Election to treat revocable trust as part of estate for income tax purposes.

Both estates and revocable inter vivos trusts can function to settle a decedent's affairs and distribute assets to heirs. In the case of revocable inter vivos trusts, the grantor transfers property into a trust revocable during his lifetime. On the grantor's death, the power to revoke ceases and the trustee then performs the settlement functions typically performed by an estate's executor.

Before the Taxpayer Relief Act of 1997 (TRA '97), a decedent's revocable trust (which becomes irrevocable at death) and the decedent's estate were required to file separate income tax returns. However, new Sec. 646 provides an election to treat a "qualified revocable trust" as part of the decedent's estate for Federal income tax purposes. This election is available for estates of decedents dying after Aug. 5, 1997.

The TRA '97 Committee Report states that "a qualified revocable trust is any trust (or portion thereof) which was treated under section 676 as owned by the decedent with respect to whom the election is being made, by reason of a power in the grantor (i.e., trusts that are treated as owned by the decedent solely by reason of a power in a nonadverse party would not qualify)."

Under Sec. 676, the grantor is treated as the owner of the trust if he possesses the power to revoke. Since new Sec. 646(b)(1) specifically refers to Sec. 676, it is clear that, to qualify under Sec. 646, the trust must be revocable. Other trusts treated as owned by the grantor by reason of a reversionary interest (Sec. 673), power to control beneficial enjoyment (Sec. 674), administrative powers (Sec. 675) or the ability to control income (Sec. 677), would appear to be ineligible for this treatment. A power to revoke held by the grantor's spouse and attributed to the grantor under Sec. 672(e) is likewise ignored for this election.

If elected, Sec. 646 treatment applies to tax years ending after the decedent's death and before the date that is two years after such death (if no Federal estate tax return is required) or six months after the final determination of Federal estate tax liability (if a Federal estate tax return is required). These deadlines are prescribed by Sec. 646(b)(2).

It is quite possible for an estate's administration to extend beyond either of these periods. If no Federal estate tax return is required to be filed (generally, if the gross estate and adjusted taxable gifts are under $625,000 (for 1998)), the administration period may extend beyond two years due to family disputes, lawsuits, problems locating beneficiaries or delays in gathering assets and paying expenses.

If there is no dispute between the fiduciary and the IRS as to the estate tax liability, the second period would refer to the Service's closing letter (which would constitute the final determination of estate tax liability). However, it is not uncommon to receive clearance from the state taxing authority more than six months after the IRS's closing letter is issued. Therefore, when evaluating this election, one must consider the possibility that the final state determination will arrive too late to meet Sec. 646's deadline. If estate administration extends beyond this deadline, separate tax returns for the estate and trust would be due for tax years ending after the deadline.

The election must be made by both the estate executor (if any) and the trustee of the revocable trust not later than the time required for filing the income tax return of the estate for its first tax year (including extensions).

On Jan. 26, 1998, the Service issued Rev. Proc. 98-13, which sets forth procedures and requirements for making the Sec. 646 election. Section 3.01 of this procedure requires that a statement be attached to Form 1041, U.S. Income Tax Return for Estates and Trusts, that:

1. Identifies the election as a Sec. 646 election.

2. Contains the decedent's name, address, date of death and taxpayer identification number (TIN).

3. Contains the qualified revocable trust's name, address and TIN.

If the trust does not have a TIN because it was reporting pursuant to Regs. Sec. 1.671-4(b)(2)(i)(A) (which allows reporting under the grantor's TIN under prescribed circumstances), the trust must obtain a TIN unless Form 1041 is not required under the following conditions (set forth in Section 3.03 of Rev. Proc. 98-13):

* Form 1041 for the estate's first tax year is filed before the due date for filing Form 1041 for the trust for the tax year ending after the decedent's death;

* The trust items attributable to the decedent are reported pursuant to Regs. Sec. 1.671-4(b)(2)(1)(A) or (B); and

* The entire trust is a qualified revocable trust.

4. Contains the estate's name, address and TIN.

5. Provides a representation that, at the decedent's death, the trust (or a portion thereof) subject to this election was treated under Sec. 676 as owned by the decedent of the estate referred to in Sec. 646(a) because of the decedent's power to revoke (determined without regard to Sec. 672(e)).

