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1 Presenting a live 90-minute webinar with interactive Q&A IRC 645 Election: Estate Planning for Qualified Revocable Trusts in Taxable Estates Deferral Opportunities, Active Participation Rules and Separate Share Rule Considerations TUESDAY, JANUARY 16, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Priya Prakash Royal, Esq. LL.M., Managing Attorney, Royal Law Firm, Washington, D.C. John E. Dawson, Member, Dickinson Wright, Las Vegas Christiana M. Lazo, Counsel, Ropes & Gray, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 I. QUALIFIED REVOCABLE TRUSTS ELIGIBLE FOR IRC 645 ELECTION Christiana M. Lazo 5 ROPES & GRAY

6 Qualified Revocable Trust - Defined Trust treated under IRC 676 as owned by decedent because of decedent s power to revoke the trust 6 ROPES & GRAY

7 Qualified Revocable Trust - Defined QRT Decedent incapacitated at death, but agent or legal representative of decedent could revoke the trust during decedent s incapacity (T.D. 9032, Preamble) Decedent held power to revoke the trust only with the consent or approval of a non-adverse party, including decedent s spouse (Treas. Reg (b)(1)) Not QRT Trust treated as owned by decedent under IRC 676 only because of spousal attribution rule of IRC 672(e) (Treas. Reg (b)(1)) Non-adverse party, and not decedent, held power to revoke the trust (Treas. Reg (b)(1)) 7 ROPES & GRAY

8 IRC 645 Election Trustee of decedent s QRT and executor of decedent s estate may make the election Election causes treatment of QRT as part of decedent s estate for federal income tax purposes Election is irrevocable QRT is not treated as separate trust, but it is treated as a separate share under IRC 663(c) (Treas. Reg (e)(2)(iii)(A)) 8 ROPES & GRAY

9 Election Period Election Period Begins on date of decedent s death Terminates on earlier of Day on which electing trust and estate have distributed all assets; and Day before the applicable date Treas. Reg (f)(1) 9 ROPES & GRAY

10 Election Period (Continued) Applicable Date: If federal estate tax return must be filed, later of: Day 2 years after decedent s death Day 6 months after date of final determination of liability for estate tax, which is earliest of Date 6 months after issuance of estate tax closing letter, unless a claim for refund is filed within 12 months after issuance of letter Date of final disposition of claim for refund, unless suit instituted within 6 months after final disposition Date of execution of settlement agreement that determines liability for estate tax Date of issuance of a decision, etc., unless a notice of appeal or petition for certiorari is filed within 90 days after issuance Expiration of statute of limitations for assessment of tax If no federal estate tax return must be filed, day 2 years after decedent s death (Treas. Reg (f)(2)) 10 ROPES & GRAY

11 II. ADVANTAGES OF IRC 645 ELECTION 11 ROPES & GRAY

12 II. Advantages of IRC 645 Election Consolidated income tax returns No estimated taxes required for 2 years after death of decedent (Treas. Reg (e)(4)) $600, rather than $300 or $100, personal exemption available (Treas. Reg (e)(2)(ii)(A)) (but, loss of additional personal exemption) Fiscal year selection for estate Recognizing loss on pecuniary bequest satisfied with assets with fair market value less than basis Waiver of active participation requirements Longer S corporation stock holding period Availability of charitable set aside deduction Qualification for amortization of reforestation expenditures (IRC 194) Eligibility for deduction for medical expenses incurred by decedent paid by the estate in one-year period after decedent s death (IRC 213(c)) Defer application of throwback rules in the case of a foreign trust funded by a US person 12 ROPES & GRAY

13 Fiscal Year Selection for Estate Death of grantor generally causes revocable trust to be a separate taxpayer All trusts must adopt a calendar year Estates may select a calendar or fiscal year 13 ROPES & GRAY

14 Benefits of Fiscal Year Selection Permits opportunistic selection of fiscal year to defer payment of tax Where beneficiary and estate have different taxable years, beneficiary includes in income amounts received during taxable years of estate ending within beneficiary s taxable year (IRC 662(c)) 14 ROPES & GRAY

