Trust treatment: final regs issued on election to treat revocable trusts as part of estate.

On Dec. 24, 2002, the U.S. Treasury Department issued final regulations under Internal Revenue Code Sec. 645 relating to the election for certain revocable trusts to be included for income tax purposes as part of the deceased grantor's estate, and not as a separate trust (67 F.R. 78371-01).

The final regulations provide the procedures and requirements for making the election; rules regarding the tax treatment of the trust and estate while the election is in effect; and rules regarding termination of the election. They also modify the proposed regulations in a number of ways that can generally be considered pro-taxpayer.

For example, the definition of a trust qualifying to make the Sec. 645 election is expanded.

Also, the final regulations simplify the filing requirements of an electing trust, as well as the procedures for furnishing a taxpayer identification number to payors.

Sec. 645

Pursuant to Sec. 645, if both the executor (if any) of an estate and the trustee of a qualified revocable trust so elect, the "electing" trust--a qualified revocable trust (QRT) that makes the Sec. 645 election--will be included for income tax purposes as part of the estate, and not as a separate trust, during the election period.

The election period begins on the date of the decedent's death and terminates on the day before the "applicable date."

If Form 706 is not required for the decedent's estate, the applicable date is two years after the date of the decedent's death.

If Form 706 is required, the applicable date is six months after the date of final determination of liability for estate tax [Sec. 645(b)].

Form 706 is required if the date of death value of the decedent's gross estate exceeds the Sec. 2010(c) applicable exclusion amount [Sec. 6018(a)(1)].

Qualified Revocable Trust

The final regulations changed the definition of a QRT. The regs state that a QRT is a trust that is treated as owned by the decedent under Sec. 676 by reason of a power that was exercisable by the decedent only with the consent or approval of a nonadverse party or only with the approval or consent of the decedent's spouse. [Treas. Reg. Sec. 1.645-1(b)(1)].

The preamble to the final regulations also clarifies that a trust qualifies as a QRT if the grantor's power to revoke the trust lapses prior to the grantor's death as a result of the grantor's incapacity.

Under the proposed regulations to Sec. 645, issued Dec. 18, 2000, (65 F.R. 79015-01) a qualified revocable trust was defined as any trust--or part of a trust--that the decedent was treated as owning under Sec. 676 by reason of a power to revoke the trust [determined without regard to Sec. 672(e)].

The proposed regulations to Sec. 645 also provided that a trust that was treated as owned by the decedent under Sec. 676 solely by reason of a power held by a nonadverse party was not a QRT. The power was required to be held by the decedent only.

Tax Treatment and Filing Requirements

If an executor is appointed for the decedent's estate, the executor and trustee of the QRT jointly make the Sec. 645 election by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate [Treas. Reg. Sec. 1.645-1(c)(1)]. If there is no executor, the trustee alone flies the Form 8855 [Treas. Reg. Sec. 1.645-1(c)(2)].

Keep in mind, however, that Form 8855 is not yet available. The U.S. Treasury Department, in its commentary to the final regulations, indicated that the form should have been available within six months of the date of issuance of the final regulations, which was Dec. 24, 2002.

The final regulations require that the election be made no later than the date on which Form 1041 is required to be filed for the related estate.

If there is not time to wait for Form 8855 to become available, Treas. Reg. Sec. 1.645-1(c)(1) suggests that the taxpayer use the manner prescribed under "published guidance" for making the election.

Under the proposed regulations, the election was made by attaching a statement to Form 1041 for the first taxable year of the related estate. The proposed regulations also provided what was required to be included on the election.

It is logical then, because Form 8855 is not yet available, the proposed regulations would dictate how to make the election.

If there is both an executor and a trustee, the trustee of the electing trust must timely provide the executor of the related estate with all of the trust information necessary to permit the executor to file a complete, accurate and timely Form 1041 for the combined electing trust and related estate for each taxable year during the election period [Treas. Reg. Sec. 1.6451 (c)(1)(ii)(A)(2)].

The trustee and executor are required to allocate the tax burden of the combined electing trust and related estate in a manner that reasonably reflects their respective tax obligations [Treas. Reg. Sec. 1.6451(c)(1)(ii)(B)(3)].

If the tax burden is not reasonably allocated, the preamble to the final regulations suggest that gifts may be deemed to have been made to the extent that the electing trust or related estate pays a disproportionately larger share of the income tax.

It would seem that a gift tax consequence could only arise if the beneficiaries of the electing trust and related estate are not the same persons.

