1. The wealth transfer tax issues surrounding financial derivatives and some of the investment products discussed in this outline primarily deal with the valuation of the holdings and how the investments should be reported for estate tax purposes. Even on some of the more traditional financial instruments like exchange-traded futures contracts and listed options, it is unclear how they should be treated on an estate tax return.
2. Most troubling is whether the ongoing obligations that investors have when owning certain financial derivatives will be deductible for estate tax purposes under Section 2053 if those liabilities are still subject to future contingencies. The IRS recently issued final Treasury Regulations under Section 2053 that may provide an avenue to ensure deductibility that previous years was likely not available to taxpayers.
B. Contingent Liabilities under Section 2053
1. Generally, if a decedent's estate remains liable for the decedent's contingent liability, and the facts indicate a real possibility that the liability will actually arise, the estate may take the contingency into account in valuing the asset.476 If, however, there is no way to determine if the liability will be satisfied and in what amount, then the liability is non-deductible.477
2. In 2009, the IRS issued final regulations on the deductibility of certain claims for estate tax purposes.478 Of importance to the issues at hand, the Treasury Regulations provide that post-death events are considered in determining whether and to what extent a deduction will be allowable under Section 2053.479
3. Prior to the issuance of the Treasury Regulations, the courts had been divided on whether and to what extent bona fide claims against the decedent should be deductible if subsequent events either extinguished or reduced the claim.480
476 See Guggenheim v. Helvering, 117 F.2d 469 (2d Cir. 1941), cert. denied, 314 U.S. 621 (1941), and Rev. rul. 84-25, 1984-1 C.B. 191.
477 See Coleman v. Comm’r., 52 T.C. 921 (1969), acq., 1978-1 C.B. 1, and May Est. v. Comm’r, 8 T.C. 1099 (1947).
478 T.D. 9468, 74 F.R. 53652 (10/20/09).
479 “Events occurring after the date of a decedent's death shall be considered in determining whether and to what extent a deduction is allowable under section 2053.” Treas. Reg. § 20.2053-4(a)(2). Such post-death events that will be taken into account must occur prior to the expiration of the 3 year assessment period under Section 6501 or subsequent periods in determining the amount of any overpayment of estate tax due in connection with a claim for refund under Section 6511(a). Treas. Reg. § 20.2053-1(d)(2).
480 See e.g., Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929), Smith Est. v. Comm’r, 198 F.3d 515 (5th Cir. 1999), Jacobs v. Comm’r, 34 F.2d 233 (8th Cir. 1929), and Kyle Est. v. Comm’r, 94 T.C. 52 (1990).
a. Effective for estates of decedent’s dying on or after October 20, 2009, the Treasury Regulations provide that amounts are deductible if they are:
(1) bona fide claims that are personal obligations of the decedent existing at the death;
(2) that are enforceable against the decedent’s estate at the time of the payment; and
(3) that are actually paid by the estate in settlement of the claim (or are sufficiently ascertainable481 as described in the Treasury Regulations).482
4. Certain claims will be deductible although not yet paid “provided that the amount to be paid is ascertainable with reasonable certainty and will be paid.”483 As discussed below, a decedent’s obligation under certain financial derivatives at the date of death can often be ascertained because an active market will often exist to close out the position. However, it is not necessarily “reasonably certain”
that it will be paid because it is often based upon the price movement of an underlying stock price, index or interest rate.
5. The Treasury Regulations provide, “If a decedent has a recurring obligation to pay an enforceable and certain claim but the decedent's obligation is subject to a contingency… the amount of the claim is not ascertainable with reasonable certainty for purposes of the rule for deducting certain ascertainable amounts.” As such, “the amount deductible is limited to amounts actually paid by the estate in satisfaction of the claim.”484
6. The Treasury Regulations provide “if a decedent's gross estate includes a particular asset and there are one or more claims against the decedent's estate integrally related to that particular asset,”485 then the executor may deduct the “current value” of the claim if:
a. The claim is a personal obligation of the decedent;
b. The claim is enforceable when paid;
c. The value of the claim was determined by a qualified appraisal or qualified appraiser;
d. The value of such claim is subject to post-death events; and
e. The aggregate value of the claim or the assets exceeds 10% of the decedent’s gross estate (or the claim does not exceed $500,000).486
