I Owe the IRS $4,000 from a Schedule D / Capital Dividend. Why?

January, 23 2023 by Carolyn Richardson, EA, MBA

I just received a letter from IRS for my 2020 tax return that says I now owe over 4 grand due to a schedule d/capital dividend for over 8 grand. I was given a check for 10,000 in 2020 from my grandfather's will. I don't understand where the 8,000 amount comes from or why I have to pay it if inheritance is free.

-Kristen, MI



Hello Kristen,

Thank you for your question regarding why the IRS is taxing you on money you inherited from your grandfather. You stated that the IRS is billing you for $4,000 due to a capital gain or dividend of over $8,000. You are confused because you don’t understand where the $8,000 came from and believe it should be tax free since it is inherited.

While we don’t have enough information from your question to determine exactly why the IRS thinks this capital gain is taxable, given that you specified that it was from a capital gain, there are a couple of likely possibilities that we can think of which would result in a taxable gain to you. And yes, while many inheritances are nontaxable, this generally only applies to cash received through inheritance and the fair market value of any assets you may inherit. Those can be transferred to you without paying any tax on your increase in net wealth. But any income earned from that cash or assets, once it is distributed to you as a beneficiary, is taxable income.

Generally, you would only have a capital gain or dividend if there were property and/or stocks involved. For the sake of simplicity, we’re going to assume that this capital gain or dividend was generated by stock that your grandfather owned, rather than some other type of property. Using this assumption, there may be a couple of reasons you have a taxable gain. The $10,000 check you received from the estate is a nontaxable distribution from the estate, so that is not reported on your return and it’s the reason why the IRS notice is not referring to it.

First, did you inherit any stock from your grandfather that generated this capital gain or dividend? While inheriting the stock itself is not a taxable event, any income generated by that stock, such as dividend or capital gain distributions, would be taxable to you since it is now your stock. Essentially, the stock is given to you by your grandfather’s estate, and it now belongs to you just as it would if you had purchased the stock yourself. If you inherited that stock and then sold the stock, the sale would be treated as a long-term capital gain or loss and reported on your own tax return on Schedule D, “Capital Gains and Losses” or Form 8949, “Sales and Other Dispositions of Capital Assets.” When computing the gain or loss from the sale of inherited stock, you are allowed to revalue the stock’s cost basis to the fair market value as of the date of your grandfather’s death. There are certain instances where the fair market value might be different from the date your grandfather passed away. The administrator of your grandfather’s estate should be able to tell you the cost basis of the stock or other kind of asset you inherited. If you sell the stock shortly after that, the gain or loss would generally be fairly small, depending on the market fluctuations of the stock price. Generally, when inherited assets, like stock, are sold, the gain or loss is treated as long-term. This is true even if you only had possession of the stock or other property for a day or two. For federal tax purposes, assets that are held long-term have more favorable capital gains tax rates.

That being said, the IRS may not be aware that the stock was inherited and has a higher cost basis. In situations such as these, the brokerage who sold the stock for you may have reported the sale to the IRS without the accompanying cost basis information (this is sometimes referred to as a stock transaction that is not “covered”). If this is the case, the IRS does not know the cost basis and will assess tax based only on the sale price of the stock, assuming $0 as the stock’s cost basis. For example, if you inherited stock from your grandfather that was worth $20,000 on the date he passed away, and you sell the stock a month later for $21,000, your taxable gain is $1,000 and will be subject to long-term capital gain rates. But if it is not reported on the return and the IRS does an income match later on, all they see is a sale for $21,000, and they will assess the tax due based on a gain of $21,000 (the sale price less a cost basis of $0).

The second scenario would be that your grandfather’s estate sold the stock and reported the gain on the sale of the stock to the IRS. Generally, any income earned by the estate before all the assets are distributed to the beneficiaries would be taxable to either the estate or possibly to the beneficiaries. If the income is earned by the estate and distributed to the beneficiaries, the estate would report the income to the beneficiary and the IRS via a Schedule K-1. The Schedule K-1 is an income reporting form that is generated by the estate and issued to the beneficiary, showing their share of the estate’s income, if any. The income itself retains the same character as it would if the income was reported and taxed to the estate. So, if the administrator of the estate sold stock that was owned by the decedent, any gain on the sale would be taxable as long-term capital gain income on the estate return. However, if the income from the sale of stock was distributed to the beneficiary before it was taxed at the estate tax level, then the income would be reported on Schedule K-1 and included as income on the beneficiary’s personal tax return.

Regardless of which of these things may have happened (or if something else happened), the amount of tax being assessed sounds extraordinarily high. Since most capital gain income received as a beneficiary is treated as long-term and receives favorable tax treatment, the tax rate should be limited to around 20%, based on your other income, and not 50%, as stated in your question.

If none of these scenarios sounds familiar to you, you should check with the executor of your grandfather’s estate to verify everything that was reported to the IRS by the estate and its tax treatment. If that person is not available to answer your questions, you may want to seek the advice of a tax professional. If you are already a member of TaxAudit, you can call our toll-free number at 800-922-8348 to report your notice, and we will review the notice to determine if it is correct. We would recommend gathering all the documents you have related to the estate and anything you received from the estate regarding income or distributions, plus a copy of the IRS notice, to provide to anyone you consult with.

While we are unsure if this response will actually answer your question regarding your IRS letter, we hope it gives you some leads on determining if it is correct.

Sincerely,
Carolyn Richardson, EA, MBA