Revocable trusts in the past few years have become very popular will substitutes touted as beneficial for reducing probate court administrative burdens and costs. Estates are afforded many tax benefits during the administration process (many of which are discussed later within this article). Due to the increasing use of revocable trusts as will substitutes, a new statute was needed to provide revocable trusts more equitable tax treatment during a normal estate administration period. In order to effectuate this purpose, section 645 (“Section 645”) of the Internal Revenue Code of 1986 (“Code”) was enacted in 1997. Section 645 sets forth the statutory requirements for making the election to treat certain trusts as part of an estate. Final regulations for Section 645 were issued on December 4, 2002.
Section 645, as enacted, was comprised of only approximately 230 words, but it has taken about four years for the final regulations to be issued. This is partially attributable to statutory language being the succinct verbalization necessary to rectify a legal need. But the statutory language must then be analyzed in order for proper implementation. In order to provide for as many as possible fact patterns that may arise in the implementation process, it would be helpful if one could look into a crystal ball to view the future. As the possible fact patterns are predicted, regulations can then be provided for them. Since the statute was enacted, different fact patterns have arisen and clarification has been requested. The new final regulations clarify and change the proposed regulations and a prior revenue procedure that was issued by the Internal Revenue Service (the “Service”) in an attempt to provide simplification and guidance for many of the situations that may arise.
History and Statutory Language
Section 645 was originally enacted as section 646 of the Code under section 1305 of the Taxpayer Relief Act of 1997, P.L.105-34, 111 stat. 788 (1997). It was redesignated as Code section 645 by P.L. 105-206 and it applies with respect to estates of decedents dying after August 5, 1997.
After its redesignation as Code section 645, the statute reads as follows:
Sec. 645. CERTAIN REVOCABLE TRUSTS TREATED AS PART OF ESTATE
(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 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.
The statute basically sets forth three important parameters: 1) what trusts are eligible to make the election, 2) what time period the election is in effect, and 3) how to make the election. Since the statute is fairly short, many of the words have a significant meaning.
Initial Guidance- Revenue Procedure 98-13
In order to assist with implementation of the statute, guidance from the Service was initially issued in the form of Revenue Procedure 98-13, 1998-1 C.B. 370. The Service acknowledged in section 2 of that revenue procedure that if the decedent had a revocable intervivos trust, often time the trustee performs settlement functions typically performed by an executor of an estate.
1. How to Make the Election. Section 3 sets forth the procedures and requirements for making the election (“Section 645 Election”). The Section 645 Election was made by attaching a statement that included the required information to the first income tax return for the estate. A copy of the statement also had to be attached to the return for the trust (if the trust was required to file for the taxable year ending after the decedent’s death). The election statement had to be signed by the executor and the trustee unless there was no executor. In such a case only the trustee of the trust was required to sign the statement, but the trustee had to include a representation that there was no executor and that no executor would be appointed. The election was considered made when the estate or trust filed this statement with its income tax return, whichever first occurred.
2. Taxpayer Identification Number (TIN) for the Trust. Paragraph 3 of section 3 provided that the trustee of the qualified revocable trust had to obtain a TIN unless a Form 1041 was not required to be filed.
3. Taxpayer Identification Number for the Estate. The estate must always obtain a TIN but if no executor of the estate was appointed, the trustee of the qualified trust had to obtain a TIN for the estate.
4. Filing of Income Tax Return for the Trust. The trust did not have to file a Form 1041 for its taxable year ending after the death of the decedent if: (1) the income tax return for the estate’s first taxable year was filed before the due date of the income tax return for the trust; (2) all the trust items attributable to the decedent were reported pursuant to regulation section 1.671-4(b)(2)(i)(A) or (B); and (3) the entire trust was a qualified revocable trust. For most trusts, the practical effect was that a Form 1041 would have to be filed since the estate would elect a fiscal year-end after December 31 resulting in no income tax return for the estate’s first taxable year being filed before the due date of the income tax return for the trust. If a Form 1041 for the trust was filed for the taxable year, then the trust had to file an amended Form 1041, excluding all items of income, deductions and credits attributable to the trust during the election period. Those items were includible on the return for the decedent’s estate, and a copy of the required statement was required to be attached to the estate’s income tax return.
