New problem for some executors and heirs

Executors who have to file a federal estate tax return, and some heirs who receive assets from an estate that is subject to the federal estate tax, may be facing a significant new problem as a result of rules just issued by the IRS.

The problem only affects larger estates – generally those where the deceased person’s assets, large lifetime gifts, and life insurance proceeds total more than $5.45 million. But for those estates, it’s a serious issue.

The problem stems from a law passed by Congress last year. The law says that an executor who files an estate tax return must now also fill out a form – called Form 8971 – identifying all heirs to the IRS as well as the value of the assets to be distributed to them. Each heir must also be given a related form (called Schedule A) identifying the assets they will receive and their value.

If the estate is subject to the federal estate tax, then the heirs must use the value of the assets as stated on Form 8971 as their capital gains tax basis if they eventually sell them. There’s a 20% penalty for claiming a different value.

(The idea was to prevent a perceived tax abuse where an executor claims a low value to save on estate taxes, and an heir later claims a higher value for the same asset to save on capital gains taxes.)

The IRS has just released proposed regulations explaining how all this will work in practice. And while the IRS’s proposed rules clarify some things, they also highlight some serious issues.

For instance, Form 8971 must be filed fairly quickly after the deceased person’s death, and an executor might not yet know exactly which estate assets will be given to which heirs, or which assets will be sold to fund a particular bequest. If that happens, then the executor must send the heirs a Schedule A that includes the value of all assets that could even conceivably be used or sold to fund their bequest.

So imagine that an estate is worth $7 million, and a distant relative or friend is going to receive an inheritance equal to 1% of the estate. That beneficiary might have to be given highly detailed and personal information about the entirety of the deceased person’s financial affairs – something the deceased person almost certainly never expected to happen.

What’s more, a relative or friend might look at the lengthy list of assets and assume that he or she is going to get a lot more than the actual bequest. This could leave an executor with a number of very angry and frustrated beneficiaries.

The Schedule A form itself doesn’t help much. Here’s what it tells the heirs: “You have received this schedule to inform you of the value of property you received from the estate of the decedent named above.” As you can see, a beneficiary could read this and easily assume that he or she is receiving all the property listed.

Nor does Schedule A clearly explain (in language a non-expert could understand) the fact that heirs face a big penalty if they sell an asset and claim a different basis.

For this reason, many executors are going to have to go to some lengths to tell beneficiaries what they need to know and keep them from getting false hopes.

Another big problem is that, under the IRS’s proposed rules, if an heir later transfers an inherited asset to a family member (or even just a portion of an asset), the heir must then file a second Form 8971, and must send a Schedule A to the family member. Many heirs will be totally unaware of this requirement, and as a result many family members might have no clue what the required basis is and end up inadvertently owing a 20% tax penalty.

Here are some other important points in the IRS’s proposed rules:

  • Oddly, an executor who files an estate tax return has to file a Form 8971 even if no estate tax is owed, and therefore the heirs aren’t legally required to use the value on the form as their basis. (This could happen, for instance, if there’s a large marital or charitable deduction.)
  • However, if an executor is filing a return solely to claim “portability” of the estate tax exemption (so a surviving spouse can later use his or her own exemption plus the spouse’s exemption), a Form 8971 doesn’t have to be filed.
  • An executor who files a Form 8971 doesn’t have to declare cash, assets in certain retirement accounts, or items of tangible personal property worth less than $3,000.
  • If additional assets are discovered after an estate tax return is filed, their capital gains tax basis will be zero unless the estate files a supplemental return.
  • If no estate tax return is filed, but one should have been filed, then all estate property will have a zero basis until a return is filed.

You should note that the IRS has only issued proposed regulations. Taxpayers can comment before they become final, and the IRS might tweak them later. But for now, though, we should assume the IRS means what it says.

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