SEPARATE SHARE RULES AND SECTION 645 ELECTING TRUSTS
By
W. Birch Douglass, III
McGuireWoods LLP
Richmond, Virginia
September 2001
I.
INTRODUCTION ...................................................................................................... 1
A.
B.
C.
D.
II.
Revocable Trusts as Will Substitutes...................................................................... 1
Overview of Separate Share Rules. ........................................................................ 2
Summary of Election to Treat QRTs as Part of Estate. .......................................... 2
Impact of 2001 Act. ................................................................................................ 4
STATUTORY PROVISIONS AND STATUS OF REGULATIONS ....................... 4
A.
B.
C.
D.
Section 663(c). ........................................................................................................ 4
Final Regulations under Section 663. ..................................................................... 5
Section 645.............................................................................................................. 5
Proposed Regulations under Section 645. .............................................................. 6
III. SECTION 663 FINAL REGULATIONS ................................................................... 7
A.
B.
C.
D.
E.
F.
G.
Definition of Separate Shares. ................................................................................ 7
Creation, Valuation, and Allocation. ...................................................................... 8
Spouse's Elective Share. ......................................................................................... 9
Qualified Revocable Trusts ("QRTs"). ................................................................... 9
Pecuniary Formula Bequests................................................................................... 9
Income in Respect of a Decedent.......................................................................... 10
Effective Date Rules. ............................................................................................ 10
IV. SECTION 645 PROPOSED REGULATIONS ........................................................ 10
A.
B.
C.
D.
E.
F.
G.
H.
V.
The Election. ......................................................................................................... 10
Definition of a QRT. ............................................................................................. 10
Required Written Statement. ................................................................................. 11
Tax Identification Numbers ("TINs") and Forms 1041. ....................................... 12
Application of the Separate Share Rule. ............................................................... 13
Duration of the Election. ....................................................................................... 13
Treatment on Termination of the Election. ........................................................... 14
Effective Date Rules. ............................................................................................ 14
SUBCHAPTER J SEPARATE SHARE RULE IN OPERATION .......................... 14
A.
Basic Rules............................................................................................................ 14
i
B.
C.
D.
E.
F.
G.
Typical Applications. ............................................................................................ 15
Marital Deduction Planning. ................................................................................. 19
Disclaimers. .......................................................................................................... 23
Generation-Skipping Planning. ............................................................................. 24
S Corporations. ..................................................................................................... 24
Effect of Rate Compression. ................................................................................. 26
VI. DISCUSSION OF SECTION 645 AND ITS APPLICATION ................................ 27
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
K.
L.
VII.
A.
B.
C.
D.
E.
F.
G.
H.
I.
Definition of a Qualified Revocable Trust ("QRT"). ............................................ 27
Duration of Election Period. ................................................................................. 30
Effect of Election .................................................................................................. 32
Use of Fiscal Year Other than Calendar Year. ..................................................... 34
Distributable Net Income ("DNI"). ....................................................................... 34
Charitable Set-Aside Deduction. .......................................................................... 36
S Corporation Election. ......................................................................................... 36
Passive Loss Active Participation Rules. .............................................................. 38
GST Separate Share Rule...................................................................................... 38
Other Special Situations, Advantages, and Disadvantages.. ................................. 39
Filing of Returns. .................................................................................................. 40
Absence of Estate. ................................................................................................. 42
MAKING THE SECTION 645 ELECTION DECISION .................................... 42
Factors to Consider. .............................................................................................. 42
Tax Considerations. .............................................................................................. 43
Effect on Beneficiaries. ......................................................................................... 44
Practical Aspects. .................................................................................................. 44
Guidelines if No Probate Estate. ........................................................................... 45
Guidelines for Partially Funded QRT with Complete Pour Over. ........................ 46
Guidelines if Not a Complete Pour Over. ............................................................. 46
Taking Full Advantage of the Election Period. .................................................... 48
Administration of Entities Following Termination of Election. ........................... 48
ii
SEPARATE SHARE RULES AND SECTION 645 ELECTING TRUSTS
By
W. Birch Douglass, III
McGuireWoods LLP
Richmond, Virginia
I.
INTRODUCTION
A.
Revocable Trusts as Will Substitutes.
1.
The Taxpayer Relief Act of 1997, P.L. 105-34 (the "1997 Act")
made certain changes that increase the attractiveness of funded
revocable trusts as will substitutes. These changes are found in
sections 645 and 663 of the Internal Revenue Code of 1986, as
amended (the "Code") [Hereafter, references to a "section" means
a section of the Code or regulations thereunder, as the case may
be.]
2.
Among their many advantages, revocable trusts are popular as
testamentary substitutes in place of wills as a means of avoiding or
minimizing probate, particularly in jurisdictions with burdensome
probate costs and procedures. In addition, during lifetime such
trusts provide a convenient vehicle to manage a person's assets
and, in the event of incapacity, a less expensive alternative to a
guardianship or conservatorship.
3.
Estates and formerly revocable trusts (sometimes referred to as
"postmortem trusts" but called "QRTs" in the proposed regulations
under section 645) have historically been treated as separate
taxable entities, subject to slightly different income tax treatment.
The election to treat the two as a combined entity under section
645 narrows these differences.
4.
The Code treats the separate and independent shares of different
beneficiaries as separate shares for purposes of calculating
distributable net income ("DNI") and for certain other, but not all,
purposes.
5.
Most revocable trusts are silent regarding the handling of an
"administrative" trust following the grantor's death and until the
trust is divided and any subtrusts are funded. The IRS has
provided no specific guidance in this matter. Most trustees treat
the undivided trust as a complex trust and defer accounting for the
separate interests or subtrusts until funding actually begins, after
which compensating distributions, allocations, and adjustments
1
may be made as appropriate to reflect the situation that would have
resulted had the trust actually been divided, and the subtrusts
funded, as of the grantor's death in accordance with the terms of
the trust instrument.
B.
Overview of Separate Share Rules.
1.
C.
There are three separate share rules to be aware of in administering
trusts and estates.
a.
The subchapter J rule.
b.
The subchapter S rule.
c.
The GST rule.
2.
The subchapter J separate share rule found in section 663(c)
requires that the separate and independent shares of different
beneficiaries in the same estate or trust be treated as separate
shares or trusts in determining the DNI allocable to the respective
beneficiaries.
3.
The subchapter S separate share rule found in section 1361(d)(3)
provides that separate shares are treated as separate trusts for
purposes of determining permitted S corporation shareholders.
4.
The GST rule found in section 2654(b)(2) applies the same
separate share concepts in identifying trusts for generationskipping transfer tax purposes.
5.
Until the 1997 Act, the section 663(c) separate share rule applied
only to trusts and not to estates. This allowed personal
representatives to time distributions in such a manner as to carry
out DNI in the most favorable way to the estate and its
beneficiaries. It also meant that one beneficiary or class of
beneficiaries could be taxed on income payable to, or accruing to,
a separate beneficiary or class of beneficiaries.
6.
The 1997 Act imposes the separate share rule of section 663(c) on
estates of decedents, thereby minimizing the planning
opportunities through the use of a probate estate instead of a
postmortem trust.
Summary of Election to Treat QRTs as Part of Estate.
1.
Before the 1997 Act, the lifetime advantages of revocable trusts
frequently were offset by the disadvantages of certain income tax
2
rules applicable to such trusts following the grantor’s death as
compared to those applicable to probate estates.
2.
The 1997 Act eliminated many, but not all, of the previous
disparities in the income tax rules between postmortem trusts and
estates. In acknowledgment of the fact that revocable trusts are
used as testamentary substitutes for nontax reasons, Congress
significantly reduced the differences in the income tax treatment
between the two types of postmortem entities by permitting an
election to treat trusts that were revocable by a decedent during life
as a part of the decedent’s estate for income tax purposes.
3.
No separate share rule exists for purposes of section 645. This
means the entire QRT (and not simply one or more separate shares
of the QRT) will be subject to the election.
4.
If the decision is made not to make the election in spite of the
income tax benefits (because of anticipated administrative
difficulties, for instance), the reasons for that decision should be
documented in the fiduciaries' files.
5.
From the drafting perspective, the practitioner should consider
whether a general authorization to make postmortem elections will
suffice, or whether it is appropriate to add to the will and trust
specific authority for the fiduciaries of both to make the section
645 election. The practitioner should also consider whether such
authority should be conditioned upon agreements between the
fiduciaries regarding equitable adjustments and the allocation of
the tax liability. Similarly, one should consider whether specific
exculpatory language should be added to exonerate the fiduciaries
from liability for the consequences of making, or not making, the
section 645 election.
6.
Most of the questions, both substantive and procedural, raised in
this outline would not arise if the election were for treatment of the
QRT as an estate rather than for treatment as part of an estate.
There seems to have been no tax policy reason to have conditioned
the substantive income tax treatment of a postmortem trust, or the
procedural requirements for such treatment, on the existence or the
dispositive terms of a concurrent estate. Concerns about “multiple
trust abuse” could easily be addressed by requiring all electing
trusts to share one personal exemption and one set of tax brackets,
and by allocating dollar amounts (such as the section 469(i)(2)
passive activity loss deduction limitation) to each such trust
proportionately. As currently enacted, the section 645 election
effectively requires a merger with any existing estate for income
tax purposes, with the resulting uncertainties noted below.
3
D.
II.
Impact of 2001 Act.
1.
The many uncertainties in, and possible future of, The Economic
Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16
(the "2001 Act"), will raise additional complexities in determining
how to fund separate shares (for example, because of carryover
basis) and whether to make the section 645 election (for example,
because the gross estate is below the filing level).
2.
The "cover all contingencies" and formula drafting that will be
used by some lawyers may make it difficult to determine the
existence of separate shares.
3.
If interim planning involves the use of disclaimer provisions, the
personal representative and trustee may not know until the end of
the nine months what dispositve scheme will be in place. This
makes postmortem planning more difficult.
4.
For QRTs that otherwise would have to file returns or pay
estimated income taxes before the expiration of the disclaimer
period, the section 645 election may be beneficial if for no other
reason than to give the fiduciaries more time to engage in
postmortem planning.
5.
In some situations where disclaimers will be part of the
postmortem planning, a section 645 election may cause
unnecessary complexity.
STATUTORY PROVISIONS AND STATUS OF REGULATIONS
A.
Section 663(c).
1.
The following new sentence was added to section 663(c) by the
1997 Act:
Rules similar to the rules of the preceding provisions of this
subsection shall apply to treat substantially separate and
independent shares of different beneficiaries in an estate
having more than 1 beneficiary as separate estates.
2.
The General Explanation says the following concerning the
reasons for the change:
The Congress understood that estates typically do not have
separate shares. Nonetheless, where separate shares do
exist in an estate, the inapplicability of the separate share
rule to estates may result in one beneficiary or class of
beneficiaries being taxed on income payable to, or
4
accruing to, a separate beneficiary or class of
beneficiaries. Accordingly, the Congress believed that a
more equitable taxation of an estate and its beneficiaries
would be achieved with the application of the separate
share rule to an estate where, under the provisions of the
decedent's will or applicable local law, there are separate
shares in the estate.
