A tax practitioner working with the estate of an S corporation shareholder who died in 2010 must contend with numerous issues. This article points out some of the issues and discusses some of the choices that a practitioner can consider.
The estate tax repeal that, courtesy of the 2010 Tax Relief Act, 1 became optional presents the first consideration. The now-elective estate tax holiday presents income tax consequences related to basis that the practitioner should take into account prior to making the election. On August 5, 2011, the IRS released long-awaited guidance, in Rev. Proc. 2011-41 2 and Notice 2011-66, 3 on the filing requirements related to the election.
Notice 2011-66 discusses the mechanics of making the election under Sec. 1022 to have the so-called carryover basis rules apply instead of the traditional basis consequences under Sec. 1014.
Rev. Proc. 2011-41 deals with the consequences of making the election under Sec. 1022.
Treatment of S Corporation Basis
To understand the first issue, the practitioner must briefly review and then contrast how the basis of S corporation stock is treated under the two alternatives. Basis is important because it is a limiting factor for deduction of losses as well as the limit for receipt of tax-free distributions.
This article is concerned only with decedents holding S corporation stock. Thus it does not discuss the section of the law 4 dealing with nonresident aliens, who are not eligible to hold S corporation stock. 5
Under the general rules prior to 2010 and after 2010, the basis of S corporation stock held by a decedent at his or death is adjusted in the following manner:
Sec. 1014(a)(1) generally adjusts the basis to an amount equal to the fair market value (FMV) at the date of the decedent’s death. Sec. 1014(c) states that this rule does not apply to income in respect of a decedent (IRD) as that term is defined in Sec. 691. This is discussed further later in the article.
If the basis of the stock is greater than the FMV of the stock, the basis is reduced to FMV. This reduction in basis, without income tax effect (i.e., no deduction), is the equitable offset to the increase in basis, also without income tax effect (i.e., no income), that occurs when the FMV of the stock exceeds basis.
Consider the alternative treatment of Sec. 1022 next. This section, applicable for estates of 2010 decedents electing its application, provides the successor-in-interest to the decedent a basis equal to that of the decedent with limited asset basis adjustments up to FMV. This commonly is referred to as “carryover basis.”
The often-used term “carryover basis” is really a misnomer. If the basis at the date of death is greater than the FMV, basis is reduced to FMV. The potential downward adjustment is unlimited. If the decedent’s basis was $10 million and the asset is worth only $1 million at the time of the decedent’s death, the basis in the hands of the successor-in-interest is $1 million. This rule is the same under Sec. 1014 and Sec. 1022.
In the reverse situation, if the basis were $1 million and the FMV $10 million, the basis in the hands of the successor-in-interest would be limited to the decedent’s basis of $1 million plus the portion, if any, of the limited basis increase of the new Sec. 1022 regime. Under the regime of Sec. 1014, the upward adjustment from basis to FMV is unlimited.
As mentioned earlier, if the basis at the date of death is less than FMV, the elective regime of Sec. 1022 allows limited increases in basis. The increases can be considered as analogous to a “basis layer cake.”
The first layer of the basis cake is the basis of the property, capped at FMV, in the hands of the decedent. 6
The second layer of the basis cake is the $1,300,000 of step-up in basis permitted by Sec. 1022(b)(2)(B). Rev. Proc. 2011-41 refers to this as the aggregate basis increase. 7
The third layer of the basis cake is the potential increase in the step-up permitted by the amount of certain unused losses in the hands of the decedent. 8 The new revenue procedure refers to this as the carryovers/unrealized losses increase. 9
The basis of property passing to a beneficiary can be increased by any portion of the second and third layer that the estate representative elects.
The basis of property passing to a surviving spouse can be increased by any portion of the second, third, and fourth layers as allocated by the estate representative.
