Estates and Beneficiaries
I recently encountered a situation in which the so-called “basis consistency” rule was implicated. This rule requires consistency between the estate tax value of a decedent’s property – its fair market value (“FMV”) as reported on the decedent’s estate tax return – that passes to a beneficiary, and the basis claimed by a beneficiary for such property; in general, this means that the “stepped-up” basis of the property in the hands of the beneficiary can be no greater than the FMV of the property reported by the estate to the IRS. The rule is aimed at preventing the government from being whipsawed between a lower valuation of a property for purposes of determining the estate tax attributable to the property, and a higher valuation for purposes of determining the beneficiary’s basis for the property and their income tax consequences on its subsequent disposition.
Prior to the enactment of this rule in 2015, the FMV of a property at the date of the decedent’s death was deemed to be its value as appraised for estate tax purposes: the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
However, the value of the property as reported on the decedent’s estate tax return provided only a rebuttable presumption of the property’s basis in the hands of the beneficiary. Thus, unless the beneficiary was estopped by their previous actions or statements with regard to the estate tax valuation, they could rebut the use of the estate’s valuation as their basis in the property by clear and convincing evidence.
What About Corporations and Shareholders?
While considering the application of this rule, I tried to recall whether a similar consistency rule applied between a corporation and its shareholders in the context of an in-kind distribution by the corporation, whether as a current distribution (a dividend or dividend-equivalent), as part of a redemption of stock that is treated as a sale or exchange for tax purposes, or as a liquidating distribution.
In-Kind Distributions, Generally
Under the Code, if a corporation distributes property (other than its own obligation) to a shareholder in respect of their stock in the corporation, and the FMV of the property exceeds its adjusted basis in the hands of the corporation, then gain must be recognized by the corporation in an amount equal to such excess, as if the corporation had sold the property.
Repeal of “General Utilities”
Prior to the enactment of this recognition rule, a corporation was permitted to distribute appreciated property to its individual shareholders without recognizing gain, but the shareholders’ basis for the property would nevertheless be stepped up without any corporate-level tax having been paid.
In repealing this rule, Congress explained that under a double-tax system for corporations, the distributing corporation generally should be taxed on any appreciation in value of property distributed to its shareholders; for example, had the corporation sold the property and distributed the proceeds, it would have been taxed on the gain from the sale.
According to Congress, the result should not be different if the corporation distributed the property to its shareholders and the shareholders then sold it.
At the same time, the courts have rejected the suggestion by many corporate taxpayers – in an attempt to reduce the corporate-level gain – that this corporate-gain-recognition rule requires that the FMV of the property distributed by the corporation must be the same as the FMV of the property received by the shareholders. The courts have noted that the FMV of an entire interest in a property is greater than the sum of its fractional parts (for example, the FMV of a real property distributed by a corporation vs the aggregate value of the various tenancy-in-common interests in the property received by its distributee-shareholders).
Similarly, the rules that address the tax treatment of a shareholder’s receipt of property distributed from a corporation in respect of its stock, including the rule that determines the basis of such property in the hands of the shareholder, refer to the FMV of the property received by the shareholder, not the FMV of the property distributed by the corporation.
Who Decides FMV?
Of course, this begs the question: who determines the FMV of the distributed property?
Is it the corporation? After all, the corporation has to report on its income tax return any gain recognized on the distribution. It must also report on such return the value of any property distributed. The corporation must also issue a Form 1099 to the shareholder.
In the case of an S corporation, the corporation has to determine its gain on the distribution, which it must then allocate among its shareholders; this allocation, as well as the amount distributed to each shareholder, is reflected on the Sch. K-1 issued to each shareholder.
Alternatively, should each shareholder be free to determine the FMV of the property distributed to them? For example, may (or must) a shareholder who already owns an interest in the larger asset of which the distributed property is a part (as where the shareholder and the distributing corporation were co-owners before the distribution) assign a greater value to their distribution if it causes them to become the majority owner of the asset?
Provided the corporation’s determination of FMV is reasonable, it should control; otherwise, each shareholder would be free to determine the FMV of the property received by the shareholder which may result in different values for similarly situated persons and which, in turn, may lead to abuses.
Why an In-Kind Distribution?
Now, you may be wondering, how can this scenario ever occur? Why would a corporation distribute appreciated property to its shareholders and thereby intentionally trigger corporate-level tax and gain? Even if the corporation were in liquidation mode, wouldn’t it sell its properties for cash, rather than distribute them to its shareholders?
Two possible situations come immediately to mind: in the first, the corporation has sufficient net operating loss carryovers to offset a significant part of the corporate-level gain, which allows the corporation to remove the property from corporate solution with one level of tax; in the second, the corporation was going to sell the property anyway, but its shareholders plan to share the proceeds other than in accordance with their stock ownership – by distributing the property to its shareholders, the corporation enables each shareholder to sell its share of the property for the desired consideration.