3.
In describing the provision, the General Explanation states:
The Act extends the application of the separate share rule
to estates. There are separate shares in an estate when the
governing instrument of the estate (e.g., the will and
applicable local law) creates separate economic interests
in one beneficiary or class of beneficiaries such that the
economic interests of those beneficiaries (e.g., rights to
income or gains from specified items of property) are not
affected by economic interests accruing to another separate
beneficiary or class of beneficiaries. For example, a
separate share in an estate would exist where the
decedent's will provides that all of the shares of a closelyheld corporation are devised to one beneficiary and that
any dividends paid to the estate by that corporation should
be paid only to that beneficiary and any such dividends
would not affect any other amounts which that beneficiary
would receive under the will. As in the case of trusts, the
application of the separate share rule is mandatory where
separate shares exist.
B.
C.
Final Regulations under Section 663.
1.
Final regulations (T.D. 8849) regarding the 1997 Act change to
section 663(c) were published on December 28, 1999 at 64 F.R.
72540.
2.
The final regulations clarify the definition of separate shares and
narrow the application of the separate share rules for estates as had
been set forth in the proposed regulations.
Section 645.
1.
The 1997 Act added new section 646, which was then redesignated
as section 645 by the Internal Revenue Service Restructuring and
Reform Act of 1998, P.L. 105-206. Under the new section, an
election may be made to treat QRTs as part of a decedent’s estate
for income tax purposes.
5
2.
Section 645 provides:
(a) GENERAL RULE. — For purposes of this subtitle, if
both the executor (if any) of an estate and the trustee of a
qualified revocable trust elect the treatment provided in
this section, such trust shall be treated and taxed as part of
such estate (and not as a separate trust) for all taxable
years of the estate ending after the date of the decedent’s
death and before the applicable date.
(b) DEFINITIONS. — For purposes of subsection (a) —
(1) QUALIFIED REVOCABLE TRUST. — The
term “qualified revocable trust” means any trust
(or portion thereof) which was treated under
section 676 as owned by the decedent of the estate
referred to in subsection (a) by reason of a power in
the grantor (determined without regard to section
672(e)).
(2) APPLICABLE DATE. — The term “applicable
date” means —
(A) if no return of tax imposed by chapter
11 is required to be filed, the date which is 2
years after the date of the decedent’s death,
and
(B) if such a return is required to be filed,
the date which is 6 months after the date of
the final determination of the liability for tax
imposed by chapter 11.
(c) ELECTION. — The election under subsection (a) shall
be made not later than the time prescribed for filing the
return of tax imposed by this chapter for the first taxable
year of the estate (determined with regard to extensions)
and, once made, shall be irrevocable.
D.
Proposed Regulations under Section 645.
1.
Proposed regulations (REG-106542-98) under section 645 were
published on December 18, 2000 at 65 F.R. 79015. The IRS
cancelled the scheduled April 11, 2001 hearings on the proposed
regulations, as no requests were made to speak at the hearing.
6
2.
The written comments of The American College of Trust and
Estate Counsel dated April 6, 2001 are attached to this outline as
Exhibit A. The written comments of certain members of the
Postmortem Income Tax Planning Committee of the American Bar
Association's Section of Real Property, Probate and Trust law
dated April 9, 2001 are attached as Exhibit B.
3.
Issuance of final regulations by June 30, 2002 is on the 2001
Priority Guidance Plan was issued by the IRS and the Treasury
Department.
4.
Prior to the promulgation of the proposed regulations, the IRS
issued Rev. Proc. 98-13, 1998-4 I.R.B. 21, setting forth the
requirements for making the election.
5.
III.
a.
The criteria of the required written statement to effect the
election are similar to those contained in the proposed
regulations.
b.
In most situations Rev. Proc. 98-13 requires an electing
QRT to obtain a tax identification number ("TIN") and file
a Form 1041 for the QRT's short taxable year beginning
with the decedent's death and ending December 31 of that
year. However, the proposed regulations give the option
not to obtain a TIN or file a Form 1041 for the QRT.
c.
The proposed regulations, when finalized, will replace Rev.
Proc. 98-13.
In Notice 2001-26, 2001-13 I.R.B. 942, the IRS announced that
estates and QRTs of decedents dying after December 31, 1999 and
before the effective date of the final section 645 regulations may
choose to use either the election and reporting procedures set forth
in Rev. Proc. 98-13 or those set forth in the proposed regulations.
SECTION 663 FINAL REGULATIONS
A.
Definition of Separate Shares.
1.
The final regulations reflecting the 1997 Act changes were
promulgated on December 28, 1999 and apply the provisions to
estates of decedents dying after that date.
2.
The regulations clarify the definition of separate shares and narrow
the application of the separate share rules for estates as set forth in
the proposed regulations that were published in January 1999.
7
B.
3.
A separate share ordinarily exists if the economic interests in one
beneficiary or class of beneficiaries neither affect nor are affected
by economic interests accruing to another beneficiary or class of
beneficiaries.
4.
A separate share generally exists only if it includes both corpus
and the income attributable thereto and is independent from any
other share.
5.
Bequests of specific property and specific sums of money
described in section 663(a)(1) are not separate shares.
6.
The income on bequeathed property is a separate share if the
recipient of the specific bequest is entitled to such income.
Creation, Valuation, and Allocation.
1.
Separate shares come into existence upon the earliest moment that
a fiduciary may reasonably determine, based upon the known facts,
that a separate economic interest exists.
2.
The fiduciary must use a reasonable and equitable method to
determine the value of each separate share and in calculating the
DNI allocable to each share.
3.
4.
a.
This gives the fiduciary flexibility, within limits, in
applying the separate share rules.
b.
Redeterminations in value of the separate shares must be
taken into account.
In computing DNI for each separate share, the portion of gross
income that is income within the meaning of section 643(b) must
be allocated among the separate shares in accordance with the
amount of income each share is entitled to under the terms of the
governing instrument or applicable local law.
a.
Similar allocation rules are provided for the amount of
gross income that is not attributable to cash received by the
trust or estate.
b.
This includes original issue discount, the distributive share
of partnership tax items and the pro rata share of S
corporation tax items.
Any expense or loss that is applicable solely to one separate share
is not available as a deduction to any other share.
8
5.
C.
D.
E.
Interest imposed by state law on a pecuniary bequest or delayed
estate distribution is a payment of interest by the estate and not a
distribution for purposes of section 661 and 662.
Spouse's Elective Share.
1.
The elective share of a surviving spouse constitutes a separate
share of the estate.
2.
An elective share that is entitled to income and shares in
appreciation or depreciation is a separate share under the general
rules.
3.
Under a special rule in the final regulations, an elective share that
is not entitled to income and does not share in appreciation or
depreciation is also treated as a separate share.
Qualified Revocable Trusts ("QRTs").
1.
QRTs are subject to the separate share rules.
2.
A QRT that elects under section 645 to be treated as part of the
decedent's estate for income tax purposes is always a separate
share of the estate.
3.
Nonelecting QRTs are also subject to the separate share rules
applicable to estates and not to the rules that apply to separate
share trusts.
4.
An electing QRT itself may have two or more separate shares.
Pecuniary Formula Bequests.
1.
Pecuniary formula bequests constitute separate shares of the estate.
2.
Any pecuniary formula bequest that is entitled to income and
shares in appreciation or depreciation is a separate share under the
general rules.
3.
Under a special rule in the final regulations, a pecuniary formula
bequest that is not entitled to income and does not share in
appreciation or depreciation is also treated as a separate share as
long as the governing instrument does not provide that it is to be
paid or credited in more than three installments.
9
F.
G.
IV.
Income in Respect of a Decedent.
1.
Income in respect of a decedent (IRD) is allocated among the
separate shares that could potentially be funded with the IRD
irrespective of whether a share is entitled to receive any income
under the terms of the governing instrument or applicable local
law.
2.
The amount allocated to each share is based upon the relative
values of the shares that could potentially be funded with the IRD.
Effective Date Rules.
1.
The final regulations are applicable to estates and qualified
revocable trusts of decedents dying after December 28, 1999.
2.
For estates and QRTs of decedents who died after August 5, 1997
but before December 28, 1999, the IRS will accept any reasonable
interpretation of the separate share provisions. Presumably, the
IRS will accept the same approach for a decedent who died on
December 28, 1999.
3.
For trusts other than QRTs regulation section 1.663(c)-2 of the
regulations is applicable for taxable years of such trusts beginning
after December 28, 1999.
SECTION 645 PROPOSED REGULATIONS
A.
B.
The Election.
1.
If an election is filed for a QRT, the QRT will be treated and taxed
for all purposes of subtitle A as a part of its related estate (and not
as a separate trust) during the election period.
2.
Once made, the election is irrevocable.
3.
To be valid, the required written statement must be attached to a
timely filed Form 1041 for the first taxable year of the related
estate or the QRT, depending upon the existence of a personal
representative for the related estate.
Definition of a QRT.
1.
A QRT is any trust (or portion thereof) that on the date of death of
the decedent was treated as owned by the decedent under section
676 by reason of a power held by the decedent (determined
without regard to section 672(e)).
10
C.
2.
The proposed regulations take the position that the trust is not a
QRT if it was treated as owned by the decedent under section 676
by reason of a power that was exercisable by the decedent only
with the approval or consent of another person.
3.
The proposed regulations also take the position that a section 645
election for a QRT must result in a domestic estate.
Required Written Statement.
1.
2.
If there is a personal representative, the written statement must
a.
Identify the election as an election under section 645.
b.
Contain the name, address, date of death, and TIN of the
decedent.
c.
Contain the name and address of the QRT and, if a TIN has
been obtained after the death of the decedent, the TIN of
the QRT.
d.
Contain the name, address, and TIN of the related estate.
e.
Provide a representation that the trust for which the election
is being made meets the definition of a QRT under section
645 and the regulations.
f.
Contain a statement from the personal representative,
signed and dated under the penalties of perjury, stating
(i)
The personal representative elects to treat the QRT
as part of the related estate under section 645.
(ii)
The personal representative understands that the
personal representative is required to make a timely
return of income for the combined related estate and
QRT on Form 1041 and to pay timely any tax due
thereon.
If there is no personal representative, the written statement must
a.
Identify the election as an election under section 645.
b.
Contain the name, address, date of death, and TIN of the
decedent.
11
D.
c.
Contain the name and address of the QRT and, if a TIN has
been obtained after the death of the decedent, the TIN of
the QRT.
d.
Provide a representation that the trust for which the election
is being made meets the definition of a QRT under section
645 and the regulations.
e.
Provide a representation that there is no personal
representative and to the trustee's knowledge and belief,
one will not be appointed.
f.
