Separate share rules and section 645 electing trusts




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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

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.] 1

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. 1

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. 1

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. 1

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. 1

B. Overview of Separate Share Rules. 2

1. There are three separate share rules to be aware of in administering trusts and estates. 2

a. The subchapter J rule. 2

b. The subchapter S rule. 2

c. The GST rule. 2

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. 2

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. 2

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. 2

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. 2

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. 2

C. Summary of Election to Treat QRTs as Part of Estate. 2

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

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

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. 3

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. 3

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. 3

6. Most of the questions, both substantive and procedural, raised in this outline would not arise if the election were for treatment of the QRT as an estate rather than for treatment as part of an estate. There seems to have been no tax policy reason to have conditioned the substantive income tax treatment of a postmortem trust, or the procedural requirements for such treatment, on the existence or the dispositive terms of a concurrent estate. Concerns about “multiple trust abuse” could easily be addressed by requiring all electing trusts to share one personal exemption and one set of tax brackets, and by allocating dollar amounts (such as the section 469(i)(2) passive activity loss deduction limitation) to each such trust proportionately. As currently enacted, the section 645 election effectively requires a merger with any existing estate for income tax purposes, with the resulting uncertainties noted below. 3

D. Impact of 2001 Act. 4

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). 4

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. 4

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

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. 4

5. In some situations where disclaimers will be part of the postmortem planning, a section 645 election may cause unnecessary complexity. 4

II. STATUTORY PROVISIONS AND STATUS OF REGULATIONS 4

E. Section 663(c). 4

1. The following new sentence was added to section 663(c) by the 1997 Act: 4

2. The General Explanation says the following concerning the reasons for the change: 4

3. In describing the provision, the General Explanation states: 5

F. Final Regulations under Section 663. 5

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. 5

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. 5

G. Section 645. 5

1. The 1997 Act added new section 646, which was then redesignated as section 645 by the Internal Revenue Service Restructuring and Reform Act of 1998, P.L. 105-206. Under the new section, an election may be made to treat QRTs as part of a decedent’s estate for income tax purposes. 5

2. Section 645 provides: 6

H. Proposed Regulations under Section 645. 6

1. Proposed regulations (REG-106542-98) under section 645 were published on December 18, 2000 at 65 F.R. 79015. The IRS cancelled the scheduled April 11, 2001 hearings on the proposed regulations, as no requests were made to speak at the hearing. 6

2. The written comments of The American College of Trust and Estate Counsel dated April 6, 2001 are attached to this outline as Exhibit A. The written comments of certain members of the Postmortem Income Tax Planning Committee of the American Bar Association's Section of Real Property, Probate and Trust law dated April 9, 2001 are attached as Exhibit B. 7

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. 7

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. 7

a. The criteria of the required written statement to effect the election are similar to those contained in the proposed regulations. 7

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. 7

c. The proposed regulations, when finalized, will replace Rev. Proc. 98-13. 7

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. 7

III. SECTION 663 FINAL REGULATIONS 7

I. Definition of Separate Shares. 7

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. 7

2. The regulations clarify the definition of separate shares and narrow the application of the separate share rules for estates as set forth in the proposed regulations that were published in January 1999. 7

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. 8

4. A separate share generally exists only if it includes both corpus and the income attributable thereto and is independent from any other share. 8

5. Bequests of specific property and specific sums of money described in section 663(a)(1) are not separate shares. 8

6. The income on bequeathed property is a separate share if the recipient of the specific bequest is entitled to such income. 8

J. Creation, Valuation, and Allocation. 8

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. 8

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. 8

a. This gives the fiduciary flexibility, within limits, in applying the separate share rules. 8

b. Redeterminations in value of the separate shares must be taken into account. 8

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. 8

a. Similar allocation rules are provided for the amount of gross income that is not attributable to cash received by the trust or estate. 8

b. This includes original issue discount, the distributive share of partnership tax items and the pro rata share of S corporation tax items. 8

4. Any expense or loss that is applicable solely to one separate share is not available as a deduction to any other share. 8

