Tax Benefit Rule Does Not Apply to Transfers at Death

If a sole proprietor is able to deduct an expense he incurred in the year he died for property that was not used up in the year he died, must his estate then report the amount as income in the following year for the amount of taxes saved by the deduction in the prior year? This question is answered by considering the tax benefit rule. The court addressed this for the first time in Estate of Backemeyer,147 T.C. 17, concluding that the tax benefit rule does not apply to transfers at death.

Estate of Backemeyer

In Estate of Backemeyer, the husband purchased farm inputs (supplies) and died in year 1 and his surviving wife, who had inherited the farm inputs, used the farm inputs in operating the farm in year 3.

The IRS agreed that the tax benefit rule did not apply to the surviving wife’s farming activity. That was not in dispute.

Instead, the IRS argued that the husband’s estate had to include income in Year 3 in the amount of the tax benefit he received from his prior deduction for the farm inputs, due to the tax benefit rule.

About the Tax Benefit Rule

The tax benefit rule requires an amount be included in income in the current year in the amount of the tax benefit the taxpayer received in a prior year, if the assumptions underlying the deduction in the prior year turn out to be false.

For example, if a sole proprietor deducts the costs of supplies in year 1 and then uses the supplies personally in year 2, he must include an amount in income in year 2 equal to the tax benefit from year 1. This is required because the assumption in year 1 that the item would be used in a business, rather than the item being used personally, turned out not to be true in year 2. Without this rule, taxpayers would be able to deduct the same expense in year 1 and then again in year 2. This would create an impermissible double deduction.

The tax benefit rule is summarized using a four-part test. This test says that:

an amount must be included in gross income in the current year if, and to the extent that: (1) The amount was deducted in a year prior to the current year, (2) the deduction resulted in a tax benefit, (3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and (4) a nonrecognition provision of the Internal Revenue Code does not prevent the inclusion in gross income.

Death is Not Inconsistent With the Deduction

In Estate of Backemeyer, the question was whether there was an event that was inconsistent with the deduction. The taxpayer argued that there was no event that was fundamentally inconsistent with the premises on which the deduction was originally based. The court agreed with the taxpayer.

It distinguished the leading court case on point in which the tax benefit rule was applied to a corporation that was liquidated, nothing that the:

liquidation of a corporation or a sale of expensed business inputs entails some level of forethought and affirmative intent to act accordingly, death ordinarily does not involve such planning. As the Court of Appeals for the Eighth Circuit has observed, while death may be beneficial for tax purposes, it is difficult to regard it as a tax avoidance scheme.

Based on this, the court concluded that a transfer at death is not “fundamentally inconsistent with the premise” on which the business deduction is initially based. So the tax benefit rule does not apply to transfers at death.

Taxpayers who have had the IRS raise this issue on audit should contact a tax advisor to discuss this case and what it means for them.

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