Congress expects the basis reporting requirement to generate $1.5 billion in additional revenue over 10 years. It’s anticipated that taxable estates will incur significant administrative costs in complying with the new rules, which may far exceed the revenue that will actually be generated. Indeed, in the preamble to the proposed regulations, the IRS specifically requests comments on “whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility.” Nevertheless, pending the resolution of various issues in final regulations or rulings by the IRS, practitioners should pay close attention to the new reporting rules to avoid the imposition of potentially costly penalties. With the March 31, 2016 deadline fast approaching, practitioners must not only ensure that they comply with the new reporting requirements, but that they create best practices to ensure that the reporting is done efficiently and causes minimal confusion for beneficiaries.
- Treasury Regulations Section 20.2010-2(a)(1).
- Proposed Treas. Regs. Section 1.6035-1(a)(2).
- Prop. Treas. Regs. Section 1.1014-10(d); Treas. Regs. Section 1.6035-1(g)(1).
- Prop. Treas. Regs. Section 1.1014-10(b).
- Prop. Treas. Regs. Section 1.6035-1(b).
- Prop. Treas. Regs. Section 1.1014-10(b)(2).
- Prop. Treas. Regs. Section 1.1014-10(c)(3)(i)(A).
- Prop. Treas. Regs. Section 1.1014-10(c)(3)(i)(B).
- Prop. Treas. Regs. Section 1.1014-10(c)(3)(ii).
- Temp. Treas. Regs. Section 1.6035-2T; IRS Notice 2016-19, 2016-9 IRB 362.
- Internal Revenue Code Section 6035(a)(3)(B).
- Prop. Treas. Regs. Section 1.6035-1(c)(1).
- Prop. Treas. Regs. Section 1.6035-1(c)(2).
- Prop. Treas. Regs. Section 1.6035-1(c)(3).
- Prop. Treas. Regs. Section 1.6035-1(c)(4).
- Prop. Treas. Regs. Section 1.1014-10(c)(2).
- See James I. Dougherty & Eric Fischer, “Treasury Releases 2017 Greenbook,” http://wealthmanagement.com/estate-planning/treasury-releases-2017-greenbook (Feb. 12, 2016).
- Prop. Treas. Reg. Section 1.6035-1(f).