The Tax Rules Were Never Friendlier, But Changes May be on the Way
The biggest loophole in the tax code may soon be coming to an endâ€”at least according to the messages sent by the Obama administration and its recent budget proposals. The American Taxpayer Relief Act of 2012 (ATRA) set a whole new tone for most estate plans when it took the dreaded estate tax off the table. However, it is no secret that the IRS has been making a concerted effort to recapture some of the revenues lost from property transfers by way of gift or upon death. This article discusses the Serviceâ€™s focus on tracking the step-up basis and the need to secure qualified appraisals in this environment.
The biggest loophole in the tax code may soon be coming to an endâ€”at least according to the messages sent by the Obama administration and its recent budget proposals. Â The American Taxpayer Relief Act of 2012 (ATRA) set a whole new tone for most estate plans when it took the dreaded estate tax off the table. Â However, it is no secret that the IRS has been making a concerted effort to recapture some of the revenues lost from property transfers by way of gift or upon death.
The Administration has already proposed rollbacks of the lifetime estate exemption to $3,500,000 (the 2009 level) while raising the top estate tax rate to 45%.Â More interestingly, however, are the attempts to make death itself a taxable event.Â This plan would require a capital gains tax on appreciated assets to be reported on the decedentâ€™s final tax returnâ€”even though no assets had been sold. Â By the way, letâ€™s not forget the other proposals to raise the capital gains tax as wellâ€”to a rate that could reach as high as 28% with the new 3.8% investment tax.
Experts maintain that if a Republican-controlled Congress stays in place, the Administration will not get everything that it wants on its wish list. Â However, many experts contend that, in any case, a little tweaking of one or more of the Presidentâ€™s revenue raising proposals is always a possibility.
This article is not intended to speculate on these unknownsâ€”or what Congress may or may not do to tax estates in the coming years.Â Instead, the article calls attention to certain steps that have already been taken and, more specifically, on the recent IRS interest in targeting what some call the biggest tax-slasher of all timeâ€”â€śbasis step-upâ€ť.
Tightening the step-up â€śloopholeâ€ťâ€”Has the IRS taken the first step?
Practitioners have long relied on the premise that, with little more than a credible appraisal on hand, Section 1014 will allow a beneficiary to unilaterally increase the tax basis of an inherited asset to his or her tax advantage. Â However, it is now contended that the step-up process is beginning to look like an outright tax bonanza for many now that practically everybody is off the hook for estate taxes. Â That is right. Â For most of us, there will be no more estate tax OR capital gains taxes upon sale. Â Sounds too good to be true. Â But, how long will it last?
It appears that Congress found at least one way to remedy the step-up loophole issue by asking, â€śWhy not start tracking the basis of inherited assets and make sure that the asset values claimed as step-up matches those values reported on the estate tax return?â€ť Â This led to steps for enforcing the rules of basis consistency. Â Effective July 31, 2015, if an estate tax return needs to be filed, responsible parties must abide by the following guidelines for basis-consistency (authorized by the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015):
First, Section 1014(f) was added
In this section, the IRS simply declared flatly that there must be consistency with the basis of an inherited asset and the valuation reported on an estate tax return.
Second, Section 6035 was created
This spelled out the new filing requirements to be followed by executors and responsible parties for estates. Â For every estate return that is filed after July 31, 2015, a basis-consistency statement (known as Form 8971) must be sent separately to IRS no later than 30 days after the filing of the return.Â On this form, specific details are to be provided about the inherited assets and the purported values that were shown on the estate return. Â Most important, a copy of Schedule A must be sent separately to each beneficiary as well as to the IRS. Â For privacy reasons, Schedule A only identifies specific details and values that are placed on the assets that are going to each of the beneficiaries. Â The purpose, of course, is to put that individual on notice as to the amount that he or she should be claiming for basis step-up in order to minimize taxes.
Avoiding penalties for non-compliance under the new basis-consistency rules
A close reading of Form 8971 brings to mind some cautionary notes for all â€śresponsible partiesâ€ť (including executors or other individuals required to file the estate return).Â These individuals need to be aware of the responsibilities that apply when they participate in the process of establishing basis step-up in order to minimize taxes. Â This could apply to tax return preparation and also to involvement with the preparation of appraisals and other valuation information that is reported on Form 8971 and Schedule A.