15 Potential Pitfalls of Fiscal Year Selection Surviving spouse as income beneficiary Joint return filing rates available to surviving spouse for tax years ending not more than 2 years after decedent s death if surviving spouse has a dependent child living with him/her (IRC 2(a)) If joint return filing rates are lower, fiscal year selection may push income into a later tax year for surviving spouse and, because of higher rates, add to cost 15 ROPES & GRAY

16 Realizing Loss on Pecuniary Bequest Satisfaction Estate may realize loss on in-kind distributions of pecuniary bequests with assets with a fair market value less than basis (IRC 267(b)(13)) Electing QRT is entitled to same loss realization Non-electing trust would not be entitled 16 ROPES & GRAY

17 Waiver of Active Participation Requirements Passive loss rules: No current deduction of net losses from passive activities of estate and trust if estate and trust does not materially participate IRC 469(i) permits deduction of up to $25,000 of passive losses attributable to real estate rental activities in which taxpayer actively participates Taxpayer income in excess of $100,000 reduces the $25,000 deduction Taxpayer s estate is deemed to have actively participated in real estate rental activities for tax years of estate ending within 2 years of decedent s death (IRC 469(i)(4)) Revocable trusts making an IRC 645 election will be eligible for the same 17 ROPES & GRAY

18 Longer S Corporation Stock Holding Period Only certain trusts are eligible S corporation shareholders; Grantor trusts are one; But, death of grantor generally causes revocable trust to cease to be a grantor trust; Special rule allows revocable trust to hold S corporation stock for 2 years after death of grantor without terminating S corporation election (IRC 1361(c)(2)(A)(ii)) 18 ROPES & GRAY

19 Longer S Corporation Stock Holding Period Does not require all of trust property to be includible in grantor s estate to qualify Relevant with community property If IRC 645 election is made, the 2-year period begins to run when S corporation stock is transferred from the QRT to a new trust during the election period (or deemed distributed at the end of the election period ) (Treas. Reg (h)(1)(iv)(B)) This is because testamentary trust includes a trust receiving S corporation stock from an electing QRT pursuant to the QRT s terms 19 ROPES & GRAY

20 Availability of Charitable Set Aside Deduction Estate qualifies for income tax deduction for amounts paid to or irrevocably set aside for qualified charities (IRC 642(c)); Trust generally does not benefit from an income tax deduction for amounts irrevocably set aside; Result: gains realized after grantor s death in a revocable trust with charity as residuary beneficiary deductible only on distribution if no IRC 645 election is made 20 ROPES & GRAY

21 Illustration A died on October 1, During A s lifetime he created and funded a revocable trust, Trust Y, which A retained the power to revoke during his lifetime. A suffered from dementia which, unfortunately, left him incapacitated in his final years of life. However, pursuant to the terms of Trust Y, A s guardian could revoke Trust Y on the date of A s death. Pursuant to the terms of Trust Y, all of the residue passes ½ to each of a trust, Trust Z, for the benefit of A s child, B, and a public charity, C. A s residuary estate includes an interest in an S corporation. The Trustee of Trust Y has come to you for advice on the question of whether or not he should make an election pursuant to IRC 645 to treat Trust Y as part of A s estate. 21 ROPES & GRAY

22 Illustration (Continued) A s dementia should not prevent qualification of Trust Y as a QRT because A s guardian retained the power to revoke Trust Y as agent for A. 22 ROPES & GRAY

23 Illustration (Continued) An IRC 645 election will have the following potential advantages for the Trustee of Trust Y: Fiscal year selection If Trust Y does not make the IRC 645 election, Trust Y will have a calendar year. A distribution from Trust Y to a beneficiary on December 31, 2016 will be includible in the beneficiary s 2016 income and ultimately be liable for income tax on this distribution of income on April 15, If Trust Y does make the IRC 645 election, Trust Y may share the Estate s fiscal year. If the Estate selects a fiscal year ending September 30 th, then the Estate s and Trust Y s first fiscal year will end September 30, A distribution from Trust Y to a beneficiary on December 31, 2016 will not be includible in the beneficiary s income until The beneficiary will not be liable for income tax on this distribution of income (other than estimated income tax payments) until April 15, ROPES & GRAY