481 Treas. Reg. § 20.2053-1(d)(4).
482 Treas. Reg. § 20.2053-4(a).
483 Treas. Reg. § 20.2053-1(d)(4)(i).
484 Treas. Reg. § 20.2053-1(d)(6)(ii).
485 Treas. Reg. § 20.2053-1(d)(4)(b)(1).
486 Treas. Reg. §§ 20.2053-1(d)(4)(b) and (c).
7. The Treasury Regulations further provide that claims that “later mature” may be deducted in connection with a timely filed claim for refund, and estates can preserve their right to claim a refund by filing a protective claim.487 The IRS has recently issued guidance related to the filing of a protective claim for refund of estate tax.488
8. How and to what extent the 2009 final Treasury Regulations are applicable to the financial derivatives discussed below is unclear. However, they do seem to provide a significant avenue for executors who otherwise would struggle with how to report certain financial derivatives for estate tax purposes. It’s likely that executors will want to take advantage of these procedures. As such, executors should be prepared to close financial derivative positions of the decedent during the administration of the estate.
C. Futures and Forward Contracts
1. It is unclear how to report a futures (or forward) contract for estate tax purposes. As discussed above, a futures contract is a bilateral, executory contract where both the long and the short party have obligations and rights under the contract. As such, there are three possible ways that a futures or forward contract can be reflected on an estate tax return:
a. Report on Schedule F (Miscellaneous Property) of IRS Form 706 the gross value of the underlying property of the contract (the futures price on identical contracts traded on the date of death), and then report on Schedule K (Debts) the liability under the contract (for example, for the forward buyer (long party) the payment of the futures price under the decedent’s contract) as a deductible item (this method, hereinafter referred to as the “Gross Value Method”).
b. Report on Schedule F any net value inherent in the contract (difference between the futures price on the decedent’s contract and the futures price on identical contracts traded) on the date of death (this method, hereinafter referred to as the “Net Value Method”);
c. For exchange-traded futures contracts or actively-traded forward contracts, report on Schedule F, the publicly-traded value of the contract (the average between the highest and lowest quoted price on the date of death) (this method, hereinafter referred to as the “Exchange-Traded Method”).
2. Gross Value Method
a. The Gross Value Method is indirectly supported by Technical Advice Memorandum 8601007.489 The IRS concluded that for purposes of determining the income tax basis under Section 1014 of a commodity futures contract owned by a decedent on date of death, the basis is determined by the valuing the rights under the contract, rather than the net value.
b. The decedent in the ruling died holding regulated futures contracts to sell (short) and to buy (long) a particular commodity. These contracts were subsequently closed by the estate a month after date of death. The decedent’s estate included the net fair market value of the commodity contracts on the estate tax return.
487 Treas. Reg. §§ 20.2053-1(d)(5).
488 Rev. Proc. 2011-48, 2011-47 I.R.B. 527.
489 Tech. Adv. Mem. 8601007.
c. The ruling points out futures contracts create both obligations and rights to the holder. As such, “[T]he rights created by the Commodity Contracts are considered property interests that are includible in A's gross estate, while the corresponding obligations are considered liabilities that are reflected in the determination of A's taxable estate.” Thus, the ruling implies that the value of the rights created under the contract are correctly included as an asset of the gross estate with the obligations being reported as possibly deductible liabilities of the estate.
d. The ruling provides, “If a contract holder desires to terminate his obligation other than by taking or making delivery of the underlying commodity, he must enter into a closing transaction. In a closing transaction, the contract holder acquires an identical offsetting contract (e.g., a long contract offsets a short contract for the same commodity in the same delivery month) at the current price for such contract. The contract holder's rights and obligations under both contracts are then netted and cancelled by the Exchange clearing house. The difference between the prices stated in the contracts is either paid to, or collected from, the contract holder and represents his profit or loss with respect to the transaction.” The prices stated in the contract refer the futures prices for the commodity under both contracts.