Contain the TIN obtained by the trust to file as an estate
under Regulation section 301.6109-1(a)(4)(ii)(B).
g.
Contain a statement from the trustee of the QRT, signed
and dated under the penalties of perjury, stating
(i)
The trustee elects to treat the QRT as part of the
related estate under section 645.
(ii)
The trustee understands that the trustee is required
to make a timely return of income for the QRT on
Form 1041 taking into account the section 645
election and to pay timely any tax due thereon.
Tax Identification Numbers ("TINs") and Forms 1041.
1.
If there is a personal representative, a TIN must be obtained for the
related estate, but the QRT is not required to obtain a TIN in its
own name.
2.
All payors of an electing QRT shall be furnished a Form W-9
showing
3.
a.
The name of the related estate as the primary name on the
form.
b.
The name of the electing QRT as the secondary name.
c.
The TIN of the related estate.
d.
The address of the trustee
If there is no personal representative, the trustee must obtain a TIN
to file as an estate, and there is no requirement to obtain a TIN for
the electing QRT, and Forms W-9 would be furnished in the usual
fashion using that TIN.
12
E.
F.
4.
The fiduciaries may treat the QRT as an electing trust from the
decedent's date of death until the due date for the section 645
election, and no Form 1041 is required for the QRT for the short
taxable year from the date of death until December 31.
5.
If a section 645 election is made after a Form 1041 is filed by the
QRT, the trustee must amend the Form 1041. However, the
amended return cannot itself effect a valid section 645 election.
Application of the Separate Share Rule.
1.
The separate share rule of section 663(c) treats an electing QRT
and its related estate as separate shares for purposes of computing
DNI and applying the distribution provisions of sections 661 and
662.
2.
If a distribution is made by an electing QRT or its related estate,
the DNI of the share making the distribution must be determined
and the distribution provisions of sections 661 and 662 must be
applied using the separately determined DNI applicable to the
distributing share.
Duration of the Election.
1.
The election period begins on the date of the decedent's death and
terminates on the day before the applicable date. The election does
not apply to successor trusts.
2.
If a Form 706 is required to be filed for the decedent's estate, the
applicable date is the day that is six months after the date of final
determination of liability for estate tax.
3.
Solely for purposes of determining the applicable date under
section 645, the date of final determination of liability is the
earliest day on which any of the following has occurred:
a.
The issuance by the IRS of an estate tax closing letter,
unless a claim for refund of estate tax is filed within six
months thereafter;
b.
The final disposition of a claim for refund, unless suit is
instituted within six months thereafter;
c.
The issuance of a decision, judgment, etc. resolving the
liability of the estate tax, unless a notice of appeal or
petition for certiorari is filed within 90 days thereafter; or
13
d.
G.
H.
V.
The expiration of the period of limitations for assessment
of the estate tax provided in section 6501.
Treatment on Termination of the Election.
1.
On the close of the last day of the election period, the combined
related estate and electing QRT (or just the QRT if there is no
related estate) is deemed to distribute the share or shares
comprising the electing QRT to a new trust in a distribution to
which section 661 and 662 apply.
2.
The new trust must include such distribution in gross income to the
extent required under section 662.
Effective Date Rules.
1.
The regulations are to apply on or after the date the final
regulations are published in the Federal Register.
2.
As noted above, Notice 2001-26 allows estates and QRTs of
decedents dying after December 31, 1999 and before the effective
date of the final regulations to choose to use either the election and
reporting procedures set forth in Rev. Proc. 98-13 or those set forth
in the proposed regulations.
SUBCHAPTER J SEPARATE SHARE RULE IN OPERATION
A.
Basic Rules.
1.
The separate share rule only applies if a single trust or estate has
multiple beneficiaries and those beneficiaries have substantially
separate and independent shares.
2.
The rule is mandatory and not elective.
3.
The rule does not apply to the beneficial interests in simple trusts,
discretionary "sprinkling" or "spray" trusts, or separate trusts that
may have been created under the same trust instrument even
though such trusts themselves may be treated as separate shares.
4.
A separate share may itself have multiple beneficiaries with equal,
disproportionate, or indeterminate interests; and the same person
may be a beneficiary of more than one separate share.
5.
When separate and independent shares exist, the DNI allocation
rules are applied separately to each independent share as if it were
a separate trust or estate. This means one beneficiary could receive
14
amounts in excess of the trust's or estate's total DNI yet only be
taxable on a ratable portion of the DNI.
6.
B.
The separate share rule does not permit the treatment of separate
shares as separate trusts under subchapter J for any purpose other
than allocation of DNI. A trust with separate shares will continue
to be treated as one trust for all other purposes, including the
following:
a.
TINs.
b.
Tax return filing requirements.
c.
Income tax payments, including estimated taxes.
d.
Personal exemption.
e.
Excess deductions, unused net operating losses, and capital
loss carryovers on termination of the trust.
7.
If there are three or more separate shares and income of at least
two of the shares is accumulated, the taxes payable by the trust are
calculated based on the accumulated income from all shares. Thus,
the total taxes attributable to the separate shares could exceed what
would have been payable had true separate trusts been created.
The compression of income tax rates creates more situations in
which this could be a potential problem.
8.
Any deduction or loss that is attributable solely to one separate
share must be used in calculating the DNI for that share and is not
available to any other separate share.
Typical Applications.
1.
Even for a relatively simple estate the separate share rule will
come into play.
Situation 1. Father’s will leaves S Corp. stock to Son and
residue equally to Son, Daughter 1, and Daughter 2. Under
local law, Son is entitled to all S Corp. dividends received
by the estate. Because of financial needs of Daughter 2, a
partial distribution of the residue is made to her during the
same fiscal year S Corp. pays a dividend in order to provide
the estate with funds to pay the income taxes on the S Corp.
K-1 income reportable by the estate.
15
As a result of the 1997 Act, the separate share rule applies in this
example, creating four separate shares. Although the bequest of
the S Corp. stock itself is not a separate share by reason of section
663(c)(1), the income (dividends) is a separate share. The interests
of Son, Daughter 1, and Daughter 2 are also separate shares.
Assuming no other income, the partial funding would not carry out
any of the DNI resulting from the K-1 income. Were there to be
income from sources other than S. Corp., only one-third of the
residue’s separate share DNI would carry out to Daughter 2 with
the principal distribution to her. When the S Corp. stock is
ultimately distributed to Son, along with an amount equal to all
dividends paid during the period of administration, the DNI to be
carried out to him would not exceed the K-1 income for the year of
distribution (taking into account any application of the 65-day rule
that now applies to estates as well as trusts).
2.
Events outside the control of the fiduciary can bring the separate
share rule into play.
Situation 2. The facts are the same as in Situation 1 except
that instead of leaving a specific bequest of S Corp. stock to
Son, Father’s will gives Son the right to have S Corp. stock
allocated to his one-third of the residue.
Assuming Son has not exercised his right to have the S Corp. stock
allocated to his share at the time the partial distribution is made to
Daughter 2, it seems that one-third of the S Corp. K-1 income
should be taken into account in determining Daughter 2’s share of
DNI. Presumably the result would be different if Son had already
filed a paper with the personal representative electing to have the S
Corp. stock allocated to his share, as the regulations state that
separate shares come into existence at the earliest moment that a
fiduciary may reasonably determine that separate shares exist.
Does it make a difference when such election is made during the
fiscal year? What if made after the distribution to Daughter 2?
3.
Although the nature of the rights of surviving spouses to elective
shares varies from state to state, the final regulations treat all
elective shares the same.
Situation 3. Father, who lives in a Uniform Probate Code
type of state, leaves his residence and a cash bequest to
Wife who is not the mother of Children. Father leaves
balance of his assets to Children by beneficiary designation
and by will. Wife timely claims an elective share of the
augmented estate. The estate promptly pays its portion of
the elective share using part of the income earned by the
16
estate since Father's death but not using any part of the
deferred compensation received by the estate from Father's
former employer.
Wife's elective share is a separate share. Because there is no
prohibition on using IRD to fund the estate's portion of the elective
share, a ratable share of the gross income includible in DNI that is
IRD (the deferred compensation) must be allocated to the elective
share of Wife, whether or not actually paid to Wife. However,
because Wife is not entitled to any income earned by Children or
the estate pending payment of the elective share, no part of the
other gross income includible in DNI is allocated to Wife even
though a part of the elective share was in fact paid out of such
income. If the state's elective share statute provides for interest to
be paid by the persons paying the elective share, the interest will
be includible in Wife's gross income under section 61 (and not
under section 662) and treated as a nondeductible personal interest
expense by the estate or Children pursuant to section 163(h).
4.
Wills that pour over to funded revocable trusts are quite common
as a probate avoidance technique whether or not there is a
surviving spouse.
Situation 4. Mother's will leaves an annuity for five years
to Jane, a former household employee, and pours the
residue over to revocable trust created by Mother and
funded during her life with all of her portfolio assets. Trust
assets are distributable outright to Children. Executor and
Trustee decide not to make the election under section 645.
Jane's annuity is a separate share as is the residue of the estate.
Further, the revocable trust is a separate share and may itself have
two or more separate shares.
5.
In the trust setting, the most common application of the separate
share rule is in trusts whose income either is payable in fixed
shares to designated beneficiaries or may be accumulated for their
future benefit.
Situation 5. Mother's will creates a trust under which half
of the income is payable quarterly to Daughter who is age
27. The other half of the income may be paid out or
accumulated in Trustee's discretion for Son who is age 22.
Once Son reaches age 25, his half of the income is payable
in the same fashion as Daughter's. The trust terminates
when Son attains age 35. Son is in graduate school, and
Daughter is married to an entrepreneur with significant
17
nonpassive tax losses. The trust assets consist of a
portfolio of securities, several closely held stocks, a vacant
lot on which Daughter wishes to build a new principal
residence, and an undivided interest in a mountain cabin
used by Son and his cousins on hunting trips.
The separate share rule applies in Situation 5 and produces logical
results. If Son is paid his half of the income, DNI will be allocated
equally to Son and Daughter. Alternatively, if Trustee withholds
and accumulates all or part of Son's half of the income, half of DNI
will reported to Daughter and Son's accumulation will be taxed to
the trust (perhaps with an equitable adjustment made so that Son's
half of the trust bears the income tax costs).
6.
In trusts that authorize principal distributions, the results can
surprise the beneficiaries.
Situation 6. The facts are the same as in Situation 5 except
that Trustee is authorized to make advancements out of
principal to Son or Daughter. Trustee distributes the
interest in the cabin to Son, in part to minimize Trustee's
potential liability for hunting accidents. Trustee does not
distribute all of Son's half of the income.
If the value of the undivided interest in the cabin in Situation 6 is
greater than the accumulated income for the year, half of the DNI
will be reported to Daughter and half to Son because the principal
distribution carried out all of his separate share DNI. Thus, DNI
would be reported equally by Son and Daughter even though
distributions during the year to Son and Daughter were not equal.
