Tax Issues Associated With Options In Wills and Trusts

Overview

As part of an estate plan, an heir may be given an option to buy certain assets of the decedent at a specified price.  In agricultural estates, such an option is typically associated with farmland of the decedent, and often gives the optionee (the person named in the will with the right to exercise the option) a very good deal for the property upon exercise of the option. 

Often the question arises as to the basis of the property in the hands of the optionee when the option is exercised and the resulting tax consequences when the property is later sold. 

Tax issues associated with the exercise of an option – it’s the topic of today’s post.

Options – The Basics

There is no question that an option can be included in a will.  A testator has the right to dispose of their property as desired.  The only significant limitation on testamentary freedom involves the inability to completely disinherit a spouse.  Even if the will leaves nothing for the surviving spouse, under state law the surviving spouse has a right to an elective share entitling the surviving spouse to “elect” to take a portion of the estate regardless of what the deceased spouse’s will says (except, of course, if a valid prenuptial agreement was executed).   Under most state laws, a surviving spouse’s elective share comprises anywhere from between one-third to one-half of the decedent’s estate.  In addition, in some states, the spousal elective share can include retirement assets or life insurance. 

Tax Issues

What are the tax consequences when an optionee exercises an option?  Does the exercise result in tax consequences to the decedent’s estate?  What are the tax consequences if the optionee later sells the property that was acquired by the exercise of the option? 

Decedent’s estate.  The exercise of an option results in no tax consequence to the decedent’s estate.   The exercise of the option, followed by the sale of the property by the estate to the holder of the option does not result in gain or loss to the estate.   In Priv. Ltr. Rul. 8210074, Dec. 10, 1981, the decedent's son was given an option under the terms of the parent’s will to purchase some of the parent’s farmland at $350/acre. The son exercised the option and paid the estate $26,668 for the land. At the time the option was exercised, the farmland was worth $114,293 (as valued on the parent’s estate tax return). The IRS determined that the combined basis of the option and the real estate subject to the option was $114,293 with $26,668 of that allocable to the land. Thus, when the real estate was sold to the son for $26,668, it equaled the basis in the land in the hands of the estate resulting in neither gain nor loss to the estate.

Optionee’s basis. 

When the optionee exercises the option in a will or trust, the primary question is what the income tax basis of the property received under the option is in the optionee’s hands.  I.R.C. §1014 is the applicable basis provision for property acquired from a decedent.  The provision states in pertinent part, “(a)In general Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be— (1) the fair market value of the property at the date of the decedent’s death,… (b)Property acquired from the decedent For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent….

This ‘”stepped-up” basis rule applies to property required to be included in the decedent’s gross estate, including property that is subject to an option in a will (or trust) that grants the beneficiary an option to purchase the property at a beneficial price from the estate.  The option is treated as property acquired from the decedent and receives an income tax basis equal to its fair market value as of the date of the decedent’s death.  Its basis is the estate tax value of the property subject to the option less the price the beneficiary must pay to exercise the option.  A beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the optionee’s basis in the property. 

In Cadby v. Comr., 24 T.C. 899 (1955), acq., 1956-2 C.B. 5, the decedent died in 1942.  His will included a provision directing the executor and trustee to sell some of the decedent’s stock to a family member and another person for $25,000 upon proof that the family member had purchased from the decedent’s surviving spouse preferred stock in the same company for $6,000 if payment were made within two years of the decedent’s death.  If payment wasn’t made within the specified timeframe, disposition of the stock was left to the discretion of the executor and trustee. Shortly after the decedent’s death, the family member sold his rights under the will to a third party for $13,000.

In determining the tax consequence of the transaction to the family member, the Tax Court noted that the fair market value of the decedent’s stock interest subject to the option was $55,243 as of the date of death as denoted on the decedent’s federal estate tax return.  In addition, the family member paid $6,000 for the stock he purchased from the decedent’s surviving spouse.  Thus, the family member’s income tax basis in the stock was $61,243.40.  From that amount, the Tax Court subtracted the option price of $25,000 and the payment to the surviving spouse of $6,000.  The result, $30,243.40, was the option price.  Because the family member held a one-half interest in the option, that one-half interest was worth $15,121.70.  Thus, the sale for $13,000 did not trigger any taxable income to the family member. 

IRS Position

Twelve years after the Tax Court’s ruling in Cadby, the IRS issued a Revenue Ruling formally stating its position that a beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the beneficiary’s basis in the property.  Rev. Rul. 67-96, 1967-1 C.B. 195.  In 2003, the IRS issued a private letter ruling again confirming the Tax Court’s approach in Cadby.  Priv. Ltr. Rul. 200340019 (Jun. 25, 2003).  Under the facts of the ruling, under the terms of Mother's will, the taxpayer was given the right to purchase the Mother’s home upon the Mother’s death at an amount less than fair market value.  The basis in the option and in the home upon exercise of the option was determined in accordance with Rev. Rul. 67-96.  Thus, the basis in the option upon its exercise was measured by the difference between the value of the home for federal estate tax purposes and the option price.  In addition, as a result of exercising the option, the taxpayer’s basis in the home was the sum of the basis of the option and the actual option price paid. 

Conclusion

Options can play an important role in transitioning a farming or ranching business to the next generation.  Not only must thought be given to the financial ability of the optionee to exercise the option, the income tax issues triggered upon exercise of the option and, when applicable, the subsequent sale of the property acquired by exercising the option must also be considered.