To summarize, the Section 645 Election was considered to have been made on the first of the filing of (1) the estate’s income tax return with the original required statement attached or (2) the trust income tax return with a copy of the required statement attached. Once the trust made the election all items of income, deductions, and credits attributable to the trust would be excluded from the trust return and reported on the estate’s income tax return.
Since Revenue Procedure 98-13 was intended only for temporary guidance, many issues were left unanswered. Proposed regulations were issued on December 18, 2000. REG 106542-98, 65 Fed Reg 79015 (Dec. 18, 2000). An overview of the clarifications and provisions of the proposed regulations is as follows:
1. How to Make the Election. Section 1.645-1(c) of the proposed regulations clarified that the Section 645 Election is to be made on the first income tax return for the estate since there was some confusion as to which return controlled the making of the election.
2. Filing of Income Tax Return for the Trust. Section 1.645-1(d)(1)(ii) of the proposed regulations set forth that the QRT (defined herein) for which a Section 645 Election would be made had the option not to file a Form 1041 during the election period. However, the proposed regulations were interpreted as requiring a Form 1041 for the short period ending after the decedent’s death if the trust obtained a TIN. Section 1.671-4(d)(2) of the proposed regulations clarified that any required return for the time period before the death of the decedent would have a filing date based as if the grantor had survived until the end of the year. If the election were not made, then the QRT would be subject to penalties and interest for failure to obtain a TIN and to file a timely return.
3. Taxpayer Identification Number for the Trust and Estate. Section 1.645-1(d)(2) of the proposed regulations provided that an electing trust was not required to obtain a TIN in its own name if a personal representative had been appointed for the related estate. If an election were to be made, the estate would always need a TIN. If no personal representative had been appointed, then the trustee of the electing trust was required to obtain a TIN as an estate but was not required to obtain a TIN as an electing trust. The trustee would apply for a TIN for the trust by filing IRS Form SS-4 and indicating that it was applying in the name of the trust followed by the words: “Filing as an Estate under Section 645.” See Prop. Reg. §§ 1.645-1(d)(1)(i)(B) and 301.6109-1(a)(4)(ii)(B). If the trustee was uncertain as to whether or not the election would be made, then the trustee would obtain a new TIN upon the decedent’s death even if the trust had an existing identification number. See Prop. Reg. §§ 1.645-1(d)(1)(ii)(B) and 1-301.6109-1(a)(3).
4. Payors of the Electing Trust. The proposed regulations clarified that during the election period, the trust was to give payers of income the TIN of the estate (and if there was no personal representative, the TIN which the trust acquired as an estate). See Prop. Regs. §§ 1.645-1(d)(2) and 301.6109-1(a)(4)(ii).
5. Consequences on Termination of the Election Period. Section 1.645-1(f) of the proposed regulations addressed the issue of the appropriate tax consequences when the electing trust was no longer treated as part of the estate due to the expiration of the election period. Since the trust is treated as part of the estate, under section 1.645-1(h) of the proposed regulations, the estate is deemed to distribute all of the trust assets to a new trust upon the termination of the election. The new trust must obtain a new TIN. It then has the normal year-end of a regular trust under Code section 644, which would be a calendar-year end.
6. Expiration of the Election Period. The proposed regulations provided some definitions. Under section 1.645-1(f) of the proposed regulations, the election period expires on the day before the “applicable date.” If no Form 706 estate tax return is required to be filed, then the “applicable date” will be two years after the date of the decedent’s death. If Form 706 is required to be filed, the “applicable date” is six months after a “final determination” of the estate’s tax liability. The proposed regulations set forth specific events which would constitute the “final determination” in order to determine the “applicable date.”