For starters, the penalties are directed at meeting filing deadlines.Â Unless there is reasonable cause, simple failure to timely file Form 8971 and Schedule A could trigger penalties starting at $50 per form. Â It is $260 per form if filed after the 30-day period. Â Further, if â€śintentional disregard of the filing requirementsâ€ť is shown, the ante could be raised to $530 per form.
More importantly, aside from meeting filing deadlines, there is the subtle message that penalty assessments could extend further. Â The guideline instructions indicate that penalties could also apply if one does not â€ścorrectly stateâ€ť the information reported on Form 8971 and on Schedule A.Â With broad language such as this, another level of responsibility emerges for all responsible parties. Â Put another way, it is evident that the IRS radar screen intends to monitor the valuation figures that are reported on estate tax for basis consistency.Â At the same time, it is also recognized that â€ścorrectly statingâ€ť the value of any asset is not always a clear-cut task. Â Valuations and appraisals are a subjective exercise that could depend on a wide range of variables.Â And now, while IRS appears to be paying closer attention to step-up consistency, all estate participants (including tax professionals and valuation consultants) need to be mindful of the risks associated with any appraisal that is substandard or prepared by a valuation professional who is not deemed to be qualified.
Who is at greatest risk for not complying with the basis-consistency rules?
Before responding to this question you may be wondering, â€śWhat do all these new basis-consistency warnings have to do with estates in general in America?â€ť Â After all, the new basis-consistency rules only apply when an estate tax return is filed, and not even one percent of estates will need to file a return in the first place. Â (In fact, if you file a return simply to make a special electionâ€”such as for generation-skipping tax purposesâ€”you will not be subject to the new basis-consistency guidelines.)
Does all this mean that the vast majority of taxpayers who inherit assets will be free from IRS efforts to match stepped-up basis with the reported estate value? Â Probably not; for two obvious reasons.Â First, the budget deficit is not expected to go away anytime soon and Congress is well aware of the capital-gains tax dollars that are being lost because of step-up. Â Second, it is not conceivable that the IRS intends to monitor basis step-up for the super-wealthy only and let everyone else off the hook completely after ATRA.
Locking in basis step-up to maximize tax-saving benefits
After the 2012 Tax Act took place, it did not take long for savvy family planners to recognize that the real tax benefits could be achieved by establishing the highest value legally possible for estate purposes (not the lowest).Â All that is required is an independent, qualified appraisal. Â Nowadays, except for the ultra-rich, when an appraiser comes back with an asset value higher than expected, the beneficiary might have reason to celebrate.
With this new shift in the playing field, estate experts have been bringing to the table a host of creative ideas and recommendations that could further enhance the benefits of step-up.Â Consider the following:
- Get a qualified appraisal for all inherited assets
Even though an estate return may not be required, many will argue that it is a good idea to get an independent appraisal for all inherited assets regardless of their nature or size. Â In the past, when executors compiled an inventory of assets for estate purposes, they would often be advised not to bother including certain, insignificant, personal-use assets owned by the decedent since it would only add to unnecessary accounting and possible hurdles with probate administration.Â However, with the changing mindset about the step-up advantage, many are starting to realize that simple appraisals of obscure, personal-use assets might provide an unexpected tax advantage. Â To the reader, this might sound a bit like over-reach, especially for smaller estates. Â However, executors need to be reminded that an appraisal for a seemingly insignificant asset might do more than provide step-up benefits down the road. Â It just might nip-in-the-bud potential controversies among family members seeking to divide assets and honor specific bequests.
Some common examples of assets for which an independent appraisal might be helpful in small-sized estates include:
â€˘ household effects and furnishings
â€˘ personal property and collectibles
â€˘ personal residence
Say, for example, Jane decided to sell the family residence that she inherited from her father along with heirloom jewelry from his private collection. Â The burden of proof is on Jane to prove her tax basis in those assets in the event that they are sold or abandoned. Â Under Section 1221, any personal-use assets that Jane inherits are capital assets by definition. Â If they are later sold at a profit, they would generally be taxed at capital gains rates and without proof to support step-up Jane might have to face an unwelcome capital gains tax. Â Conversely, Section 1221 does not provide for a capital loss deduction for personal-use assets when sold at a loss. Â However, if Jane did not have an appraisal to support her basis, she could still have a potential tax issue.Â If questioned by the IRS, she would be unable to prove that she indeed sold at a lossâ€”and not a gain.
- Get a qualified appraisal for intangibles if they have an intrinsic value
Whether or not an estate tax return is required, beneficiaries should consider getting an appraisal for inherited assets known as intellectual propertyâ€”especially if there is reason to believe that they could eventually be sold at a profit.