The estate representative can allocate the three top layers to specific assets. It should be noted that in no case can the allocation to any specific asset permit the resultant basis to exceed the FMV of the asset. 12
The third layer or the carryovers/unrealized losses increase consists of the total of (1) any unused net operating loss carryovers, (2) capital loss carryovers, and (3) unrealized Sec. 165 losses of the decedent. 13
The amount of these losses could be, and frequently is, different for regular tax purposes and alternative minimum tax (AMT) purposes. Net operating losses are required to be computed separately for AMT purposes. 14 Capital loss carryovers are also computed separately for AMT purposes. 15 It would appear then that the basis increase under this provision could be different for regular tax and AMT purposes. The statute and the recently issued guidance are silent on this issue. These differences are discussed further later in the article.
Sec. 165 covers business, investment, and casualty losses. Notice 2011-41 restricts the basis increase under Sec. 1022 from unrealized Sec. 165 losses to those unrealized losses from a trade or business 16 or any transaction entered into for profit not from a trade or business. 17 These sections can encompass corporate stock including stock in an S corporation. The revenue procedure illustrates this in the following example:
Example 3. D owned 100 shares of stock that D held for profit within the meaning of section 165(c)(2). The stock is a capital asset, and any gain or loss from the sale of the stock would be long-term capital gain or loss under sections 1221 and 1222(3). D died in 2010, still owning the stock. As of D’s date of death, D’s adjusted basis in the stock pursuant to section 1011 was $5,000, and the stock’s FMV on D’s date of death was $1,000. D did not sell the stock during life, and thus did not incur a loss under section 165(c)(2) reportable on D’s final Form 1040. The stock is considered to be property owned by and acquired from D. D’s executor made the Section 1022 Election. If D had sold the stock immediately prior to D’s death, D would have had a net long-term capital loss of $4,000. Based on D’s 2010 taxable income, D would have been able to deduct $3,000 of the loss and $1,000 would have been carried over to future years. 18 For purposes of section 1022, however, the full unrealized net long-term capital loss of $4,000, that would have been available to D if D had sold the stock before death, is available as a Carryovers/Unrealized Losses Basis Increase.
The unrealized losses of Sec. 165 could be significant to estates under certain circumstances. Recall the example above of a decedent with an asset with a basis of $10 million and a value at date of death of $1 million. If the asset is a personal asset, the unrealized loss at death is wasted. But, if the asset were to be covered by Sec. 165(c)(1) or Sec. 165(c)(2), the unrealized loss of $9 million would increase the nonspousal basis limitation from $1,300,000 to $10,300,000. This provision has a certain symmetry since the loss, had it been realized by the decedent prior to death, would likely be part of a net operating loss or capital loss carryforward, which would have also increased the upward basis limitation.
The symmetry does not necessarily produce equity. The decedent’s estate still has to have an asset with value in excess of basis to which the carryover could be applied. Assuming the same facts as above where there is a potential increase of $10,300,000 but in which the total FMV of all estate assets, including the asset of $1 million that produced the large Sec. 165 loss, is $5 million. The basis of all gain assets can be increased to FMV, but the balance of the potential basis step-up is lost.
The revenue procedure does indicate that the basis step-up under Sec. 1022 can be applied to specific assets including specific blocks of stock. 19 For S corporations, basis is kept separately for each share or block of shares with losses in excess of basis on one block of stock being permitted to reduce the basis of other blocks of stock. 20 The elective and specific allocation of stock basis step-up could allow an executor to allocate the limited basis step-up to particular blocks of S corporation stock with a lower basis.
Income in Respect of a Decedent
If the asset held by the decedent is stock in an S corporation that owns an asset representing IRD, Sec. 1367(b)(4) mandates some distinctive treatment.
Sec. 1367(b)(4)(A) provides that “section 691 shall be applied with respect to any item of income of the S corporation in the same manner as if the decedent had held directly his pro rata share of such item.”
Sec. 1367(b)(4)(B) goes on to require that the basis of the stock determined under Sec. 1014 be reduced “by the portion of the value of the stock which is attributable to items constituting income in respect to the decedent.”
There is no guidance or case law discussing how to determine “the portion” of the stock value attributable to IRD. This task can be more difficult than is immediately apparent.
Query: If stock of a cash-basis S corporation is valued at five times earnings and then discounted 30% for lack of marketability and/or minority ownership, what portion of the value should be apportioned to the cash-basis accounts receivable imbedded within?
