Section 645 Election to Treat Revocable Trust as Part of the Grantor's Estate - Final Regulations Provide Guidance

August 19, 2003 Published Work
Estates & Probate Newsletter of the Connecticut Bar Association, August 2003
Revocable trusts are an integral part of many of the estate plans we prepare for our clients. They are attractive planning vehicles because they provide an asset management vehicle during a client's lifetime and a Will substitute upon his or her death. Although in most circumstances a revocable trust is income tax neutral during the grantor's life, once he or she dies the trust becomes a "taxpayer," a status that generates income tax consequences that need to be considered.
I. Tax Implications of Continuing Trusts
Upon the death of the grantor, the trust will become irrevocable. Accordingly, it will have a calendar tax year, which will be a short year beginning from the grantor's date of death through December 31st. The trust will likely be considered a complex trust since the trustee will not typically be required to make immediate distributions. As such, there is the potential for the income earned by the trust to be taxed at an extraordinarily high income tax bracket unless the trustee is able to do post-mortem planning in order to make distributions to beneficiaries, which will cause the trust's income to be taxable to them. While this is a possible solution to the tax dilemma that a continuing trust might face, it may not be a perfect solution since it could possibly result in the beneficiaries reporting substantially more income than they anticipated and, as a result, inadvertently trigger underpayment penalties for them. Accordingly, even though the continuing trust is intended to be used as an estate administration substitute, without additional planning, it does not offer the same post-mortem income tax planning opportunities that are available to a decedent's estate.
II. Estate's Income Tax Advantages
  • A decedent's estate has several income tax advantages not available to a revocable trust. These include:
  • The option to adopt a fiscal year for income tax purposes and thereby permit an executor to defer the reporting of income and plan for the use of deductible expenses.
  • The ability to take advantage of the charitable set aside deduction under Internal Revenue Code ("IRC") §642(c).
  • Recognition of loss upon the satisfaction of a pecuniary bequest with assets having a fair market value less than basis under Code §267(b).
  • Not being subject to the active participation requirements of the passive loss rules for tax years ending less than two years after decedent's date of death.
III. Code §645 Election
For decedents dying after August 5, 1997, Congress created an opportunity for trustees of a funded revocable trust to duplicate the post-mortem tax planning opportunities available to decedent's estates. A revocable trust will be entitled to these tax advantages if, upon the grantor's death, a Code §645 election is properly made. Should the executor (if any) of a decedent's estate and the trustee of a "qualified revocable trust" make the election under Code §645, the trust will be treated for income tax purposes as a part of the decedent's estate for all tax years of the estate ending after the decedent's date of death and before the "applicable date." A Code §645 election, once made, is irrevocable.
IV. IRS Guidance/Final Regulations
  • The Code §645 election was enacted by the Taxpayer Relief Act of 1997, P.L. 105-34, §1305(a). IRS rules for making the election were originally set forth in Rev. Proc. 98-13. In December 2000, the Service published Prop. Reg., §1.645(1) which contains alternate election and reporting requirements.
  • These regulations, with generally pro-taxpayer amendments, were finalized on December 24, 2002 (T.D. 9032). IRS Notice 2001-26 provides that estates and revocable trusts of decedents who die after December 31, 1999 and before the effective date of final Code §645 regulations, may use either the election and reporting requirements under Rev. Proc. 98-13 or those in Prop. Reg. 1.645(1).
  • The focus of this article is on the final regulations which provide easier and more flexible §645 election procedures and requirements.

V. Qualified Revocable Trust

  • A Code §645 election is effective only if made with respect to a "qualified revocable trust" ("QRT").
  • A QRT is any trust (or portion thereof) "owned" for income tax purposes by the decedent under Code §676 because of a power held by the decedent, determined without regard to Code §672(e) (which treats a grantor as holding any power or interest held by his or her spouse).
  • A trust is not a QRT if it is treated as owned by the decedent because his or her spouse is granted the power of revocation. However, a trust is a QRT if it is treated as owned by the decedent because he or she had the power to revoke with the consent of the decedent's spouse.
VI. Applicable Date
  • For estates not filing an estate tax return, the "applicable date" is the date that is two years after decedent's date of death.
  • If an estate tax return is filed, the applicable date is the date that is six months after the date of the final determination of estate tax liability. The final determination date can be based on a number of possible events such as the issuance of an estate tax closing letter, the execution of a settlement agreement fixing the estate tax liability, a court decree resolving the estate tax liability, etc.

VII. Election Procedures

  • The straightforward election procedures are set forth in IRC Reg. §1.645.
  • If there will be no Executor appointed, the QRT Trustee files the election. In this event, the election must include QRT Trustee's representation that there is no executor and to the trustee's knowledge and belief, one will not be appointed.
  • The election is currently made on a statement attached to the initial Form 1041 of the estate, if there is an executor, and, if not, to the Form 1041 filed for the first tax year of the QRT taking into account the trustee's election to treat the trust as an estate under Code §645.
  • The IRS has announced that it will publish a §645 election form (Form 8855) by June 24, 2003.
VIII. Filing Requirements
If there is an executor, one Form 1041 is filed for the combined QRT and related estate under the name and TIN of the estate (the QRT does not need to file a Form 1041 for the balance of the tax year after decedent's death). One $600 personal exemption is permitted and all items of income, deduction and credit are combined, except as required under the separate share rule (explained below). If there is no executor, the QRT trustee files Form 1041 treating the trust as an estate.
IX. Separate Share Rule
  • The QRT and related estate are treated as separate shares for purposes of calculating distributable net income ("DNI"). Accordingly, if distributions are made from the QRT and/or the related estate, the DNI of the entity making the distribution would have to be determined.
  • Distributions between the QRT and related estate shares will affect the computation of DNI. The following example is provided in IRC Reg. §1.645(e)(2)(iii)(B):
The residue of A's estate is to be distributed to the electing QRT. The sole beneficiary of QRT is C. The estate share has $15,000 of gross income, $5,000 of deductions and $10,000 of taxable income and DNI. A's estate distributes $15,000 to QRT. The distribution reduces the DNI of A's estate by $10,000. QRT has $25,000 of gross income and $5,000 of deductions. The QRT's DNI is increased by $10,000 (the amount of the related estate's DNI reduction) and QRT's DNI is therefore $30,000. QRT distributes $35,000 to C, and as a result, C must include $30,000 in gross income. The Form 1041 filed for A's estate and QRT would report $40,000 of gross income.
X. Termination of Election Period
At the close of the election period (the applicable date), a distribution is deemed to be made by the combined QRT and related estate, if there is an executor, or, if there is no executor, from the QRT. The deemed distribution is to a new trust and consists of the QRT share, as determined under the separate share rule discussed above. The combined related estate and QRT, or the QRT, as the case may be, is entitled to a distribution deduction with respect to the deemed distribution. The new trust will include the distribution in gross income to the extent required under the inclusion rules of Code §662.

XI. Planning Strategies
  • There are several circumstances in which a Code §645 election can prove beneficial. Some benefits can flow directly and immediately to the QRT beneficiaries. For example:

    B is an individual beneficiary of a QRT for which a Code §645 election has been made. The QRT and related estate have a taxable year of December 1, 2002 through November 30, 2003. B receives a taxable distribution on December 15, 2002. Pursuant to Code §662(c), B will not have to report any income as a result of the distribution until 2003, and will have until April 15, 2004 to file an income tax return including the income from the distribution. If no election had been made, the distribution would have been taxable to the beneficiary in 2002, and the tax attributable to the distribution payable on April 15, 2003, just four months later. The election permits a deferral of the tax payment of sixteen months.