SPECIAL PROBLEMS IN ADMINISTERING ESTATES AND
SEPARATE SHARE RULES AND SECTION 645 ELECTING TRUSTS
By
W. Birch Douglass, III
McGuireWoods LLP
Richmond, Virginia
September 2001
I. INTRODUCTION 1
A. Revocable Trusts as Will Substitutes. 1
B. Overview of Separate Share Rules. 2
C. Summary of Election to Treat QRTs as Part of Estate. 2
D. Impact of 2001 Act. 4
II. STATUTORY PROVISIONS AND STATUS OF REGULATIONS 4
A. Section 663(c). 4
B. Final Regulations under Section 663. 5
C. Section 645. 5
D. Proposed Regulations under Section 645. 6
III. SECTION 663 FINAL REGULATIONS 7
A. Definition of Separate Shares. 7
B. Creation, Valuation, and Allocation. 8
C. Spouse's Elective Share. 9
D. Qualified Revocable Trusts ("QRTs"). 9
E. Pecuniary Formula Bequests. 9
F. Income in Respect of a Decedent. 10
G. Effective Date Rules. 10
IV. SECTION 645 PROPOSED REGULATIONS 10
A. The Election. 10
B. Definition of a QRT. 10
C. Required Written Statement. 11
D. Tax Identification Numbers ("TINs") and Forms 1041. 12
E. Application of the Separate Share Rule. 13
F. Duration of the Election. 13
G. Treatment on Termination of the Election. 14
H. Effective Date Rules. 14
V. SUBCHAPTER J SEPARATE SHARE RULE IN OPERATION 14
A. Basic Rules. 14
B. Typical Applications. 15
C. Marital Deduction Planning. 19
D. Disclaimers. 23
E. Generation-Skipping Planning. 24
F. S Corporations. 24
G. Effect of Rate Compression. 26
VI. DISCUSSION OF SECTION 645 AND ITS APPLICATION 27
A. Definition of a Qualified Revocable Trust ("QRT"). 27
B. Duration of Election Period. 30
C. Effect of Election 32
D. Use of Fiscal Year Other than Calendar Year. 34
E. Distributable Net Income ("DNI"). 34
F. Charitable Set-Aside Deduction. 36
G. S Corporation Election. 36
H. Passive Loss Active Participation Rules. 38
I. GST Separate Share Rule. 38
J. Other Special Situations, Advantages, and Disadvantages.. 39
K. Filing of Returns. 40
L. Absence of Estate. 42
VII. MAKING THE SECTION 645 ELECTION DECISION 42
A. Factors to Consider. 42
B. Tax Considerations. 43
C. Effect on Beneficiaries. 44
D. Practical Aspects. 44
E. Guidelines if No Probate Estate. 45
F. Guidelines for Partially Funded QRT with Complete Pour Over. 46
G. Guidelines if Not a Complete Pour Over. 46
H. Taking Full Advantage of the Election Period. 48
I. Administration of Entities Following Termination of Election. 48
SEPARATE SHARE RULES AND SECTION 645 ELECTING TRUSTS
By
W. Birch Douglass, III
McGuireWoods LLP
Richmond, Virginia
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 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. 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 generation-skipping 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.
C. 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 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.
D. 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 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 closely-held 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. 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.
C. 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.
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.
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.
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.
5. 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.
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.
B. 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.
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.
3. 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.
4. Any expense or loss that is applicable solely to one separate share is not available as a deduction to any other share.
5. 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.
C. 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.
D. 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.
E. 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.
F. 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.
G. 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. 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.
B. 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)).
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.
C. Required Written Statement.
1. 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.
2. 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.
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.
D. 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
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
3. 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.
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.
E. 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.
F. 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
d. The expiration of the period of limitations for assessment of the estate tax provided in section 6501.
G. 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.
H. 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 amounts in excess of the trust's or estate's total DNI yet only be taxable on a ratable portion of the DNI.
6. 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.
B. 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.
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 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 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.
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. 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.
C. 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.
4. 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.
5. 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.
6. 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 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 two-pocket 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 three-pocket 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 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.
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.
D. 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.
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 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 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. 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).
G. 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.
2. 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. 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).
2. 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 non-adverse 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, 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. 105-220, 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.
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.
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.
B. 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.”
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.
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.
C. 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.
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.
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 applied using the separately determined DNI applicable to the distributing share.
3. 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.
4. 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
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. 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.
G. 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.
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.
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.
4. 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 apply." Careful practitioners will want to make any necessary S election at the earlier possible time.
H. 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.
I. 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 of the entire QRT in order for the allocation to apply to the subtrust.
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.
J. 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.
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.
K. 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.
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:
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.”
4. 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.
L. 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.
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).
B. 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?
C. 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?
D. 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?
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?
E. 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
5. 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.
F. 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).
G. 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).
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.
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.
c. 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.
ii) In the absence of clarifying legislation, the fiduciaries should enter into an agreement to this effect at the time they make the election.
H. 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.
I. 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 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.
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.
5. 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.
6. 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.
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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