7. Appointment of Personal Representative after Section 645 Election is Made. The proposed regulations provided guidance for the situation when a personal representative is appointed after the Section 645 Election is made. See Prop. Reg. § 1.645-1(g) (which is included herein in the analysis of the final regulations).
New Final Regulations
After the notice of proposed rulemaking was published, written comments were received. The following are the types of issues for which clarifications, additions, or amendments to the proposed regulations were requested: (1) which type of trust qualified to make the election, (2) what is the proper terminology as to the representative of the estate, (3) how to make the election, (4) when the election must be filed, even if no income tax return is required for the first taxable year, (5) who must file the election, (6) whether a TIN is required for the qualified electing trust, (7) whether DNI is deemed distributed from one share to another, (8) what are the requirements for estimated tax payments, (9) what is the duration of the election period, (10) whether the provisions of the statute apply to a successor trust, and (11) what are the proper tax filings for the entities. The final regulations attempt to address the issues that were raised.
The following will discuss the comments that were submitted, the provisions of the new final regulations and how the final regulations clarify or change the proposed regulations.
Final Regulation Section 1.645-1(a)- In General
Subsection (a) provides that if an election is filed, the qualified revocable trust is treated and taxed for purposes of subtitle A of the Code (subtitle A covers the income tax sections of the Code) as part of the related estate and not as a separate trust during the election period. Subsection (a) then details the topics covered in the ensuing subsections (b) through (g) of regulation section 1.645-1.
Final Regulation Section 1.645-1(b)- Definitions
1. Qualified Revocable Trust. Paragraph (1) defines a “qualified revocable trust” (“QRT”) (which is a trust for which a Section 645 Election may be made). 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 Code section 676 (which refers to a power to revoke) by reason of a power held by the decedent (determined without regard to Code section 672(e) (which relates to the grantor as holding any power held by the grantor’s spouse). The proposed regulations had provided that a trust, in which the power was held solely by a nonadverse party, was not a QRT. Additionally, the proposed regulations provided that if the power was exercisable by the decedent only with the approval or consent by another person, the trust could not be a QRT and comments were raised concerning this prohibition. Responding to the comments, the Service acknowledged that many people use revocable trust for management purposes and to protect from undue influence. In order to further these purposes, many trusts provide that the revocation is not effective unless consented to by a nonadverse party. Therefore, the final regulations provide that a trust, which is owned by the decedent under Code section 676 by reason of a power that is exercisable only with the approval or consent of a nonadverse party, is a QRT. Clarification is also provided that if the power to revoke is held by the decedent’s spouse, and not by the decedent, then the trust is not a QRT.
Although not specifically provided for in the final regulations, clarification was requested regarding whether or not a trust qualified as a QRT if the grantor’s power to revoke lapses due to the grantor’s incapacity. In the Summary of Comments and Explanation of Revisions to the final regulations (“Explanation”), the Service states that if an agent or legal representative of the grantor can revoke the trust under state law, then the trust will qualify as a QRT even if the grantor is incapacitated as of date-of-death.
Finally, as to the definition of a QRT, the proposed regulations prohibited a foreign trust from qualifying as a QRT. Under the final regulations, the requirement that the QRT be a domestic trust was removed. The Service noted that the election treats the trust as part of the estate for subtitle A purposes of the Code only, but not for purposes of subtitle F, which relates to procedures and administration. Accordingly, information reporting under Code section 6048 will continue to apply to foreign trusts making such an election.
2. Electing Trust. Paragraph (2) defines an “electing trust” as a QRT, which has made a Section 645 Election.
3. Decedent and Related Estate. Paragraphs (3) and (5) define the “decedent” as the individual who is treated as the owner of the QRT under section 676 and “related estate” as the estate of the decedent who is treated as the owner of the QRT, respectively.