IRD is defined in Regs. Sec. 1.691(a)-1(b) as “those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent.” Such items include accounts receivable held by a cash-basis taxpayer and installment sale gains arising from the sale of property by the decedent prior to his or her death.
Sec. 1022(f) states that this section is inapplicable to “property which constitutes a right to receive an item of income in respect of a decedent.” The property subject to this section, for purposes of this discussion, is the S corporation stock. The stock itself is arguably, not “property which constitutes a right to receive an item of income in respect to a decedent.” This leads, in turn, to very disparate treatment of S corporation stock, between the traditional Sec. 1014 step up (down) to FMV treatment and the new elective Sec. 1022 modified carryover basis treatment.
Example 1: J and his twin brother K each operate consulting practices as cash-basis S corporations. They are both struck by lightning and killed in 2010. They each have $100,000 of accounts receivable at the time of their unfortunate demise. A valuation expert values each of their practices at the amount of receivables, or $100,000 each. Each has a basis in the S stock of zero at the time of his death.
J’s spouse elects to use the step-up in basis rules for his estate. Under Sec. 1367(b)(4), J’s spouse reduces the normal basis of $100,000 under Sec. 1014 by the amount of IRD, or $100,000. This gives the surviving spouse a basis of zero. When she collects the receivables, she will report the $100,000 as income and increase her stock basis, under Sec. 1367(a)(1)(A), by the income reported. She will then reduce the stock basis, under Sec. 1367(a)(2)(A), when the cash is distributed. If she were to liquidate the corporation at this time, she would have no gain or loss. If any estate tax were to be paid on the $100,000 included in J’s estate, the widow would get a deduction, under Sec. 691(c), for the estate tax paid on the IRD.
K’s spouse, on the other hand, decides to use the modified carryover basis rules. Under Sec. 1022(a)(2)(A), K’s widow carries over K’s basis of zero. Because Sec. 1022 does not contain a provision similar to Sec. 1367(b)(4)(B), his widow is able to allocate, under Sec. 1022(c), $100,000 to the S corporation stock. Arguably, the stock of K’s S corporation is not “property which constitutes a right to receive an item of income in respect of a decedent under section 691” and consequently Sec. 1022(f) does not take the stock out of the purview of Sec. 1022 if the widow elects its application.
Like J’s spouse, K’s spouse also reports the collection of the receivables as income and, under Sec. 1367, increases her basis from $100,000 to $200,000. The subsequent distribution of cash would reduce the basis back to $100,000. If she were to liquidate the corporation, she would have a long-term capital loss of $100,000.
Observation: Taken at face value, the law appears to permit this outcome. The cautious practitioner needs to consider whether Congress intended this result. Is the practitioner required to correct drafting errors before guidance or technical corrections come out? Or is this a Gitlitz double dip—legal until the law is changed? 21
While long-term capital losses have limited utility at 15% capital gain rates and an annual limit on losses against ordinary income of $3,000, capital gain rates are scheduled to increase to 20% in 2013, increasing the value of these losses. The limited step-up in basis also increases the likelihood that some estate assets will not be stepped up to FMV, and thus the sale of these assets could generate considerable capital gains. Such gains could be offset by the capital loss generated on the liquidation of the S corporation in the preceding example.
Other Carryforward Losses of a Decedent
A decedent holding S corporation stock may have loss carryforwards other than those listed in Sec. 1022(b)(2)(C). Loss carryforwards could also include losses suspended due to lack of basis, losses suspended under the at-risk rules, and passive activity losses. The decedent may also have unused Sec. 179 expensing election carryovers related to the interest held in the S corporation.
Losses Suspended Due to Lack of Stock Basis
First on this list is the carryover, under Sec. 1366(d)(2), of losses and deductions not deducted due to lack of stock basis. Regs. Sec. 1.1366-2(a)(5) provides that suspended losses are “personal to the shareholder and cannot in any manner be transferred to another person.” The statement in the regulation is not supported in the statute, but neither is any other alternative treatment of these losses after the death of the stockholder. This would appear to represent to most practitioners a barrier to taking a deduction in a post-Mayo world. 22 It would appear these losses just disappear.