The following hypothetical illustrates some of the issues that may be encountered under the second situation.
“But I Want More”
S corporation has several shareholders. As an S corporation, it has only one class of stock issued and outstanding. Its governing provisions (including its certificate of incorporation, by-laws, shareholder agreements, and state law) do not contradict the identical rights enjoyed by each share of stock to current and liquidating distributions.
The corporation proposes to make a pro rata, in-kind distribution of non-depreciable property to its shareholders. The FMV of the property, as reasonably determined by the corporation, exceeds the corporation’s adjusted basis for the property. The property constitutes a capital asset in the hands of the corporation, and the corporation has held the property for more than one year.
For tax purposes, the corporation is treated as having sold the property to its shareholders. Under the S corporation rules, the corporation’s long term capital gain from the deemed sale is allocated among, and recognized by, the shareholders in accordance with their stock ownership. The S corporation will issue a Sch. K-1 to each shareholder that reflects the amount of gain allocated to the shareholder and the FMV of the property distributed to the shareholder.
Each shareholder will take the property distributed to them with a starting basis equal to the FMV of such property, and each shareholder will begin a new holding period for such property.
Shortly after receiving their in-kind distribution, the shareholders sell their respective interests in the property to an unrelated buyer. With one exception, each shareholder receives an amount equal to the FMV of their interest in the property as reported to them by the S corporation. Because this amount is also equal to their basis for their respective interests in the property, these shareholders do not realize any gain on the sale to the buyer.
However, one shareholder receives consideration in excess of the FMV of the distribution reported to the shareholder on the Sch. K-1 issued to them by the S corporation.
If the story ended here, this shareholder would recognize short term capital gain (taxable at the rates applicable to ordinary income) equal to the excess of the consideration received for their interest in the property over their basis for such property.
But what if this shareholder took the position that, based on the amount paid by the buyer, the FMV of the property interest distributed to them was actually greater than the distribution amount reported by the S corporation on the shareholder’s Sch. K-1?
And what if, consistent with this position, the shareholder reported a greater amount of capital gain on their tax return than the amount reported by the corporation on the shareholder’s Sch. K-1 as their share of the gain from the deemed sale of the property?
Finally, what if the shareholder claimed a basis in the distributed property equal to this greater value on which they have been taxed? In that case, the shareholder will not realize any gain on the sale of their interest in the property to the buyer.
By taking a position that differs from the S corporation’s as to the value of the property distributed, will the shareholder have succeeded in converting what would have been short term capital gain into long term capital gain?
As I contemplated this question, I identified a number of issues, with which I will leave you:
- Should the “extra” consideration received by the one shareholder be treated as having been paid pro rata to all the shareholders, following which they paid over the extra consideration to that shareholder in a separate transaction? If so, how should that payment be treated? Would its tax treatment depend upon the facts and circumstances? For example, should it be treated as a bonus (i.e., compensation)?
- May the IRS treat the excess payment received by the one shareholder as an additional payment or distribution from the corporation?
- Depending upon the facts and circumstances, including any agreement among the shareholders, might the arrangement that leads to the one shareholder’s receipt of the extra consideration be interpreted as a second class of stock that would end the corporation’s “S” status?
- May the one shareholder avoid accuracy-related or fraud penalties by disclosing to the IRS its position as to the FMV of the property distributed? In the case of an S corporation, is the shareholder required to disclose this position as an inconsistent position?
- What if the sale of the property by the shareholders does not occur for several years? What if the statute of limitations on assessment of any deficiency for the year of the distribution has expired? Would the common law duty of consistency require that the one shareholder be barred from claiming that their basis for the property is greater than the amount of the distribution reported by the S corporation?
In light of the forgoing issues – not to mention several others not set forth above – and in the interest of facilitating the administration and fair application of the tax law, should Congress act to prohibit the shareholders of a corporation – as in the case of the beneficiaries of a decedent’s estate – from claiming a different FMV and basis for the property distributed to them by a corporation, regardless of whether such distribution takes the form of a dividend, a redemption of stock, or a liquidation of the corporation?
 If the property were depreciable in the hands of the shareholders, the related party sale rules may apply to treat the gain as ordinary.
 Assume that the corporation determines the amount of the distribution made to a shareholder by simply applying the shareholder’s percentage ownership of the corporation to the FMV of the property as a whole – it does not discount the fractional interest received by each shareholder.
 Perhaps the one shareholder negotiated a better deal?
 Query whether the gain is capital in light of the fact that the shareholders never intended to hold the property except for a brief period prior to its sale.