24 Illustration (Continued) An IRC 645 election will have the following potential advantages for the Trustee of Trust Y: Charitable set aside qualification If Trust Y makes the IRC 645 election, gains allocated to the charity s ½ of the residuary may be deducted on the fiduciary income tax return even if only set aside, and not distributed, to charity in any given year. 24 ROPES & GRAY

25 Illustration (Continued) An IRC 645 election will have the following potential advantages for the Trustee of Trust Y: S corporation stock holding period extended Absent an IRC 645 election, the maximum holding period for the Trustee of Trust Y of the S corporation stock without terminating the S corporation election would be 2 years from A s date of death (October 1, 2018) (assuming Trust Z was not otherwise a permissible S corporation shareholder). The IRC 645 election extends that maximum holding period for the Trustee of Trust Y until 2 years from the date the Trustee of Trust Y distributes the S corporation stock to the trustee of Trust Z. If the Trustee of Trust Y does not distribute the S corporation stock to the trustee of Trust Z until October 1, 2018, Trust Z could continue to hold the S corporation stock without terminating the S corporation election, even assuming it was not otherwise a permissible S corporation shareholder, until October 1, ROPES & GRAY

26 Christiana M. Lazo ROPES & GRAY LLP T M Avenue of the Americas New York, NY Christiana.Lazo@ropesgray.com 26 ROPES & GRAY

27

28 MECHANICS OF MAKING THE 645 ELECTION BY: JOHN E. DAWSON

29 DEFINITIONS 1. An Electing Trust is a QRT for which a valid section 645 election has been made. Once the QRT makes the election, it is treated as an electing trust throughout the entire election period. 2. An Executor is an executor, personal representative, or administrator that has obtained letters of appointment to adminster the decedent s estate through formal or informal appointment procedures. If more than one jurisdiction has appointed an executor, then, for purposes of this election, only the person from the primary or domicilary proceeding is the executor. 3. A Related Estate is the estate of the decedent who was treated as the owner of the QRT on the date of the decedent s death. 29

30 DEFINITIONS continued 4. A Filing Trustee is the trustee of an electing trust who, when there is no executor, has been appointed by the trustees of each of the other electing trusts to file the Forms and has agreed to accept that responsibility. 5. A Filing Trust is an electing trust whose trustee was appointed as the filing trustee by all electing trust(s) if there is no executor. If there is no executor and only one QRT is making the election, that QRT is the filing trust. 30

31 FORM 8855 Use Form 8855 to make a Section 645 Election 31

32 Double Click on the picture to view the form 32

33 Double Click on the picture to view the form 33

34 EMPLOYER IDENTIFICATION NUMBER The Trustee of a Qualified Revocable Trust ( QRT ) MUST obtain a new employer identification number for the QRT upon the death of the Decedent. Parts I and III require that a Trustee enter the EIN obtained by the Trustee following the death of the Decedent. 34

35 OBTAINING A TAX ID NUMBER Regardless of whether or not an Executor is appointed, the Trustee of each QRT must obtain a Tax ID Number ( TIN ) upon the death of the Grantor. 35

36 PART I: ESTATE (OR FILING TRUST) INFORMATION 36

37 IF THERE IS AN EXECUTOR OF THE RELATED ESTATE, THE FOLLOWING APPLIES: 1. The Executor must obtain an EIN for the estate prior to filing the Election. 2. The Executor completes the information requested in Part I. 3. The Executor also attests to the making of this election and the conditions for a valid 645 Election by signing under penalties of perjury and dating the form. 4. If a foreign address, enter the information in the following order: City, Province or State and Country. Do not abbreviate Country Name. Follow the Country s practice for entering a postal code. 37