At-Risk Rules of Sec. 465
The at-risk rules of Sec. 465(a)(1) limit loss deductions of individuals and closely held C corporations to “the aggregate amount with respect to which the taxpayer is at risk.” Losses not deductible in any given year by virtue of these rules are treated as deductions, again subject to the limits of Sec. 465, in the first succeeding year. 23
When an S corporation shareholder dies, he or she may have unused losses that were limited by Sec. 465. What happens to the unused losses?
The IRS’s rulemaking process has been stagnant with regard to the at-risk regulations, including Prop. Regs. Sec. 1.465-67, which is relevant to this analysis. The IRS proposed the regulation in the summer of 1979. It has remained unchanged, still in proposed form, for over 30 years. A discussion of the authority represented by proposed regulations older than the now-defunct space shuttle program is beyond the scope of this article, but practitioners dealing with decedents with large, suspended at-risk losses are advised to explore this in greater depth.
The proposed regulation allows suspended at-risk losses to be added back to the transferor’s basis if three conditions are met. The first is that the taxpayer has to dispose of his or her entire interest in the activity. The fact that the decedent has died should satisfy this requirement. The second condition is that the basis of the transferee must be determined, in whole or in part, by reference to the basis of the transferor. Sec. 1022(a), if elected, provides that the successor-in-interest will use the basis of the decedent. The third requirement is that the transferor has suspended losses at the time of disposition.
If all conditions are met, the basis in the hands of the successor-in-interest would appear to be increased by the previously suspended Sec. 465(a) losses. Note that this increase would occur before any of the optional step-up in basis under Sec. 1022 is applied.
Passive Losses Under Sec. 469
The passive loss rules of Sec. 469 limit the deduction of losses from certain passive activities against income from nonpassive sources. If losses from passive sources are greater than income from passive sources, the excess, other than the limited amounts allowed for real estate rental activities with active participation, is carried over to the next succeeding tax year.
If a taxpayer dies with unused passive loss carryovers, Sec. 469(g)(2) makes one basis-related adjustment prior to permitting a deduction on the final return of the decedent. The loss carryover is first reduced by the amount by which the basis of the activity in the hands of the transferee exceeds the basis in the hands of the decedent at the date of death.
Example 2: Decedent D had a $45,000 passive loss carryover, a $20,000 basis in the activity at the date of death, and the activity was worth $35,000. If the basis in the hands of the decedent’s successor (estate, spouse, or other heirs) were to be adjusted up to $35,000, then the $45,000 passive loss carryover is reduced by the $15,000 of basis increase. Any remaining passive loss carryover—here, the remaining $30,000 of carryover—is allowed as a deduction on the final return of the decedent.
It is worth noting that the language describing this adjustment does not refer to either Sec. 1014 or Sec. 1022. The statute, at Sec. 469(g)(2)(A)(i), refers to “the basis of such property in the hands of the transferee.” Under the old estate tax rules, the “basis in the hands of the transferee” would generally be determined under Sec. 1014 and the FMV standard contained therein. Under the elective regime of Sec. 1022, the “basis in the hand of the transferee” would be the carryover basis of the decedent increased by an allocated increase of basis under Sec. 1022(b).
When the basis adjustment related to IRD that is mandated by Sec. 1367(b)(4)(B) is made, the reduced basis would be the basis limit applied for purposes of Sec. 469.
Example 3: Assume the same facts in Example 2—$45,000 passive loss carryover at death, $20,000 basis at date of death, and stock value of $35,000. Assume further that there is $5,000 of IRD inside the corporation and reflected in the value of $35,000.
Under the Sec. 1014 basis system, the basis in the hands of the transferee would be $30,000, the $35,000 value under Sec. 1014 reduced by the $5,000 reduction mandated by Sec. 1367(b)(4)(B). Under 469(g)(2), this reduced basis, not the FMV of $35,000, would be the limiting factor in determining the deduction on the decedent’s final return. In this example the deduction would be $35,000—the $45,000 of initial unused passive losses, reduced by the $10,000 of difference between the basis of the stock in the hands of the decedent ($20,000) and the basis in the hands of the transferee (FMV of $35,000 reduced by $5,000 of IRD under Sec. 1367(b)(4)(B)).
