Mitigation of excess gain on inherited property

Editor: Christine M. Turgeon, CPA

A statute of limitation, such as on assessment under Sec. 6501 or on credit or refund under Sec. 6511, imposes a cutoff that can be useful for the administration of the tax system. At the same time, such a cutoff can be inequitable when the same tax item is treated differently in two tax years and one of the years is closed at the time of the inconsistent treatment due to the running of the statute of limitation. Either the taxpayer or the government may be disadvantaged. For example, a taxpayer may be harmed by the inclusion of the same item of income in two tax years or the disallowance of a deduction in two tax years. On the other hand, the government may be harmed if an item of income is not included in either year or if a deduction is allowed in both years.

Mitigation requirements

The mitigation provisions of Secs. 1311 through 1314 offer potential recourse in the above-described situations, provided the statutory requirements are met, by authorizing correction of errors that otherwise would be uncorrectable by operation of law. This item focuses on one specific context for using these rules to seek an adjustment: correcting excess gain on inherited property.

First, however, a summary of the mitigation provisions’ requirements may be useful. Sec. 1311 authorizes adjustments of the tax for a closed year if all the following conditions exist:

• First, there must exist a “determination” as defined in Sec. 1313. This generally is a court decision (with respect to the taxpayer or a related taxpayer) that has become final, a closing agreement, or a final disposition on a claim for refund. Also, the taxpayer and the IRS can enter into an agreement on Form 2259, Agreement as Determination Pursuant to IRC 1313(a)(4), that constitutes a determination for purposes of the mitigation provisions.
• Second, there must have been an error in the way an item was handled in a barred year that falls within one of the categories (referred to as “circumstances of adjustment”) set forth in Sec. 1312.
• Third, on the date of the determination, correction of the error is prevented by some rule of law (typically, the expiration of the period of limitation for assessment or refund under Sec. 6501 or Sec. 6511, respectively).
• Finally, except in situations described in Sec. 1312(3)(B) and Sec. 1312(4), the position adopted by the successful party in the proceeding resulting in the determination must be inconsistent with that party’s erroneous treatment in the barred year.

Where mitigation applies, Sec. 1314(b) extends the applicable statute of limitation for one year from the date the determination is made, in order to allow the error to be corrected in the barred year.

Applicable circumstances

The circumstances of adjustment set forth in Sec. 1312 are as follows:

• The double inclusion of an item of gross income;
• The double allowance of a deduction or credit;
• The double exclusion of an item of gross income;
• The double disallowance of a deduction or credit;
• Correlative deductions and inclusions for trusts or estates and legatees, beneficiaries, or heirs;
• Correlative deductions and credits for certain related corporations; and
• Basis of property after erroneous treatment of a prior transaction.

The first four circumstances of adjustment are relatively straightforward. The last three are more complicated, with Sec. 1312(7), which deals with problems involving basis, generally regarded as posing the most difficulty. This is the mitigation provision that potentially could correct excess gain on inherited property, as will be discussed. To invoke Sec. 1312(7), the asserting party must prove the existence of four additional conditions:

• The relevant determination “determines the basis of property”;
• There exists a “transaction on which such basis depends” or a “transaction which was erroneously treated as affecting such basis”;
• “In respect of ” the “transaction … there occurred” an error described in Sec. 1312(7)(C), which includes, for example, the erroneous recognition or nonrecognition of gain or loss or the erroneous inclusion or exclusion of gross income; and
• The taxpayer with respect to whom the erroneous treatment occurred must fall into one of the categories listed in Sec. 1312(7)(B).

Court decisions

The Seventh and Fourth Circuits have disagreed as to how Sec. 1312(7) applies to the following common situation. A taxpayer receives property by bequest or inheritance and, on selling the property, determines gain or loss by using the value of the property reported on the estate tax return as basis. Later, after the year in which the sale occurred is closed for refund purposes, the IRS determines an estate tax deficiency based on a higher valuation of the property, and the taxpayer seeks to recompute the gain realized on the sale.

In O’Brien, 766 F.2d 1038 (7th Cir. 1985), the Seventh Circuit held that no relief is available under Sec. 1312(7) in this situation. The transfer of the decedent’s property at death is the transaction “on which basis depends” (i.e., the transaction that determined basis), but the miscomputation of gain on the sale of the property was not an error “in respect of ” that transaction. In other words, while computing gain on the sale depends on the use of the correct basis, it is the transfer upon death that was the basis-determining transaction, and the error (i.e., the overstatement of gain on the sale) was not “in respect of ” that transaction.

However, three years earlier in Chertkof, 676 F.2d 984 (4th Cir. 1982), the Fourth Circuit described the same type of situation as “a classic example of the sort of nonculpable trap into which [a taxpayer] is all too likely to fall” and concluded that Sec. 1312(7) could provide relief. The court’s opinion makes only a passing reference to the requirement that the error sought to be corrected must be in respect of a transaction on which basis depends, and its reasoning on that issue is unclear.

The court possibly regarded the “error in respect of ” requirement as being satisfied by its determination that the decedent’s death and the related transfer of property was the transaction “on which basis depends.” That is because the date-of-death valuation amount (later successfully challenged by the IRS) was “used both to calculate estate taxes, and to put the government and the taxpayer in a position to compute income taxes once a future gain or loss is recognized,” and, therefore, the error — using too low a basis when the property was sold — related back to (and was “in respect of ”) the transferupon- death transaction.

Editor Notes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City. For additional information about these items, contact Turgeon at christine.turgeon@pwc.com. Contributors are members of or associated with PricewaterhouseCoopers LLP.