With the temporary regulations on portability set to expire at the end of June, 2015, the IRS issued the final regulations on the portability election under IRC §2010 in TD 9725.  These regulations generally apply to estates of decedents dying on or after June 12, 2015 and gifts made on or after that date.

Generally the portability rules are one of the most significant developments in the area of estate taxation since the introduction of the unlimited marital deduction for transfer tax purposes in the Economic Recovery Tax Act of 1981 and, when combined with the significantly increased unified credit, significantly modifies the issues to be decided when a couple establishes an estate plan. 

The provision was first added to the law by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 with a scheduled sunset at the end of 2012.  However the American Taxpayer Relief Act of 2012 removed the sunset and made the provision permanent.

Generally the concept behind the portability election is to enable a married couple to “save” the amount that could have been transferred to a non-spouse at the first death without having to either actually transfer assets worth the unified credit to a party other than the spouse or establish a credit shelter trust (with its required annual filings, accountings and basic administrative issues). 

Rather, the surviving spouse’s can simply “tack on” any unused exclusion that is left over from the death of the first spouse to die when the estate tax return of the surviving spouse is prepared.  But to do so the executor or other representative must make an election for the estate of first spouse to die to provide the portability amount (called the deceased spouse unused exclusion amount, or DSUE) to the surviving spouse and the decedent must still be the survivor’s “last predeceased spouse” when use is made of that transferred amount.

Consider a case where the spouses have a combined estate of $10,000,000.  In 2015 each individual has the ability to transfer $5,430,000 to others, either in lifetime gifting or at death.  Let’s assume that no such gifts have been made at the date the first spouse passes away and the spouse have an “I love you” will—that is, the decedent’s estate is left in full to the survivor.  In that case we end up with the following situation

 

No estate tax is due since all assets passed to the survivor—but we have a problem when the survivor dies.  That spouse’s estate is now in excess of $5,430,000.  So, assuming no change in that amount or any change in the total value of the survivor’s assets, there will be estate tax due on the second death.

Traditional planning would have transferred the entire $5,000,000 to a bypass trust.  That may still make sense—there are valid advantages to that strategy (most significantly, getting all appreciation on the decedent’s assets out of the survivor’s estate which could reduce estate taxes) but there are also problems with that:

• The terms of the trust must be decided upon and included in the will prior to the death of the first spouse;
• Annual income tax returns will be required for the trust;
• There will be no adjustment of basis in those assets on the death of the survivor, often meaning significant income taxes will be due if those assets are sold;
• The trust must be administered (requiring accountings and the like); and
• The surviving spouse has restrictions on his/her ability to make use of assets in the trust (which may not be a problem in the view of the decedent’s heirs but certainly is most often seen as a problem by the surviving spouse)

Portability allows us to simply “carry over” any exclusion not used at the first death and apply it at the second.  So in our case, presuming no exclusion was used at the first death, the election was made, and our original decedent is still the survivor’s last predeceased spouse at his/her death, the following is the estate’s available exclusion:

Continuing with our assumption that neither the exclusion amount nor asset values have changed, the survivor’s estate can transfer the entire $10,000,000 to heirs without triggering any estate.  The portability election “preserved” the $5,430,000 of exclusion that was wasted in the first case.

But, as with all provisions of the law, the devil is in the details—and it’s up to the regulations to straighten out some of those details.  The IRS released identical temporary and proposed regulations on this issue in June of 2012.

The final regulations generally adopt the temporary regulations, though some revisions were made and, more interestingly, some comments in the preamble to the final regulations give some hints of guidance to come.

The preamble discusses the issue of obtaining an extension of time to make the election.  Generally the law provides that the election is to be made or before the due date for filing the Form 706 for the estate.  However, as many commentators pointed out when the law was first passed, there is no due date for an estate that is not, when combined with lifetime gifts, is not in excess of the exclusion amount at the date of death.

