Carryover Basis, GST Tax, and Portability

Capital Letter No. 29

September 6, 2011

Ronald D. Aucutt

An extra base hit of carryover basis guidance dominated August, although it was not quite a home run. But a couple of GST tax issues made it home, and portability is on deck.

Dear Readers Who Follow Washington Developments:

August is typically a quiet month, particularly with Congress in recess, although that very fact can sometimes help focus attention on the administrative guidance that the IRS and Treasury work on year-round. This year, the weeks before Labor Day brought significant administrative elaboration of the carryover basis rules for 2010 estates and a clarification of some GST tax rules for 2010 gifts and estates. The elaboration of carryover basis rules came as triple guidance – Notice 2011-66 and Rev. Proc. 2011-41 at the beginning of August and the 2010 estate tax return on the Labor Day weekend. But without Form 8939 itself and its accompanying instructions, the guidance was not quite a home run. Even so, a triple is one of the most exciting plays in baseball, and the unfolding of guidance for 2010 estates since the 2010 Tax Act last December has been anything but dull.

Parallels in Recent Estate Tax Dialogue

Legislative Background

In December 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the 2010 Tax Act”) retroactively reinstated the estate tax, which had been suspended for 2010 by the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”). But section 301(c) of the 2010 Tax Act permits an “election out” of the estate tax back into the carryover basis regime for 2010 that had been enacted by EGTRRA.

Section 6018, enacted by EGTRRA and now applicable only to the estates of 2010 decedents whose executors elect out of the estate tax, requires formal reporting to the IRS and to recipients of property from the decedent if the fair market value of all property except cash acquired from the decedent exceeds $1.3 million. Before the enactment of the 2010 Tax Act, the IRS released a draft Form 8939 for this purpose, but even that draft indicated that the form would be heavily dependent on instructions, which have yet to be issued.

Section 6075(a) provides that Form 8939 is to be “filed with the return of the tax imposed by chapter 1 for the decedent’s last taxable year [that is, the decedent’s final 1040 due April 18, 2011] or such later date specified in regulations.” It is now clear that there will not be any such regulations, but on March 31, 2011, an IRS News Release (IR-2011-33) announced that Form 8939 will not be due on April 18, 2011, and should not be filed with the final Form 1040. The news release concluded:

Treasury and the IRS plan to issue future guidance that will provide a deadline for filing Form 8939 and for electing to have the estate tax rules not apply to the estates of persons who died in 2010. The prior deadline was April 18, which remains the deadline for filing a decedent’s final Form 1040 this filing season. The forthcoming guidance will also explain the manner in which an executor of an estate may elect to have the estate tax not apply.

A reasonable period of time for preparation and filing will be given between issuance of the guidance and the deadline for filing Form 8939 and for electing to have the estate tax rules not apply. The Form 8939 is not currently available, but will be made available soon after the guidance is issued. Both will be made available on IRS.gov.

Notice 2011-66: The “Section 1022 Election”

On August 5, 2011, the IRS provided the first substantive guidance regarding both the carryover basis rules and the election out of the estate tax. Confirming what many have assumed, Notice 2011-66, 2011-35 I.R.B. 179, provides that Form 8939 will be used to make what it calls the “Section 1022 Election” out of the estate tax, as well as to report and value property as required by section 6018 and to allocate the basis increases provided in section 1022 as enacted by EGTRRA.

Notice 2011-66 provides that Form 8939 must be filed on or before November 15, 2011. In general, the IRS will not grant extensions of time to file Form 8939 and will not accept a Form 8939 filed late, and, once made, the Section 1022 Election and basis increase allocations will be irrevocable. As explicit exceptions, the IRS will allow additional Forms 8939 to make additional allocations of Spousal Property Basis Increase as additional property is distributed to the surviving spouse, and will allow other changes to a timely filed Form 8939, except making or revoking a Section 1022 Election, on or before May 15, 2012 (six months after November 15). The IRS also retains the discretion, under “9100 relief” procedures, to allow an executor to amend or supplement a Form 8939 or even to file a Form 8939 late (and thus make the Section 1022 Election late). Obtaining 9100 relief can be cumbersome and expensive, and the IRS has made it clear in Notice 2011-66 that its standards for that relief are likely to be quite restrictive, except in the case of the allocation of additional basis increases to assets that are discovered, or revalued in an IRS audit, after a timely Form 8939 is filed. But this anticipated strictness must be balanced against one of the apparent historical purposes of the Section 1022 Election, which was to relieve concern about a constitutional challenge to what would otherwise have been an unmitigated retroactive reinstatement of the estate tax.