4. Executor. Paragraph (4) defines “executor.” Under the proposed regulations, the term “personal representative” was used to indicate the fiduciary of the related estate. In the final regulations the word “executor” is used instead of “personal representative.” With the exception of changing the terminology to “executor,” the definition is generally the same as in the proposed regulations. The Explanation notes that it is not identical to the definition of “executor” under section 2203 of the Code in that it does not include a person who has actual or constructive possession of the decedent’s property as allowed under section 2203.
5. Election Period. Paragraph (6) defines “election period” as the period of time for which the electing trust is treated as part of the related estate (which is further explained in subsection (f)).
Final Regulation Section 1.645-1(c)- The Election
Subsection (c) of the final regulations sets forth the rules for making the election. In order to determine the appropriate method to make the election, a fact-finding must be made as to whether or not there is an executor. If there is an executor, then paragraph (c)(1) applies and if there is no executor, paragraph (c)(2) applies. If there is an executor of the related estate, under paragraph (c)(1), the executor and the trustee of each QRT make the election by filing a form to be provided by the Internal Revenue Service, which is called the “election form” (this form has been designated Form 8855.) The Explanation sets forth that this form will be available within six (6) months after the date of the publication of the final regulations. Under subparagraph (c)(1)(i), in order to have a valid election, the election form must be filed no later than the time prescribed for filing the Form 1041 for the first taxable year of the related estate.
Guidance had been requested concerning whether the election must be made by filing a Form 1041 for the end of the related estate’s first taxable year if a Form 1041 was not otherwise required to be filed for the first taxable year of the combined electing trust and related estate, such as due to insufficient income. The final regulations clarify that the election form must be filed within the time prescribed for filing under section 6072 regardless of whether sufficient income exists to require the filing of that return. The election form will be deemed timely filed if it is filed within the time for which an extension is properly granted for the first taxable year.
Subparagraph (c)(1)(ii) contains additional conditions for making the election if an executor has been appointed. This subparagraph states that in addition to providing the information required in the election form, the trustee of each QRT and the executor, by signing the election form, 1) each agrees to the election, 2) as to the trustee of each QRT, each is responsible for providing information to the executor, in order to permit the executor to file a complete and accurate income tax return, 3) each agrees to allocate the tax burdens in a reasonable manner relating to each one’s tax obligations, 4) each insures that its tax obligations will be timely paid and 5) the executor will file a complete, accurate and timely tax return.
Under subsection (c)(2), if there is no executor, then the election may be made by the trustees of each QRT agreeing to join in the election by filing the election form by the time period for filing under section 6072 for the first taxable year of the trust (taking into account the trustee’s Section 645 Election, including any appropriate extensions granted). This return must also be filed regardless of whether or not there is sufficient income to require the filing of a return. If more than one QRT is making the election, the trustees must elect one trustee responsible for filing the income tax return for the combined electing trusts and the filing trustee must agree to accept the responsibility. The filing trustee has basically the responsibilities of the executor and the other trustees have the same responsibilities as a trustee of a QRT. Additionally, a statement must be included that no executor exists and to the knowledge and belief of the trustee, one will not be appointed. See Reg. §§ 1.645-1(c)(2)(ii)(E). Finally, the statement must indicate that if an executor is appointed after the election form is filed and the executor agrees to make the Section 645 Election, the trustee will then file a revised income tax form with the executor.
One commentator to the final regulations was concerned about the liability of the executor if an election was made since the executor is the responsible party for filing the return. The Service did not change the regulations and noted that the Section 645 Election only applied to subtitle A and not to subtitle F of the Code. Even though an election is made, the electing trust and related estate continue to be separate taxpayers for purposes of the administrative provisions the Code. Accordingly, each fiduciary has responsibility relating to the filing of tax returns for its entity and paying its appropriate tax liability. The Explanation noted that if the tax burden was not reasonably allocated, gifts may be deemed to have been made.