e. In the case of the death of the holder of a futures contract, one would substitute the “price stated in the contract held by the decedent with the price at which identical contracts (i.e., identical as to quantity, quality and delivery month) were traded on the date of decedent's death.” In other words, the basis of the contract at death under Section 1014 (and presumably the amount includible for estate tax purposes under the Gross Value Method) would be the futures price on such traded identical contracts. That futures price would inherently take into account any gain or loss on the contract from inception to the date of death. For example, assume a forward buyer (long position) purchased a futures contract to buy 100 shares of IBM at $50 per share on September 1. The total futures price under the contract would be $5,000. Assume prior to September 1, the forward buyer dies, at a time when September contracts for IBM have a futures price of $5,300 (based upon subsequent appreciation in IBM). The basis and the amount includible for such contract would be $5,300. The obligation side of the contract ($5,000) would be reflected as a liability, thus netting out to $300 of additional value at the time of death. If however, IBM drops and the contract is closed with an offsetting contract with a futures price of $5,200, the estate would recognize a $100 long term capital loss.
f. The ruling concludes the gain or loss recognized by the decedent’s estate is “the difference between the prices at which identical contracts were traded on Exchange on the date of A's death and the prices stated in the offsetting contracts acquired for closing purposes.” There seems to be some confusion as to whether “prices at which identical contracts were traded” means the futures price of the commodity or the fair market value of the decedent’s contract.490 I believe the “prices at which identical contracts were traded” refers to the futures price of the commodity on such identical contracts.
3. Net Value Method
a. The Net Value Method is supported by the Fifth Circuit ruling in Commissioner v. Covington. 491 The IRS specifically referred to this case in Technical Advice Memorandum 8601007, but in the ruling chose an alternative method to the one described in the case.
490 See Sprechman, “Estate Administration with Sophisticated Investment Positions,” 43 Tax Mgmt. Memo. 483 (12/02/02) (author concludes that the estate essentially received a step-up in basis for the entire value of the contract, not just the asset component).
491 120 F.2d 768 (5th Cir. 1941), cert. denied, 315 U.S. 822 (1941).
b. The Covington case involved the issue of whether commodity futures trading losses were capital or ordinary in nature. In coming to the conclusion that the losses were capital in nature, the court illustrated that gain or loss that is realized on a regulated futures contract that is closed by offsetting is determined by taking the difference between the contract prices stated in the original contract and in the contract acquired for losing purposes. Thus, it is the “net” gain or loss that should be reflected.
c. In the IBM example, illustrating the Gross Value Method, the Covington ruling would stand for the proposition that the amount includible on the decedent’s death should be $300 (the net difference between the futures price of the decedent’s contract [$5,000] and the futures price of the identical contracts [$5,300].
4. Exchange-Traded Method
a. This method is based upon the assumption that if the futures contract in question is actively traded on an exchange or on the over the counter market, it should be valued based upon the selling price of such contract (having exactly the same terms) like a publicly-traded stock or bond.
b. The Treasury Regulations provide, “In general, if there is a market for stocks or bonds, on a stock exchange, in an over-the-counter market, or otherwise, the mean between the highest and lowest quoted selling prices on the valuation date is the fair market value per share or bond.”492
D. Options
1. Buyer Positions
a. If the decedent bought a call or put option, the value for estate tax purposes is the mean between the lowest and highest quoted price on the valuation date if the option is publicly traded.493
b. If the option is not listed, the value could be reflected as the value of the underlying property less the strike price.494
2. Seller Positions
a. If the decedent sold a call or put option, the premium received upon selling the option is already an asset in the estate of the decedent.
b. However, the decedent’s estate continues to have ongoing liabilities under the option contract to buy or sell the underlying property. Theoretically, the fair market value of the option, as listed on the exchange on date of death, is a liability that is a proper deduction from the gross estate under Section 2053. The amount of the liability would typically include more than the difference between the strike price under the option and the price of the underlying property (the “intrinsic value”) on the date of death because the value of the option would also reflect time value between date of death and the date of exercise. The value of the option should not depend on whether the decedent sold the option without owning the underlying property (“naked option”) or not. For example, if the decedent sold a call right on
492 Treas. Reg. § 20.2031-2(b).
493 Treas. Reg. § 20.2031-2(b).
494 See Rev. Rul. 196, 1953-2 C.B. 178.
XYZ stock and the decedent does not own any XYZ stock (a naked call), the potential liability is unlimited.
c. According to Technical Advice Memorandum 820417,495 no deduction under Section 2053 is allowable.