Ordinarily Form 8939 will be filed by the executor appointed by the appropriate probate court. Sometimes, however, there is no such executor, such as when all of the decedent’s property is held in trust. In that case, a Form 8939, or multiple Forms 8939 as the case may be, will be filed by the trustees or others in possession of that property (often called “statutory executors” after the definition in section 2203). Notice 2011-66 states that if those statutory executors do not agree regarding the election, or attempt in the aggregate to allocate more basis increase than the law allows, the IRS will notify those statutory executors that they have 90 days to resolve their differences. If the executors fail to resolve their differences within the 90-day period, the IRS, after considering all relevant facts and circumstances disclosed to it, will determine whether the election has been made and how the allocations should be made.

Revenue Procedure 2011-41

Also on August 5, 2011, the IRS released Rev. Proc. 2011-41, 2011-35 I.R.B. 188, elaborating the rules governing the allocation of the basis increases allowed by EGTRRA and providing a number of other clarifications.

The elaborations and clarifications will be especially helpful to executors in making decisions about the sale or distribution of assets (although they might have been even more helpful if they had been published earlier this year). For example, Section 4.03 of Rev. Proc. 2011-41 clarifies that the executor may allocate the basis increases allowed by EGTRRA even after the asset has been sold or distributed. Section 4.02(2)(b) and Example 3 make it clear that the “General Basis Increase” includes all unrealized losses in capital assets at the moment of the decedent’s death, without regard to the limitations on immediate deductibility that would apply for income tax purposes in the event of a sale. Section 4.06(1) provides that the recipient’s holding period of property subject to the carryover basis rules includes the decedent’s holding period (whether or not the executor allocates any basis increase to the property). Section 4.06(2) provides that such property generally retains the character it had in the hands of the decedent. Section 4.06(3) provides that the depreciation of property in the hands of the recipient is determined in the same way it was in the hands of the decedent.

In more technical contexts, Sections 4.06(4), (5), and (6) of Rev. Proc. 2011-41 helpfully address the specialized rules under Code sections 469 (passive activity losses), 1040 (recognition of gain on the satisfaction of a pecuniary bequest with appreciated property), and 684 (sale or exchange treatment of transfers to nonresident aliens). And in a clarification outside of the carryover basis rules, Section 4.07 confirms that a testamentary trust that otherwise qualifies as a charitable remainder trust under Code section 664 will still qualify if the executor makes a Section 1022 Election, even though the election out of the estate tax will mean that no estate tax deduction under section 2055 will be allowable, which would appear to have disqualified the trust under Reg. § 1.664-1(a)(1)(iii)(a).

The 2010 Estate Tax Return

The 2010 estate tax return (Form 706) was posted on the IRS website on September 3, 2011. The declaration above the signature line had been revised (even from the draft dated August 31) to read as follows:

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. I understand that a complete return requires listing all property constituting the part of the decedent’s gross estate (as defined by statute) situated in the United States. I (executor) understand that if any other person files a Form 8939 or Form 706 (or Form 706-NA) with respect to this decedent or estate, that [sic] my name and address will be shared with such person, and I (executor) also hereby request [that] the IRS share with me the name and address of any other person who files a Form 8939 or Form 706 (or Form 706-NA) with respect to this decedent or estate. Declaration of preparer other than the executor is based on all information of which preparer has any knowledge.

