The IRS has finally issued Form 8939, Allocation of Increase in Basis for Property Acquired from a Decedent, and long-awaited guidance for executors of decedents who died in 2010 and who are deciding whether to elect out of the estate tax and apply the carryover basis rules of Sec. 1022 (Rev. Proc. 2011-41; Notices 2011-66 and 2011-76). Rev. Proc. 2011-41 contains optional safe harbors for the substantive provisions of Sec. 1022, Notice 2011-66 contains the rules for making the carryover basis election and generation-skipping transfer (GST) allocation for 2010, and Notice 2011-76 extends the due date for filing Form 8939 and provides other forms of relief. The carryover basis election is made by filing Form 8939 by January 17, 2012. No further extensions are allowed, despite how late the final Form 8939, instructions, and IRS Publication 4895, Tax Treatment of Property Acquired from a Decedent Dying in 2010, were published.
A few general observations are necessary as one prepares the Form 8939. First, the form cannot be viewed in the same light as a Form 706. Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, is generally a complete listing of the decedent’s assets and liabilities. In contrast, Form 8939 includes many assets that the decedent does not own, excludes assets that would normally appear on Form 706, and excludes debts, expenses, or claims of the decedent. Second, while Form 8939 appears to be much simpler than Form 706, with fewer schedules and computations, what it gains in simplicity it loses in the volume of detail required for each property. For each property on Form 8939, the executor must provide the date acquired, cost basis, fair market value, amount of gain that the recipient would report as ordinary income if the recipient sold the property, whether the property is eligible for a basis increase, and how much basis increase is allocated to each property.
Only the executor, if one has been appointed, can make the election. This appears to be a hard and fast rule no matter how little property the executor controls or how much property other fiduciaries hold. Therefore, steps should be taken to appoint or replace the executor so that the “right” person serves.
If no executor has been appointed, the IRS will accept Form 8939 from any person in actual or constructive possession of the decedent’s property for the property he or she actually or constructively possesses. If the IRS receives both a Form 8939 and a Form 706 from different authorized filers, the IRS will correspond with each filer and require them to collectively sign and file either a restated Form 706 or Form 8939 within 90 days of the IRS’s communication. If they fail to do this, the IRS will decide whether to elect out of the estate tax and will allocate the basis in any manner it deems appropriate. Therefore, it is in the estate’s best interest that the parties agree on a method of filing rather than allowing the IRS to determine it.
If the IRS receives more than one Form 8939 for the same decedent from multiple authorized filers attempting to allocate more than the allowable basis increase, it will similarly reject the filings and request a single Form 8939 signed by all persons within 90 days of the IRS notice. Failing receipt of this, the IRS will determine the basis allocations in its sole discretion.
The IRS will not grant an extension of time past January 17, 2012, to file Form 8939 or accept protective or conditional elections, except in the case of individuals serving in the United States Armed Forces under Sec. 7508 or those affected by a presidentially declared disaster or by a terrorist or military act under Sec. 7508A. All others wishing an extension must file a private letter ruling request under Reg. Sec. 301.9100-3 and attach a user fee of $14,000 ($625 and $2,000 for estates with adjusted gross income under $250,000 and $1 million, respectively) (Rev. Proc. 2011-1).
Property Included on Form 8939
The executor making an election must report all property (other than cash) “acquired from the decedent” (Sec. 6018(b)(1)). Property acquired from the decedent includes:
- Property acquired by bequest, devise, or inheritance;
- Property the decedent transferred during his or her lifetime to a qualified revocable trust (whether or not the trust makes a Sec. 645 election) or to any other trust that the decedent had the power to alter, amend, or terminate; and
- Property passing by reason of the decedent’s death without consideration (Sec. 1022(e)).
In addition, the statute includes the surviving spouse’s one-half share of community property as property acquired from the decedent (Secs. 1022(d)(1)(B)(iv) and 1022(d)(1)(C)). The exhibit illustrates the relationship between property acquired from the decedent and property owned by the decedent.
