Here is a scenario I recently came across. Married clients each of whom had Traditional IRA’s with some Form 8606 basis in them. The husband passed away last November and going into 2008 still had about $20,000 in basis in his IRA. Prior to his death we had taken about $32,000 in 1099-R distributions. Before the end of the year we consolidated his IRA with his surviving spouse’s IRA since she was the sole primary beneficiary. Since the husband’s IRA was zero at year-end this really threw the CPA for a loop when it came for how to enter the Form 8606 data into her tax prep software. My guess is that technically only a proportionate amount of the $20,000 in basis should have been used to offset the $32,000 in distributions since the balance wasn’t fully liquidated in the truest sense – rather it was just transferred. However, the CPA seemed ok with exhausting all of the remaining 8606 basis for the deceased husband since a) we had more than that in distributions and b) his Form 5498 balance at year-end showed zero (actually about $1,000 in residual interest). This effectively diluted 8606 basis calculation on the surviving spouses IRA but the basis and FMV of her IRA were both relatively small by comparison prior to the consolidation.

Did this CPA account for things in a reasonable manner? The client seemed ok with it but I was under the impression that inherited IRA basis flows proportionately with where the assets go. However, in practice this seems tough to implement on Form 8606. If the CPA made a mistake what should I be aware of with regards to how it should have been reported should the IRS question anything down the road?