Take-Away: Estate plans these days’ focus on obtaining an income tax basis ‘step-up’ on the death of the owner of appreciated assets to avoid capital gain recognition by heirs and trust beneficiaries. While an income tax basis adjustment occurs on the death of the owner, there are two notable exceptions to the income tax basis ‘step-up-on-death’ rule: (i) income-in-respect-of-a decedent; and (ii) when the recipient of the inherited asset had transferred that asset to the decedent within one year of the decedent’s death.

Background: IRC 1014 provides that on the death of a decedent, the value of an asset that is included in the decedent’s taxable estate receives an income tax adjustment to the asset’s date-of-death fair market value, which has the effect of washing away capital gain tax exposure in the hands of the heir. There are two important exceptions to this general rule, however: IRD and ‘boomerang’ assets

IRD: Income-in-respect-of-a-decedent (IRD), e.g. an IRA, has no income tax basis to begin with as it is income, not property.  Consequently, the income-in-respect-of-a-decedent asset will continue to be subject to ordinary income taxation after the decedent-owner’s death. That is why the beneficiary of an inherited IRA must still pay ordinary income taxes on distributions from the inherited IRA to its designated beneficiary. Other sources of IRD include deferred compensation benefits, unpaid bonuses, accumulated interest income, Series EE bond interest, etc. The Tax Code provides: (c) Property representing income in respect of a decedent. 1. This section shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under [IRC]section 691.

Boomerang Assets: Gifts Within One Year of Death: There is no date-of-death income tax basis adjustment for property that is received from the decedent if the property was received from a person who the property is being left to as a devise or bequest. [IRC 1014(e).]

  • IRC 1014(e): This Tax Code section provides: Appreciated property acquired by decedent by gift within 1 year of death. 1. In general, in the case of a decedent dying after December 31, 1981, if- (a) appreciated property was acquired by the decedent by gift during the 1-year period ending on the date of the decedent’s death, and (b) such property is acquired from the decedent by (or passes from the decedent to) the donor of such property (or the spouse of such donor), 2. The basis of such property in the hands of such donor (or spouse) shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent.
  • 12-Month Rule: Note that this is not a contemplation of death rule, where an intent to increase income tax basis via death of the holder must be proved for the Code section to apply. It is a strict 12-month rule that is mechanically applied regardless of the intent of the donor.
  • Avoiding the Rule: Since IRC 1014(e) is literally applied, a lifetime gift to the decedent can return to the donor if the donee lives longer than one year with a ‘new’ basis adjustment. Or, if the donee bequeathed or devised the gifted asset to the donor’s child and died within one year of the gift, it too would avoid the application of IRC 1014(e) and the asset would receive an income tax basis adjustment to the asset’s fair market value on the donee’s death.
  • ‘Passes Back’: Despite IRC 1014(e) having been in place for some time, there is still considerable confusion however as to how property passes back to the original donor (or his/her spouse) for purposes of triggering the application of IRC 1014(e). Only a handful of private letter rulings have addressed the question of how passes back will be interpreted.
  • Example: Son gives an appreciated asset to his elderly father. Father dies within a year of the gift from son. Father leaves the same asset in trust for the son’s lifetime benefit. Son did not acquire the asset from his father on his father’s death; rather, a trust acquired the asset on the father’s death. Does IRC 1041(e) still apply as the son will indirectly benefit from the asset that had been given to his father?
    • Right? The answer might turn on if the son, as the beneficiary of the father’s trust, has a right to the trust’s income, or a limited right of withdrawal over the trust’s principal, which limited rights might trigger a proportionate adjustment to the income tax basis of the asset that is now held in trust.
    • “No Property Interest:” Conversely, if the trust is a wholly discretionary trust, where the son has no enforceable rights and his interest in the trust is expressly not treated under the Michigan Trust Code as a property interest, then arguably IRC 1041(e) will not apply, and the asset held in the trust should receive a full income tax basis adjustment on the father’s death. [MCL 700.7815(1).].
    • Multiple Beneficiaries: If the son is just one of many discretionary beneficiaries of his father’s trust, IRC 1014(e) should not apply at all since the son’s interest in the discretionary trust cannot be quantified due to the presence of other similarly situated trust beneficiaries.

Conclusion: With the uncertainty how the IRS will view a lifetime gifted asset that passes back indirectly to the donor, that may then prompt some thinking on how a trust is structured. If one spouse is in poor health and his/her life expectancy is limited, an appreciated asset could be placed in that ill health spouse’s name. On the ill spouse’s death within one year, if that asset passed back to the surviving spouse outright, IRC 1014(e) would apply. If the asset passed to a conventional credit shelter trust where the surviving spouse was the sole lifetime beneficiary with the right to receive all income or the right to a 5+5 power of withdrawal, then IRC 1014(e) could still apply, or at least be applied on in a pro rata manner with regard to all of the assets held in the trust. If, however, the asset passed to a credit shelter trust where the surviving spouse was a discretionary beneficiary along with other beneficiaries, e.g. the decedent’s children, then it is probable that IRC 1014(e) will not apply at all. The point is that if end-of-life income tax basis planning is a possibility, you need to think through how, and to whom, the gifted asset will be passed back at the donee’s death.