This could include literary compositions, artwork, and other creative works of the decedent that may have an ascertainable value that is not easy to discernâ€”such as copyrights, patents, and trademarks.
It is reminded that, in most cases, the valuation of intellectual property is a highly specialized area that should only be undertaken by an experienced valuation professional in order to avoid any allegation that the asset value was not â€ścorrectly statedâ€ť.
- Re-visit your lifetime gifting plans
For most, gone are the days when a rush to make year-end gift transfers to the kids (under the annual exclusion) is a smart move. Â In fact, for most taxpayers, giving away assets simply to lower the value of your estate might now be counter-productive.Â If Dad were to give Junior a piece of property that has been appreciating in value, he may have unwittingly created a capital gains tax burden for Junior who would be deprived of the benefit of step-up.
- All business interests that are inherited should be appraised, regardless of size
An independent appraisal of an ongoing business venture, regardless of size, might provide immediate (step-up) tax benefits such as depreciation, etc., in addition to eliminating capital gains and recapture taxes upon sale. Â And so, a valuation professional experienced in business appraisals could provide valued benefits whenever any kind of business interest, including goodwill, is inherited.Â Interests could include: a small family run carryout shop, a furniture remodeling company, a real estate company or, for that matter, any ongoing business venture for which the decedent had an ownership interest.
- Consider dismantling estate planning techniques that no longer serve a purpose
There are many, of course. Â However, the by-pass trust comes to mind as one of the most common strategies that needs to be re-evaluated.Â With this technique, husbands and wives can easily lock in both of their lifetime exemptions to avoid estate taxes.Â There are also other popular trust strategies, such as the â€śintentionally defective grantor trustâ€ť, that may no longer be needed and might even be counter-productive after ATRA. Â By using these and other more exotic techniques, the benefit of basis step-up might be lost forever and beneficiaries might be faced with an unnecessary tax burden.Â This, of course, is not to mention the continuing costs associated with trust management, accounting, and administration.
Discounting asset values: One key challenge that is expected to face estates and valuation professionals
In addition to considering the above suggestions for locking in the benefits of step-up, estate beneficiaries should also be aware of another new twist in estate planning. Â It involves the recent IRS attempt to change valuation standards by prohibiting discounts in order to raise estate tax revenues. Â This IRS effort to â€śincreaseâ€ť asset valuations highlights a dichotomy that has now been created in the estate planning world.
Challenges lie ahead for â€śresponsible partiesâ€ť and valuation professionals
These are interesting times in which we live, especially if you happen to be a tax or valuation professional on the new playing field. Â The IRS has always been well armed with an abundance of rulings and court decisions to counteract those estate professionals who have made a good faith effort to minimize the fair market value of assets on the basis of â€śhighest and best useâ€ť standards referred to in Treasury Reg. 20.2031-1(b).Â Now, however, unless you are among the super-wealthy, these IRS rebuttals are starting to reveal a huge disconnect with estate planners everywhere. Â In fact, many estate experts will simply use the IRSâ€™ very own arguments in their attempts to substantiate the highest (rather than lowest) values allowable under law and sound valuation theory.
This disconnect was brought to light in the following message dealing with discounting asset values, which the IRS sent in a recent, highly-publicized, press release.Â It stated, Â â€śThe Treasury Department proposed a crackdown on wealthy families attempting to avoid the estate tax.â€ťâ€¦â€śThe Treasuryâ€™s action will significantly reduce the ability of these taxpayers and their estates to use (certain) techniques solely for the purpose of lowering their estate and gift taxes.â€ťÂ One of the â€śloopholesâ€ť that was targeted in this release was the use of â€śaggressive discountsâ€ť for the transfer of minority interests among family members.Â For the most part, these interests are owned by family-owned entities such as corporations, partnerships, and the ever-popular LLCs and FLPs.Â In general, the minority interests that are transferred have significant restrictionsâ€”particularly â€ślack of marketabilityâ€ť and â€ślack of controlâ€ť.Â And, because of these restrictions, the courts have had little success in denying discounts of value, even when the discounts appear to be a bit on the high side
Discounting techniques for minority interests have served estate planners remarkably well for more than twenty years, thanks to the friendly IRS Revenue Ruling 93-12 which made them possible.Â However, the IRS perceived that too many abuses were taking place and, as suggested in this new release, the magic of discounting minority interests may soon be coming to a halt.
