Take-Away: While an estate’s personal representative must now report to the IRS and estate beneficiaries date-of-death values for basis consistency purposes, it does not make much sense to report the value of an IRA account which has no basis. Apparently, however,  that is required under the IRS’s proposed Regulations for its new basis consistency reporting regime. There is though other helpful information that IRA beneficiaries would like to receive from the estate that the personal representative is not obligated to provide to them.

Background: In 2015 Congress established a tax basis consistency rule to eliminate perceived abuses when inherited assets were subsequently sold by heirs. This basis consistency rule is found in IRC 6035. In general, the income tax basis of an asset that is inherited cannot exceed the final federal estate tax value that is reported to, and accepted by, the IRS. IRC 1014(f).

  • Basis Reporting: Date-of-death values are to be reported by the personal representative of the decedent’s estate [or trustee of a trust] on IRS Form 8971, which is to be furnished to both the IRS and the beneficiaries who inherit the assets from the decedent. The purpose is to alert both the beneficiary and the IRS as to the tax  basis that is stepped-up on the decedent’s death to the date-of-death value, which will then control future capital gain reporting by the beneficiary.
  • Big Exception: This reporting of basis is only required, however, if the decedent’s estate must file a federal estate tax return [Form 706] as required by IRC 6018, which means that if there is no federal estate tax to be paid because of the decedent’s available federal applicable exemption amount [$5.45 million] and thus no Form 706 to be filed, there is no need to comply with IRC 6035, and consequently no need to furnish a Form 8971 to the IRS and the estate beneficiaries.
  • Smaller Exception: Another exclusion from the basis consistency rules is an asset that is treated as income in respect of a decedent, or IRD. IRD has no tax basis. Thus there is no step-up in the basis of those IRD assets. IRC 1014(c). Recall that the most common form of IRD is an IRA. Therefore it is not surprising that the proposed Regulations say that IRC 6035 (imposing the tax basis consistency requirement) does not apply to IRD. Proposed Regulation 1.6035-1(b)(1)(ii).
  • Now Starts the Confusion: The Instructions to Form 8971 says only cash is not to be reported on the Form, as cash has no tax basis. But there is no mention of excluding IRD assets in the Instructions. Does that mean that an IRA must be reported on Form 8971, even though it receives no step-up in basis on the IRA owner’s death? Does the personal representative have to report IRA date-of-death values, when neither the beneficiary of the inherited IRA nor the IRS will make any use of that disclosed information? That seems to be the case if the Instructions are to be literally followed.
  • Adding to the Confusion: It is bad enough when the IRS’s Instructions to Form 8971 leaves us hanging. Life gets even more complicated when you consider that some IRAs contain assets that are not treated as income in respect of a decedent, or IRD.
  • (i) Roth IRA: Consider a Roth IRA which was funded with after-tax dollars, and which grows, hopefully, in an income-tax-free environment. Generally, a Roth IRA is not IRD when it is inherited. Since a Roth IRA is not IRD, arguably it needs to have its date-of-death value reported on Form 8971, while a regular IRA’s value can be excluded since it is usually IRD. But distributions from a Roth IRA must be qualified distributions, meaning that the Roth IRA must have been in existence for at least 5 years prior to the distribution being tax-free. Consequently, if the owner of the Roth IRA died prior to 5 years from the date the Roth IRA was created, the distributions from that Roth IRA will still be treated as IRD, and thus the nonqualified Roth IRA does not need to be reported on Form 8971. Head spinning yet?
  • (ii) Investment in Contract: This terminology is used to described contributions of after-tax dollars made to a regular IRA. Most often this results when a voluntary non-deductible contribution is made to the IRA. An investment in contract in a regular IRA is also not treated as IRD, but it is also not treated as tax basis in the IRA account. [Other situations when an investment in contract occurs with a regular IRA is when there is a loan outstanding with the IRA account or when excess contributions are made to the IRA.] Thus, the beneficiary of an inherited IRA is entitled to recover the decedent’s investment in contract in the IRA income tax-free, even though the IRA account does not receive a step-up in basis on the IRA account owner’s death under IRC 1014. But since the investment in contract is not IRD, shouldn’t it also be reported on Form 8971, like all other assets owned by the decedent that are not IRD?

Practical Issues: It seems from the way the Instructions are written to formally complete Form 8971 that the date of death value of a Roth IRA must be reported. In addition, if a regular IRA holds investment in contract assets, they too must be reported to the IRS and the IRA beneficiary, even though this information is meaningless to both the IRS and the beneficiary [there being not tax basis adjustment to either type of asset under IRC 1014.] But neither type of asset is exempted from Form 8971.

  • Investment In Contract?: How does the personal representative of a decedent’s estate identify the investment in contract Often this information is impossible to readily identify, yet it is the information that is most helpful to the inheritor of the regular IRA, since that amount will be a tax-free return of asset to the beneficiary of the inherited IRA. This information may be much harder to access if the after-tax contribution to the regular IRA was made decades earlier in time.
  • Qualified Roth IRA? It may be easier for the personal representative to confirm if the Roth IRA was held by the decedent for at least 5 years, to then decide whether, or not, to report the Roth IRA’s date-of-death value on Form 8971. This information will be highly relevant to the beneficiary of the Roth IRA if that account did not exist for 5 years prior to the owner’s death, as the distributions from the Roth IRA account that was not in existence for at least 5 years will be taxable IRD to the beneficiary of the Roth. So the date that the minimum existence for at least 5 years requirement is met will be highly relevant to the beneficiary of the Roth IRA who does not want to pay taxes on distributions from the inherited Roth IRA.
  • Allocation of Income Tax Deduction: You have heard from me about this tax deduction from time to time in the past. If a regular IRA is included in the owner’s taxable estate for federal estate tax purposes, or a portion of a nonqualified Roth IRA is included in the deceased owner’s taxable estate and some of the account is treated as IRD, then a federal income tax deduction is available to the beneficiary of that taxable inherited asset. This deduction is intended to off-set, in part, the double taxation that occurs when IRD is subject to both federal estate tax on the owner’s death and federal income tax when required minimum distributions are received by the beneficiary from the inherited IRA. IRC 691(c). Thus, the beneficiary of the inherited IRA (or Roth IRA that is not yet 5 years old) will want to know how much of the federal estate tax paid is attributable to their inherited IRD asset, so that they can avail themselves of the IRC 691(c) income tax deduction. So far the federal tax laws do not impose a duty on the personal representative of a decedent’s estate to report to the beneficiary his/her portion of the federal estate tax liability that was attributable to their inherited IRA.

Conclusion: Not every personal representative who prepares a Form 706 federal estate tax return will be aware of proposed Regulation 1.6035-1b)(1)(ii) that says that IRC 6035, and thus Form 8971, does NOT apply to income in respect of a decedent. Instead they will blindly follow the Instructions to Form 8971 and conclude that only cash need not be reported on the Form, when in fact other IRD assets also need not be reported. As such, there will result in an over-reporting of regular IRA date-of-death values. At the same time, the date-of-death values of a Roth IRA will also have to be reported on Form 8971 when there can be no capital gain ‘games’ played with the assets that are held in that account by the Roth IRA beneficiary- distributions from the Roth IRA being tax-free. But there is no requirement for the personal representative to provide to a regular IRA beneficiary any information on the investment in contract amount (if any) portion of that regular IRA, nor any obligation to advise the beneficiary of the Roth IRA if the Roth IRA has been in existence for at least 5 years. Let’s hope the IRS updates its instructions to Form 8971 to exclude IRD assets besides cash, and perhaps it includes in future reporting some more helpful information to the beneficiaries of inherited IRAs.