Under the elective Sec. 1022 system, the basis in the hands of the transferee is either the carryover basis of $20,000 or, if the step-up of Sec. 1022(b) or (c) is allocated to the stock, up to the FMV, $35,000. Absent a corollary for Sec. 1367(b)(4)(B) in the Sec. 1022 world, the $35,000 basis is not reduced for the $5,000 of IRD imbedded in the stock. This logically would change the deduction on the decedent’s final return for suspended passive losses. The deduction should now be $30,000—the $45,000 of carryover reduced by the difference between the decedent’s basis of $20,000 and the basis in the hands of the transferee of $35,000.
However, this is not the case. Rev. Proc. 2011-41, §4.06(4), states “Because property owned by the decedent at death will be treated under section 1022 as having been transferred by gift, section 469(j)(6), rather than section 469(g)(2), applies to determine the decedent’s adjusted basis in such property.” Thus under the elective Sec. 1022 system, there is no deduction on the decedent’s final return, and the decedent’s basis is increased, in the hands of the successor-in-interest, by the unused passive loss carryovers. This increase, according to the revenue procedure, is considered as occurring just prior to death, and therefore there are no unused passive loss carryovers at death and therefore no deduction on the decedent’s final return.
Since Sec. 1022 contains an FMV cap, this limitation, if less than the newly increased basis under Secs. 1022 and 469(j)(6), will limit the basis, in the hands of the successor-in-interest, to FMV.
Passive losses relate to an “activity.” An S corporation may contain a number of activities, some of which could be passive and some not. An activity is not necessarily property. The adjustment under 469(g)(2) refers to the basis of “property.” This can lead to problems in applying the law to fact sets.
Example 4: The stock of an S corporation has a basis of $100,000 in the hands of the decedent, D, prior to his death. The S corporation contains a trade or business in which D materially participates (i.e., not a passive activity) as well as rental property that is properly classified as a passive activity. The suspended passive activity losses related to this activity at the time of D’s death are $50,000. The stock is valued at $120,000, of which $40,000 is related to the passive activity and $80,000 is related to the active trade or business.
Under Sec. 469(g)(2), assuming the elective Sec.1022 regime does not apply, a deduction is permitted on the decedent’s final return for the amount of the suspended passive losses equal to the excess, if any, of the basis of property in the hands of the transferee over the basis of the property in the hands of the decedent. What is the deduction, if any, on the decedent’s final return? If done on a global scale, the successor-in-interest will own stock with, under Sec. 1014, a basis $20,000 higher than the decedent’s. This would indicate a deduction on the decedent’s final return of $30,000 ($50,000 total less the $20,000 step-up in basis).
If this calculation must be done on an activity-by-activity basis, the answer is less clear. To answer this, the practitioner needs to know the basis of the “property” referred to in Sec. 469(g)(2). Is it the basis of the S corporation stock in its entirety, including the basis related to the activity that is not a passive activity to the shareholder/decedent or just the basis of the stock attributable to the passive activity itself? We have no guidance in this area. Temp. Regs. Sec. 1.469-2T(e)(3) lays out an allocation procedure, based on recognized gain, when a sale, exchange, or other taxable disposition of a passive activity has occurred. One seemingly reasonable method would be to apply the same approach using unrealized gain. If detailed information regarding basis of assets and unrealized gain inside an entity is not available, then another reasonable answer would be that all of the stock basis, including the active business portion, would be used.
Sec. 179 Expensing Election Carryovers
If a shareholder is allocated Sec. 179 expensing election deductions and is unable to use the deduction currently due to the income limitation of Sec. 179(b)(3)(A), the unused amount is carried forward indefinitely until used. The basis of the S shareholder’s stock is reduced immediately by the full amount of the deduction. 24 Upon the death of a shareholder with an unused deduction carryover, the unused deduction carryover is added back to the basis of the shareholder’s stock immediately before the transfer, and the carryover deduction is eliminated. This rule applies to dispositions including gifts and death. 25
A practitioner assisting the executor of a 2010 decedent holding S stock should make sure the carryover deduction is eliminated from the decedent’s final return and the basis schedules are adjusted upward by any unused Sec. 179 carryover. This is a needless exercise for those adjusting stock basis under Sec. 1014. It is important for an estate seeking elective Sec. 1022 treatment.