Final Regulation Section 1.645-1(d)- TIN and Filing Requirements for a QRT
Final regulation section 1.645-1(d) addresses the TIN number and filing requirements for a QRT. Under the proposed regulations, the trustee of a QRT could choose to obtain a TIN for the QRT to file as an estate and not to obtain a TIN for the QRT to file as a trust. The Explanation states that one of the intended purposes of the proposed regulations was to simplify and lessen the reporting burdens on the trustees and executors which were imposed in Revenue Procedure 98-13 by removing the requirement for the electing trusts and QRTs to obtain a TIN. However, under the proposed regulations if the trustee of the QRT obtained a TIN to file as a trust (instead of as an estate), then the trustee was required to file an income tax return for the short taxable year ending as of December 31. If the Section 645 Election was made after the income tax return was filed for the first taxable year of the QRT, then the trustee of the QRT had to file an amended income tax return as a trust, excluding the items which would be attributable to the combined entity. It then had to 1) obtain another TIN to file as an estate, 2) prepare a revised Form W-9 with the new TIN to give to its payors, and 3) file a Form 1041 as an estate. So in effect the proposed regulations proved to be more burdensome than the requirements under Revenue Procedure 98-13 if a TIN was obtained for the QRT, which is oftentimes automatically applied for by the trustee upon the death of the grantor.
Under the final regulations, regardless of whether or not an executor is appointed, the trustee of each QRT automatically must obtain a TIN upon the death of the grantor and furnish this TIN to the payors. See Reg. § 1.645-1(d)(1). Under section 1.645(d)(2)(i) of the proposed regulations, the trustee of a QRT has the option not to file an income tax return for the short taxable year if a Section 645 Election will be made. This paragraph further provides though, if a valid election is not made for the QRT, then “the QRT will be subject to penalties and interest for failing to timely file a Form 1041 and pay the tax due thereon.” Therefore, a trustee should feel fairly certain that an election will be made before failing to file a timely Form 1041 for the short period year, especially if substantial taxes would be due with such a return.
The remaining subparagraphs under regulation section 1.645-1(d)(2) provide that if the trustee is uncertain as to whether a Section 645 Election will be made, the trustee can file a Form 1041 for the short taxable year. Subsequently, if a Section 645 Election is made, an amended return must be filed excluding the income, deductions, and credits which are includible in the combined entities’ Form 1041.
Final Regulation Section 1.645-1(e)- Tax Treatment and General Filing Requirements During the Election Period
Section 1.645-1(e) of the regulations sets forth the rules regarding the tax treatment and general filing requirements for an electing trust and its related estate during the election period. Under paragraph (1), the final regulations specifically state that the election once made is irrevocable which is just a restatement of the provisions of the statutory requirements of Code section 645(c). The tax treatment under regulation subsection (e) is then determined by whether or not there is an executor. If an executor has been appointed, then paragraph (2) applies and if no executor has been appointed, then paragraph (3) applies. The paragraphs are both very similar other than if an executor exists, the executor is responsible for filing the returns for the combined entity and otherwise, the returns are filed by the filing trustee.
During the election period, each electing trust is allowed the favorable tax treatment afforded an estate and is treated as part of the related estate for all purposes of subtitle A of the Code (which is related to determining the combined entity’s income tax liability). The examples given under the regulations to illustrate the benefits to a QRT for making a Section 645 Election are that 1) the electing trust would be entitled to a charitable deduction for any amounts permanently set aside for charity without the requirement that the amount be actually paid (Code section 642(c)); 2) the active participation requirements are waived for two years under the passive activity loss rules under Code section 469(i)(4) for an electing trust, and (3) and Code section 194(b)(4) would apply, allowing the electing trust to qualify for amortization of reforestation expenditures.
The income tax return is filed under the TIN of the related estate; however, information regarding the name and the TIN of each electing estate must be provided in the tax return. All items of income, deductions and credits of each electing trust and the related estate are combined. Only one personal exemption is allowed under Code section 642(b), which is currently $600. Tax is computed under Code section 1(e) for the combined taxable income. Except for a final Form 1041, an electing trust is not required to file an income tax return during the election period.
