Informed taxpayers are aware that only the wealthiest individuals should have concerns about the federal estate and gift tax, for gifts given and decedents dying in 2018 through 2025. Thanks to the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, the basic exclusion amount is more than $11 million per individual ($22 million for married couples), indexed for inflation. Now estate planners are spending less time and using fewer resources trying to avoid federal estate taxes for clients. They are instead paying closer attention to minimizing clients' income tax bills. Further, more taxpayers have been modifying their old estate plans, if not dismantling them completely.
BASIS-BUILDING: THE BEST PLANNING STRATEGY FOR NONTAXABLE ESTATES
Estates got more good news when the TCJA did not attempt to eliminate what some call the biggest loophole in the Code — basis "step-up." Too often, taxpayers fail to recognize this major tax-saving benefit in Sec. 1014, which allows inheritors to step up the tax basis of inherited assets to their date-of-death value. On the other hand, tax professionals have been keeping a close eye on this major tax benefit and have been prompt in sharing ideas for building basis in this new estate-planning environment. Here are just a few of the popular suggestions that are seen more frequently since the TCJA's enactment:
- Review clients' overall lifetime gifting plan: Avoid gifting highly appreciated property so that clients and their families can lock in the basis step-up adjustment at death. Alternatively, consider gifting assets with a high tax basis or those that are slower to appreciate in value.
- Consider transferring assets to the spouse who is likely to die first: However, clients may want to use an irrevocable trust so that the basis step-up is not lost under Sec. 1014(e). This strategy might also work well with asset transfers to older family members.
- Grantor trusts can help establish basis step-up: Irrevocable grantor trusts have become increasingly popular in estate planning. Under Sec. 675(4)(C), substitution powers are available by which the grantor can transfer high-basis assets to the trust in exchange for low-basis assets. The grantor could then hold the assets until death and thereby secure a basis step-up for his or her heirs.
- Revisit old credit shelter trusts: Credit shelter (bypass) trusts were likely funded when married couples faced a federal estate tax. After the TCJA, however, these trusts should be reexamined to determine whether it would be better to include the trust assets in the estate of the surviving spouse so that step-up benefits can be obtained. Techniques for modifying these trusts should be explored.
- Other existing trusts may also no longer be necessary: Life insurance trusts, qualified personal residence trusts, and other irrevocable trusts also must be reviewed since they may now have negative tax consequences. As with any legal documents, the taxpayer's attorney should be consulted to determine whether modifications could be made without compromising nontax advantages, such as divorce or creditor protection.
Establishing a higher tax basis for assets from an estate might be a major tax saver; however, estate planners and beneficiaries need to be aware that some strings may be attached. Most important, evidence is mounting that the IRS is well aware that creative step-up techniques will, in many cases, wipe out revenues from capital gains taxes. And when independent appraisers are relied upon to establish basis step-up, the methods and assumptions they use could be subject to increasing scrutiny in the coming years.
It is interesting to note that prior to tax legislation in 2015, the IRS was short on weapons to challenge date-of-death valuations — particularly when stepped-up values for basis were not consistent with the values used for estate tax purposes. The Service had to rely on a "duty of consistency" approach under a quasi-estoppel doctrine to support its challenges to date-of-death valuations. This all changed in 2015 with the passage of the Surface Transportation and Veterans Health Care Choice Improvement Act, P.L. 114-41.
Since that time, "basis consistency" became a statutory requirement, and it sends a clear message to estate executors and responsible parties by way of Secs. 1014(f) and 6035, both of which were added by the Surface Transportation and Veterans Health Care Choice Improvement Act. Under threat of penalty, the valuations that are used for estate tax reporting must not only be accurate, they must also match the basis claimed by the beneficiary. To accomplish this, for estates subject to the requirement, new Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, is now required to be filed with the IRS, and Schedule A of the form must be sent to the beneficiaries. Schedule A provides specific details on every asset valuation that is reported by the estate. For more, see "Estate Basis Consistency and Reporting: What Practitioners Need to Know," JofA, June 2016.