Reduced Basis Debt from Corporation to Shareholder
There does not appear to be any prohibition, under either the old or new estate rules, against increasing the basis of debt owed a shareholder by an S corporation that was previously reduced by losses under Sec. 1366(d)(1)(B). The increased basis will reduce or eliminate gain on repayment or provide additional basis for loss deductions flowing through after death. Note that any basis increase under Sec. 1014 or 1015 cannot exceed FMV. It is advisable to have a competent appraiser value any reduced-basis note held by a decedent because the FMV could be different from face value.
Alternative Minimum Tax
In any carryover basis situation, it is important to be careful to determine the basis of property for both regular tax and AMT purposes. If basis is different for regular tax and AMT purposes and the executor elects the carryover basis rules of Sec. 1022, then the basis of the decedent’s successor-in-interest will be different for regular tax and AMT purposes. 26
As mentioned earlier, in situations where unused losses can affect basis, for example Sec. 1022(b)(2)(C), the amount of the unused losses will frequently be different for regular tax and for AMT purposes.
It appears that an estate electing Sec. 1022 will have a second and distinct basis layer cake for AMT purposes that could differ significantly in the first and third layers (decedent’s basis and carryover losses) from the basis layer cake used for regular tax purposes. Both cakes are subject to the various limitations of Sec. 1022, albeit to differing degrees. Some of the situations where this could occur are discussed in the following paragraphs.
Example 5: Decedent D dies holding S corporation stock in a construction company. Due to differing treatment under AMT for depreciation 27 and contract accounting, 28 the basis at death in the S corporation stock is $1 million for regular tax purposes and $1,800,000 for AMT purposes. Assume further that D had a net operating loss (NOL) carryforward of $600,000 for regular tax purposes and an NOL carryforward for AMT purposes of $900,000. D also has a capital loss carryforward of $400,000 for regular tax purposes and a capital loss carryforward of $150,000 for AMT purposes. Finally, D held stock purchased under an incentive stock option plan with an unrealized loss for regular tax purposes of $2 million and an AMT unrealized loss, using the higher AMT basis, of $5 million. The unrealized loss on this stock qualifies as an unrealized loss under Sec. 165(c).
The loss carryover adjustment to the third layer of the regular tax basis cake is $3 million, and the loss carryover adjustment for regular tax purposes is $6,050,000. Combined with the differing initial stock basis between regular tax and AMT purposes, the total basis difference (assuming no FMV limitation) is $3,850,000 ($4 million for regular tax purposes and $7,850,000 for AMT purposes). (The layer 2 adjustment and, if applicable, the layer 4 adjustment are the same for both regular tax and AMT purposes and can therefore be disregarded for the current comparative purposes.) This shows how the differences in regular tax treatment and AMT treatment can produce significant differences in the first decedent basis layer and the third “carryover loss” layer.
Sec. 1022(a)(1) states that property acquired from a decedent dying after December 31, 2009, shall be treated, for all income tax purposes, as transferred by gift. The regulations, at Regs. Sec. 1.1366-2(a)(6) state, for purposes of the loss limitations of Sec. 1366(d), that “the basis of stock in a corporation acquired by gift is the basis of the stock that is used for purposes of determining loss under section 1015(a).”
Another area of difference has to do with the FMV cap. Gifts have, under Sec. 1015(a), a unique rule that provides the basis for loss is the lower of the FMV of the asset at the date of the gift or the donor’s basis at the time of the gift, while the basis for gain on subsequent sale of the stock is the donor’s basis. This leads to two different cost basis amounts, one for gain and one for loss. Sec. 1022 does not contain such a bifurcation; it states the basis of the asset in the hands of the successor-in-interest shall be the lesser of the decedent’s basis or FMV.
