On Aug. 5, the IRS issued guidance for executors wrestling with the decision whether to opt out of the estate tax for 2010.

Legislation enacted late last year reinstated the estate tax retroactively to the beginning of the year. For people who died in 2010, it included a provision that permits their executors to opt out of estate tax and apply the carryover basis rules that applied before the estate tax returned. This might be a good strategy if executors believe opting out will produce a better tax outcome.

The guidance takes the form of two publications: Notice 2011-66, which establishes the timing and manner of the election, and Revenue Procedure 2011-41, which provides guidelines on allocating basis increases among assets under the carryover basis rules.

Carryover basis rules
Traditionally, the tax basis of inherited property is "stepped up" to the property’s fair market value on the date of death. That means the recipient can turn around and sell the property without generating taxable gains.

But when the estate tax disappeared in 2010, it was replaced with a modified carryover basis regime. Carryover basis means that, instead of a stepped-up basis, a recipient inherits the deceased person’s basis. So, for example, if someone dies owning $100,000 worth of stock with a $20,000 tax basis, that basis carries over to the recipient. If the recipient sells the stock, he or she will realize an $80,000 gain.

The carryover basis regime that took effect in 2010 allowed an executor to allocate two types of basis increases to assets in the estate. The first is a "general basis increase," which consists of up to $1.3 million of increases, plus certain carryovers (capital loss or net operating loss carryovers) and unrealized losses possessed by the deceased. The general basis increase can be allocated to any assets. The second is the "spousal basis increase,' which consists of up to an additional $3 million in increased basis allocable to assets left to a surviving spouse. Increased basis allocated to an asset can’t exceed the asset’s date-of-death fair market value.

For people who died in 2010, executors have a choice: They can allow the estate tax to apply, or they can opt out and apply the modified carryover basis rules. For estates that don’t exceed the $5 million exemption (less any gift tax exemption used during life), there’s generally no reason to opt out: Estate tax liability is zero, and all of the deceased person’s assets receive a stepped-up basis.

For larger estates, the decision is more complicated. Essentially, the executor’s task is to determine whether the present value of the potential income tax cost under the modified carryover basis rules would be less than the estate tax liability. This requires an analysis of a variety of factors, including the date-of-death values and tax bases of all assets, their projected future values and expected sale dates, anticipated future income tax rates, and the ability to allocate increased basis to a surviving spouse or others. An executor must also consider potential conflicts among beneficiaries over which assets receive basis increases.

Timing and manner of election
Notice 2011-66 provides that the election to opt out of estate tax for someone who died in 2010 (the section 1022 election) must be made by filing Form 8939, "Allocation of Increase in Basis for Property Acquired From a Decedent," no later than Nov. 15, 2011. The form is also used to report and value assets and to allocate basis increases among them. Once the form is filed, the election and allocations are irrevocable. The executor must also give the beneficiaries a statement with information as to the basis of the assets within 30 days after filing the form. The IRS plans to issue Form 8939 and instructions "early this fall."

The notice makes clear that the IRS generally won’t grant extensions to the Nov. 15 deadline or accept forms filed after that date, with two important exceptions: First, an executor who filed a timely and complete Form 8939 (complete except for the allocation of the full amount of the spousal property basis increase), can file additional forms to allocate increased basis to a surviving spouse as assets are distributed to him or her. The amended form must be filed within 90 days of the distribution of the property to which the spousal property basis increase is allocated. This exception is important because decisions on which assets will be distributed to the spouse, and therefore are eligible for the $3 million spousal basis increase, might not be made until after the initial Form 8939 is filed.

Second, an executor who filed a timely Form 8939 may make changes to that form (other than making or revoking a section 1022 election) until May 15, 2012.

The notice also establishes procedures for dealing with multiple forms. This can happen when there’s no court-appointed executor (for example, if the deceased person’s assets are held in trust or otherwise pass outside of probate). Under those circumstances, trustees or others "in actual or constructive possession" of the deceased person’s property will be deemed to be executors entitled to file Form 8939 with respect to property they control.

If multiple forms make conflicting allocations or they collectively allocate more basis increases than the law allows, the IRS will give the statutory executors 90 days to agree on an allocation and jointly file a single Form 8939. If they fail to do so, the IRS will "allocate the available basis increase as the IRS, in its discretion, may determine."

Allocation guidelines
Rev. Proc. 2011-41 addresses several allocation issues that have caused confusion among executors. It clarifies that, in calculating the general basis increase, unrealized capital losses as of the date of death are included, without regard to limitations on capital losses that would have applied if the deceased had lived. Rev. Proc. 2011-41 also provides that:

• An executor may allocate increased basis to assets that have already been distributed or sold by the estate. For assets that have been sold, the executor can add basis up to their date-of-death fair market value, even if their value has declined and the additional basis would generate a loss.
• An executor may allocate spousal basis increases to assets that have already been distributed and, as noted above, may allocate additional spousal basis increases as assets are distributed. Spousal basis increases may even be allocated to assets that have already been sold, provided the executor certifies on Form 8939 that the sale proceeds have been earmarked for the spouse.
• If the carryover basis rules are elected, the holding period of inherited property, for purposes of eligibility for long-term capital gains treatment, includes the period during which the deceased person held the property. This is the case regardless of whether the executor allocates increased basis to the property.

These guidelines allow executors a great deal of flexibility in deciding whether to distribute assets to beneficiaries or to sell them and distribute the proceeds, without an adverse impact on the timing of the section 1022 election. In addition, executors are free to distribute assets as they see fit, without the need to consider how long capital assets have been held since the date of death.

Allocating generation-skipping tax exemption for 2010 decedents
The generation-skipping transfer (GST) tax was applicable in 2010, except that the GST tax rate for taxable transfers in 2010 was zero. Therefore, the estate of someone who died in 2010 can allocate the decedent’s available GST exemption. If the estate elects out of estate tax, the executor allocates the decedent’s available GST exemption on Schedule R of Form 8839. If the Form 8839 is timely filed, this will be considered a timely allocation of the decedent’s GST exemption.

Be prepared
Notice 2011-66 and Rev. Proc. 2011-41 offer needed guidance for executors of estates of those who died in 2010. You should work with an estate tax advisor and your attorney to determine whether you should opt out of the estate tax and develop a basis allocation strategy so you can act quickly once Form 8939 is released.

Contact our tax services team >