On June 8, 2015 the Treasury approved final regulations governing the portability of the unified gift and estate tax applicable exclusion amount. The final regulations replace previously released temporary regulations and provide further guidance on making a portability election.
Portability: Legislative and Regulatory History
Section 303 of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (TRUIRJCA) of 2010 created a “portable” applicable exclusion amount effective January 1, 2011 and set to expire December 31, 2012. Pub. L. 111-312. Under the Act, if a spouse died after December 31, 2010 and the deceased spouse’s executor made the proper election on IRS Form 706 (called a “portability election”), the surviving spouse was entitled to use, for estate or gift tax purposes, the amount of the deceased spouse’s unused applicable exclusion amount. This amount is referred to as the Deceased Spouse Unused Exclusion (DSUE) amount.
Under Sec. 303 of TRUIRJCA, the executor of the deceased spouse’s estate makes a portability election on behalf of the surviving spouse by filing the decedent’s estate tax return on which the DSUE amount is calculated. The executor of an estate loses the ability to make a portability election by choosing not to file an estate tax return or filing the return and including an affirmative statement that the surviving spouse does not wish to make the election.
On June 12, 2012 the Treasury approved Temporary Regulations that provided guidance on making a portability election. IRB 2012-28. The Temporary Regulations defined important terms, explained in more detail how to make a portability election, how to compute the DSUE amount, the appropriate uses of the DSUE amount by the surviving spouse and special rules in cases where the surviving spouse is a nonresident and either a non-citizen or is the beneficiary of a Qualified Domestic Trust (QDOT). 26 C.F.R. 20.2010-1T-3T and 26 C.F.R. 25.2505-1T-2T.
Six months after the Treasury released the Temporary Regulations, President Obama signed the American Taxpayer Relief Act (ATRA) making the portable applicable exclusion amount permanent effective January 1, 2013. Public Law 112-240. The only amendment ATRA made to the language in Sec. 303 of TRUIRJCA was replacing “basic exclusion amount” with “applicable exclusion amount.”
Finally, on June 8, 2015, the Treasury published Treasury Decision 9725 (“final regulations”) that replaced the previously released temporary regulations and provided further guidance on making a portability election. TD 9725, IRB 2015-26. The final regulations apply to estates of decedents with surviving spouses who pass away after June 12, 2015. In general, the regulations made final many of the Temporary Regulations put into effect three years earlier. However, there were a number of substantive additions. For example, the final regulations clarify when an extension of time to file for portability will be possible under Treasury Regulation 301.9100-3 and when a portability election made by a non-appointed executor may be superseded. 26 C.F.R. 20.2010-2(a)(1), (6)(ii). In addition, the regulations provide further guidance on the application of a deceased spouse’s DSUE amount when a nonresident surviving spouse who is not a citizen of the U.S. or is the beneficiary of a QDOT later becomes a U.S. citizen. 26 C.F.R. 20.2010-2(c)(4)(ii) and Example 4, 26 C.F.R. 20.2010-3(c)(2), (3)(ii), 26 C.F.R. 25.2505-2(d)(2), (3)(ii).
Basic Portability Rules
The legislative and regulatory guidance has produced a number of basic portability rules. First, only the DSUE amount may be transferred to a surviving spouse. The Generation Skipping Transfer Tax (GSTT) applicable exclusion amount cannot be transferred. This creates a new level of complexity in large estates where amounts are transferred to a surviving spouse and then to grandchildren. Second, the surviving spouse must be a U.S. citizen or resident alien. In general, a nonresident alien or the beneficiary of a QDOT cannot benefit from the portable DSUE amount. Third, the portability election must be made on an Estate Tax Form 706 that is timely filed after the deceased spouse’s death (including extensions). Fourth, the estate tax return must be complete and properly prepared with certain exceptions (discussed below).
Filing Form 706 (Basic Rules/Deadlines)
One of the requirements for making a portability election is that the Form 706 must be complete, properly prepared and timely filed. In general, the portability rules divide estates into two groups: small estates and large estates. Large estates are required by statute to file an estate tax return. By statute, the executor of the estate of every deceased U.S. citizen or resident who passes away in 2015 and whose gross estate plus taxable gifts is more than $5.43 million must file an estate tax return. Secs. 6018(a),6075(a). Small estates are not required by statute to file an estate tax return due to the size of the estate. However, executors of small estates may choose to file an estate tax return in order to make a portability election.