This strict new basis-consistency rule might be regarded as the first real IRS effort to monitor aggressive tax-saving valuations — even though it targets only those estates that incur an estate tax liability. However, recent history shows that the Service has already begun keeping an eye open for any (too-good-to-be-true) valuations that serve to eliminate income taxes. One of the IRS's tools is the Sec. 6662(e) 20% accuracy-related penalty, which applies when it is shown that a tax underpayment results from a "substantial valuation misstatement." In addition, an accuracy-related penalty applies under Secs. 6662(b)(5) and (g) for an underpayment of tax resulting from "any substantial estate or gift tax valuation understatement," defined as the value of property claimed on an estate or gift tax return that is 65% or less of what is determined to be the correct value.
Consequently, all professional advisers are now wary of a wide range of penalties that might apply to valuation misstatements. Tax return preparers face a risk of penalty under Sec. 6694 if they knew, or should have known, of a valuation misstatement that constituted an unreasonable position lacking reasonable cause. A valuation professional who knew, or should have known, about a substantial valuation misstatement that was used on a tax return or claim for refund faces a risk of penalty under Sec. 6695A.
TIMING COULD BE EVERYTHING FOR A CREDIBLE VALUATION
How to stay in compliance when determining fair market value for step-up purposes
The general rule under Regs. Sec. 1.1014-1 is that the "basis of property acquired from a decedent is the fair market value of such property at the date of the decedent's death" (or the alternative valuation date). However, the more time elapses, the more difficult it can become to establish a defensible valuation when looking back to the date of death.
To find specific guidelines on how to secure an acceptable fair market value (FMV) for estate and inherited basis purposes, many refer to the instructions for Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. However, even when a return is not required, it is logical to conclude that these same guidelines are expected to be followed when determining FMV for step-up purposes to avoid a valuation misstatement.
A closer look at the time-sensitivity factor
The Form 706 instructions seem to suggest that it would not be a good idea to delay obtaining an independent (date-of-death) appraisal for inherited assets — unless those assets happen to be cash or marketable securities. The form instructions and Rev. Rul. 59-60 make clear that a snapshot approach must be followed. That means the valuation must be based on the facts and circumstances that are available on the specific valuation date (the date of death) and not months or years later.
In one example in the form instructions, the IRS demonstrates the importance of time sensitivity by providing guidelines for valuing a publicly traded security at the time of death. The FMV of the security must be the mean between the highest and lowest selling prices quoted on the specific valuation date. And, to be even more specific, if there were no sales with which to compare on the valuation date (such as on a weekend), it is necessary to find the mean values on the "nearest trading dates" (i.e., outside that weekend).
With this kind of fixation on time sensitivity, it is easy to see why some beneficiaries could face IRS challenges if they wait too long to obtain an appraisal for assets that are not tracked daily like publicly traded securities. Those assets might include a small business operation, a family limited partnership, a sole proprietorship, a limited liability company, a real estate holding entity, or, for that matter, any other type of investment property.
Hurdles facing historical appraisals
Retrospective valuations can be daunting for an independent appraiser who is attempting to establish a defensible valuation for an inherited asset that is likely to lower someone's tax bill. It's not always easy to dig up historical books, records, and data, but they are needed to formalize a valuation report under acceptable valuation standards, as expected by the IRS.
With more passage of time, the independent appraiser will face greater challenges because "subsequent events" that might occur after the date of death can affect the property's value. However, subsequent events are generally not expected to be considered when determining the date-of-death value. The AICPA Statement on Standards for Valuation Services, VS section 100, paragraph .43, Subsequent Events, states: "Generally, the valuation analyst should consider only circumstances existing at the valuation date." It goes on to state, essentially, that subsequent events indicative of conditions that were not known, or knowable, on the date of death should not be used in the valuation. This is the general rule, even though disclosures of subsequent events may be warranted, so long as it is indicated they are for informational purposes only and do not affect the valuation.
However, events that were reasonably foreseeable on the valuation date by a hypothetical buyer and seller should, in certain cases, not be disregarded. This was clearly demonstrated in at least one Tax Court case in which the sale price of (non-publicly traded) stock after the date of death was accepted as an indicator of its FMV on the date of death (Estate of Noble, T.C. Memo. 2005-2).