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. 9

K. Spouse's Elective Share. 9

1. The elective share of a surviving spouse constitutes a separate share of the estate. 9

2. An elective share that is entitled to income and shares in appreciation or depreciation is a separate share under the general rules. 9

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. 9

L. Qualified Revocable Trusts ("QRTs"). 9

1. QRTs are subject to the separate share rules. 9

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. 9

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. 9

4. An electing QRT itself may have two or more separate shares. 9

M. Pecuniary Formula Bequests. 9

1. Pecuniary formula bequests constitute separate shares of the estate. 9

2. Any pecuniary formula bequest that is entitled to income and shares in appreciation or depreciation is a separate share under the general rules. 9

3. Under a special rule in the final regulations, a pecuniary formula bequest that is not entitled to income and does not share in appreciation or depreciation is also treated as a separate share as long as the governing instrument does not provide that it is to be paid or credited in more than three installments. 9

N. Income in Respect of a Decedent. 10

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. 10

2. The amount allocated to each share is based upon the relative values of the shares that could potentially be funded with the IRD. 10

O. Effective Date Rules. 10

1. The final regulations are applicable to estates and qualified revocable trusts of decedents dying after December 28, 1999. 10

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. 10

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. 10

IV. SECTION 645 PROPOSED REGULATIONS 10

P. The Election. 10

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. 10

2. Once made, the election is irrevocable. 10

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. 10

Q. Definition of a QRT. 10

1. A QRT is any trust (or portion thereof) that on the date of death of the decedent was treated as owned by the decedent under section 676 by reason of a power held by the decedent (determined without regard to section 672(e)). 10

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. 11

3. The proposed regulations also take the position that a section 645 election for a QRT must result in a domestic estate. 11

R. Required Written Statement. 11

1. If there is a personal representative, the written statement must 11

a. Identify the election as an election under section 645. 11

b. Contain the name, address, date of death, and TIN of the decedent. 11

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. 11

d. Contain the name, address, and TIN of the related estate. 11

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. 11

f. Contain a statement from the personal representative, signed and dated under the penalties of perjury, stating 11

(i) The personal representative elects to treat the QRT as part of the related estate under section 645. 11

(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. 11

2. If there is no personal representative, the written statement must 11

a. Identify the election as an election under section 645. 11

b. Contain the name, address, date of death, and TIN of the decedent. 11

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. 12

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. 12

e. Provide a representation that there is no personal representative and to the trustee's knowledge and belief, one will not be appointed. 12

f. Contain the TIN obtained by the trust to file as an estate under Regulation section 301.6109-1(a)(4)(ii)(B). 12

g. Contain a statement from the trustee of the QRT, signed and dated under the penalties of perjury, stating 12

(i) The trustee elects to treat the QRT as part of the related estate under section 645. 12

(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. 12

S. Tax Identification Numbers ("TINs") and Forms 1041. 12

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. 12

2. All payors of an electing QRT shall be furnished a Form W-9 showing 12

a. The name of the related estate as the primary name on the form. 12

b. The name of the electing QRT as the secondary name. 12

c. The TIN of the related estate. 12

d. The address of the trustee 12

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. 12

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. 13

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. 13

T. Application of the Separate Share Rule. 13

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. 13

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. 13

U. Duration of the Election. 13

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. 13

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. 13

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: 13

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; 13

b. The final disposition of a claim for refund, unless suit is instituted within six months thereafter; 13

c. The issuance of a decision, judgment, etc. resolving the liability of the estate tax, unless a notice of appeal or petition for certiorari is filed within 90 days thereafter; or 13

d. The expiration of the period of limitations for assessment of the estate tax provided in section 6501. 14

V. Treatment on Termination of the Election. 14

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. 14

2. The new trust must include such distribution in gross income to the extent required under section 662. 14

W. Effective Date Rules. 14

1. The regulations are to apply on or after the date the final regulations are published in the Federal Register. 14

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. 14

V. SUBCHAPTER J SEPARATE SHARE RULE IN OPERATION 14

X. Basic Rules. 14

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. 14

2. The rule is mandatory and not elective. 14

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. 14

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