38 IF THERE IS NO EXECUTOR OF THE RELATED ESTATE, THE FOLLOWING APPLIES: 1. The Filing Trustee must obtain an EIN for the Filing Trust prior to filing the Election. 2. The Filing Trustee completes the information requested in Part I. 3. The Filing Trustee also attests to the making of this election and the conditions for a valid 645 Election by signing under penalties of perjury and dating the form. 4. If a foreign address, enter the information in the following order: City, Province or State and Country. Do not abbreviate Country Name. Follow the Country s practice for entering a postal code. 5. If Form 8855 was filed by the filing Trustee because there was no Executor and an executor is subsequently appointed, an amended election must by timely made. 38

39 HOW TO MAKE AN AMENDED ELECTION 1. The Executor and the Trustee(s) of each electing Trust must complete and file a new Form 8855 and print at the top of the form the following: AMENDED ELECTION. 2. File an amended Form 8855 within 90 days of the appointment of the Executor. 39

40 CAUTION If an Executor is appointed after the filing of an election, the failure to timely file an amended election will result in the election period terminating the day before the Executor is appointed. 40

41 PART II: DECEDENT INFORMATION The Executor or filing Trustee completes this section. 1. List the name of the Decedent. 2. Provide the Social Security Number of the Decedent in the space provided. 3. Fill in the Decedent s date of death. 41

42 PART III: QUALIFIED REVOCABLE TRUST INFORMATION 1. If there is more than one QRT joining in the election, Part III must be completed. 2. Part III is completed by the Trustee, of each respective Trust, that is joining in the election. 3. Space is provided for two QRT s. If there are more than two QRT s joining in the election, use additonal Part III pages. If additional pages of Part III are attached, the Executor or filing Trustee should indicate on the top of the first page of Part III how many additional pages are attached and the total number of QRT s are that joining in the election. 42

43 RETENTION OF COPY OF FORM The Executor, if one is appointed, and the Trustee of each electing Trust, must retain a copy of the completed Form If Form 8855 is amended, a copy of the Amendment must also be retained by the Executor, if any, and each Trustee of an elective Trust. 3. Proof that the Form 8855 was timely filed must also be retained by the respective Executor and Trustee(s). 43

44 WHEN TO FILE ELECTION 1. File the election by the due date (including extensions, if any) of the Form 1041 for the first tax year, of the related estate or if there is no Executor, treat the trust filing as an estate. 2. In general, the due date for the first income tax return is the 15 th day of the 4 th month after the close of the first yax year. 3. Once made the election is irrevocable. 44

45 WHO MUST SIGN If more than one Trustee of an electing Trust, only one Trustee is required to sign unless the governing document requires all Trustees to sign. 45

46 WHERE TO FILE If you are located in Connecticut, Delaware, District of Columbia, Georgia, Illinois, Indiana, Kentucky, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Tennessee, Vermont, Virginia, West Virginia, Wisconsin THEN send the election to: Department of the Treasury Internal Revenue Service Center Cincinnati, OH

47 WHERE TO FILE continued If you are located in Alabama, Alaska, Arizona, Arkansas, California, Colorado, Florida, Hawaii, Idaho, Iowa, Kansas, Louisiana, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, New Mexico, North Dakota, Oklahoma, Oregon, South Dakota, Texas, Utah, Washington, Wyoming THEN send the election to: Department of the Treasury Internal Revenue Service Center Ogden, UT

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49 IRC 645 Elections for Qualified Revocable Trusts Income tax reporting and application of "Separate Share" rule after a Section 645 election Priya Prakash Royal, Esq., LL.M. ROYAL LAW FIRM PLLC Royal Law Firm PLLC

50 Income Tax Reporting: Form Income, deductions, and credits Reported on the combined 1041 for the estate and the electing trust Reporting is under the TIN for the related estate Without the election, the trust (now irrevocable after the decedent s death), will have a short year ending on December 31 st. Usually trustee is not required to make distributions, which will classify the trust as a complex trust. It will subject the trust to the high income tax bracket (absent any post-mortem planning and distributions to beneficiaries within the tax year). Distributions to beneficiaries in the tax year without the ability to defer deductions for administrative expenses would result in potentially higher income taxes for the beneficiaries than would have been incurred with the election. 50 Royal Law Firm PLLC