Under subparagraph (3), the separate share rules of Code section 663(c) are specifically applicable to the combined electing trust and related estate. The estate and each electing trust are treated as separate shares and further, the related estate and each electing trust may have additional separate shares within them. The separate share rules are used for purposes of computing distributable net income (“DNI”) and applying the distribution provisions of Code sections 661 and 662. Under section 1.645-1(e)(2)(iii)(B) of the final regulations, the DNI of each separate share is adjusted for distributions between the shares for which Code sections 661 and 662 would apply. This would apply if distributions were made to a beneficiary of another share of the combined electing trust and related estate so that DNI would be increased or reduced for that share depending on whether or not it is the distributor or the distributee of the DNI. This is done solely for the purposes of calculating the DNI of each share.
A comment had been raised under the proposed regulations that an amount could be distributed from one share to another share that included an item of DNI, which was not included in the gross income of the combined electing trust and related estate. This is as a result of the operation of Code section 661(c) (for example, if a portion of the DNI distributed consisted of tax-exempt interest). Accordingly, the final regulations provide in section 1.645-1(e)(2)(iii)(B) that the amount of the distribution deduction under Code section 661 is determined without regard to the application of Code section 661(c).
Clarification had also been requested as to whether electing trusts were entitled to the benefits afforded an estate with regard to estimated tax payments under Code section 6654(l)(2) (since this section is not included in subtitle A). The final regulations clarify that, even though treated for all purposes of subtitle F of the Code as separate taxpayers, each electing trust and the related estate is entitled to the benefit of the two-year exception to an estate’s obligation to pay estimated tax payments for each entity for which a Section 645 Election is made. See Reg. § 1.645-1(e)(4).
Final Regulation Section 1.645-1(f)- Duration of the Election Period
Section 1.645-1(f) of the regulations sets forth the rules for determining the duration of the election period. Paragraph (1) provides that the period begins on the date of death of the grantor and terminates upon the earlier of: 1) the day on which both the electing trust and related estate have distributed all of their assets, or 2) the day before the applicable date (which is defined in paragraph (2)). The regulations specifically set forth that the election does not apply to successor trusts, which are distributees under a trust instrument.
Problems arose with the definition of “applicable date” in the proposed regulations. Under the proposed regulations, the calculation of the “applicable date” depended on whether a Form 706 was required to be filed. If a Form 706 was not required, then the “applicable date” was two years after the death of the decedent. If a Form 706 was required, the proposed regulations provided that the “applicable date” would be the date that is six months after the date of the final determination of estate tax liability. The final regulations were changed to provide a minimum election period of two years. If a Form 706 is required to be filed, the final regulations provide that the “applicable date,” is the later of two years or six months after the final determination of estate tax liability. The final determination estate tax liability is the earliest of the following: (a) six months after the issuance of an estate tax closing letter, unless a claim for refund is filed within twelve months of the date of the issuance of the letter; (b) the final disposition of a claim for refund, unless suit is instituted within six months with respect to the claim; (c) the execution of a settlement agreement; (d) the date of issuance of a decision, judgment, decree or other order by a court, unless notice of appeal is filed within 90 days; or (e) the expiration of the statute of limitations for assessments of estate tax under Code section 6501. The important change from the proposed regulations is the provision that the final determination is six months after the date of issuance of the closing letter instead of the actual date of the closing letter itself.
Examples given under section 1.645-1(f)(2)(iv) of the final regulations for determining the duration of the election period are as follows:
Example 1. “A died on October 20, 2002. The executor of A’s estate and the trustee of the Trust, an electing trust, made a section 645 election. A Form 706 is not required to be filed as a result of A’s death. The applicable date is October 20, 2004, the date that is two years after A’s death. The last day of the election period is October 19, 2004. Beginning October 20, 2004, Trust will no longer be treated and taxed as part of A’s estate.”