In brief, valuation professionals and â€śresponsible partiesâ€ť need to be aware of the challenges they face when they try to use every tool available under the law in order to support the most favorable determination of value for inherited assets for step-up purposes.Â They need to be cognizant of any changing valuation standards, including those involving discounting or any other regulatory measures that will serve to increase (rather than decrease) the determination of asset values.
Challenges and hurdles that face the IRS and practitioners
As shown, any arguments that the IRS might raise in order to increase the valuations of inherited assets will surely be used by estate representatives when needed. Â Nonetheless, any IRS successes will not come easy and will be fraught with legal issues that could keep attorneys (on both sides) busy for years to come.Â Nothing less could be expected when attempts are made to challenge the standards of determining fair market value that have long been accepted by the courts.
These challenges can best be illustrated by referring to this latest IRS effort to prohibit discounts on the value of minority interests that are transferred within families. Â Generally, the reason that the courts have allowed these discounts in the first place is that the donor has retained certain controls and interests over those interests. Â At the same time, the doneeâ€™s rights are usually restrictedâ€”including the right to liquidate his or her interest. Â Now, however, with a recent IRS proposal to amend section 2704, the IRS may soon be successful in having these restrictions disregarded for the purpose of determining fair market value. Â The end result? Â We may soon learn that those generous discounts of value for minority interests will soon become a thing of the past. Â On one hand, this would prove to be a win-win situation for the IRS, and a huge increase in estate taxes for a relatively few estates.Â On the flip side, however, there is seen a green light of opportunity for those in search of any authority available that allows an increase in value, by definition, to achieve step-up benefits.
Looking ahead in estate planning and cautionary notes
Whatever comes up with future legislative activity, all responsible parties need to be wary of the IRSâ€™ increased intention to track â€śbasis-consistencyâ€ť for estates. Â This is in spite of the seemingly contradictory efforts of the Service to increase asset values by revising valuation standards. Â As noted above, Section 6035 went on to amplify (penalty laden) warnings about the need for basis-consistency; but, more important, it was also reminded that all reported values must be â€ścorrectly statedâ€ť in any case. Â This suggests any valuations that are overstated, for any tax-saving purposes, are clearly at risk.
All taxpayers have been exposed to risk for misstated values, even before ATRA.Â In fact, section 6662 has long provided for a layer of penalties that range in amounts that depend on whether there had been a â€śsubstantialâ€ť or a â€śgrossâ€ť misstatement of value.
Planning alerts for tax advisers
Tax professionals are generally well aware of the penalty tiers (identified under section 6694) that could apply if they had a role in establishing tax basis with the help of outside valuations. Â These penalties apply when there has been an understatement of tax liability that came about because an unreasonable position had been taken (one that lacks substantial authority) and the preparer knew â€śor should have knownâ€ť of the circumstances.
Appraisers also need to be wary
All valuation professionals were also brought into the loop under the Pension Protection Act of 2006. Â At that time, Congress called attention to potential misstatements of value that might understate tax liability. Â Again, depending on whether those misstated values are â€śsubstantialâ€ť or â€śgrossâ€ť, penalties are now set accordingly.
A final analysis
It would be folly to try and predict what future congressional action will do with estate taxes in general, or if the existing lifetime exemption will remain permanent. Â These unknowns need to be discussed with oneâ€™s attorney when considering the need to revise an existing estate plan after ATRA. Â At the same time, it is important to recognize that the need to search for high asset values (or low values for that matter) could change as wellâ€”especially with the IRS proposals to revise valuation guidelines. Â Regardless of what future legislation brings, it remains clear that responsible parties for all estates (regardless of size) need to be mindful of the importance of â€ścorrectly statingâ€ť an asset valuation when there are tax implications involved. Â For this, the credentials and experience of the valuation professional could be critical.
Thomas J. Stemmy, CPA, CVA, EA, MMS is an experienced tax specialist and consultant. Mr. Stemmy spends the majority of his professional time working with small business owners and individualsâ€”meeting their needs for financial-related advisory services and estate planning Facing the challenges of the ever-changing and unpredictable tax code, Mr. Stemmy stays on top with continuing research and by writing for a wide audience that includes professional peer organizations as well as the general public.
Mr. Stemmy is a member in good standing with the Maryland Association of CPA’s; Maryland Society of Accountants; National Society of Accountants; National Association of Certified Valuators and Analysts, and he is credentialed as an Enrolled Agent (for IRS representations).
Mr. Stemmy can be reached at (410) 571-3195 or by e-mail to TStemmy@stmcpas.com.