REV-RUL, Basis of property acquired from a decedent., Rev. Rul. 67-96, 1967-1 CB 195, (Jan. 01, 1967)
Rev. Rul. 67-96, 1967-1 CB 195

SECTION 1014.--BASIS OF PROPERTY ACQUIRED FROM A DECEDENT

26 CFR 1.1014-1:  Basis of property acquired from a decedent.
(Also Section 1234; 1.1234-1.)
The unadjusted basis of property acquired by an individual from a decedent’s estate through exercise of an option, provided for in the will of the decedent, to purchase the property at an amount below its fair market value, is the sum of (1) the basis of the option under section 1014(a) of the Internal Revenue Code of 1954, plus (2) the option price.  The provisions of section 1234 of the Code which allow a loss on the failure to exercise an option are not applicable on nonexercise of a testmentary option.

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Advice has been requested regarding the proper basis of certain shares of corporate stork acquired by an individual through exercise of an option to purchase the shares from his father’s estate for an amount far below the fair market value of the shares.  The option was created under the will of his father and bequeathed to him.

Section 1014(a) of the Internal Revenue Code of 1954 provides a general rule that 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 the fair market value of the property at the date of the decedent’s death, or, in the case of an election under either section 2032 of the 1954 Code or section 811(j) of the 1939 Code where the decedent died after October 21, 1942, its value at the applicable valuation date prescribed by those sections.

Because the option was not an item of property held by the decedent at the time of his death the question arose whether it could acquire a basis under the provisions of section 1014(a) of the Code.  Also, in view of certain language in Helvering v. San Joaquin Fruit & Investment Co., 297 U.S. 496 (1936), Ct. D. 1098, C.B. XV-1, 196 (1936), it was asked whether the basis of the option could be added to the option price to establish the basis of the property purchased on exercise of the option.

With regard to the first question, it appears that a valuable option created by will does have a basis in the hands of the optionee.  In the case of W. Winnie Cadby v. Commissioner, 24 T.C. 899, (1955), acquiescence C.B. 1956-1, 3, the Tax Court of the United States made its position clear in regard to the basis of testamentary options.  The case involved the sale of an option created by the will of the taxpayer’s father and left to him.  The court stated that the option was property which had value and it “acquired a basis by virtue of its transmission by inheritance” equal to “its fair market value at the date of death.”

Compare Helen S. Delone v. Commissioner, 6 T.C. 1188 (1946), where the decedent bequeathed 2,544 shares of stock to his wife, subject to an option granted in the will to three key employees to purchase the stock from the wife at a price of $100 per share.  The stock had been included in the decedent’s estate for Federal estate tax purposes at a value of $125 per share and the wife claimed this amount as her basis for the stock.  The Tax Court recognized “that the option constituted a valuable, though contingent and personal, bequest to the 3 individuals” and concluded that the wife was only entitled to a basis of $100 per share since the valuation for Federal estate tax was of unencumbered stock.

See also United States v. C. M. Land, 303 F.2d 170 (1962), certiorari denied, 371 U.S. 862, in which the U.S. Court of Appeals for the Fifth Circuit in discussing the effect of a testamentary option upon the value of property includible in the gross estate, stated that “such a case does not present a problem of changing value; the interest simply is split and passes to different persons, but its total value is unaltered, and that is the value included in the estate.”

In view of the foregoing, the testamentary option in the subject case is treated as having a basis computed under the provisions of section 1014(a) of the Code.  However, if the option had been allowed to lapse, it would have been considered to have been disclaimed or renounced and, therefore, the loss provisions of section 1234 of the Code would not be applicable.

With regard to whether the basis of an option created in a will can be added to the option price to establish the basis of the property purchase on exercise of the option, it is the position of the Internal Revenue Service that those cases, such as J. Gordon Mack v. Commissioner, 148 F. 2d 62 (3d Cir. 1945), which rely on the San Joaquin case for the proposition that the basis of a testamentary option cannot be added to the option price to establish the basis of the stock acquired through exercise of the option, involved a misplaced reliance on San Joaquin for this proposition.  See John J. Kalbac v. Commissioner, 298 F.2d 251 at 254 (8th Cir. 1962).

