When new provisions are added to the IRC, it takes a few years for the first court cases to begin to appear on the issues raised by the new provision. We are now beginning to see the first cases that look at the of the portability rules found in IRC §2010(c), beginning with case of the Estate of Minnie Lynn Sower v. Commissioner, 149 TC No. 11.

The portability rules, first added to the law in 2010 and made a permanent part of the law in 2012, are meant to allow a surviving spouse to have the use of any unused exclusion amount from the deceased spouse’s estate, so long as the deceased spouse’s estate files an election to make that amount available to the surviving spouse. [IRC §2010(c)(4)]

To make the election, the deceased spouse’s estate must timely file a Form 706, the estate tax return, to compute the amount of the unused exclusion and to make the election to allow the use of that unused exclusion by the surviving spouse.

In this case Frank Sower died in 2012, leaving Minnie as his surviving spouse. Frank’s estate timely filed a Form 706 on which it determined that Frank had no estate tax liability. But there was a problem on the return—the Form 706 showed no taxable gifts but then included over $940,000 of taxable gifts on the worksheet provided to calculate taxable gifts to be reported on the return.

The Form 706 claimed that there existed an unused exclusion of over $1,250,000 available and elected to allow the amount to pass to Minnie to be used on her Form 706 when she passed away. That amount of unused exclusion did not take into account the reduction that should have taken place after accounting for lifetime gifts. Had they been taken into account Frank’s estate still would have had no estate tax liability but the unused exclusion amount would have been much lower.

Even though the return contained information that there were gifts that had not been properly considered, the IRS issued an “Initial Letter 627, Estate Closing Document” to Frank’s estate. The letter indicated that Frank’s return had been accepted as filed and, as the Court noted in the text it cited from the letter, said:

[The Commissioner] will not reopen or examine this return unless * * * [notified] of changes to the return or there is: (1) evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact; (2) a clearly defined substantial error based upon established Internal Revenue Service position; or (3) a serious administrative error.

Minnie died the following year and timely filed a Form 706. The estate claimed the deceased spouse unused exclusion amount (DSUE) equal to the amount shown on Frank’s Form 706. On her return the same error was committed that did not include the gifts she had made during her lifetime in coming up with her estate tax liability, but the return still showed an estate tax due.

In 2015 the IRS began an examination of Minnie’s return and noted the problem with her gifts. The agent also opened an examination of Frank’s return and found the same gifting error on that return. The agent adjusted the DSUE from Frank’s return downward based solely on the information the agent had from the filing. By the time the adjustments were taken into account, the agent determined that Minnie’s estate owed an additional $788,165.

Minnie’s estate claimed that the IRS had acted improperly by adjusting the DSUE coming to Minnie’s estate from Frank’s Form 706. The estate offered several reasons why the IRS should be barred from making this adjustment—but none of them were accepted by the Tax Court.

A major reason the estate faced an uphill fight in arguing the IRS should not able to adjust the DSUE is found in IRC §2010(c)(5)(B) which specifically authorizes the IRS to look at the predeceased spouse’s return. That provision reads:

(B) Examination of prior returns after expiration of period of limitations with respect to deceased spousal unused exclusion amount

Notwithstanding any period of limitation in section 6501, after the time has expired under section 6501 within which a tax may be assessed under chapter 11 or 12 with respect to a deceased spousal unused exclusion amount, the Secretary may examine a return of the deceased spouse to make determinations with respect to such amount for purposes of carrying out this subsection.

That authority was restated in the then applicable Temporary Reg. §20.2010-2(d). The current provisions, which is virtually identical, is found at Reg. §20.2010-2(d) which reads:

(d)Authority to examine returns of decedent. The IRS may examine returns of a decedent in determining the decedent's DSUE amount, regardless of whether the period of limitations on assessment has expired for that return. See § 20.2010-3(d) for additional rules relating to the IRS's authority to examine returns. See also section 7602 for the IRS's authority, when ascertaining the correctness of any return, to examine any returns that may be relevant or material to such inquiry.

In addition to this specific grant of authority, the Court pointed out that the IRS has broad rights to inquire about information relevant to a return under IRC §7602. The Court noted:

…[S]ection 7602 gives the Commissioner broad discretion to examine a range of materials to “ascertain[ ] the correctness of any return”. Under section 7602(a)(1) Congress gave the Commissioner specific authority “[t]o examine any books, papers, records, or other data which may be relevant or material”. Section 7851(a)(6) provides that subtitle F, which includes section 7602, is “applicable with respect to any tax imposed by * * * title [26]”. The Internal Revenue Code does not contain any provision exempting estate tax returns from section 7602. As a result, the Commissioner has the power to examine any relevant “books, papers, records or * * * data” to determine the correctness of an estate tax return. Sec. 7602(a)(1).

The Court concludes initially:

Here, the Commissioner properly exercised the power conferred by sections 2010(c)(5)(B) and 7602(a)(1). He examined the return filed by the estate of the predeceased spouse. The Commissioner found that the DSUE had been overstated. He adjusted the amount of the DSUE as authorized by section 2010(c)(5)(B) and the regulations, but he did not determine that there was an estate tax deficiency for the predeceased spouse’s estate.

But, the estate countered, the IRS had issued that letter that accepted Frank’s return as filed. In the view of the estate that letter amounted to a closing agreement under §7121 that would preclude the IRS from making changes to the DSUE amount flowing from that return.

The Court pointed out that the regulations specifically limit closing agreements to agreements using the prescribed forms Form 866, Agreement as to Final Determination of Tax Liability, and Form 906, Closing Agreement on Final Determination Covering Specific Matters. The Court did note that the Fifth Circuit, in the case of Treaty Pines Invs. P’tship v. Commissioner, 967 F.2d 206, 211 (1992) that a closing agreement could take other forms, but in this case the Court found there was no evidence of the type of continuing negotiations that took place in Treaty Pines and thus no evidence of a real agreement between the IRS and Frank’s estate.

The Court also found that there was no other reason that letter should serve to prevent the IRS from looking at that return to determine the proper tax on Minnie’s return.

The estate argued that this look at Frank’s return was an impermissible second examination of Frank’s return. IRC §7605(b) provides:

(b) Restrictions on examination of taxpayer

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

The Court found that this section did not apply in this case. First, the Court noted that the provisions does not apply when the IRS does not obtain any new information from the taxpayer—in this case the agent never asked for additional information from Frank’s estate, since everything he needed as already on the form.

As well, that only offers protection to the examined party (Frank’s estate in this case) and cannot be used by other taxpayers.

The estate now attempted to argue that this regulation and law could not apply to gifts before 2010—an argument the Tax Court quickly dismissed. The court noted the effective date was tied to when a decedent died and had no relationship to when the decedent made a gift.

Finally, the estate attempted to argue that looking at Frank’s return went against Congressional intent for portability and was an unconstitutional lack of due process since there was no statute of limitations.

The Court pointed that Congress had written a provision to provide for examining the prior deceased spouse’s return into the law—and the clear text of the law is the best indicator of Congressional intent.

The Court also rejected the due process claim. The Court notes that the statute for assessing tax on Frank’s return still ends as it did before and the IRS was not assessing tax against Frank’s estate. The issue was the amount of tax due on Minnie’s return, an issue that has the same statute of limitation as it always did under IRC §6501.