Property that is not acquired from the decedent is not carryover basis property and is not reported on Form 8939. This includes income in respect of a decedent, which is specifically excluded by statute (Sec. 1022(f)). Thus, the decedent’s interest in annuities, installment notes, and IRAs, to name a few examples, should not be reported on Form 8939. It also includes property transferred to a trust by the decedent during life in which the decedent retained an income interest, such as a qualified personal residence trust (QPRT) with no reversion to the estate (Rev. Proc. 2011-41, §4.01(4)). Although Rev. Proc. 2011-41 does not mention grantor retained annuity trusts (GRATs), the same would be true for a GRAT, except to the extent of any remaining annuity payments due the estate. Finally, an interest in a qualified terminable interest property (QTIP) trust funded by a predeceased spouse would not be owned by the decedent (id.). Note that all these interests would ordinarily be included on a Form 706 under Sec. 2036 or Sec. 2044. But under the carryover basis rules, such property is not acquired from the decedent and therefore is not included on Form 8939.
Proving Up Basis
Rev. Proc. 2011-41 clarifies that carryover basis is determined on a property-by-property basis, which may be extremely difficult, if not impossible, to determine (Rev. Proc. 2011-41, §4.03). The 1976 carryover basis rules allowed an executor to treat the basis of the decedent’s property as its market value on the date the decedent or the last preceding owner acquired it if the basis was unknown (former Sec. 1023(g)(3), added by the 1976 Tax Reform Act, P.L. 94-455). However, Sec. 1022 has no such provision.
Under the gift tax rules, if the donee cannot determine the basis of property, the IRS must obtain information from the donor or last preceding owner or any other person cognizant of the facts (Sec. 1015(a)). If the IRS cannot obtain the facts, the basis will be the market value, as best determined by the IRS, at the time the donor or last preceding owner acquired the property (Sec. 1015(a); Regs. Sec. 1.1015-1(a)(3)). The courts generally sustain the IRS’s opinion of value where the IRS has reasonable support for its position (see Interlochen Co., 232 F.2d 873 (4th Cir. 1956)). But the courts will not usually find that the taxpayer’s basis is zero simply because he or she cannot prove the value at the time the donor acquired it. However, the courts will rule that the basis is zero if the taxpayer has no basis information or cannot show how the property was acquired (see Hodges, T.C. Memo. 2005-168).
Consistency of Basis
While taxpayers are generally required to report income consistently with information returns, there is no similar requirement for reporting basis consistently (Sec. 6201(d)). While the beneficiary cannot dispute the basis increase under Secs. 1022(b) and (c) allocated to his or her property because the executor has sole discretion on how to allocate it, the beneficiary can dispute the underlying basis determined by the executor. Upon examination of the beneficiary’s return, if the beneficiary produces credible evidence that differs from the executor’s determination of basis, the burden of proof generally shifts to the IRS (Sec. 7491(a)(1) (the burden shifts if the taxpayer meets certain requirements, including maintaining records, cooperating with the IRS, etc.)). However, where the beneficiary inadvertently uses the wrong basis information on a 2010 tax return because the beneficiary did not know whether the estate made the carryover basis election when it filed the return, the IRS will not impose penalties (Notice 2011-76).
Property Eligible for a Basis Increase
Only property that is owned by the decedent is eligible for a basis increase (Sec. 1022(d)(1)(A)). Although most property that is acquired from the decedent is also owned by the decedent, the statute specifically excludes certain property from that which is owned by the decedent. This includes property over which the decedent had a general or specific power of appointment (Sec. 1022(d)(1)(B)(iii)). Thus, property over which the decedent had a power of appointment is reported on Form 8939 but is not eligible for a basis increase. Contrast this to Form 706, which includes property over which the decedent had a general power of appointment in his or her estate and provides a stepped-up basis under Sec. 1014 (Secs. 2041 and 1014(b)(9)). The exhibit illustrates the relationship between carryover basis property acquired from the decedent and carryover basis property owned by the decedent.
Even though some property may be both acquired from and owned by the decedent, there are two kinds of property that are not eligible for a basis increase. First, property that the decedent acquired by gift during the three-year period prior to the decedent’s death is not eligible for a basis increase, even though it is considered acquired from and owned by the decedent (Sec. 1022(d)(1)(C)(i)). This does not apply to property acquired from the decedent’s spouse unless, during the three-year period, the spouse acquired the property in whole or in part by gift (Sec. 1022(d)(1)(C)(ii)). Nonetheless, if property acquired by gift within three years of death is built-in loss property, it can create additional basis increases that can be allocated to other properties (Sec. 1022(b)(2)(C)(ii)).
Second, stock or securities of a foreign personal holding company, stock of a current or former domestic international sales corporation (DISC), stock of a foreign investment company, or stock of a passive foreign investment company (unless it is a qualified electing fund with respect to the decedent) is not eligible for a basis increase (Sec. 1022(d)(1)(D)).