If the basis step-up is elected under Sec. 1022(b), the FMV limit applies as a cap to basis for both the regular tax and AMT purposes. To the extent the FMV cap applies, the basis of a successor in-interest would initially be the same for regular tax and AMT purposes. Presumably, if the executor elects to apply an amount of basis step-up that brings the basis to less than FMV, the regular tax and AMT basis could continue to be different.
Example 6: D dies owning S corporation stock with a basis of 50,000 for regular tax purposes and a basis of $100,000 for AMT purposes.
If the carryover basis system of Sec. 1022 is elected, and the FMV of the stock is greater than or equal to the larger of the regular tax and AMT basis amount, $100,000, and no step-up is allocated to the stock, the basis, for D’s successor-in-interest, remains unchanged for both regular tax ($50,000) and AMT ($100,000) purposes. On the other hand, the executor may elect to increase stock basis under Secs. 1022(b) and (c) for regular tax and AMT purposes; neither basis may exceed the stock’s FMV.
Example 7: Assume the same facts except that the stock has a date-of-death value of $80,000. Sec. 1022(a)(2) provides that the basis will be the lesser of the adjusted basis of the decedent or the FMV of the property at the date of the decedent’s death. Therefore, the regular tax basis will be stepped up to the $80,000 FMV only if the executor elects to allocate some of the basis increase limitation to the stock. The AMT basis will be reduced to $80,000.
If the executor does not elect to allocate any basis increase to the stock, the basis for regular purposes remains 50,000, while the AMT basis is reduced to $80,000.
Neither Form 8939, Allocation of Increase in Basis for Property Acquired from a Decedent, Rev. Proc. 2011-41, nor Notice 2011-66 mentions AMT basis. There is no provision for reporting the differing amounts of losses increasing the elective step-up amounts. The guidance is likewise silent on how to report the allocation of varying amounts of step-up between regular tax basis and AMT basis of assets. Form 8939 contains reporting and allocation only for regular tax purposes.
State Tax Basis
As if the above did not produce enough potential complications, a thorough practitioner must also extend the potential disparate treatment, under a modified carryover basis system, to state tax basis. Significant federal-state differences in tax law, such as nonrecognition of federal bonus depreciation by a state, can produce drastically different tax basis in S corporation stock. These differences can be increased by different treatment for regular tax and AMT. Those practitioners who are sadists can assign the state income tax implications of the above to some poor staff member. The masochists can keep that task for themselves.
Retroactive Application of the Elective Regime
The instructions just issued require that the new Form 8939, electing treatment under Sec. 1022, is to be filed no later than November 15, 2011. Initially no extension was available. On September 13, 2011, the IRS issued Notice 2011-76 29 in which the due date for Form 8939 was changed from November 15, 2011, to January 17, 2012. No extension past this date will be granted. An amended or supplemental Form 8939 can be filed up to July 17, 2012, but only under the limited provisions of Section I.D.2 of Notice 2011-66.
Practitioners will need to revise regular tax and AMT basis schedules using the basis as finally determined under the regime the executor elects to apply. Since basis serves as a limit on deductions as well as a factor in determining the proper taxation, if any, of distributions, practitioners need to review the treatment of any S corporation stock owned by a 2010 decedent at the time of his or her death. This in turn could lead to changes to the decedent’s final return and subsequent returns for the successor-in-interest.
Example 8: Assume an initial S corporation stock basis in the hands of D, a taxpayer dying in early 2010, of $100,000 for regular tax purposes. The company, no doubt as a combination of a bad economy and the death of the founder, has a loss for the balance of 2010 of $150,000. Due to the uncertainty surrounding the estate tax, the income tax return for D’s successor-in-interest for 2010 is filed using the carryover basis of $100,000; and applying the loss limits of Sec. 1366(d), the loss deduction is limited to $100,000, the basis is now zero, and there is a loss of $50,000 in excess of basis suspended and carried over by Sec. 1366(d)(2). In 2011, the key man life insurance on D’s life owned by other stockholders (a cross-purchase, buy-sell arrangement) finally comes in, and the stock is sold for $250,000. There is no other income or loss for 2011 and no distributions. The stock basis is not increased by the tax-exempt life insurance amount and remains zero. This will, upon sale of the stock, produce a capital gain of $250,000 and result in the loss of the $50,000 suspended loss carryover.