The IRS solved this issue by declaring in the regulations that, for an estate that does not otherwise have a filing obligation, the election must be made on a Form 706 filed on or before the due date (including extensions actually granted) that would have applied had the estate had a Form 706 filing requirement.  The final regulations make clear, at Reg. §20.2010-2(a)(1) that the issue of whether an estate can obtain relief for making a “late” portability election will depend on whether or not it was required to file an estate tax return.

·       If the estate is otherwise required to file a Form 706, the IRS will not grant an extension of time to make the election via a request for a private ruling under Reg. 301.9100-3.  The IRS position has always been that the IRS has no authority to grant relief for late elections where the date of the election is set by statute.

·       If the estate is not required otherwise to file a Form 706, then the IRS can (but does not have to) grant relief via a private letter ruling request under the late election relief provisions of Reg. §301.9100-3.  The IRS position is that since no return is required, the due date was established by the IRS regulations and not Congress.  Thus the IRS possesses authority to grant relief.

To obtain such relief the taxpayer will have to meet the general requirements of Reg. 301.9100-3, which generally is going to show the taxpayer is acting in good faith and is not simply using hindsight to determine whether to make such an election.  As well, since obtaining relief requires requesting a private letter ruling, the taxpayer will need to come up with the applicable user fee and also deal with the cost of professional representation to make the request. 

Thus this option is generally only one an adviser would expect to use where there was either an oversight in handling the first spouse’s estate or the taxpayer simply was the victim of bad advice.

The final regulations note that the IRS did provide temporary automatic late election relief in Revenue Procedure 2014-18 for estates of decedents who failed to file a Form 706 and make election.  That relief expired at the end of 2014 and the IRS declined to provide such automatic relief provisions in the final regulations.  Rather, the preamble notes that the IRS “has received and continues to consider” providing relief via a future ruling.

The preamble also discuss a concern raised where the taxpayer may have file a Form 706 that showed a tax due (and thus there was no DSUE on the original Form 706) but for which the resolution of a contingent liability causes the estate to file a claim for refund the entire tax paid and, as well, create an unused exclusion that did not exist on the original return.  Some were concerned that a protective election would be required in such a case or the unused exclusion will be lost as no computation of DSUE was provided on the original return.

The IRS modified Reg. §20.2010-2(b) to clarify that so long as the executor did not explicitly elect out of portability on the original Form 706 that the estate would be held to have provided a proper computation of the DSUE.  Specifically the regulation states:

Section 2010(c)(5)(A) requires an executor of a decedent’s estate to include a computation of the DSUE amount on the estate tax return to elect portability and thereby allow the decedent’s surviving spouse to take into account that decedent’s DSUE amount. This requirement is satisfied by the timely filing of a complete and properly prepared estate tax return, as long as the executor has not elected out of portability as described in paragraph(a)(3)(i) of this section.

In the preamble the IRS also addressed commentator’s concerns that, under the temporary regulations, the election is not necessarily controlled by the surviving spouse.  Some commentators had suggested that since the only real impact from the election takes place on the surviving spouse’s estate tax return, the surviving spouse should be the one to make the election.

The IRS concedes that might be a good idea—but, unfortunately that’s not the law that Congress passed.  As the preamble notes:

A few of the circumstances described include those in which the spouse is given the right to file the estate tax return in a prenuptial or marital agreement, or the spouse has petitioned the appropriate local court for the spouse’s appointment as an executor solely for the limited purpose of filing the estate tax return and the executor does not make the portability election. The Treasury Department and the IRS recognize the possibility that an executor may exercise the executor’s discretion to not make the portability election, thus causing the estate to forfeit the opportunity to elect portability, but note that section 2010(c)(5) of the Code permits only the executor of the decedent’s estate to file the estate tax return and make the portability election. The 2012 temporary regulations address the circumstances in which an appointed executor or a non-appointed executor may file the estate tax return and decide whether or not to elect portability. The Treasury Department and the IRS believe that any consideration of what, if any, state law action might bring the surviving spouse within the definition of executor under section 2203 is outside of the scope of this regulation. Accordingly, the final regulations adopt the applicable rules in the 2012 temporary regulations without change.