51 Income Tax Reporting: Estate Advantages Income tax advantages for an estate not available to a revocable trust Option to adopt a fiscal year for income tax purposes Defer income reporting and plan deductible expense allocations/timing Estates have an higher personal exemption amount ($600) as opposed to trusts. IRC 642(b) IRC Section 642(c) charitable set aside deduction and for amounts actually paid Recognition of loss on satisfaction of a pecuniary bequest with assets with FMV less than the basis (IRC Section 267(b)) No active participation requirements on passive loss rules for tax years ending less than two years after the date of death. Therefore, generally, always opt for the 645 election. 51 Royal Law Firm PLLC

52 Separate Share Rule Applies when a qualified revocable trust is treated as part of the decedent s estate The trust s portion of income, deductions, and credits are treated as separate from the estate s portion of the income, deduction, and credits Therefore DNI (Distributable Net Income) has to be calculated separately for each. Separate shares occur when the governing instrument (Will/Trust) directs that separate shares or accounts be maintained for each beneficiary (IRC Section 663(c)). Not the same as separate trusts. Each beneficiary is only taxed on DNI to the extent of distributions made to that particular beneficiary. 52 Royal Law Firm PLLC

53 Separate Share Rule - Continued Separate share is not elective. If the rule applies, it must be followed. Separate share exists if it includes both the income and the principal attributed to the income and is independent from any other share Any expense or loss that is applicable to any particular separate share cannot be allocated to any other share 53 Royal Law Firm PLLC

54 Fact Pattern 1: DNI allocation and calculation Decedent s estate planning documents included a family trust and other assets outside of the trust which were part of the estate. The executor of the estate and the trustee of the trust elected to file a combined Form 1041 with a Section 645 election. For the current year, the trust had $70,000 of interest income and $10,000 of administrative expenses. The trust distributed the balance of the interest income ($60,000) to the surviving spouse. The estate has $20,000 of dividend income and $5,000 of administrative expenses. The estate did not make any distributions. How is the DNI calculated? 54 Royal Law Firm PLLC

55 Fact Pattern 1: DNI computation The DNI must be calculated separately for each estate and trust The trust s DNI is, therefore, $60,000 (net income distributed to the surviving spouse). The K-1 to the surviving spouse would report the $60,000 of interest income. The estate would pay tax on $15,000 on dividend income. If the DNI calculations were combined, the total DNI would be $75,000 but part of the income would be reported as interest income and part as dividend income on the K-1 to the beneficiary. 55 Royal Law Firm PLLC

56 Fact Pattern 2: Planning Advantages Decedent died on November 1, The related estate and the decedent s QRT (qualified revocable trust) made a Section 645 election to report the entities on a combined Form The tax year for the estate ends on October 31 st, Albus is the sole beneficiary of the QRT and the related estate. He received a distribution of $50,000 on November 15, What are the consequences of making the IRC 645 election? 56 Royal Law Firm PLLC

57 Fact Pattern 2: Planning Advantages As a result of the 645 election, Albus will not have to report the distribution in 2012 and will report it only in his 2013 tax return which will be filed on or about April 15, Without the election, Albus would have had to report the income on his 2012 income tax return (filed on or about April 15, 2013). The 645 election deferred the payment of income tax significantly. 57 Royal Law Firm PLLC

58 Fact Pattern 2: Taking it further Assume further that Albus has a sporadic income stream with long periods of unemployment followed by periods of high income from contract work due to which his tax bracket varies significantly from year to year. Assume that in 2012, Albus had a high income stream and in 2013, had very low, other income. His income tax bracket would likely be lower in 2013 which consequently would likely lower his tax liability on the DNI from the estate whereas in 2012, the DNI would have added to his income and placed him in a higher bracket increasing his overall tax liability. 58 Royal Law Firm PLLC

59 Comments? Contact: Priya Prakash Royal, Esq. LL.M. DC, MD, PA, NJ & NY Royal Law Firm PLLC 1200 G St. NW, Suite 800, Washington DC x700 pproyal@royalesq.com 59 Royal Law Firm PLLC