Had the trust been a sprinkling one, DNI would be allocated to Son
and Daughter based on the ratio the distributions (income and
principal) to each bear to total distributions from the trust.
7.
Another commonly encountered situation is when non-pro rata
terminating distributions cover more than one taxable year.
Situation 7. The facts are same as in Situation 5 and upon
the termination date Trustee distributes all cash on hand
equally to Son and Daughter, distributes the vacant lot to
Daughter, and distributes the undivided interest in the cabin
to Son. The portfolio securities and closely held stocks are
not distributed until the next taxable year because Son and
Daughter could not decide who was to get which closely
held stocks.
18
Because of the separate share rule, only half of the DNI in
Situation 7 will be taxed to Daughter in the first year even though
she may have received more than half in value of the distributions
made during the taxable year.
8.
For trusts not subject to the separate share rule, the distribution
deduction rules allocate DNI to the beneficiaries pro rata based on
all distributions made during the year.
Situation 8. Mother creates trust for Daughter and Son and
gives Trustee the authority to sprinkle income and principal
among Daughter and Son. Son is in graduate school, and
Trustee distributes all income to Son for educational
purposes. No principal distributions are made.
Because the separate share rule does not apply in Situation 8, 100
percent of the DNI is taxed to Son for the year.
9.
C.
When the separate share rule applies and part of the income is
accumulated, the DNI taxable to the trust may be taxed at rates
higher than the beneficiaries' rates. If one of the trusts created at
death is a charitable remainder trust, avoidance of the separate
share rule would allow non-pro rata funding distributions to be
made to that trust in order to reduce overall income taxes through
the use of the tax-exempt status of the charitable remainder trust.
Marital Deduction Planning.
1.
The most common form of marital deduction planning today in
many parts of the country is a pour-over will to a revocable trust,
with a fractional formula division into a unified credit-type bypass
trust and a QTIP marital trust. The revocable trust is frequently
funded during lifetime to facilitate the management of assets or to
avoid probate expenses. Physical division of the trust assets and
funding are generally delayed for some period of time following
the grantor's death.
2.
Because the separate share rule now applies to estates, many of the
questions posed apply to marital deduction-type wills as well as
revocable trust arrangements.
3.
Following the grantor's death, the revocable trust is referred to as
the "trust before division" or the "administrative trust," and only
rarely are there specific provisions concerning its administration
pending funding.
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4.
5.
6.
This raises the question whether the interim income should be
taxed under a "two-pocket" or "three-pocket" approach. That is,
should the trust before division be disregarded (the two-pocket
approach) and treated as only two trusts or should the trust before
division be counted (the three-pocket approach) and treated as a
third trust.
a.
Superimposing the separate trust rule in the analysis adds
further complexity in determining the proper treatment of
DNI during the interim period following death, particularly
where IRD is involved.
b.
The existence of a section 645 election may add additional
complexity.
The final regulations in response to the 1997 Act change come into
play in a number of ways.
a.
It is now clear that separate shares come into existence
upon the earliest moment that a fiduciary may reasonably
determine, based upon the known facts, that a separate
economic interest exists. This makes it difficult to argue
that there is only one share (the trust before division) and
that the marital and bypass trusts can be disregarded as
separate shares until actual funding occurs.
b.
The final regulations state that a qualified revocable trust is
a separate share and may itself contain two or more
separate shares.
c.
The special rules on the treatment of IRD take on added
significance because many marital deduction/unified credit
formulas restrict or direct the allocation of items subject to
the income tax.
Under the two-pocket approach, the marital and bypass trusts are
treated as successor trusts coming into existence immediately upon
the grantor's death for purposes of determining how trust income is
taxable. The three-pocket approach treats the original trust as
continuing for a reasonable period of administration as a complex
trust, much like an estate in administration, before being divided
into the marital and bypass trusts.
Situation 9. Husband's will pours over to a revocable trust
that divides, according to a fractional formula, into a QTIP
trust and a bypass trust with all income of both trusts
payable by Trustee to Wife for life. Distribution of the
estate and funding of the trusts will be deferred until the
20
estate has been fully administered and a closing letter has
been received from the IRS.
Income accumulated by the estate in Situation 9 will be taxed to
the estate. Income distributed to Wife will be taxable to Wife,
whether the two-pocket or three-pocket approach is used and
whether or not the separate share rule applies.
In Situation 9, the proper treatment of any income distributed by
the estate to the revocable trust and retained by the trust before
division is problematic. If the income is accumulated and the twopocket approach is followed, such income will be taxed to Wife, as
both the marital trust and the bypass trust are simple trusts, and the
separate share rule is therefore not particularly relevant.
7.
Under the three-pocket approach, the proper treatment of DNI may
depend upon the application of the separate share rule.
Situation 10. The facts are the same as in Situation 9
except that the bypass trust is a sprinkling trust for the
benefit of children.
If all income received by the trust before division is accumulated
in Situation 10 and the two-pocket approach is applied, the portion
of the accumulated income attributed to the QTIP trust would be
regarded as currently distributable to Wife and would be taxed to
her even though not actually distributed. The remaining income
would be taxed to the bypass trust as a complex trust.
Using the three-pocket approach in Situation 10, all accumulated
income would be "trapped" and taxed to the trust before division as
a complex trust even though the beneficial interests in the trust
may be separate shares within the meaning of the separate share
rule.
8.
Should Trustee make a non-pro rata distribution under the facts in
Situation 10 of all or part of the income to Wife, with no
distributions to the children, the tax results are dictated by the
separate share rule.
a.
Assuming the separate share rule applies in the threepocket setting under the "earliest moment" test, the non-pro
rata distribution to Wife will be treated as a principal
distribution to the extent the distribution is in excess of the
QTIP trust's pro rata share of DNI for the year, and the
balance of the DNI will be taxed at the trust level. Note
21
that this is the same result as under the two-pocket
approach, except that the trust before division instead of the
bypass trust is the taxpayer.
b.
Were the separate share rule not to apply at this stage (as
had been thought by many practitioners in the past), all of
the DNI would be allocated to Wife under this approach so
she could pay all of the income taxes, and no DNI would be
taxed at the trust level.
9.
Avoiding the separate share rule could mean a slight tax savings
for the family if Wife's marginal federal income tax rate is less
than the trust’s.
10.
Rate compression and the required use of calendar years by trusts
substantially eliminates the ability to defer income taxes through
the use of staggered taxable years. Most opportunities to make
"trapping" distributions may now have been extinguished by the
final regulations because of the rule that separate shares come into
existence at the earliest moment the fiduciary may reasonably
determine.
11.
Before the extension of the separate share rule to estates,
practitioners were inconsistent in applying the separate share rule.
a.
Some practitioners took the position that the separate share
rule was inapplicable because the trust before division was
much like an estate. Cases and rulings do not discuss the
application of the separate share rule to a trust before
division.
b.
Other practitioners said the separate share rule must apply
to a trust or estate before division because the marital and
bypass trusts (the separate shares) are to be funded by a
formula based on facts, circumstances, and values
determined as of the deceased grantor's death, and only the
mechanical calculation of the size of each trust that
remains. Further, because the separate share rule applies to
a trust between its termination date and actual distribution,
it follows that the rule should apply on the front end
between its creation and its funding.
c.
The third choice was to apply the separate share rule to the
trust or estate before division only for taxable years
beginning after all information is available to determine the
size and proportion of both the marital trust and the bypass
trust.
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D.
12.
The final regulations provide some guidance in this area. Absent
governing instrument language to the contrary, the separate share
rule should apply to all trusts and estates before division,
particularly those involving marital deduction/unified credit or
GST formula funding. In the S corporation setting, as discussed
below, having the subchapter S separate share rule apply can be
particularly helpful when each continuing trust would be a
permitted S shareholder.
13.
The issue remains as to whether the separate share rule as now
written has the effect of forcing the marital and bypass trusts to be
recognized for DNI purposes before actual funding of those trusts.
Disclaimers.
1.
A qualified disclaimer by a beneficiary may focus attention on the
separate share rule in situations where applications of the rule
would otherwise be inconsequential.
Situation 11. The facts are the same as in Situation 9,
except that Wife disclaims all of her interest in the bypass
trust so it will pass outright to Children.
Without the disclaimer, the trust income would either be taxed all
to Wife under the two-pocket approach or, under the three-pocket
approach, taxed to her to the extent of her DNI, which in turn
depends on whether the separate share rule applies. But the
disclaimer in Situation 11 could change the situation.
2.
If the planner adopts the use of the two-pocket approach,
Children’s interest in Situation 11 should be viewed as a complex
trust with none of the income currently distributable to Children,
and they would be taxable only to the extent of actual distribution
of DNI.
3.
Under the three-pocket approach, regardless of whether the
separate share rule applies, Children’s share of income would be
taxable to the trust.
4.
If principal as well as income distributions, which are to be
charged against the marital share, are made to Wife from the trust
before division and before the disclaimer with respect to the bypass
trust, it is not clear how the DNI should be allocated. If all DNI
could be taxed to Wife, this would effectively increase the ultimate
benefits of the children by relieving them of the income tax
burden.
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E.
Generation-Skipping Planning.
1.
Because the typical GST-planned estate frequently involves the
creation of three trusts (QTIP, reverse QTIP, and bypass), the
various planning aspects discussed above are even more relevant.
It is important for the planner to consider whether a "four-pocket"
approach is appropriate.
Situation 12. The facts are same as in Situation 8, and in
addition the QTIP share is to be divided into a regular
QTIP trust and a reverse QTIP trust.
Using a trust before division and not applying the separate share
rule below that level at the outset would allow Trustee in Situation
12 to make a non-pro rata trapping distribution to the QTIP trust.
Therefore, a subsequent funding of the reverse QTIP and bypass
trusts might attract less income tax and result in more value
ultimately passing to the grandchildren.
2.
Although the separate share rule generally does not overlap with
the multiple trust rule of section 643(f), some potential exists for
overlap in the GST-planning context where the division of one
trust into separate trusts is commonplace.
Situation 13. Grandfather creates a $1.5 million sprinkling
trust under his will for the equal benefit of his
grandchildren. Executor allocates the full $1,030,000 GST
exemption to the trust. Trustee then divides the trust into
two trusts, one for $1,060,000 having a zero inclusion ratio
and a second for $440,000 having an inclusion ratio of one.
For the multiple trust rule to apply and treat the trusts as one, a
principal purpose of the trusts must be the avoidance of income
taxes. In Situation 13, was the only motivating factor the
avoidance of a GST tax? Because rate compression has taken
away most of the incentive for multiple trusts, income taxes likely
would not be viewed as a principal purpose for the division, and
the IRS would respect the separateness of the trusts in Situation 13.
Under the multiple trust rule, it would first operate to treat the
trusts as one solely for income tax purposes, and then be applied to
determine how the DNI is allocated.
F.
S Corporations.
1.