Whether an executor is required to file an estate tax return on behalf of a large estate or is filing on behalf of a small estate in order to make a portability election, the estate tax return must be timely filed. This requirement is met for both large and small estates if Form 706 is filed within nine months of the death of the deceased spouse. The executor may file Form 4768 to request an automatic six month extension of time to file, making the deadline to file 15 months after the decedent’s death. If the executor is filing a tax return on behalf of a large estate and wishes to make a portability election then he or she must do so within the nine-month time period (or 15-months with an extension). There is no possibility of extending the time to file under 26 C.F.R. 301.9100-3. On the other hand, an executor filing an estate tax return on behalf of a small estate in order to make a portability election may be entitled to relief under 26 C.F.R. 301.9100-3.
In general, section 26 C.F.R. 301.9100-3 allows taxpayers to request an extension of time to file regulatory elections. The taxpayer must establish that he or she acted reasonably and in good faith and the grant of relief will not prejudice the interests of the government. The final regulations do state that an extension to file an estate tax return may be available for small estates under 26 C.F.R. 301.9100-3. However, in order to obtain relief under Sec. 301.9100-3 a taxpayer must obtain a Private Letter Ruling (PLR) from the IRS. Obtaining a PLR is expensive (there is a $10,000 filing fee) and there is no guarantee that the IRS will grant the requested relief.
In Rev. Proc. 2014-18, the IRS established a simplified method to obtain an extension of time to file for those executors who failed to make a portability election by filing a timely estate tax return. The simplified procedure provided automatic relief and eliminated the PLR filing fee. However, this procedure only applied to the estates of decedents passing away between January 1, 2011 and December 31, 2014. In comments on the Temporary Regulations, practitioners expressed a desire for the final regulations to extend the method established by Revenue Procedure 2014-18. The final regulations do not extend this procedure, though in the preamble to the final regulations the IRS did say they are continuing to consider requests for permanent extensions of this type of relief.
Complete and Properly Prepared: Making the Election
Whether an executor is required to file an estate tax return on behalf of a large estate or is filing on behalf of a small estate in order to make a portability election, the estate tax return must be complete and properly filed. This requirement is satisfied if Form 706 (along with any required schedules and attachments) is prepared and submitted according to the Instructions to Form 706 and the Treasury Regulations issued under 26 U.S.C. §6018.
The Instructions to Form 706 and the final regulations require that the estate tax return include a computation of the DSUE amount in order to make a portability election. The DSUE amount is equal to the lesser of: (1) the basic exclusion amount in effect in the year of the decedent’s death; or (2) the excess of the decedent’s applicable exclusion amount over the sum of the decedent’s taxable estate and the decedent’s adjusted taxable gifts. 26 C.F.R. 2010-2(c). Some practitioners had hoped that the final regulations would provide for a protective election in cases where the DSUE amount was uncertain. For example, an executor might not be able to determine whether an asset should be included in an estate at the time of the decedent’s death. This would make calculating the DSUE amount very difficult. The proposal by practitioners was that an executor could make a protective election at the time of the first spouse’s death, making the portability election and reserving the right to recalculate the DSUE amount if subsequent events affected the deceased spouse’s Form 706. However, the final regulations do not provide for this type of protective election. The DSUE amount must be calculated in order for the return to be considered complete. 26 U.S.C. 2010(c)(5)(A), 26 C.F.R. 2010-2(b).
Section 20.2010-2(a)(7)(ii)(A) of the final regulations provides a special rule applicable to small estates not required to file an estate tax return. If the executor is filing the estate tax return on behalf of a small estate in order to make a portability election and the estate includes property that is entitled to a charitable or marital deduction, then the executor is not required to appraise a value for such property on the estate tax return. This exception is not available if the value of the charitable or marital deduction property is needed to determine the value of property passing from the decedent to a recipient of the property or the estate’s eligibility for an estate or GST tax benefit. In addition, the final regulations reserve the right for the IRS to include additional instances where this simplified reporting exception will not be applicable. To file an estate tax return under this rule the executor must provide a description of the marital deduction or charitable deduction property, name any owners or beneficiaries of the property and provide information showing the property is entitled to a charitable or marital deduction. Finally, the executor must estimate the fair market value of the gross estate, including the marital or charitable deduction property and report this value on the estate tax return.