6. Is signed and dated by both an executor or administrator of the estate and a trustee of the qualified revocable trust.

If there are multiple trustees, executors or administrators, only one trustee, executor or administrator must sign this statement (unless otherwise required by the governing instrument or local law).

If there is no probate estate (and, hence, no executor or administrator), the election may still be made. However, a TIN must still be obtained for the estate and only a trustee of the qualified revocable trust must sign the statement. In this event, the statement must also include a representation that there is no executor or administrator and that neither an executor nor an administrator will be appointed.

Section 3.02 of Rev. Proc. 98-13 requires the original election statement to be attached to the Form 1.041 filed for the estate's first tax year. A copy also must be attached to the Form 1041 filed for the trust's first tax year ending after the decedent's death, unless no Form 1041 is required for the trust under Section 3.03 of this revenue procedure (as previously discussed). The election is considered made when the original statement is attached to the Form 1041 filed for the estate's first tax year or when a copy is attached to the Form 1041 filed for the trust, whichever occurs first. Once made, the election is effective from the date of the decedent's death.

Section 3.02 further states that, "If the election is made, then the items of the trust, including income, deductions and credits, that are attributable to the qualified revocable trust for the period subsequent to the decedent's death must be excluded from the Form 1041 filed for the trust for the taxable year ending after the date of the decedent's death and must be reported on the estate's Form 1041."

The practitioner is left with little or no guidance on other issues, such as differing tax attributes and fiduciary accounting for the estate and trust. Some of the differences in tax attributes between estates and trusts are:

* Estates are allowed a charitable deduction for amounts permanently set aside for charitable purposes, while post-death revocable trusts are allowed a charitable deduction only for amounts paid to charities.

* The active participation requirement under the passive loss rules is waived for estates (but not revocable trusts) for two years after the owner's death.

Therefore, combining an estate and a qualified revocable trust can provide tax benefits. Since estates can use a fiscal year, the taxation of distributions to calendar-year beneficiaries may be deferred up to 11 months. In contrast, trusts must use a calendar year.

Example 1: D died on Feb. 15, 1998. His executor selects a tax year ending Jan. 31. Income received by D's estate in 1998 and distributed to a calendar-year beneficiary on Jan. 15, 1999 will be reportable in the beneficiary's 1999 return.

To be able to select an initial fiscal year for the estate with the maximum number of months, a TIN should be obtained and a Form 1041 filed for the qualified revocable trust--even though not required under Section 3.03 of Rev. Proc. 98-13.

Example 2: D dies on Dec. 15, 1998. Her qualified revocable trust was reporting under Regs. Sec. 1.671-4(b)(2)(1)(A) and, thus, does not have a TIN. D's estate and trust make the Sec. 646 election. A TIN and Form 1041 will be required for this trust unless the estate's Form 1041 is filed on or before Apr. 15, 1999 (the due date of the trust's return for the tax year ending Dec. 31, 1998).

However, to maximize income deferral and/or absorb large deductions, the estate's first tax year will begin Dec. 15, 1998 and end Nov. 30, 1999. Therefore, a TIN should be obtained for the trust and its return filed by Apr. 15, 1999.

Observations: Section 3.03 of Rev. Proc. 98-13 does not indicate whether the due date for filing the trust's return is the original or extended due date. Section 3.03 also does not indicate whether the trust's tax "year" ending after the decedent's death can be a short year or whether it must be a full "year."

The fiduciary accounting for a trust and estate may be combined, since the combined results are reported only on the estate's Form 1041. However, this may lead to problems if the estate or trust exists beyond the deadline set forth in Sec. 646(b)(2) (as was discussed). Once this deadline has passed, returns will have to be filed for each entity. In such event, a TIN will be necessary for the trust, even though not Previously required under Section 3.03 of Rev. Proc. 98-13.

There are a number of provisions in the TRA '97 and related revenue procedure that require additional guidance. Until such guidance is issued, the practitioner must proceed with caution when filing returns for an estate and a qualified revocable trust.