Because only certain types of trusts are allowed to be shareholders
in an S corporation, careful planning is critical to avoid accidental
24
loss of subchapter S status by having the S stock held by or
distributed to an impermissible shareholder.
2.
An estate can hold S stock indefinitely as long as administration is
not unduly prolonged, and an electing QRT can hold S stock
throughout the election period. The typical revocable grantor trust
can hold S stock for two years after the grantor's death. For trusts
meeting the qualified subchapter S trust (QSST) requirements, the
income beneficiary can make an election to have the S stock
portion of the trust treated as a grantor trust and thus be a permitted
S shareholder with the beneficiary as the deemed owner. An
electing small business trust (ESBT) election may be available for
trusts not meeting the QSST requirements or for other trusts
preferring ESBT treatment over QSST treatment.
3.
For QSST qualification and election purposes as well as trust
identification purposes, trusts having multiple deemed owner
beneficiaries with substantially separate and independent shares
within the meaning of section 663(c) are treated as separate trusts
by reason of section 1361(d). That same section also provides that
a successive beneficiary of the trust is automatically treated as
having made a QSST election unless such beneficiary affirmatively
refuses to consent to such election.
Situation 14. Husband created trust for Wife with S stock.
Wife made QSST election, and Executor made a partial
QTIP marital deduction election. Wife has just died, and
the trust is to terminate and go equally to three children.
Because of the partial QTIP, Trustee will not distribute the
trust assets until Wife's estate receives a closing letter from
the IRS.
The facts in Situation 14 are those found in Private Letter Ruling
9212031 in which the IRS held that the interests of the children in
the trust pending distribution were subject to the separate share
rule, that each of the three separate shares was an individual QSST,
and that under the successive beneficiary rule the QSST election
made by Wife would automatically be treated as made by each
child.
The same result occurs in the case of a trust before division when
the separate share rule applies and the grantor makes a QSST
election before death as in Private Letter Ruling 9422041. Simply
making a QSST election does not mean the S election is
necessarily safe. If any of the separate trusts are not simple trusts,
the trustee of the trust before division must actually distribute
25
currently all of the income of each separate trust to its beneficiary.
Failure to distribute the income in this manner violates the
subchapter S requirements and can create many problems for
counsel for the estate or corporate counsel in giving tax and legal
opinions for loan transactions and sales transactions involving the
stock or corporate assets.
4.
G.
Because the DNI rules are inapplicable to the S income of an
ESBT, the separate share rule is only relevant to the non-S income,
if any, of the ESBT. Section 641(d).
Effect of Rate Compression.
1.
The top federal income tax rate of 39.6 percent is reached in 2001
once a trust has $8,900 of taxable income. If the separate share
rule applies in a situation where all or substantially all of the
income has been distributed to one beneficiary or trust instead of
pro rata to all beneficiaries and trusts, the excess over that to which
the recipient beneficiary was entitled would be subject to tax at the
trust level.
Situation 15. Grandfather creates a $1 million separate
share trust for his five teenage grandchildren who otherwise
have no taxable income. DNI for the year 2001 is $30,000.
Trustee disburses $10,000 for Grandchild One's education
and accumulates the remaining $20,000. Grandchild One is
taxed on $6,000 (1/5th of the DNI) and pays $600 of tax at
his 10% federal income tax rate. The trust pays almost
$8,400 in taxes on the remaining $24,000 at its higher rate.
Total taxes are about $9,000.
Alternatively, had Grandfather in Situation 15 created the trust as a
sprinkling one, Grandchild One would have paid tax of $1,000 on
$10,000 of DNI, and the trust's taxes would have been reduced to
about $6,900, for total taxes of approximately $7,800 which means
a savings of about $1,200 over the taxes in Situation 15.
Further savings would have been possible had Grandfather created
a separate $200,000 trust for each grandchild earning $6,000
annually. The $10,000 disbursed for Grandchild One out of his
trust would result in $6,000 of DNI being taxed to him and cause
$600 of tax. Each other trust would itself report $6,000 and pay
taxes of about $1,500. Total taxes would be approximately $6,600,
representing overall savings of $2,500 over Situation 15.
26
2.
VI.
Although the tax differences in these scenarios as a result of rate
compression are not major, the planner cannot overlook them when
planning for the client.
DISCUSSION OF SECTION 645 AND ITS APPLICATION
A.
Definition of a Qualified Revocable Trust ("QRT").
1.
2.
To be a QRT, the trust must have been treated under section 676 as
owned by the decedent by reason of a power held by the decedent,
without regard to section 672(e).
a.
A section 645 election may be made with respect to more
than one QRT.
b.
If the decedent's power was only over a portion of the trust,
such portion is itself a QRT, and the section 645 election
may be made over such portion.
c.
It is not clear how things should be handled if the "portion"
of the trust over which the decedent had a power of
revocation was a horizontal slice (for example, the income
portion or the principal portion of the trust) or over a
specific asset in the trust (for example, the stock in an S
corporation).
Section 676(a) relates to revocable trusts and provides:
(a) GENERAL RULE — The grantor shall be treated as
the owner of any portion of a trust, whether or not he is
treated as such owner under any other provision of this
part, where at any time the power to revest in the grantor
title to such portion is exercisable by the grantor or a nonadverse party, or both.
3.
Section 672(e)(1) deals with powers deemed held by the grantor
and provides:
(e)(1) IN GENERAL — For purposes of this subpart, a
grantor shall be treated as holding any power or interest
held by —
(A)
any individual who was the spouse of the
grantor at the time of the creation of such power or
interest, or
(B)
any individual who became the spouse of the
grantor after the creation of such power or interest,
27
but only with respect to periods after such
individual became the spouse of the grantor.
4.
A trust that is revocable by the grantor’s spouse is not a QRT even
though such a power would make the trust a grantor trust under
section 676. Section 645 specifically provides that powers held by
a spouse that usually are attributed to the grantor under section
672(e) are not attributed to the decedent for QRT purposes.
5.
In addition, the Conference Report confirms that “trusts that are
treated as owned by the decedent solely by reason of a power in a
nonadverse party would not qualify.” H.R. Conf. Rep. No. 105220, at 711.
6.
It is not clear at this time whether a trust revocable by the grantor
with the consent of a nonadverse party would qualify for the
section 645 election.
Situation 16. Grantor is an elderly widower, and Children
as well as his attorney are concerned that he might be
influenced to make large gifts to his caregivers. Attorney
drafts revocable trust requiring the written consent of
Attorney or a member of Attorney's law firm in order for
Grantor to amend or revoke the trust.
This type of situation is not uncommon. Similarly, the consent of
an unrelated third party is sometimes used with regard to trusts
created by wealthy individuals in advance of entering into second
marriages, particularly in states whose rules on marital property,
elective shares, and renunciation rights are less than clear as to the
treatment of revocable trust assets
Under the proposed regulations, the trust in Situation 16 would not
qualify as a QRT so as to participate in a section 645 election.
There appears to be no policy reason, or statutory basis, for the
position taken in the proposed regulations.
If the final regulations allow the consent of a nonadverse party, be
aware that because section 672(e) does not apply (that is, because
the spouse’s power to revoke will not be attributed to the
decedent), a revocation power exercisable by the grantor only with
the spouse’s consent may not qualify where the spouse is an
adverse party.
7.
The typical revocable trust used as a will substitute should
generally qualify as a QRT.
28
8.
The typical joint trust used in community property states, under
which each spouse may unilaterally revoke his or her own share of
the trust estate, should also meet the QRT requirements because
the decedent’s share of the trust estate will satisfy the section 676
requirement that a “trust (or portion thereof)” was “treated under
section 676 as owned by the decedent.”
9.
Under a joint trust, the deceased grantor's share will usually consist
of the deceased grantor's separate property and half of any
community property owned by the grantors. The surviving
grantor's share typically consists of the remaining property that
will be held in a separate trust that will continue to be revocable by
the surviving spouse.
10.
If a joint trust is revocable only by action of both spouses, the trust
may not qualify as a QRT, as the spouse is likely to be an adverse
party. However, at the second death, any “portion” of an originally
joint trust which remained subject to the surviving spouse’s sole
power of revocation would qualify for the election.
11.
A trust that is includible in the decedent's gross estate under
section 2041 because the decedent held a testamentary general
power of appointment or an unlimited power of withdrawal is not a
QRT and does not qualify for the election. Being treated as the
owner for income tax purposes under section 678 does not make
the trust a QRT. Also, a QTIP trust includible in the gross estate
under section 2044 is not a QRT.
12.
Similar to an estate, most revocable trusts will require a “winding
up” period before being distributed to the beneficiaries.
a.
Before distribution of a revocable trust following the
grantor's death, administration expenses and estate taxes
must be determined and paid. The administration of the
revocable trust (or, in the case of a joint trust in a
community property state, the decedent’s share of the trust)
will continue at least until these functions are completed.
Thereafter, the trust may terminate, continue on different
terms, or divide into multiple trusts or shares, as directed by
the trust agreement.
b.
Even though the terms of a revocable trust may direct that
it be divided into separate trusts or separate shares "on the
date of the grantor’s death," typically the trust cannot
actually be divided and distributed until years after the date
of the grantor's death when the deceased grantor’s debts,
expenses, and estate tax liabilities have been determined.
29
B.
c.
Because of the difficulty in determining debts, expenses,
and taxes, such a trust will often function as a single,
undivided entity for several years following the grantor's
death and until the trustee is in a position to make
distributions.
d.
Customarily, the trustee of a such a postmortem revocable
trust would treat the trust as an “administrative trust”
during the winding up period, that is, as a separate tax
entity that holds and administers the decedent’s trust (or
share of a joint trust) until the typical bypass and marital
trusts, or separate trusts for children (the “subtrusts”) are
actually funded.
e.
Alternatively, the trustee could treat the subtrusts as
coming into existence immediately upon the death of the
grantor so that postmortem income is not taxed to a
temporary “administrative trust.” Although nothing in the
statute specifically precludes such subtrusts from qualifying
and making the section 645 election themselves, it seems
doubtful that they can. Where the election is to be made,
the use of an administrative trust is advisable, especially at
the first death where assets were held in a joint trust. The
administrative trust will clearly constitute the decedent’s
“portion” which is entitled to make the section 645
election.
f.
The section 663 separate share final regulations make clear
that separate shares come into existence at the earliest
moment that a fiduciary may reasonably determine, based
upon the known facts, that a separate economic interest
exists. These separate share rules apply to all QRTs,
whether or not the section 645 election is made.
Duration of Election Period.
1.
Generally, it appears that the election is intended to apply to a
reasonable period for administration of the decedent’s estate and
winding up of the QRT.
2.
If the election is made, the election period will begin on the date of
the grantor’s death.
3.
The election period cannot extend indefinitely; nevertheless, it is
not entirely clear when the election period ends.
4.
The general rule of section 645(a) provides that the election period
ends on the “applicable date.”
30
5.