In essence the IRS suggests that the surviving spouse would need to consider bringing action in the applicable state court against the executor in such a circumstance.

Another concern raised by commentators related to the requirement in Reg. 20.2010-2(a)(7) that an estate must file a complete and properly prepared return in order to have a valid election.  The IRS had provided for certain circumstances where reduced information could be filed with certain Forms 706 filed to make this election than would be needed for a traditional Form 706.

Some commentators wanted the regulations to give specific examples of what deficiencies in a filing would be serious enough to cause a return to fail to be deemed to be a complete and proper return.  The IRS declined to do this, noting:

The Treasury Department and the IRS acknowledge that, as with all tax returns, some errors or omissions made with respect to an estate tax return will be considered minor and correctible. However, the Treasury Department and the IRS consider the issue of whether an estate tax return is complete and properly prepared to be determined most appropriately on a case-by-case basis by applying standards as prescribed in current law.

Presumably the Courts will apply a “substantial compliance” test in such cases, though we aren’t likely to learn the limits of such substantial compliance until we see actual cases where the issue is raised by the IRS and the courts actually rule on the issue.

The IRS also declined generally to liberalize the rules for when an estate provide detailed valuation information, though the IRS did add a clarification to Reg. §20.2010-2T(a)(7)(ii)(A)(2) to provide that the “other Code sections” whose need for a value could trigger the more detailed filing requirements does not include the general income tax provision found in IRC. §1014 that a date of death value is generally used for the basis of inherited property.

The final regulations also contain some changes to the interaction of Qualified Domestic Trusts (QDOTs) and the DSUE rules.  QDOTs are used when the taxpayer’s spouse is not a U.S. citizen and therefore the assets transferred to the spouse could “leave the country” and be held by the spouse on his/her date of death and not be includable in a U.S. estate.

The IRS made a modifications to the rules applicable in such cases in the final regulations.  The modification deals with the case where the spouse becomes a U.S. citizen at some time following the date of death of the first spouse to die. 

The IRS notes the following with regard to the final regulations:

The Treasury Department and the IRS conclude that, if the surviving spouse of the decedent becomes a citizen of the United States and the requirements under section 2056A(b)(12) and the corresponding regulations are satisfied so that the tax imposed by section 2056A(b)(1) no longer applies, then the decedent’s DSUE amount is no longer subject to adjustment and will become available for transfers by the surviving spouse as of the date the surviving spouse becomes a citizen of the United States. Accordingly, the final regulations make clarifying changes in §§20.2010-2(c)(4), 20.2010-3(c)(3), and 25.2505-2(d)(3).

The final regulations do provide a special rule outside the QDOT context for a surviving spouse who becomes a U.S. citizen after the death of a U.S. citizen spouse.  In such a case, so long as the executor makes the DSUE election, the surviving spouse, after becoming a U.S. citizen subject to the taxes, will be able to utilize the DSUE amounts.  Such a rule is included in §§20.2010-3 and 25-2505-2 of the final regulations.

The IRS also declined to make any changes in the regulations describing the agency’s right to examine the DSUE amount.  Generally the IRS can challenge the calculation of the DSUE at any time it has an impact on a return being filed and taxes paid (or that should have been paid).  Thus, even though a decedent may have died in 2011 the Form 706 electing DSUE filed at that time, the IRS could still challenge the value of the assets and, by extension, the amount of DSUE available, on a gift tax return filed by a surviving spouse in 2025. 

Such an exam could also treat an asset passing to a nonspouse as having a value greater than reported even though the lower basis had been used by the non-spouse to report a taxable gain on sale of the asset in a year where the heir no longer had the right to file a claim for refund.