In order to be considered complete an estate tax return must include certain attachments. These attachments include the decedent’s death certificate and a certified copy of the will (if any). Other documents that may be required include Form 712 (Life Insurance Statement), Form 709 (Gift and GSTT Tax Return), Form 706-CE (Certificate of Payment of Foreign Death Tax), trust instruments, power of appointment instruments and/or state certification of payment of death taxes.
The Effect of Portability on the Use of Bypass Trusts
The portable applicable exclusion provides an additional tool for planning for many Americans, particularly families with estate values between the two exclusion amounts (between $5.43 million and $10.86 million in year 2015). Prior to the introduction of portability, each spouse had an estate tax exemption. If the first spouse to die failed to use his or her entire exemption amount, then the surviving spouse could not utilize the unused amount. Commonly many had the first deceased spouse leaving everything to the surviving spouse. Under Sec. 2056(a) bequests to a surviving spouse are deducted from the deceased spouse’s gross estate for purposes of calculating estate tax. This is referred to as the marital deduction. If most of the property passed to the surviving spouse under the marital deduction, a large portion of the exclusion of the first spouse to pass away was unused. When the surviving spouse passed away, all of the couple’s assets were included in the surviving spouse’s estate with only one applicable exclusion amount. This caused the estate of the surviving spouse to pay a large amount of tax. To avoid this result, the traditional remedy was for the couple to establish a bypass trust (also called a “credit exclusion trust” and an “AB trust”).
Under a bypass trust arrangement, a deceased spouse leaves assets to an irrevocable trust. As long as the value of trust assets was less than the deceased spouse’s exclusion amount there would not be any estate tax. Upon funding the trust the assets receive a step-up in basis. Typically, the bypass trust will pay income generated by the trust assets to the surviving spouse. Upon the surviving spouse’s death, the trust property can be passed to the couple’s children. Since the surviving spouse was never the owner of the trust assets, the assets would not be included in the surviving spouse’s gross estate and would not receive a step-up in basis upon the death of the surviving spouse. One reason to establish a bypass trust prior to portability was to avoid inclusion of the bypass trust assets in the surviving spouse’s estate upon death (since the surviving spouse only had one applicable exclusion amount available). However, portability now allows the surviving spouse his or her applicable exclusion amount but also the unused exclusion amount of his or her deceased spouse. Additionally, by relying on portability the assets in the surviving spouse’s estate at the time of death will receive a step-up in basis. This reduces potential income taxes for beneficiaries upon the sale of these assets.
Nonetheless, bypass trusts continue to be an important tool for many clients. For second marriage clients, bypass trusts can provide security for a surviving second spouse but ensure assets pass to and are controlled by children from a first marriage. Further, a bypass trust can (and now routinely does) include provisions and techniques to ensure that the assets in that trust receive a step up in basis on the death of the second spouse.
While a bypass trust is not necessary in many circumstances to save estate taxes, there may be instances when a bypass trust can still be a useful planning tool. The tax benefits of establishing a trust are often the first to be considered. However, there are a number of non-tax benefits for setting up a trust. These include asset management, disposition control and creditor protection. In certain circumstances these considerations may provide sufficient benefit to establish a bypass trust despite estate tax considerations. Further, many revocable trust plans include funding options that allow a surviving spouse to determine, at the time of death of the first spouse, whether to use a bypass trust or whether to “port” any unused credit of a deceased spouse. The flexibility allows the surviving spouse to use a bypass trust for various reasons, such as creating incentives for descendants, protecting assets from creditors (which assets otherwise would be owned by the surviving spouse outright), and establishing dynasty trust planning. These are some of the reasons that bypass trusts will continue to be designed into revocable trust plans, even after portability was made permanent.
The introduction of portability has offered new opportunities for planning and new flexibility for those with taxable estates and those without a taxable estate.
September 15, 2015