Where no estate tax return is required to be filed, under section
645(b)(2)(A) the applicable date is clearly two years after the date
of death (which may not be two full taxable years).
a.
Under the 2001 Act, this rule takes on more importance.
For example, in the year 2009, the gross estate would have
to be in excess of $3,500,000 for the estate to be able to
take advantage of section 645 treatment for more than two
years after death.
b.
Because the 2001 Act did not change section 645 and, for
decedents dying after December 31, 2009, replaces existing
section 6018 (estate tax return filing requirements) with
new section 6018 (return reporting allocation of basis
increase), it appears that an estate and QRT of a decedent
dying after repeal takes effect could only use section 645
for the two years no matter how large or complicated the
estate and trust may be.
6.
Where an estate tax return is required to be filed, section
645(b)(2)(B) defines the “applicable date” as “the date which is 6
months after the date of the final determination of the liability for
[estate] tax.”
7.
The term “final determination” is not defined in the statute. The
proposed regulations take a practical approach and provide that the
"final determination" is the earliest day on which a number of
events might occur.
a.
Under the proposed regulations, the "final determination"
will often occur before the expiration of the statute of
limitations.
b.
Because the personal representative has no control over the
receipt of a closing letter and no way of knowing the date
on which it might be issued, planning for the final year of
the election period may be difficult.
(i)
The receipt of a "closing letter" does not constitute
evidence of "final determination of estate tax
liability." See Rev. Proc. 83-19, 1983-1 C.B. 677
(ii)
See Estate of Brocato v. Commissioner, T.C. Memo
1999-424, and Estate of Bommer v. Commissioner,
T.C. Memo 1995-197, holding that a closing letter
does not estop the IRS from continuing an audit and
suggesting that only a "formal closing agreement" is
a bar to further adjustments.
31
C.
c.
If a section 6166 election is made, the statute of limitations
on collection of tax is suspended and refunds may be
claimed within two years of each installment payment.
This does not necessarily constitute an extension of time to
assess liability. In addition, under section 6511(a) refunds
may be claimed within two years of each installment
payment.
d.
If litigation is instituted, the section 6503(a)(1) statute of
limitations on assessments is extended until 60 days after a
decision becomes final.
e.
Because the applicable date does not occur until after the
final determination of estate tax liability, delaying the
settlement of an estate tax audit by the personal
representative can provide the trustee of the electing QRT
with additional time for postmortem planning.
8.
Because the applicable date is unlikely to coincide with the end of
a calendar month or quarter, extra work will be required with
respect to allocations and adjustments.
9.
The trustee may terminate the election early by distributing all of
the trust's assets.
a.
This can minimize the number of fiduciary returns.
b.
More importantly, this allows the trustee to time the end of
the election period to coincide with the end of a calendar
month or quarter instead of waiting for the applicable date
to arrive.
c.
The estate would continue its administration using its same
tax identification number.
d.
Unfortunately, most QRTs designed as will substitutes are
not in a position to be distributed before receipt of the
closing letter.
Effect of Election
1.
Making the election generally will result in favorable treatment for
the QRT. However, where the beneficiary of the estate is not
simply the revocable trust (a pure “pour over” plan), and
particularly where the fiduciaries of the entities are not identical,
the personal representative should consider carefully any
differential effect on the beneficiaries of the estate that the election
may have before consenting to make it.
32
2.
All items of income, deduction, and credit for the estate and the
QRT will be reported on a single Form 1041 during the election
period, combining the activities of both (or all qualifying
consenting) entities.
3.
Questions have arisen whether an electing QRT is "treated ... as
part of [the] estate" for purposes other than income tax reporting
purposes. For example, if an IRA is payable to an electing QRT,
does the section 645 election mean the related estate is treated as
the beneficiary of the IRA, thereby resulting in the application of
the less favorable rules that apply to estates as opposed to the
extended payout rules provided for trusts treated as "designated
beneficiaries."
4.
The proposed regulations do not address the treatment of sales or
other transactions between an electing QRT and its related estate or
between two electing QRTs.
Situation 17. Each of Estate, QRT 1, and QRT 2 own
stock in Family Corp. Estate pours over to QRT 1. QRT 2
is a dynasty trust, and all parties wish it to own 100 percent
of Family Corp. Assuming there has been appreciation
since death or death occurred in 2010 after the arrival of the
carryover basis rules, will the gain be recognized by Estate
and QRT 1? What if an installment note is used, and
payments are made after the election period ends?
These questions are perhaps best answered by looking at the
treatment of distributions from one entity to the other. By analogy
to those rules and to other rules in the Code treating multiple
persons as one for tax purposes (for example, husband and wife,
grantor trusts, and single-member LLCs), these transactions would
be disregarded. The IRS is aware of the need for guidance in this
area, and perhaps the final regulations will address these matters.
Bear in mind that the distribution of an installment note generally
accelerates the balance of the unrecognized gain. If the deemed
distribution by the QRT at the end of the election period would be
an acceleration event, can the problem be avoided by distributing
the asset to be sold to the successor trust or beneficiaries? It is
unlikely the application of the separate share rule would avoid the
problem because its only function is to determine DNI. If and
when carryover basis arrives, this concern will take on more
importance.
33
D.
Use of Fiscal Year Other than Calendar Year.
1.
Since 1987 most trusts (including QRTs) have been required to use
a calendar year as provided in section 644(a). Technically, this
remains the case for an electing QRT. Nevertheless, because all of
its income, deductions, and credits are reported on the estate’s
return during the election period rather than on its own, the
practical effect is that the trust assets are treated as if they are part
of the estate, which may select a fiscal year other than the calendar
year.
2.
An estate may select a taxable year ending up to 12 months
following the date of the decedent's death. In situations where
there is no estate — and thus the electing QRT is the only
postmortem entity — the trustee will be the fiduciary selecting the
fiscal year, based on the same factors traditionally considered by a
personal representative or administrator. If a year ending with the
month preceding death is selected, the beneficiaries’ tax liability
often can be postponed.
Situation 18. Grantor died June 1, 2001 with a QRT, and
distributions have been since that date to the beneficiaries
of the QRT. The first year of the QRT will end December
31, 2001 if no section 645 election is made. If a section
645 election is made, the first fiscal year of the QRT could
end as late at May 31 2002.
Absent a section 645 election, the distributions made in 2001 from
the QRT will be taxed to the beneficiaries on calendar year 2001
returns (to the extent of DNI) and that tax will be due April 15,
2002.
If a section 645 election is made, the 2001 distributions, as well as
those made on or before May 31, 2002 will be includible by the
beneficiaries in their calendar year 2002 returns, and the tax on
those distributions will not be due until April 15, 2003.
E.
Distributable Net Income ("DNI").
1.
The separate share rules of section 663(c) treat an electing QRT
and its related estate as separate shares for purposes of computing
DNI and applying the distribution provisions of sections 661 and
662.
2.
If a distribution is made by an electing QRT or its related estate,
the DNI of the share making the distribution must be determined
and the distribution provisions of sections 661 and 662 must be
34
applied using the separately determined DNI applicable to the
distributing share.
3.
4.
A distribution from one share to another share to which sections
661 and 662 would apply if made to a beneficiary other than
another share of the combined related estate and electing QRT may
affect the computation of the DNI of the share making the
distribution and the share receiving the distribution.
a.
As a result, the proposed regulations provide that (i) the
share making the distribution must reduce its DNI by the
amount of the distribution deduction that it would be
entitled to under section 661 had the distribution been made
to another beneficiary and (ii) solely for purposes of
calculating DNI, the share receiving the distribution must
increase its gross income by the same amount.
b.
The distribution has the same character in the hands of the
recipient share as in the hands of the distributing share.
A QRT and its related estate are treated as separate shares for DNI
purposes even if no section 645 election is made.
Situation 19. Estate under a pour-over will has no taxable
income or DNI (for example, because administration
expenses are claimed on Form 1041 instead of Form 706),
but Electing QRT has substantial DNI (for example,
because large IRA payments or other IRD items are
received by Electing QRT). Estate makes a "bypass"
distribution to Beneficiary of Electing QRT.
If the governing instruments or state law authorize bypass
distributions, the distribution should be treated as made directly
from Estate to Beneficiary and should not carry out DNI. If
neither the governing instruments nor state law authorizes the
bypass distribution, it will likely be treated as a constructive
distribution to Electing QRT followed by a constructive
distribution to Beneficiary and would carry out DNI of Electing
QRT.
If Estate had some DNI and the bypass distribution were to be
treated as a constructive distribution, the distribution would reduce
Estate's DNI and increase the gross income of Electing QRT for
DNI purposes.
If Estate has DNI and Electing QRT has no DNI, the IRS might
argue that, as to bypass distributions, Beneficiary is treated as
having a separate share interest in Estate for DNI purposes
35
F.
Charitable Set-Aside Deduction.
1.
Under section 642(c), only an estate, and not a nonelecting QRT, is
entitled to a charitable deduction for amounts of income
“permanently set aside” for charitable purposes. A nonelecting
QRT must actually pay the amount to charity in the taxable year
for which it is deducted or by the end of the following taxable year
as provided in sections 642(c)(1) and (2).
2.
Section 642(c) itself has not been changed, but now distributions
from a QRT that elects section 645 treatment also will be eligible
for the set-aside deduction, which will be taken on the estate’s
return. This should facilitate planning for distributions to
charitable beneficiaries from an electing QRT.
Situation 20. QRT provides for various pecuniary gifts to
individuals and the balance of its assets for certain
charitable purposes, but because of ambiguities and
uncertainties with respect to the names and tax status of
named organizations and lack of accurate knowledge as to
the magnitude of estate taxes, Trustee is unwilling to make
distributions until these matters have been resolved.
Without a section 645 election, Trustee must pay income taxes on
the income received and accumulated pending distribution to the
charitable beneficiaries at some future date.
If a section 645 election is made, a section 642(c) set-aside
deduction should be available even though the ultimate recipients
have yet to be determined.
3.
G.
Section 681 disallows a section 642(c) deduction for trusts having
income that would be classified as unrelated business income if the
trust were a tax-exempt entity. This rule, however, does not apply
to estates. An electing QRT will be able to avoid this section 681
disallowance because the deduction will be taken on the estate’s
return. This will be helpful where the QRT owns an interest in a
passthrough business entity or a sole proprietorship.
S Corporation Election.
1.
Although making the election will provide some advantage to a
QRT that holds S corporation stock, the failure of Congress to
modify the provisions of section 1361 to conform to the intent to
equalize the treatment of estates and QRTs continues to result in
different treatment of S corporation stock held by the two types of
entities.
36
2.