Example 2. “Assume the same facts as Example 1, except that a Form 706 is required to be filed as a result of A’s death. The Internal Revenue Service issues an estate tax closing letter accepting the Form 706 as filed on March 15, 2005. The estate does not file a claim for refund by March 15, 2006, the day that is twelve months after the date of the issuance of the estate tax closing letter. The date of final determination of liability is September 15, 2005, and the applicable date is March 15, 2006. The last day of the election period is March 14, 2006. Beginning March 15, 2006, Trust will no longer be treated and taxed as part of A’s estate.”
Final Regulation Section 1.645-1(g)- Executor Appointed After the Section 645 Election is Made
Section 1.645-1(g) of the final regulations provides for the situation when an executor is appointed after the Section 645 Election is made. Paragraph (1) provides that in order for the election period to continue past the appointment of an executor of the related estate, the executor must agree to the trustee’s election by filing within 90 days of the appointment a revised election form in accordance with the instructions to the form. If the executor does not agree to the election or a proper revised election form is not filed, the election period terminates the day before the appointment of the executor.
If the executor agrees to the election, section 1.645-1(g)(2) provides that an amended Form 1041 must be filed using the TIN of the electing trust to reflect all items of income, deduction and credit of the related estate and the electing trust, including information for the related estate, from the beginning of the election period. The related estate’s name and TIN must be provided on the amended form. The amended form must then provide that it is a final Form 1041. All other forms must be filed under the name and TIN of the related estate.
Under section 1.645-1(g)(3) of the regulations, if the election period terminates because the executor does not agree to the Section 645 Election, the executor has to file all Forms 1041 under the name and TIN of the estate, and the trustee of the electing trust does not have to amend any returns previously filed during the election period. However, after the termination of the election, the trustee of the electing trust must obtain a new TIN.
Final Regulation Section 1.645-1(h)- Treatment of an Electing Trust and Related Estate Following Termination of the Election
Section 1.645-1(h) of the final regulations sets forth the rules concerning the tax effects upon the termination of the Section 645 Election. Under paragraph (1), since the electing trust and estate are treated as separate shares, the share comprising the electing trust is deemed distributed upon the termination of the election period. This distribution is deemed distributed to a new trust. All items of income attributable to the share of the electing trust is then included in the calculation of DNI that is distributed to the new trust. The combined electing trust and related estate, if any, is entitled to a distribution deduction under Code section 661 as a result of the deemed distribution. The new trust, accordingly, includes the deemed distribution in gross income to the extent required under Code section 662.
Confusion existed as to whether net capital gains attributable to the electing trust were includible in DNI for purposes of calculating the deemed distribution to the new trust upon termination of the election period. The final regulations clarify that capital gains are includible in DNI of the share of the electing trust for purposes of Code sections 661’s deduction provisions and 662’s inclusion provisions.
As to TIN requirements, under section 1.645-1(h)(2) of the regulations, if an executor has been appointed, the executor, under the name and TIN of the related estate, files the Form 1041 in the year of termination. Subparagraph (4) specifically provides that the estate retains its same taxable year without regard to the election termination; therefore, the executor files the final Form 1041 for the combined entities during the election period but includes all items of income, deductions and credits, if any, for the related estate for its entire taxable year.
The electing trust must also file a Form 1041 in the year of termination under its name and its TIN to notify the Service that the electing trust is no longer in existence and indicate that this is a final return. Also, if the electing trust terminates during the election period, the trustee of an electing trust is required to file a Form 1041 at that time and indicate that that is a final return and the trust is no longer in existence. In either of these two events, no items of income, deduction or credit for the electing trust will be included on the return since they are all reported on the combined Form 1041.
The Explanation discusses whether or not a trustee needs to obtain a new TIN for the new trust if an executor had been appointed. The Explanation sets forth that a new TIN may not be required and that the trustee should consult the instructions to Form 1041 when the election terminated in order to make such a determination. The regulations just state that the former electing trust may need a new TIN and section 301.6109-1(a)(4) should be consulted. If a new TIN is not required, the trustee of the former electing trust must file the Form 1041 for the new trust under its TIN, which it obtained following the death of the decedent. If a new TIN is required, the trustee must furnish this new number to each of its payors.
