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George F. Bearup, J.D. Senior Legal Trust Advisor

13-Apr-21

Income Tax Attributes- You Die, You Lose Them

Take-Away: Many tax attributes that an individual accumulates during lifetime from certain assets or transactions end with the individual’s death. While the assets that created the income tax attribution are inherited by the deceased individual’s beneficiaries, the tax attributes that arise from those assets do not. Hence the need to plan to preserve tax attributes.

Background: In today’s estate planning climate with its laser focus on the ‘use-it-or-lose-it’ approach to using the large federal transfer tax exemptions while they exist, not much attention is given to income tax attributes, which if not used during the taxpayer’s lifetime are lost on the taxpayer’s death. These tax attributes are the equivalent to assets in the sense that their existence can substantially reduce income tax liabilities. Examples of income tax attributes that are created during lifetime that can be lost on the taxpayer’s death include: (i) capital loss carryovers; (ii) net operating losses; and (iii) charitable deduction carryovers. Some lifetime planning  steps can be taken, though, to use the income tax attributes before they are permanently lost on the taxpayer’s death.

Net Operating Losses and Capital Loss Carryovers: The source of the ‘use-it-or-lose-it’ approach to these tax attributes is found in Revenue Ruling 74-175. That Revenue Ruling contains the following statement: “[I]n the absence of any express statutory language, only the taxpayer who sustains a loss is entitled to take the deduction.” In short, any tax loss used to offset taxable income is lost at the taxpayer’s death unless the Tax Code specifically states otherwise.

  • NOLs: Net operating losses (NOLs) can offset any type of income. Thus, NOLs are more efficient when used to offset ordinary income.
  • Capital Loss Carryovers: Capital loss carryovers are more difficult to plan for because these losses can only offset capital gains (with the exception that excess capital losses up to $3,000 –or $1,500 for married filing separate returns- can be deducted against ordinary income.) Under current rules there is an income tax basis adjustment on the taxpayer’s death. [IRC 1014.] Accordingly,  incurring capital gains in an effort to utilize capital losses is not much help if the same appreciating assets are held until death (though that may change if many in Congress get their wish later this year.)
  • Charitable Contribution Carryovers: Charitable contributions are limited by the donor’s adjusted gross income (AGI) which may be carried forward for five additional tax years. However, like NOLs and capital loss carryovers, a charitable contribution deduction carried over for the following five years ends upon the donor’s death. The source of this terminable charitable tax deduction carryover is in the Tax Code Regulations. [Regulation 1.170A-10(d)(4).]

Planning to Preserve Tax Attributes: Some steps, admittedly few, can be used to preserve some of these income tax attributes.

  • Surviving Spouses: If the deceased taxpayer was married at the time of his or her death and they filed a joint income tax return for that year, the survivor can utilize NOL or capital loss carryovers to offset earned in the same tax year, even if the income is earned after the taxpayer’s death. [Regulation 1.2-1(b).] However, once the year of death has ended, the NOL or capital loss attributable  is lost. Comparable to an NOL and capital loss carryover, for married filing jointly taxpayers, an allocation of the taxpayer’s charitable income tax deduction carryover to the survivor is also allowed, for that year. [Regulation 1.170A-10(d)(4).]
  • CARES Act Loss ‘CarryBack:’ With an NOL, any such loss incurred in the year of the taxpayer’s death can still be carried back to earlier tax years for a limited period of time. [IRC 172 was created under the CARES Act.]
  • Roth IRA Conversions: As noted, NOLs can offset any type of income. NOLs are more efficient when used to offset ordinary income. If the taxpayer has significant NOLs and also a large traditional IRA, a Roth IRA conversion could effectively use a large portion of the taxpayer’s NOLs. By converting the traditional IRA to a Roth IRA, there is an acceleration of ordinary income that then uses the NOLs.
  • Gift-Sale Strategy: Assume the taxpayer has appreciated assets and also has capital loss carryovers. The taxpayer is thinking of making a large gift, following the use-it-or-lose-it planning theme for 2021. Instead of making a gift of an appreciated asset, the taxpayer makes a gift of cash equal to the appreciated asset’s value. Next, in a taxable sale, the donee then purchases the appreciated  asset from the donor using the gifted cash. (Let’s hope the IRS does not apply the step-transaction doctrine.) The existing capital loss carryover offsets the donor’s gain that is recognized, and the donee now has a basis in the asset that is equal to the cost, i.e. the purchase price paid, instead of the lower income tax basis that normally exists with a lifetime gift. In effect, the donor’s existing capital loss carryforward is leveraged to ‘gift’ a basis step-up to the lifetime gift.
  • Trusts: Similar to the Roth IRA conversion strategy, a donor with charitable income tax deduction carryforwards, may need to accelerate income in order to use the charitable income tax deduction carryforward. The problem, however, is that charitable income tax deductions are always limited by the donor’s adjusted gross income for the year. So even when income is accelerated into the current year, e.g. a Roth IRA conversion,  there is still a limit on how much of the charitable income tax deduction carryforward can be used to offset that accelerated income. However, unlike individuals, trusts do not have any adjusted gross income limitations. Rather, the charitable deduction for trusts is limited by the trust’s gross income, which generally means its taxable income. A charitably inclined donor could contribute assets to a separate, taxpaying,  irrevocable trust. Hopefully the trust’s assets generate the same amount of gross income that the donor would have otherwise given to the charity. Assume that the transfer of assets to the trust is incomplete for federal gift tax purposes, e.g. the donor retains a power of appointment over the transferred assets. The trust makes the contribution to the charity with the trust’s gross income, which will offset the gross income dollar for dollar. Thus there is no risk of the donor dying with substantial unused charitable income tax deduction carryforwards.
  • Other Tax Attributes: There are several other tax attributes that can be lost on the taxpayer’s death. Some examples include: (i) investment interest expense carryovers [IRC 163(d)]; (ii) foreign tax credit carryovers [IRC 691(b)]; (iii) passive activity losses [IRC 469)g)]. Admittedly it is very difficult to plan to preserve these tax attributes.

Unrealized Losses: While we frequently use the phrase step-up in income tax basis on death, in fact the income tax basis is adjusted either up, or down, at the time of the decedent’s death to its fair market value on the date of death. Like the other tax attributes, unrealized losses are disappear on the asset owner’s death. One section of the Tax Code that is intended to prevent abuse may actually be used to ‘preserve’ these unrealized losses. The Tax Code provides that if loss property is sold to a related party, the loss is disallowed. [IRC 267(d)(1).] If that related party thereafter sells the property at a gain, the gain is recognized only to the extent that it exceeds the previously disallowed loss. In short, some disallowed loss may be recouped by the related party purchaser who subsequently sells the asset for a gain, even if the original seller has died.

Conclusion: I have admittedly been harping on the use-it-or-lose-it estate planning theme for close to a year now. That effort has been focused mostly on using the applicable exemption amounts before those exemption amounts are summarily reduced by Congress. That same ‘use-it-or-lose-it’ mantra should also be applied to existing tax attributes, which are sometimes just as valuable as tangible assets. While Congress cannot accelerate (hopefully!) a taxpayer’s death, preserving tax attributes and using them as soon as practicable would seem to make a lot of sense for many taxpayers.