Section 1361(c)(2)(A)(ii) permits a funded QRT to continue to be
an S corporation shareholder only for the two-year period
beginning on the day of the decedent owner’s death. An estate,
however, may be an S corporation shareholder throughout a
reasonable period of administration (including the deferral period
where section 6166 treatment is elected). See section
1361(b)(1)(B); section 1.641(b)-3(a); and Rev. Rul. 76-23, 1976-1
C.B. 264. Therefore, where an estate tax return will be filed for
the estate and an audit is likely, a QRT may continue as an S
corporation shareholder for a potentially longer qualifying period if
it makes the section 645 election. The election could be helpful in
cases where the ultimate distributee is not a qualified S corporation
shareholder, or where there is a need to retain the stock in the QRT
for more than two years.
3.
Section 1361(c)(2)(A)(iii) provides that a trust that receives S
corporation stock pursuant to the terms of a decedent’s will is an
eligible shareholder for the two-year period beginning on the day
that the stock is transferred to it.
4.
a.
If an electing QRT transfers S corporation stock to a
subtrust that is not itself a qualified S corporation
shareholder, the subtrust probably will not be an eligible
shareholder for the additional two-year period, because
section 1361(c)(2)(A)(iii) refers to shares received
"pursuant to the terms of the a will" rather than received
"from an entity treated for income tax purposes as a
decedent’s estate."
b.
Thus, despite the availability of the section 645 election, it
may continue to be advantageous in certain circumstances
(for example, a nonresident alien beneficiary) to arrange for
a decedent’s S corporation stock to be distributed under the
will (perhaps requiring a probate administration) rather
than under a QRT. Perhaps the use of a "pour-back"
provision in the QRT to get the S stock in the hands of the
estate could be advantageous.
The proposed regulations under section 645 make it clear that an
electing QRT can hold S stock during the election period without
the need for any S shareholder election. At the end of the election
period, it unclear whether the QRT will have the usual amount of
time to make a QSST or ESBT election. Although the proposed
regulations deem the QRT to be a new trust created at the end of
the election period, they do not specifically mention S elections but
only say the QRT is a "new trust...to which sections 661 and 662
37
apply." Careful practitioners will want to make any necessary S
election at the earlier possible time.
H.
I.
Passive Loss Active Participation Rules.
1.
Section 469(i)(4) already extends the exemption from the passive
activity loss rules for “active participation” rental real estate
activities to the active participant’s estate for a period of two years
following death. The exemption is capped at $25,000, reduced by
the amount deducted by the decedent’s surviving spouse.
2.
This provision now applies as well to rental real estate held in a
QRT that elects to be treated as (part of) an estate.
3.
Presumably the dollar limitation of section 469(i)(2) will apply
each year to the activities of both entities together and will be
allocated between the estate and the QRT if both entities in fact
hold such assets.
4.
An issue may arise where both entities hold such assets and the
amount of the exemption otherwise available to the estate may be
reduced if the QRT is permitted to make the election.
5.
A personal representative may refuse to make the election unless
the trustee agrees that the estate will not lose any portion of its
otherwise available deduction.
GST Separate Share Rule.
1.
Where the separate share rule of regulation section 26.2654-1(b) is
not satisfied, making a section 645 election can avoid the need to
allocate the decedent’s GST exemption to the entire QRT.
2.
Regulation section 26.2654-1(b) permits the separate allocation of
the decedent’s GST exemption to a subtrust funded on a pecuniary
basis only if certain requirements are met:
a.
The pecuniary amount must be satisfied either by using
date of distribution values or by funding the subtrust in a
manner that fairly represents net appreciation or
depreciation in the value of the assets of the postmortem
trust and “appropriate interest” (as defined in regulation
section 26.2642-2(b)(4)(i)) must be paid at the time of
distribution.
b.
If these requirements are not met, a subtrust is not
recognized as a separate share for GST purposes and the
decedent’s GST exemption must be allocated to the value
38
of the entire QRT in order for the allocation to apply to the
subtrust.
J.
3.
Note that this GST separate share rule applies only to QRTs and
not to estates.
4.
Qualified disclaimers or court reformation proceedings are often
used to remedy drafting errors and produce the desirable separate
share treatment. Electing section 645 treatment offers a simpler
and less disruptive approach. Because section 2654(b) specifically
provides that a QRT is treated as a part of it related estate during
the election period, the GST separate share rule will not apply to
the QRT during the period of the section 645 election.
Other Special Situations, Advantages, and Disadvantages.
1.
An electing QRT loses its own personal exemption of $100.
However, where there is no estate, and the QRT is the only
postmortem entity, it will have the benefit of the $600 personal
exemption of an estate under section 642(b).
2.
Presumably an electing QRT will not be subject to the requirement
to pay estimated income taxes for any taxable year ending before
the date two years after the date of the decedent’s death, even if the
trust would not otherwise qualify under section 6654(l)(2)(B).
However, section 6654 is not part of Subtitle A and technically is
not within the section 645 language of "for purposes of this
subtitle."
3.
One disadvantage of the election is the loss of separate income tax
bracket “runs” where the electing trust is treated as “part of” an
estate. The merged entity will be taxed at a single set of rates.
However, as a result of the compressed income tax rates applicable
to estates and trusts, this disadvantage is of limited significance.
4.
For burden of proof purposes, a QRT is treated in the same manner
as an estate, whether or not the section 645 election is made, for
the period for which the election is (or, in the case of a nonelecting
QRT, would have been) effective.
5.
Section 267(b) (disallowance of losses on transactions between
related persons) and section 1239 (disallowance of capital gains
treatment on sales of depreciable property to related persons)
contain a significant exception for the sale or exchange of property
in satisfaction of pecuniary gifts by the personal representative of
an estate.
39
K.
a.
The same exceptions will apply to the satisfaction of
pecuniary gifts by the trustee of a QRT that has made the
section 645 election, as such losses and sales will be
reported on the estate’s return under the rules governing
estates.
b.
If a pecuniary bequest from an electing QRT is satisfied
with depreciated property, any realized loss can be
recognized. Also, a pecuniary bequest from an electing
QRT satisfied with appreciated property should result in the
recognition of long-term capital gain under section
1223(11).
6.
In the case of qualified timber property, the section 194 deduction
available to individuals and estates with respect to the amortization
of the amortizable basis attributable to reforestation expenditures
will be available to an electing QRT.
7.
Section 72(u) generally limits the deferral of tax on increases in the
value of annuity contracts to those held by a natural person.
Section 72(u)(3)(A) provides an exception for contracts acquired
by an estate by reason of the decedent’s death. This exception to
section 72(u) should now apply to contracts held by an electing
QRT as well.
Filing of Returns.
1.
Because the estate may elect a fiscal year and the QRT must have a
calendar year, it is possible that the QRT’s first income tax return
following the grantor’s death will be due before that of the estate.
a.
If the QRT files its first income tax return without making
the election, the election can nevertheless still be made on
the estate’s first income tax return if it has not yet been
filed.
b.
Under these circumstances, the QRT must file an amended
Form 1041 excluding the items of income and deduction
since the grantor’s date of death (which are of course
required to be included on the estate’s Form 1041) and
attach a copy of the required written statement to the
amended return.
c.
Because the amended return must be marked as a "final
return," confusing could result when the QRT
recommences filing its own returns after the election period
terminates. Obtaining a new TIN at that time may be wise.
40
2.
If the estate’s first income tax return is filed without the required
written statement, any possibility of making the election is
foreclosed unless section 9100 relief is available.
3.
The QRT is not required to file a return for its first year if it does
not have sufficient income to require it to file or if it meets specific
requirements enumerated in Rev. Proc. 98-13. These requirements
are:
4.
a.
If the QRT’s first return is not due until after the estate’s
first return;
b.
The QRT's items attributable to the decedent are reported
pursuant to regulation section 1.671-4 (b)(2)(i)(A) or (B);
and
c.
The “entire trust is a qualified revocable trust.”
Based on these requirements, it does not appear that the exception
is available
a.
For the portion of a joint revocable trust attributable to the
first spouse to die; or
b.
Where a QRT’s first taxable year ends before the date the
personal representative selects for the end of the estate’s
fiscal year if the QRT has sufficient income to require the
filing of a return.
5.
However, the proposed regulations provide that the QRT is not
required to file a Form 1041 for the short taxable year beginning
with the decedent's death if a section 645 election will be made and
if the fiduciaries will treat the QRT as an electing trust from the
decedent's date of death.
6.
Because the QRT is required to use a calendar year until the
election is made, ideally the consideration of whether to make the
election should be completed by April 15 of the year after the
grantor’s death. In the event this is not possible (or overlooked),
the election may nevertheless be made through the date of the
statutory deadline, that is, the extended due date for filing the
estate’s Form 1041 (which may be almost a year later than the
QRT’s filing due date in the case of a grantor who dies in
December).
7.
Regardless of which return is filed first, the required written
statement is to be attached to the estate’s return and a copy
attached to the QRT’s return, if any.
41
L.
VII.
Absence of Estate.
1.
Where the QRT holds all the decedent’s assets at death and there is
no probate, the trustee alone may make the election. It will still be
necessary to obtain a tax identification number for the estate.
2.
If the personal representative for the related estate is not appointed
until after the trustee has made a valid section 645 election, the
personal representative is deemed to agree to the election and to
accept the associated responsibilities unless, within 60 days of
appointment, the personal representative notifies the trustee in
writing of the personal representative's refusal to agree to the
election.
a.
If the personal representative refuses to agree to the
election, the election period terminates the day before the
effective date of the personal representative's appointment.
b.
If the personal representative and the trustee are the same
person, the personal representative cannot refuse to agree to
the election.
c.
Assuming the election continues, amended Forms 1041
must be filed.
d.
If the election terminates, the personal representative must
obtain a new TIN for the related estate and file returns for
the estate, but the QRT is not required to amend any returns
filed by it during the election period.
MAKING THE SECTION 645 ELECTION DECISION
A.
Factors to Consider.
1.
As with most other estate administration tax matters, the question
of whether to elect to treat a QRT as part of the estate must be
made on a case-by-case basis after considering all relevant factors.
2.
The factors to be considered generally fall into three separate
categories to be addressed in deciding whether to make the section
645 election.
a.
Tax considerations.
b.
Effect on beneficiaries.
c.
Practical aspects.
42
B.
3.
Guidelines can be helpful in starting the decision-making process.
4.
Once the decision has been made to make the election, a plan
should be developed to take full advantage of the election and to
deal with matters at the time the election terminates.
5.
The estate and electing QRT will share liability for the payment of
tax owed by the combined entity. Without special income tax
allocation language in the governing instruments or a separate
agreement, allocation would presumably be prorated based on the
ratio of the separate income tax liabilities, with each fiduciary
making any needed equitable adjustments (for example, to take
into account a capital loss).
Tax Considerations.
1.
The trustee and the personal representative should determine
whether the benefits available from making the election are likely
to yield a significant tax advantage to the trust and estate.
2.
Questions to be asked.
a.
Can the trust benefit from the selection of a fiscal year by
the estate?
b.
Does the trust have charitable beneficiaries?
c.
Does the trust own S corporation stock?
d.
Are any IRA or other qualified retirement benefits payable
to the trust?
e.