If no executor has been appointed, the taxable year-end of the electing trust ends on the last day of the election period. The final Form 1041 will be filed by the filing trustee for all items during the election period for the short period ending with the last day of the election period. The Form 1041 will be marked as a final return. If the trust continues after the termination of the election period, then a new TIN must be obtained for the trust. The trust reverts to the calendar year in accordance with Code section 644.
Final Regulation Section 1.645-1(j)- Effective Dates
Section 1.645-1(j) of the regulations provides the effective dates of the new final regulations. The provisions of paragraph (a) (which includes the general information), paragraph (b) (which includes the definitions), paragraph (c) (which provides rules for the election), paragraph (d) (which provides the rules for the QRT’s TIN and filing requirements), paragraph (f) (which provides for the duration of the election period) and paragraph (g) (which provides the rules for when an election is made before the appointment of an executor) apply to trusts and estates of decedents dying on or after December 24, 2002. Paragraph (e) (which provides for the tax treatment and filing of electing trusts and estates) and paragraph (h) (which provides the tax treatment following termination of the election) apply to taxable years ending on or after December 24, 2002.
Benefits of the Election
The preceding portions of this article discuss Code Section 645 and the mechanics of making and terminating the Section 645 Election pursuant to the new regulations. The benefits for making such an election should also be reviewed. Some commentators have summarized the benefits as follows: “(a) availability of a fiscal tax year under Section 644; (b) no estimated tax obligations for two years after the decedent’s death; (c) availability of the charitable set-aside deduction under section 642(c)(2); (d) eligibility to hold S corporation stock without meeting special trust rule, which could permit the trust to hold S corporation stock for a somewhat extended period of time because if a federal estate tax return is required, the Section 645 election applies until six months after the final determination of the estate tax liability); (e) waiver of the section 469 passive loss active participation requirements for rental real estate for two years after death, which allows using the estate’s exemption under 469(j)(4) to use up to $25,000 in losses of rental real estate activities even if the losses exceed the estate’s passive income; and (f) using the $600 personal exemption available to an estate rather than either a $300 or a $100 exemption available to trusts, depending upon whether they are simple or complex.” James C. Hardin III, Laura S. Pleicones, and Sarah J. Rich, Post Mortem Estate Planning: Selected Topics, 22nd Annual Estate Planning and Fiduciary Law Program Section V (July 2001) p.14.
Additionally, since the electing trust is treated as part of the related estate for all purposes under subtitle A of the Code, the exceptions applicable to estates under Code sections 267(b) and 1239 should also apply to electing trusts. Code section 267(b) relates to the disallowance of losses for sales between related parties. Code section 1269 disallows capital gain treatment on sales between related parties but both of these sections have an exception for estates. Therefore, if the electing trust is satisfying the funding of a typical “credit shelter” trust with depreciated property, which is not totally unlikely in this economy, then the loss will be allowed during the election period. Further, if a gain results on the funding, capital gain treatment should be allowed, instead of recognition of ordinary income.
Hopefully, most of the uncertainties related to making the Section 645 Election have been clarified in the final regulations. Now that the mechanics are clarified, practitioners can focus better on whether or not to make the election. The election should not be made automatically. The crystal ball should again be consulted to view the future to predict the tax and equitable effects of an election on the related estate and the QRT and the beneficiaries of each. For example, the estate and QRT could have different beneficiaries and the estate could have a loss for the year while the QRT has taxable income. By making the election, such that the entities’ incomes are combined, the beneficial interests will be altered. On the other hand if the beneficial interests are identical, offsetting one’s loss against the other’s income should be advantageous to the beneficiaries. Practitioners should predict the results of making the election from the date of the decedent’s death throughout the election period to determine if making the Section 645 Election is in the best interest of their clients.