The IRS declined to provide relief in such situations in the regulations, rather retaining full authority to make such challenges.  The existence of this extremely long period of time during which a value will need to be defended has caused some commentators to suggests advisers will need to weigh the potential need for detailed valuation support in a later year in determining whether the estate really wants to take advantage of the simplified reporting possible on certain Forms 706 that are filed solely to elect portability.

Finally the IRS addressed a problem that has arisen from the interaction of a ruling that originally was meant to grant taxpayers relief from QTIP elections under §2056(b)(7) made in error.  If a QTIP election is made for a qualifying trust, the value of the assets in the estate will be included in the estate of the surviving spouse.  Generally this is used to allow assets to be held in a trust to prevent the surviving spouse from redirecting assets away from heirs of the first spouse to die, but where such assets that need “protection” are greater than the exclusion amount.  As the QTIP election also means the assets are available to be counted as part of the unlimited marital exclusion, no estate tax is paid at the first death.

In some cases estates had mistaken made QTIP elections that applied to a credit shelter trust.  In those cases the QTIP election wasn’t needed, as no estate tax would have applied to that transfer.

If the QTIP election was treated as valid in such cases, the assets in the credit shelter trust would have been included in the surviving spouse’s estate even though the election was not needed to avoid estate tax.  To deal with this the IRS had issued Revenue Procedure 2001-38 where it ruled a QTIP election made in a situation where there was no reduction in federal estate tax would be treated as void.

Now fast forward to today’s transfer tax regime.  For the vast majority of taxpayers the actual risk to the heirs is not the estate tax (an extremely small percentage of decedents have taxable estates in excess of $5,430,000—many times fewer than had estates in excess of $1,000,000) but rather the income tax that will be due when low basis assets that have appreciated are sold.  Thus we may want all asset included in the estate of the second spouse to die.

As well, a number of states still have transfer taxes with lower amounts that can be passed to non-spouses than exist under federal law.

Both of these problems can be solved by simply leaving the assets outright to the surviving spouse.  But that opens up the possibility that the surviving spouse may decide to leave the assets inherited not to the individuals that the decedent wished to benefit but rather to parties the survivor wishes to favor.  Especially in second marriages with children from prior relationships this can be a significant concern.

To prevent the survivor from redirecting the assets, the estate planning documents would prefer to leave them in a trust where the survivor has only an income interest.  However such a terminable interest will generally mean the assets will not be included in the surviving spouse’s (likely nontaxable) estate (and thus no basis step-up) and will not eligible for state transfer tax exemptions for transfers to spouses (potentially triggering the payment of state transfer taxes).

QTIPs have traditionally solved these problems, as they bring the assets into the survivor’s estate (obtaining the step-up) and most state transfer tax regimes respect valid QTIPs.  But we have that old ruling that states the election will be void if it doesn’t reduce federal estate taxes.  Thus commentators have asked the IRS to modify the old ruling and allow for a valid QTIP election to be made. 

Of course simply saying “all QTIPs are valid” would bring back the problem of a Form 706 where a credit shelter trust accidentally has a QTIP election made.  So any solution needs to be more nuanced than simply revoking Revenue Procedure 2001-38.

In response to this the IRS stated in the preamble:

The Treasury Department and the IRS intend to provide guidance, by publication in the Internal Revenue Bulletin, to clarify whether a QTIP election made under section 2056(b)(7) may be disregarded and treated as null and void when an executor has elected portability of the DSUE amount under section 2010(c)(5)(A).

The IRS also noted that some change had made to examples found in the regulations that commentators had pointed out had erroneous basic exclusion amounts used.

Finally the IRS noted that the agency had concluded that a DSUE would not be impacted (that is, increased) by any allowable credit found in IRC §§2012-2015.  Those credits include:

·       §2012 – Credit for Gift Tax

·       §2013 – Credit for Tax on Prior Transfers

·       §2014 – Credit for Foreign Death Taxes

·       §2015 – Credit for Death Taxes on Remainders