(1) During his lifetime, the decedent had sold (written) a number of listed put and call stock options. These were “naked” options because the decedent did not own any of the underlying shares that were the subject of the options. The estate claimed a deduction on Schedule K (Debts) of the estate tax return, as a liability, “what the cost of executing closing transactions on the date of the decedent's death, to eliminate the estate's potential obligations under all outstanding options, would have been.” The IRS took the position that the deduction was not allowable because the obligations were contingent.
(2) The seller of a put option will have the stock sold to him at the option price if the stock is selling below the strike price. The maximum loss that the seller of a put option can experience is the strike price (minus the premium already received). On the other hand, the seller of
“naked” call option can be required to buy the underlying stock if the call option is exercised because the holder of the call option has the right to buy the stock from the seller at the strike price. Because the holder of the call option will only exercise the option if the stock is selling above the strike price, and because a stock can theoretically appreciate infinitely above the strike price, the seller of a “naked” call option has the potential experience unlimited loss.
(3) At the time of death, the price of the underlying stock can be determined, so the then current loss or profit is determinable. Also, it can be determined what the cost would be to close out the positions by, in the case at hand, buying a call option and put option on the same stock.
However, what happens to the underlying stock after the date of death and prior to expiration cannot be determined, and it cannot be determined whether and when the options will be exercised by the holder of the options.
(4) In concluding that the obligations were not deductible, the ruling provides
“a contingent claim where the contingency makes it uncertain whether the decedent's estate will ever be called upon to pay the claim cannot be deducted.” As such, the “no deduction is allowable on the estate tax return for the cost of executing closing transactions to eliminate uncertain contingent obligations of the estate.”
d. It would seem that if the 2009 Treasury Regulations, as discussed above, had been issued at the time of this ruling, the estate would have been able to claim a deduction under Section 2053.
e. It has been suggested, notwithstanding the foregoing ruling, one alternative method of valuing the contract of the seller unexpired options is to net the premium and the option value at date of death, similar to the Net Value Method discussed above for futures and forward contracts.
E. Short Sales
1. As discussed above, in a short sale, after the borrowed stock is sold, the investor will eventually be required to buy the stock (hopefully at a lower cost than it was originally sold) in order to
495 Tech. Adv. Mem. 820417.
close out the transaction. On the date of death, if a short sale is still outstanding, the value of the underlying stock can be determined and at such time, it will constitute an asset or liability.
2. If an investor dies with an unrealized gain on a short sale (the underlying stock is trading at a price lower than originally sold), the estate could, in theory, simply report the unrealized gain on the short sale (netting the short sale proceeds against the current value of the stock), similar to the Net Value Method discussed above for futures and forward contracts. On the other hand, the estate could report the unrealized gain as an asset (cash proceeds from the original sale of the stock) and a current liability determined by the price of the stock on the date of death. It is unclear, as discussed, whether
3. Suppose an investor who entered into a short sale dies with an unrealized gain. How should the gain be reported? There appear to be at least two possible solutions. The estate tax return could net the “asset,” and the “liability,” and report net unrealized gain from short sales. Alternatively, the cash
“proceeds” could be regarded as an asset, and a deduction taken for the liability to pay, determined by the price of the stock on the valuation date.
F. Swaps or Notional Principal Contracts
1. Similar to futures and forward contracts, swaps or notional principal contracts are bilateral, executory contracts where both parties have obligations to make payments based on the value of the underlying hypothetical investment. For example, the short party on a traditional equity swap is obligated to pay the long party any appreciation and dividends on the underlying stock. The long party is obligated to pay the short party any depreciation and interest.
2. The same reporting issues that arise with futures contracts and options discussed above apply, in theory, to swap positions held by the decedent on the date of death.
G. ETFs and ETNs
1. Although most ETFs are taxed as RICs for income tax purposes, the value for estate tax purposes is not the “public redemption price,”496 as it would be for mutual funds held by a decedent.
As discussed previously, individual ETF investors are not Authorized Participants, and as such, they do
As discussed previously, individual ETF investors are not Authorized Participants, and as such, they do