Appraisals and Other Attachments
Rev. Proc. 2011-41 and the Form 8939 instructions describe several attachments that must be included with Form 8939. Appraisals are required as under Sec. 2031, which requires appraisals to be attached only for articles having artistic or intrinsic value greater than $3,000, such as jewelry, furs, paintings, antiques, rugs, collections, etc. (Regs. Sec. 20.2031-6(b)). In addition, if the executor allocates spousal basis increase to property that has been sold, the executor must attach the will and other documents evidencing the bequest or devise to the spouse. The instructions to Form 8939 also require a copy of the death certificate, the will, trust instruments (where a trust is a beneficiary), and letters testamentary.
Form 8939 provides numerous continuation schedules to properly identify the decedent’s property. The executor may also wish to attach depreciation schedules showing the potential amount of ordinary income recapture. This is especially helpful if the property will continue to be depreciable in the hands of the beneficiary. In addition, the instructions to Form 8939 require statements to be attached for basis determination relating to partial interests, ineligible property, jointly held property, and property sold before being distributed to a surviving spouse. Finally, it may be beneficial to attach a calculation of the decedent’s share of any joint net operating or capital loss carryover. It should not be necessary to attach a calculation of the built-in losses because Form 8939 requires sufficient information to determine this.
Grouping of Small Items
In estates involving a substantial number of smaller items, the IRS guidance does not allow the executor to group these items on Form 8939. Form 706 allows a room-by-room itemization of household and personal effects, grouping of articles individually worth less than $100, or an aggregate value appraised by a competent appraiser or dealer (Regs. Sec. 20.2031-6(a)). The Form 8939 instructions, however, require enough detail to easily identify the property.
Ordinary Income Property
Sec. 6018(c)(5) requires the executor who makes the Sec. 1022 election to report to the recipient sufficient information to determine whether any gain on the sale of the property would be ordinary income. This applies even to built-in loss property, but not to IRD, which is not reported on Form 8939. Although the character of property generally is determined by its use in the hands of the current owner, not the prior owner, there are exceptions to the general rule.
Rev. Proc. 2011-41 reinforces that the character of the recipient’s property is the same as it would have been in the hands of the decedent for the decedent’s trade or business and depreciable property (Rev. Proc. 2011-41, §4.06(2)). But it also recognizes that the character of the property may be affected by a subsequent change in the recipient’s use of the property. Nonetheless, property that is subject to depreciation recapture under Secs. 1245 and 1250 will always be subject to recapture when sold by the recipient, regardless of whether the property is converted to personal use (Regs. Secs. 1.1245-3(a)(3), 1.1250-1(c)(1), and (e)(2)).
Within 30 days after filing Form 8939, the executor is required to furnish Schedule A to the beneficiaries showing the executor’s contact information and detailed information about the property distributed to the beneficiary. The deadline to furnish beneficiary information is now February 17, 2012 (Notice 2011-76). In particular, the executor must give the beneficiary information about the property’s basis, date acquired, whether any gain on its sale would be ordinary, the amount of basis increase allocated to it, and its fair market value on the decedent’s date of death (Secs. 6018(c) and (e)).
Property that actually has been distributed to the surviving spouse outright or in a trust for which a QTIP election can be made should be listed on Schedule A. In addition, property should be listed on Schedule A if it has been sold and the executor can trace the proceeds distributed to the spouse. Such property is eligible for the spousal basis increase (Rev. Proc. 2011-41) if the executor checks the box to certify that the proceeds have been distributed to the surviving spouse outright or in a QTIP trust. Property that has been distributed to other beneficiaries should be listed on a separate Schedule A for each beneficiary. Property that has not yet been distributed or has been sold and the proceeds were not distributed to or for the benefit of the spouse should be listed on a single Schedule A for the estate. Thus, Schedule A is a snapshot of which property was actually distributed to which beneficiary as of the date the Form 8939 is filed.
Allocating the GST Exemption
Because the GST provisions continue to apply to decedents in 2010, Notice 2011-66 provides that an executor who elects out of the estate tax may allocate the decedent’s available GST exemption by attaching Schedule R of Form 8939 to the form. Form 8939 contains Schedules R and R-1, much like Form 706, except there is no tax calculation or signature line. All the normal rules of chapter 13 and the Form 706 instructions should be applied. If Form 8939 is timely filed, the GST allocation will be considered timely filed under Sec. 2632. If Form 8939 is timely filed without attaching Schedule R, the automatic allocation rules of Sec. 2632 will apply (Notice 2011-76).