The third sentence of this declaration, referring to Form 8939, reinforces the approach announced in Notice 2011-66 for reconciling inconsistent positions or conflicting allocations by multiple “statutory executors.” Perhaps one of the reasons this form was finalized on the Saturday before Labor Day is that the draft dated August 31 did not include this sentence, although the August 25 draft of the 2011 return did. (There is, of course, no Section 1022 Election and no Form 8939 for 2011 estates.) The wording adopted on the Labor Day weekend was apparently imported from the July 2011 version of the return for the estates of nonresidents who are not citizens (Form 706-NA), which probably explains the somewhat out-of-place second sentence, referring to property situated in the United States. The haste with which the change was made is also evident in the ungrammatical placement of the word “that” (which is also true of Form 706-NA and for which Capital Letters provides some help in the quoted text). As noted above, this guidance has been anything but dull.

A question frequently asked about the 2010 Form 706 is whether the special September 19, 2011, due date provided for estates of decedents who died before December 17, 2010, the date of enactment of the 2010 Tax Act, can itself be extended for six months in the usual way. It is encouraging, especially with September 19 now less than two weeks away, that Line 9 of Part 1 of the 2010 Form 706 retains the usual “[i]f you extended the time to file this Form 706, check here.” It is theoretically possible that those words would be applied only to estates of decedents who died after December 16, but that appears extremely unlikely, and it should be expected that the instructions will make it clear that all 2010 estate tax returns are eligible for the automatic six-month extension of time. Thus, the surge of filings between now and September 19 may consist of Forms 4768, not Forms 706.

Form 8939

Section 7 of Rev. Proc. 2011-41 states that the IRS expects 7,000 executors to file Form 8939. The IRS news release accompanying Notice 2011-66 (IR-2011-33) said the IRS expects to issue Form 8939 “early this fall.” Now that the substantive guidance of Rev. Proc. 2011-41 and Notice 2011-66 has been completed and the due date of November 15 has been confidently announced, we would hope to see Form 8939, along with its instructions and the related Publication 4895, issued “soon after the guidance is issued,” as the IRS said in IR-2011-33 in March.

Rev. Proc. 2011-41 begins by stating that “[t]his revenue procedure provides optional safe harbor guidance….,” but arguably does not deliver much in the way of true “safe harbors” that have been discussed since carryover basis became a serious possibility in late 2009, including default rules if no allocations (or incomplete allocations) are made, de minimis rules, reliance on reasonable estimates of purchase prices, and the presumably reduced documentation needed when allocated basis increases produce a basis that is clearly far less than the fair market value of an asset. Form 8939 and its instructions are needed for that. Until then, carryover basis guidance will not be all the way home, but will be waiting on third base for one more swing to make contact.

Miscellaneous GST Tax Issues

Also like runners on base waiting to come home, there were a few questions about the GST tax that were also resolved as an incident to the recent triple guidance for 2010 estates.

It has long been thought that if an executor elects out of the estate tax and files a Form 8939 to report the necessary carryover basis information, any GST exemption that is needed could also be allocated on or with the Form 8939. After all, because most elections out of the estate tax will involve the largest estates, these are also the estates in which generation-skipping is most likely to be observed. Notice 2011-66 confirms that GST exemption allocations can be made on Schedule R of Form 8939. That is the same schedule that is used to allocate GST exemption on an estate tax return, and it would not be surprising if the Schedule R for the Form 8939 turned out to be essentially identical to the Form 706 Schedule R, with only references to Form 706, the QTIP election, and other estate tax concepts altered or removed.

Many transfers in 2010 to trusts were “direct skips” – for example, where only grandchildren and not children of the donor are beneficiaries of the trusts – in order to qualify for the “move down” rule of section 2653 so that future distributions to grandchildren when the GST tax rate is not zero will not be taxed. In such cases, it may be important to affirmatively elect on the 2010 gift tax return not to permit a deemed allocation of GST exemption under section 2632(b) or (c). This will not always be desirable, however, especially where there are no other likely uses for GST exemption in the future, because the “move down” permits the tax-free skip of only a generation or two, while the allocation of GST exemption will cause a long-term trust to be exempt as long as it lasts. But if the 2010 direct skip gift is made outright to a skip person like a grandchild or great-grandchild, there are no future GST tax characteristics to protect and no conceivable reason to want GST exemption to be allocated. The IRS helpfully acknowledges this in section II.B of Notice 2011-66, which states:

[Reg. § 26.2632-1(b)(1)(i)] provides that “… a timely filed Form 709 accompanied by payment of the GST tax (as shown on the return with respect to the direct skip) is sufficient to prevent an automatic allocation of GST exemption with respect to the transferred property.” Because it is clear that a 2010 transfer not in trust to a skip person is a direct skip to which the donor would never want to allocate GST exemption, the IRS will interpret the reporting of an inter vivos direct skip not in trust occurring in 2010 on a timely filed Form 709 as constituting the payment of tax (at the rate of zero percent) and therefore as an election out of the automatic allocation of GST exemption to that direct skip. This interpretation also applies to a direct skip not in trust occurring at the close of an estate tax inclusion period (ETIP) in 2010 other than by reason of the donor’s death.

The “payment of tax (at the rate of zero percent)” is certainly an odd notion, as is the concept of a zero rate itself, but, like the zero rate, it produces the right result.

The notion of the zero rate is also reaffirmed in the 2010 estate tax return. Line 8 of Part 2 of Schedule R, line 8 of Part 3 of Schedule R, and line 6 of Schedule R-1 all provide for the calculation of “GST tax due” by multiplying the previous line by zero. Meanwhile, the second page of Schedule R-1 (page 26 of the entire return) includes the usual comprehensive instructions for trustees about the payment of the (zero) tax. (The 2010 gift tax return that the IRS posted on its website on March 18, 2011, was also consistent with this approach. In Part 3 of Schedule C, the “applicable rate” in column G is filled in as “0,” and column H, which instructs “multiply col. B by col. G,” is also filled in with “0.”)

The 2011-12 Priority Guidance Plan: Portability

The Treasury-IRS Priority Guidance Plan for the 12 months beginning July 1, 2011, was released on September 2, 2011. A future Capital Letter will discuss the Plan in more detail. Besides a contemplated Notice on decanting (item 13), the only two new projects under the heading of Gifts and Estates and Trusts relate to “[g]uidance under §1022 concerning estates of decedents who die during 2010” (item 6) and “[g]uidance on portability of Unified Credit between spouses under §2010(c)” (item 7). Item 6, regarding 2010 estates, identifies Rev. Proc. 2011-41 and Notice 2011-66, but without an explicit assertion that they have completed the guidance. Nevertheless, the Plan reinforces the assumption that the next guidance will be Form 8939 itself, and that any other substantive guidance can and will be provided by the form, instructions, and Publication 4895.

That leaves portability as the only remaining announced guidance project related to the 2010 Tax Act – the next priority, as it were, now that Rev. Proc. 2011-41 and Notice 2011-66 are completed. And well it might be the next priority, as the first estate tax returns making the portability election are due October 1, 2011! The August 25, 2011, draft of the 2011 estate tax return, by the way, says nothing about portability, which has fueled speculation that the “election” of portability required by section 2010(c)(5)(A) will be presumed in the case of any return for a married decedent that provides the information necessary to determine the exclusion amount that was available and the exclusion amount that was used, and therefore the amount of “deceased spousal unused exclusion amount” contemplated by section 2010(c)(4). Arguably part 4 of the August 25 draft does that, because it asks for the customary information about beneficiaries other than charity and the surviving spouse (line 5), as well as all federal gift tax returns (line 7).

Curiously, the draft 2011 return changes “applicable credit amount” to “applicable exclusion amount,” on lines 9, 10, and 11. That change might have been intended to reflect the shift in section 2010(c) to a focus on the “exclusion amount,” rather than the credit, in the accounting that is required between spouses. Moreover, those lines are exactly where we should expect portability to be reflected, albeit in the return of the surviving spouse, not necessarily the first spouse to die. It would make no sense to deduct the “applicable exclusion amount” from the “gross estate tax,” which would be the effect of that change in the draft. But it is still only a draft (unlike the 2010 return that was finalized on September 3), and we should assume that more IRS work might produce both a more rational formulation for lines 9, 10, and 11 and an answer to the burning question of whether an overt affirmative election other than merely filing the return is necessary in order to make use of portability at all.

Ronald D. Aucutt