THE ULTIMATE TAX TRAP: 'ZERO TAX BASIS'
As shown, with many inherited assets, there are certain risks for failing to obtain a timely appraisal that will be counted on to substantiate the stepped-up basis. The new basis-consistency rules have created another risk that can arise out of the failure to obtain an appraisal: a zero basis for the inherited property.
Under the rules in Prop. Regs. Sec. 1.1014-10(c)(3)(ii), if an estate tax return was required to be filed for a decedent's estate under Sec. 6018(a) and the executor of the estate failed to file a return, a taxpayer inheriting property from the decedent would have a zero basis in the property until a final value was established for the property. Thus, if an executor of an estate did not file Form 706, it could bring on the worst tax nightmare for a taxpayer inheriting an asset from the estate: a zero basis for the asset. With a zero basis, the taxpayer is potentially liable for tax on the full amount realized on the asset's disposition.
Consider this example. A taxpayer inherits an investment property from the decedent before the enactment of the basis-consistency requirement in Sec. 1014(f) and the related asset value reporting requirements in Sec. 6035. The executor of the decedent's estate does not have the investment property appraised, which results in gross undervaluing of the investment property by the executor. Because of this undervaluation, the executor determines that the estate is below the applicable estate tax exemption amount and, consequently, does not file a Form 706 for the estate.
Six years later, the taxpayer sells the investment property. If the IRS asks the taxpayer to substantiate the basis of the investment property inherited from the decedent, there might be some difficulty going back that far to obtain a defensible date-of-death valuation. At the same time, if the IRS were to contend that the value of the property was great enough that an estate tax return was required for the decedent's estate, not only could the estate be facing an estate tax liability and failure-to-file penalties, but the taxpayer could be found to have a zero tax basis for the asset under Prop. Regs. Sec. 1.1014-10(c)(3)(ii). On June 1, 2016, the AICPA submitted comments (available at aicpa.org) on the zero-basis rule in the proposed regulations.
A PERENNIAL CONCERN
The TCJA's effective doubling of the basic exclusion amount to more than $11 million per individual has further limited the number of taxpayers subject to estate and gift taxes; however, it has added to the reach of the new basis-consistency requirement. Given the potentially severe consequences of a misstep in the requirement and related reporting, wealthier taxpayers are well-served by advisers who provide education and emphasize compliance. And for clients not subject to estate and gift taxes, the higher exclusion amount has other consequences warranting review of the full array of estate planning vehicles and instruments.
At the heart of this examination lies a concern that will always be paramount for taxpayers, even of relatively modest means, as well as their donees and heirs. A well-documented and defensible appraisal is necessary for inherited property that is to be gifted or bequeathed. In tax and wealth planning, basic advice or reminders of how to avert problems of establishing the value of assets is certainly one way to establish the value of a CPA's services.
About the author
Thomas J. Stemmy, CPA, CVA, E.A., is president/managing partner of Stemmy, Tidler & Morris PA in Annapolis, Md.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
- Essentials of Personal Financial Planning (#PPF1701P, text; #PPF1701E, ebook)
- Advanced Estate and Gifting Strategies (#166850, online access)
- Advanced Estate Planning Conference, June 9—13, Las Vegas
For more information or to make a purchase or register, go to aicpastore.com or call the Institute at 888-777-7077.
The Tax Adviser and Tax Section
Subscribe to the award-winning magazine The Tax Adviser. AICPA Tax Section members receive a subscription in addition to access to a tax resource library, member-only newsletter, and four free webcasts. The Tax Section is leading tax forward with the latest news, tools, webcasts, client support, and more. Learn more at aicpastore.com/taxsection. The current issue of The Tax Adviser and many other resources are available at thetaxadviser.com.
PFP Member Section and PFS credential
Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Broadridge Advisor. Visit the PFP Center at aicpa.org/PFP. Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential. Information about the PFS credential is available at aicpa.org/PFS.
FVS Section and ABV credential
Membership in the Forensic and Valuation Services (FVS) Section provides access to numerous specialized resources in the forensic and valuation services discipline areas, including practice guides, and exclusive member discounts for products and events. Visit the FVS Center at aicpa.org/FVS. Members with a specialization in business valuation may be interested in applying for the Accredited in Business Valuation (ABV) credential. Information about the ABV credential program is available at aicpa.org/ABV.