The estate tax is different from the income tax.
The latter is assessed on your income. This puts stress in defining what is income from what is not, but such is the concept.
The estate tax on assessed on what you own when you die, which is why it is also referred to as the “death” tax. If you try to give away your assets to avoid the death tax, the gift tax will step in and probably put you back in the same spot.
Granted, a tax is a tax, meaning that someone is taking your money. To a great extent, the estate tax and income tax stay out of each other’s way.
With some exceptions.
And a recent case reminds us of unexpected outcomes when these two taxes intersect.
Let’s set it up.
You may recall that – upon death – one’s assets pass to one’s beneficiaries at fair market value (FMV). This is also called the “step up,” as the deceased’s cost or basis in the asset goes away and you (as beneficiary) can use FMV as your new “basis” in the asset. There are reasons for this:
(1) The deceased already paid tax on the income used to buy the asset in the first place.
(2) The deceased is paying tax again for having died with “too many” assets, with the government deciding the definition of “too many.” It wasn’t that long ago that the government thought $600,000 was too much. Think about that for a moment.
(3) To continue using the decedent’s back-in-time cost as the beneficiary’s basis is to repetitively tax the same money. To camouflage this by saying that income tax is different from estate tax is farcical: tax is tax.
I personally have one more reason:
(4) Sometimes cost information does not exist, as that knowledge went to the grave with the deceased. Decades go by; no one knows when or how the deceased acquired the asset; government and other records are not updated or transferred to new archive platforms which allow one to research. The politics of envy does not replace the fact that sometimes simply one cannot come up with this number.
Mr. Backemeyer was a farmer. In 2010 he purchased seed, chemicals, fertilizer and fuel and deducted them on his 2010 joint return.
COMMENT: Farmers have some unique tax goodies in the Code. For example, a farmer is allowed to deduct the above expenses, even if he/she buys them at the end of the year with the intent to use them the following year. This is a loosening of the “nonincidental supplies” rule, which generally holds up the tax deduction until one actually uses the supplies.
So Mr. Backemeyer deducted the above. They totaled approximately $235,000.
He died in March, 2011.
Let’s go to our estate tax rule:
His beneficiary (his wife) receives a new basis in the supplies. That basis is fair market value at Mr. Backemeyer’s date of death ($235,000).
What does that mean?
Mr. Backemeyer deducted his year-end farming supplies in 2010. In tax-speak,” his basis was zero (-0-), because he deducted the cost in 2010. Generally speaking, once you deduct something your basis in said something is zero.
His basis in the farming supplies was zero. Her basis in the farming supplies was $235,000. Now witness the power of this fully armed and operational step-up.
Is that a Rogue One allusion? (Editor's Note: "Rogue One" is a recent spin-off movie from the "Star Wars" franchise)
No, it is Return of the Jedi. Shheeessh.
Anyway, with her new basis, Mrs. Backemeyer deducted the same $235,000 again on her 2011 income tax return.
No way. There has to be a rule.
That is what the IRS thought.
There is a doctrine in the tax Code called “economic benefit.” What sets it up is that you deduct something – say your state taxes. In a later year, you get repaid some of the money that you deducted – say a tax refund. The IRS takes the position – understandably – that some of that refund is income. The amount of income is equal to a corresponding portion of the deduction from the previous year. You received an economic benefit by deducting, and now you have to repay that benefit.
It is a great argument, except for one thing. What happened in Backemeyer was not an income tax deduction bouncing back. No, what set it up was an estate tax bouncing back on an income tax return in a subsequent year.
COMMENT: She received a new basis pursuant to estate tax rules. While there was an income tax consequence, its origin was not in the income tax.
The Court reminded the IRS of this distinction. The economic benefit concept was not designed to stretch that far. The Court explained it as follows:
(1) He deducted something in 2010.
(2) She deducted the same something in 2011.
(3) Had he died in 2010, would the two have cancelled each other out?
To which the Court said no. If he had died in 2010, he would have deducted the supplies; the estate tax rule would have kicked-in; her basis would have reset to FMV; and she could have deducted the supplies again.
It is a crazy answer but the right answer.
Is it a loophole?
Some loophole. I do not consider tax planning that involves dying to be a likely candidate for abuse.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.