By DeEtte L. Loeffler, J.D., L.LM, Taxation
Revenue Procedure 2016-49, a highly anticipated ruling, was released September 27, 2016. The IRS has announced it will not challenge QTIP elections made for trusts when the election is not required in order to reduce the decedent’s taxable estate so long as the estate also makes a portability election under IRC Section 2010(c)(5)(A). This is good news for estate planners and their clients who will no longer run the risk of having their preferred planning disregarded.
The ruling ends a controversy which began with the advent of portability in 2011. Beginning with 2011, the executor of the estate of a deceased married person has had the power to claim the unused portion of the deceased spouses’ unused exemption from the estate tax (“portability”) for use by the surviving spouse. This “deceased spousal unused exemption amount” (DSUEA) can be used by the surviving spouse to exempt lifetime gifts from the federal gift tax and to exempt transfers at death from the federal estate tax.1
Attorneys were quick to see the potential income tax advantages which portability can provide to families. Assets taxable in the estate of the surviving spouse are permitted a new fair market value basis upon the surviving spouse’s death.2 For many families, portability (coupled with the rising exemption from the estate tax under IRC Section 2010) reduced or eliminated the risk that the survivor’s estate would have to pay an estate tax. With portability, the first spouse to die could now afford to leave all of his or her assets to the surviving spouse and obtain a new income tax basis to benefit the couple’s children or other heirs.
However, not all spouses wanted such “simple” planning, especially in blended families where the surviving spouse was not the parent of all of the deceased spouse’s children. As a response to this situation, attorneys conceived the idea of funding a martial exemption or QTIP (qualified terminable interest property) trust to receive the assets of the first spouse to die. Since the assets in a QTIP trust are taxable in the estate of the surviving spouse, but the survivor does not have ownership of the assets so cannot change the ultimate beneficiaries, this “AQ” or “AQB” planning provided an acceptable option.
There remained, however, a risk that the IRS would disregard the QTIP election if the election was not required in order to prevent a tax in the estate of the first spouse to die. In a taxpayer-friendly ruling in 2001, Revenue Procedure 2001-38, the IRS had advised taxpayers that if an estate made a marital election and the election was not required in order to reduce the taxable estate, the IRS would disregard the election. This ruling benefitted taxpayers who mistakenly made the election and, as a result, might then owe an estate tax at the death of the surviving spouse because too many assets would be subject to tax in the survivor’s estate. Some attorneys were concerned the IRS might use this revenue procedure as a sword to deny the marital election and cause the QTIP Trust to be treated like a bypass trust (and so not be entitled to a basis step-up). To counter this risk, some attorneys were recommending clients make a “partial QTIP election” allowing some assets to also fund a bypass trust on the assumption that such a partial election would remove the client’s estate tax return from the category of estates covered by 2001-38.
Revenue Procedure 2016-49 eliminates this concern. The IRS has stated that it will continue to make use of Rev. Proc. 2001-38 in appropriate cases to benefit a taxpayer who made an inadvertent marital election. However, if the taxpayer also elects portability of the DSUEA on the same estate tax return, the IRS will honor both elections. Trusts designed to fund a marital trust at the first death (regardless of the size of the estate) will now be safe making the marital and portability election without the need to also partially fund a bypass trust.
1. IRC Section 2010(c).
2. IRC Section 2014.