The executor of the estate eagerly reads the newly published guidance and timely files a Form 8939 under which the executor applies $150,000 of the step-up in basis amounts from basis cake layers two, three, or four to the S corporation stock. This retroactively produces a basis in the hands of the successor-in-interest at the time of death of $250,000 ($100,000 basis at death plus $150,000 step-up). The 2010 tax return for the successor-in-interest must be amended to allow the full $150,000 of loss and, as a consequence, erase the suspended loss carryover. The basis at the end of 2010 is now $100,000. Again, there is no change to the stock basis in 2011 for the $250,000 of life insurance. This results in a 2011 capital gain on disposition of the stock of $150,000 instead of $250,000. There is no suspended loss carryover to be lost on disposition of the stock.
Example 9: Assume an initial S corporation stock basis in the hands of D, a taxpayer dying in early 2010, of $100,000 for regular tax purposes. The stock is valued at $250,000. The successor-in-interest takes a distribution in 2010 of $150,000. The income tax return for the successor-in-interest is filed without reporting the distribution as income under the belief that the traditional basis rules of Sec. 1014 will apply and the basis will be stepped up to FMV of $250,000. Subsequently, Sec. 1022 is elected and a Form 8939 is timely filed that allocates all available step-up in basis to other assets of D. Consequently, the 2010 return of the successor-in-interest will need to be amended to return the basis of the successor-in-interest to that of D. This will result in gain reporting of $50,000.
Analogous calculations would be done for AMT purposes and, if different, state purposes.
Working with the executor, the practitioner can assist in making the most of the opportunities and dodging the pitfalls involved in applying the new estate law to different fact sets. Those advising estates considering elective Sec. 1022 treatment, which also hold S corporation stock, have a number of special tax issues to consider. These possible issues should be carefully reviewed for material impact to the clients of the diligent practitioner.
1 The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.
2 Rev. Proc. 2011-41, 2011-35 I.R.B. 188.
3 Notice 2011-66, 2011-35 I.R.B. 179.
4 Sec. 1022(b)(3).
5 Sec. 1361(b)(1)(C).
6 Sec. 1022(a).
7 Rev. Proc. 2011-41, §4.02(2)(a).
8 Sec. 1022(b)(2)(C).
9 Rev. Proc. 2011-41, §4.02(2)(b).
10 Sec. 1022(c).
11 Rev. Proc. 2011-41, §4.02(3).
12 Sec. 1022(d)(2).
13 Sec. 1022(b)(2)(c).
14 Sec. 56(a)(4).
15 Regs. Sec. 1.55-1(a). See also Merlo, 126 T.C. 205 (2006), aff’d, 492 F.3d 618 (5th Cir. 2007).
16 Sec. 165(c)(1).
17 Sec. 165(c)(2).
18 Sec. 1211(b).
19 Rev. Proc. 2011-41, §4.03.
20 Regs. Sec. 1.1367-1(c)(3).
21 See Gitlitz, 531 U.S. 206 (2001).
22 See Mayo Found. for Medical Educ. & Research, 131 S. Ct. 704 (2011).
23 Sec. 465(a)(2).
24 Regs. Sec. 1.179-3(h)(1).
25 Regs. Sec. 1.179-3(h)((2).
26 For a longer discussion of the types of circumstances under which this can arise in case of S corporation stock, see Walsh, “Interaction of the AMT and S Corporation Basis Rules,” 38 The Tax Adviser 32 and 98 (January and February 2007).
27 Sec. 56(a)(1).
28 Sec. 56(a)(3).
29 Notice 2011-76, 2011-40 I.R.B. 479.
Kevin Walsh is with Walsh, Kelliher & Sharp, CPAs, APC, in Fairbanks, AK, and is chair of the AICPA’s S Corporation Technical Resource Panel. For more information about this article, please contact Mr. Walsh at firstname.lastname@example.org.