The San Joaquin case involved an option granted in a 10-year 1906 lease to buy the leased property at the termination of the lease.  The option was exercised November 30, 1916.  No will was involved, and it does not appear that any separate consideration was paid for the option.  Portions of the property were later sold giving rise to the basis question.  The case involved an interpretation of section 204 of the Revenue Act of 1924, and corresponding sections of the Revenue Acts of 1921, 1926, and 1928.  That section provides, generally, that the basis of property “acquired” after February 28, 1913, shall be its cost.  It also provides that if property was acquired before March 1, 1913, its basis shall be its cost or the fair market value of the property on March 1, 1913, whichever is greater.  The taxpayer contended that the property was acquired in 1906 and that, therefore, under this statute, basis of the property would be its fair market value on March 1, 1913.  The bulk of the Supreme Court’s opinion is devoted to denying this contention of the taxpayer.

The alternate contention of the taxpayer company in San Joaquin was that “the exercise of the option to purchase in 1916 operated to convert capital assets consisting of a vested property right, a valuable option and purchase money, into a fee simple title, a taxable transaction giving rise to a new basis, namely, the value of the land and trees on the date the option was exercised.”  San Joaquin Fruit & Investment Co., 28 B.T.A. 395, at 400.  It was the company’s position, based on Marr v. United States, 268 U.S. 536 (1925), T.D. 3755, C.B. IV-2, 116 (1925), that if the land was not acquired in 1906, then it was acquired in 1916 when the option was exercised.  The company contended that at the time there was a taxable conversion of assets resulting in gain and, although the gain was not taxed and the year was barred by the statute of limitations, since the transaction had been taxable in 1916, the basis of the new asset acquired in 1916 was its fair market value at the time.  It does not appear that the taxpayer made any other contention before the Supreme Court.

The Supreme Court devoted a short paragraph at the end of its opinion to the contention that the exercise of the option was a taxable exchange and refused to accept it.  The Supreme Court stated:

An alternative contention is that the exercise of the option and the conveyance on November 30, 1916, constituted merely an exchange of capital assets--a closed transaction--and the basis for calculation of gain was the value of the land and improvements at that date.  The capital asset, sale of which resulted in taxable gain, was the land.  This was not an asset of the taxpayer prior to the exercise of the opinion.  We think it clear that there was no combination of two capital assets--the option and $200,000 of cash, to form a new capital asset, the land, which was subsequently sold at a profit.

This language caused the Court of Appeals in the Mack case, supra, to conclude that the basis of a testamentary option could not be added to the option price to determine the basis of property acquired on exercise of the option.  However, it should be noted that it has long been recognized that the cost of a purchased option is added to the option price to establish the basis of the property acquired through exercise of the option.  Realty Sales Co., 10 B.T.A. 1217 (1928) acquiescense, C.B. VII-2, 33 (1928); C. H. Mead Coal Co., 72 F. 2d 22 (4th Cir. 1934); Commissioner v. Cummings, 77 F. 2d 670, at 673 (5th Cir. 1935); G.C.M. 7246, C.B. VIII-2, 80 (1929); Rev. Rul. 58-234, C.B. 1958-1,279.

Since the first contention of the taxpayer in San Joaquin was that the property was acquired when the lease containing the option was made, and the alternate contention was that exercise of the option and the conveyance on November 30, 1916, resulted in a closed transaction and that the basis for calculation of gain was the value of the land and improvements at that date, the Supreme Court, did not decide the issue of whether the basis of property acquired by exercise of a testamentary option would be determined by adding the basis of the option to the option price, nor did it even have such question before it.

In view of the foregoing, the decision in the San Joaquin case, does not stand for the principle attributed to it by the Mack case.  Accordingly, the Service will not follow the decision in J. Gordon Mack v. Commissioner.  Therefore, the basis of a testamentary option may be added to the option price in determining the basis of the property acquired upon exercise of the option.