Although the statute provides a penalty of $10,000 for failure to file a Form 8939 (Sec. 6716(a)), the only real penalty is that the estate is precluded from electing out of the estate tax. There is also a separate penalty of $500 for each failure to report appreciated property that the decedent acquired by gift within three years of death and a $50 penalty for each failure to furnish a recipient of carryover basis property information about the basis as required under Secs. 6018(c) and (e) (Secs. 6716(a) and (b)). It is not clear whether these penalties apply per return, per beneficiary, or per property, but they are subject to abatement if due to reasonable cause (Sec. 6716(c)).
In addition, the estate and beneficiaries could be subject to penalties for understatement of tax for years to come if they sell or depreciate assets using an overstated basis. Moreover, a six-year statute of limitation could apply if the overstatement of basis causes a 25% omission of gross income under Sec. 6501(e) (Regs. Sec. 301.6501(e)-1(a)(1)(iii)). To calm fears about penalties applying before the final Form 8939 and its instructions were released, the IRS announced that no penalties will apply to understatements of tax caused by incorrect estimates of the basis of carryover basis property (Notice 2011-66).
Return preparers can also be subject to penalties under Sec. 6694 if the information reported on Form 8939 constitutes a substantial portion of another’s tax return and causes an understatement of tax (Regs. Sec. 301.7701-15(b)(3)). “Substantial portion” is a facts-and-circumstances test and may be determined by the size and complexity of the item or the understatement. If Form 8939 is grouped with Forms W-2 and 1099, penalties would apply only if the preparer acted willfully to understate the tax liability on the beneficiary’s return (Rev. Proc. 2009-11). But if Form 8939 is categorized with flowthrough Forms 1065, U.S. Return of Partnership Income, and 1120-S, U.S. Income Tax Return for an S Corporation, penalties could apply even if the preparer’s conduct was not willful or reckless (id.). Fiduciaries are not considered tax return preparers (Regs. Sec. 301.7701-15(f)(1)(x)).
Finally, appraisers can be subject to penalties for misstatements of value. If the appraisal overstates the basis by more than 150% of the amount determined to be correct, appraisers can be penalized up to 125% of the amount they earned to prepare the appraisal (Secs. 6695A(a) and 6662(e)). The same penalty applies if they understate the value by more than 65% of its correct value (Secs. 6695A(a) and 6662(g)).
If an executor discovers a need to amend Form 8939, Notice 2011-76 allows the executor to file an amended return after January 17, 2012, without a private letter ruling under two circumstances. First, an executor may file an amended return at any time to allocate the spousal basis increase, but only if the original Form 8939 was timely filed and complete. Second, an executor may file an amended return for any reason (except to make or revoke an election) on or before July 17, 2012, but only if the executor timely filed an original Form 8939 by January 17, 2012 (Notice 2011-76). Beyond those two circumstances, the executor will need a private letter ruling to amend Form 8939. Notice 2011-66 states that such relief will be granted under Regs. Sec. 301.9100-3 if the executor discovers additional property to which remaining basis can be allocated, but does so after the deadline for filing an original or amended Form 8939. It also provides that such relief will be granted if the executor wishes to reallocate basis as a result of an IRS audit of Form 8939 and resulting redetermination of value. In no event will the IRS grant a request to reduce an allocation of basis.
IRS Examination of Form 8939
If the IRS examines a Form 8939 and adjusts the value of property, it appears that the executor’s only right to appeal the determination is to file a private letter ruling request (Notice 2011-66). The IRS can also challenge the basis of an item sold or depreciated on a beneficiary’s individual income tax return (Notice 2011-66, §I.B.). However, the individual has the normal appeal rights, including filing a Tax Court petition. The beneficiary can challenge the basis reported by the executor on Schedule A of Form 8939. However, the beneficiary should have credible evidence to support his or her position.
Beneficiaries will use the information reported on Form 8939, Schedule A, for many years to come in reporting sales and depreciating inherited property on their returns. Therefore, despite the length of time without IRS guidance and the short window to file the Form 8939 once the IRS released it, practitioners should complete the form with the best information available. It may also be advisable in some cases to disclose any uncertainties or unusual circumstances surrounding the determination of basis in the decedent’s property. Disclosure is generally the most effective remedy for uncertain positions.
Carol Cantrell is a shareholder in Briggs & Veselka Co. in Bellaire, TX. For more information about this article, contact Ms. Cantrell at email@example.com.