Does the trust expect to receive real estate passive activity
losses?
f.
Does the trust own qualified timber property?
g.
Are any GST trusts created under the trust instrument?
h.
Does the trust anticipate funding pecuniary bequests in
kind? If so, will gain or loss likely be required to be
recognized?
i.
What will the effect of the election be with regard to state
income taxation?
j.
Will the election create additional complexities with regard
to any separate share calculations?
43
C.
D.
Effect on Beneficiaries.
1.
If a benefit may accrue from the election, it will be necessary to
determine to whom the benefit will ultimately accrue and whether
different beneficiaries will be affected differentially if the election
is and is not made.
2.
Questions to ask.
a.
Will there be a probate estate?
b.
Is the trust the sole beneficiary of the will?
c.
If not, are the beneficiaries of the will and the trust
identical?
d.
Are any equitable adjustments likely to be made?
Practical Aspects.
1.
The questions regarding whether the election is likely to be
practical must be considered.
a.
Will the estate and the trust be administered by the same
persons?
b.
If not, is it likely that the trustee and personal
representative can work effectively together to take full
advantage of the election?
c.
Will time and expense be saved by eliminating the need to
file a Form 1041 for the QRT?
d.
If no estate tax return is required to be filed, is it likely that
the administration can be completed within two years of the
grantor’s death?
e.
If an estate tax return is required to be filed, is it likely that
the administration will be completed prior to the final
determination of the estate tax liability?
f.
How will the income tax burden be allocated between the
estate and the QRT and is it likely that disputes will arise
regarding such allocation?
g.
How much confusion will result from the requirement of
the proposed regulations that the TIN of the related estate
be furnished to all of the electing QRT's payors?
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E.
(i)
What is the penalty if the electing QRT obtains a
TIN and uses it with its payors?
(ii)
If a TIN is not obtained for the QRT, what problems
will arise in tracing the income of the two entities?
(iii)
How will the payors react to the requirement of the
proposed regulations that the Forms W-9 they will
receive regarding the electing QRT's assets have the
related estate's name and TIN first, the actual owner
(the electing QRT) and its address listed thereafter,
but signed by the personal representative of the
related estate (which is not the owner of the account
or asset).
(iv)
When the election period ends, how difficult will it
be to have the payors take the related estate's TIN
off the account and begin using the TIN of the
QRT?
(v)
How much confusion will result if the payors foul
up the 1099s and K-1s?
Guidelines if No Probate Estate.
1.
Generally, where there is no probate estate, the analysis of whether
to make the election will be fairly straightforward and will usually
result in a determination to make the election, unless it is likely a
personal representative will be appointed in the future who will
refuse to agree to the election.
2.
If the QRT is the only postmortem entity because it was fully
funded at death, no issues arise with regard to the allocation of the
income tax liability, and the ability to use a fiscal year should
facilitate the administration and allow some opportunity for
income tax deferral.
3.
Before making the election, state law should be reviewed to
determine the effect of the election for state law income taxation
purposes. Unexpected results may be obtained under state law.
4.
In nonconforming states, making the election for federal income
tax purposes will generally require two sets of records and
calculations, and two potentially very different returns for each
year the election is in effect. At a minimum, if the trustee does not
select a calendar year for federal purposes, the state will likely
require the trust to report on a calendar year basis
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5.
F.
G.
Even in states that have enacted conforming legislation, it is
prudent to “think through” the results of the election for state law
purposes. For example, states may apply different rules for
purposes of taxing testamentary trusts and those created under inter
vivos trusts. The election may affect which set of rules will apply.
Guidelines for Partially Funded QRT with Complete Pour Over.
a.
Advantages should flow from making the election if the
QRT has a charitable beneficiary, rental real estate,
qualified timber property, anticipated (or already realized,
by the time the election is to be made) losses, S corporation
stock, an annuity contract, or a GST problem as described
above.
b.
At a minimum, only one fiduciary income tax return,
instead of two, will need to be prepared for all years other
than perhaps the first.
c.
A possible disadvantage could be the elimination of the
opportunity to defer the taxation of income through the
estate's selection of a noncalendar fiscal year. For example,
if the estate selects a fiscal year ending in February and
makes distributions to a nonelecting QRT during January,
the trust will not be required to report the income until
April 15 of the following year. It may be possible to
minimize this disadvantage by carefully timing
distributions from an electing QRT to its subtrusts (for
example, the bypass and marital trusts).
Guidelines if Not a Complete Pour Over.
1.
Where the will does not pour over to the QRT, or where
distributions from the will are also made to beneficiaries other than
the QRT), the decision of whether to elect will require careful
consideration.
2.
Under the separate share rule, the estate and QRT will be treated as
separate shares. Thus, the income of the estate and the income of
the QRT will not be aggregated for purposes of determining the
amount of DNI carried out in distributions from either the estate or
the trust (unless bypass distributions are deemed to be constructive
distributions to the other entity). Both the personal representative
and the trustee (if they are not the same person) must determine
whether including the QRT with the estate as a combined entity
will impact negatively on benefits otherwise available to either
entity alone (for example, the limitation on passive activity losses).
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3.
Where the fiduciaries of the estate and QRT are not identical, and
especially where their beneficiaries are adverse, either fiduciary
may decide the likely benefits do not outweigh the potential
problems. For example,
a.
Will the trustee be comfortable if the personal
representative has primary responsibility for filing what
will be a “consolidated” return?
b.
At the least, the fiduciaries will have to determine an
equitable method for allocating the income tax liability
among the entities. Although the separate share rule
addresses the allocation of DNI among the beneficiaries of
the estate and the trust, apparently the personal
representative and trustee may allocate the payment of the
tax due on the consolidated entity as they determine.
Presumably, each fiduciary should only be responsible for
paying the pro rata portion of income taxes allocable to the
entity for which that fiduciary is responsible, particularly
where the beneficiaries of the entities are not the same.
c.
(i)
For instance, the estate may have a net gain and the
QRT a net loss. It would seem unfair for the QRT’s
losses to offset the estate’s gains for tax purposes, to
the benefit of the beneficiaries of the estate, without
an equitable adjustment between the two entities.
(ii)
When drafting a pour-over estate plan, consider
addressing the issue of allocation of payment of
taxes from the two entities if a section 654 election
is made.
Fiduciaries have personal liability for unpaid taxes if
distributions are made before tax liabilities are satisfied. A
fiduciary’s liability should be limited to the tax allocable to
the entity the fiduciary controls and to the distributions
actually made from that entity.
(i)
Where the persona representative has filed a
combined return for the two entities, if the trustee
distributes assets to trust beneficiaries without
reserving sufficient funds for audit adjustments, the
trustee (or the distributee), and not the personal
representative, should be the one personally liable
for the deficiency.
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(ii)
H.
I.
In the absence of clarifying legislation, the
fiduciaries should enter into an agreement to this
effect at the time they make the election.
Taking Full Advantage of the Election Period.
1.
Although administration of the QRT may unavoidably extend
beyond the termination of the election period, taking advantage of
the benefits of the election should not be delayed. A trustee of an
electing QRT should pay particular attention to a number of issues:
2.
Where a charitable bequest is from the electing QRT rather than
from the estate, such amounts should be sure to be “set aside”
while the election is still in effect. (If an amount set aside is later
paid to charity from a QRT after the election terminates, regulation
section 1.642(c)-1(a)(1) would presumably deny a second
deduction, even though the estate rather than the QRT was the
entity previously allowed the deduction for the set-aside.)
3.
If pecuniary bequests from the QRT may be satisfied with
depreciated assets, these bequests should be made from the QRT
during, rather than after, the election period in order to preserve the
use of the loss under section 267(b).
4.
If a GST trust created under the QRT will be funded on a
pecuniary basis, the trustee should be certain that, if it would not
meet the GST separate share rule, it is funded while the election is
still in effect to maximize the benefit of the GST exemption
allocation.
5.
If S corporation stock is held by the QRT, the trustee should
distribute the stock to a qualified shareholder in time to avoid
losing the S corporation election. If the section 645 election will
terminate before the estate’s administration is complete,
distribution of the stock from the trust to the estate (if authorized
under a “pour-back” provision in the trust instrument) may keep
the S corporation election in effect longer.
Administration of Entities Following Termination of Election.
1.
A number of significant questions remain regarding how the
“unwinding” of the combined entity will occur upon the
termination of the election.
2.
If the estate is closed before the applicable date and the
administration of the QRT continues, the QRT will continue to
report on the same fiscal year basis, and the tax attributes
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applicable to an estate will continue to apply to the electing trust
until the election terminates.
3.
Conversely, where the QRT administration is completed before the
applicable date but the estate remains open, the estate simply
continues its administration under the same TIN.
4.
In the case of both taxable and nontaxable estates, the
administration of both the QRT and the estate may not be
completed by time the election terminates. Under these
circumstances, the estate and QRT would resume separate
reporting for income tax purposes.
5.
6.
a.
The QRT begins reporting as a separate trust, with its new
taxable year beginning on the day after the election
terminates (and, under redesignated section 644(a), ending
at the end of that calendar year).
b.
The estate continues as a taxable entity, using its same
fiscal year and TIN, filing a single return for that fiscal
year, and including the QRT’s income for the period of that
fiscal year in which the election was in effect.
c.
Any distributions made from the estate to the QRT from
that point forward, under the pour-over provision of the
will, would carry out DNI of the estate. At that point the
same income tax issues to be considered in timing
distributions from a single entity must be considered in
coordinating distributions from the two.
The Form 1041 for the related estate for the taxable year in which
the election terminates shall include:
a.
The income, deductions, and credits of the QRT through
the last day of the election period;
b.
The income, deductions, and credits of the related estate for
its taxable year; and
c.
A deduction for the deemed distribution of the share or
shares comprising the electing QRT to the new trust.
No guidance is provided regarding the methods to follow in
allocating the income and deductions of the QRT between the
election portion of the year and the balance of the year or how
installment sales are to be treated.
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Situation 21. Electing QRT sells appreciated asset in
exchange for a promissory note, with the gain to be
reported on the installment method. Before the note is
paid, the election period ends.
Under the proposed regulations, the combined entity is deemed to
distribute the QRT share to a new trust. It appears this would be a
disposition of the installment obligation that would trigger the gain
under section 453. This would be income to the related estate.
Because the related estate is not closing, the gain would not appear
to become part of DNI and would not pass out to the QRT as part
of the distribution deduction allowable to the estate on termination
of the election.
7.
It is not clear how unused loss carryovers and excess deductions on
termination under section 642(h) are to be allocated and treated
following termination of the election. Likewise, it is not clear
what will be considered the “final year” of each entity, not only for
that purpose but also to determine whether the year’s capital gains
will be included in DNI pursuant to the regulations under section
643.
8.
Confusion is likely to result regarding income tax overpayments
and refunds for the election period and the crediting of the same to
the income tax liabilities later payable by the separate entities.
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