If, during the election period, there is an executor, a single Form 1041 is filed annually for the combined electing trust and related estate under the name and taxpayer identification number of the estate [Treas. Reg. Sec. 1.645-1(e)(2)(ii)].

Information regarding the electing trust is also reported on Form 1041.

Under the final regulations, in addition to all other grantor trusts, the trustee of an electing trust or a QRT for which a Sec. 645 election will be made must obtain a taxpayer identification number upon the death of the decedent, as required by Treas. Reg. Sec. 301.6109-1(a)(3).

However, if a Sec. 645 election will be made for a QRT, the trustee is not required to file Form 1041 for the short taxable year of the QRT beginning with the decedent's death and ending Dec. 31 of that year.

If there is no executor, the trustee of the electing trust or QRT for which a Sec. 645 election will be made obtains a taxpayer identification number upon the decedent's death and uses that number to file Forms 1041 as an estate during the election period.

However, Form 1041 must be flied for the short taxable year of the QRT beginning with the decedent's date of death if an election will not be made for the trust, or if the trustee and executor are uncertain whether or not an election will be made for the QRT by the due date of Form 1041 for the short tax year of the QRT.

Both the proposed regulations and the final regulations treat the electing trust and related estate as separate shares under Sec. 663(c) for purposes of computing distributable net income (DNI) and applying the distribution provisions of secs. 661 and 662 [Treas. Reg. Sec. 1.6451(e)(2)(ii)(B)].

The final regulations also provide rules for adjusting the DNI of the separate shares with respect to distributions made from one share to another share of the combined electing trust and related estate to which secs. 661 and 662 would apply had the distribution been made to a beneficiary.

The DNI of the share from which the distribution is made is reduced by the amount of the distribution deduction that it would have been entitled to under Sec. 661, without regard to Sec. 661(c), had the distribution been made to a beneficiary other than another share of the combined related estate and electing trust [Treas. Reg. Sec. 1.645-1(e)(2)(iii)].

Planning Considerations

Final Sec. 645 regulations continue to provide certain tax and administrative benefits upon an election to include a revocable trust as part of the decedent's estate, including:

* Taxable Year. Because the electing trust's income is taxable to the estate, that income can be reported on a fiscal year basis along with the estate's own income, rather than on a calendar year basis.

This can provide a benefit if the trust earns significant income in the year of the grantor's death.

For example, assume a grantor died Feb. 15, 2003, and the estate receives a large source of income in June 2003. A trust would be required to adopt a calendar year, thus recognizing the income that year.

However, an estate may elect a taxable year ending Jan. 31, thereby deferring the recognition of taxable income for one year.

* Estimated Tax Payments. For the first two taxable years following the decedent's death, no estimated tax payments are required for electing trust income [See Section 6654(1)].

* Passive Loss Limitations. The rule under Sec. 4690), which permits individuals (and estates for up to two years) who actively participate in a rental real property activity to deduct losses from such activity to shelter non-passive income (up to $25,000 annually), is likewise available to an electing trust for two years.

* Charitable Set-Aside. The Sec. 642(c) charitable set-aside is not available for trusts, but is available for estates, which can create significant problems if the bulk of the decedent's assets are left to charity.

In an estate, the executor does not have to distribute income during administration to the charity to avoid income tax. Instead, the income will qualify for the charitable set-aside.

In a revocable trust, however, unless the income is actually distributed to the charity, absent a Sec. 645 election, the income will be taxable to the trust.

This is the case even though the entire trust might ultimately be distributed to charity upon termination of administration.

As it is not always possible for the trustee to make distributions, the Sec. 645 election alleviates this income tax problem.

* S Corp Shareholder. The electing trust would be able to hold S Corp stock without being required to meet special rules qualifying the trust as a Qualified Subchapter S Trust [Sec. 1361(d)] or an "Electing Small Business Trust" [Sec. 1361(e)].

* Simplifying Number of Tax Returns. The Sec. 645 election results in a reduction to the number of income tax returns, and Forms K-l, as an electing trust does not file these returns.

There is little disadvantage to making the Sec. 645 election. Although the trust would have its own exemption and its own set of lower income tax brackets, the resulting tax savings would likely be offset by eliminating the cost of preparing an additional set of income tax returns.

Michael D. Foster, Esq. is a partner with Reish Luftman McDaniel & Reicher in Los Angeles and David P. Schwartz, Esq. is an associate with the firm. You can reach them at [e-mail] and at [e-mail].