Estate Tax Portability – The Authority of the IRS To Audit

Overview

Estate tax portability allows a surviving spouse to carry over any unused portion of the deceased spouse’s estate tax exclusion (DSUE) to be used to offset estate tax in the surviving spouse’s estate, if necessary.  It gets added to the surviving spouse’s own exemption.  The DSUE has become a key aspect of post-2012 estate planning, and makes it quite simple for married couple to utilize the full estate tax exclusion over both of their estates.  The full estate and gift tax coupled exclusion is $5.49 million per individual for deaths in 2017 and gifts made in 2017. 

One of the concerns about portability is the ability of the IRS to audit the estate of the deceased spouse where portability was elected.  Does the IRS have an open-ended statute of limitations to go back and examine that estate to determine if the “ported” amount of the unused exclusion was computed properly?  A recent Tax Court decision confirms that the IRS does.

Portability Basics

The election.  To “port” the unused exclusion at the death of the first spouse to the surviving spouse, an election must be made.  As noted, the amount available to be “ported” to the estate of the surviving spouse is the deceased spouse’s unused exclusion (DSUE).  IRC §2010(c)(4); Treas. Reg. §20.2010-2.  The portability election must be made on a timely filed Form 706 for the first spouse to die.  I.R.C. §2010(c)(5)(A); Treas. Reg. §20.2010-2(a)(1).  This also applies for nontaxable estates, and the return is due by the same deadline (including extensions) as taxable estates. The deadline for filing is nine months after the decedent’s date of death (with a six-month extension possible). The election is revocable until the deadline for filing the return expires.

While an affirmative election is required by statute, part 6 of Form 706 (which is entirely dedicated to the portability election, the DSUE calculation, and roll forward of the DSUE amount) provides that "a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the Form 706. No further action is required to elect portability…"^. This election, therefore, is made by default if there is a DSUE amount and an estate tax return is filed (as long as the box in section A of part 6 is not checked, which affirmatively elects out of portability).

Late election relief.  In Rev. Proc. 2014-18, 2014-7 IRB 513, the IRS provided a simplified method for certain estates to obtain an extended time to make the portability election. That relief has now expired and has been extended by Rev. Proc. 2017-34, 2017-26 IRB 1282.  The portability election must be submitted with a complete and properly filed Form 706 by the later of January 2, 2018, or the second anniversary of the decedent's death. After January 2, 2018, the extension is, effectively, for two years. The extension is only available to estates that are not otherwise required to file an estate tax return. Other estates can only obtain an extension under Treas. Reg. §301.9100-3. Form 706 must state at the top that the return is "FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A)."

An estate that files late, but within the extended deadlines of Rev. Proc. 2017-34, cannot rely on the revenue procedure if it later learns that it should have filed a Form 706. If a valid late election is made and results in a refund of estate or gift taxes for the surviving spouse, the time period for filing for a refund is not extended from the normal statutory periods. In addition, a claim for a tax refund or credit is treated as a protective claim for a tax credit or refund if it is filed within the time period of §6511(a) by the surviving spouse or the surviving spouse's estate in anticipation of Form 706 being filed to elect portability under Rev. Proc. 2017-34.

Election requirements.  Treas. Reg. §20.2010-2 requires that the DSUE election be made by filing a complete and properly prepared Form 706. Treas. Reg. §20.2010-2(a)(7)(ii)(A) permits the “appointed” executor who is not otherwise required to file an estate tax return to use the executor's "best estimate" of the value of certain property and then report on Form 706 the gross amount in aggregate, rounded up to the nearest $250,000.

Treas. Reg. §20.2010-2(a)(7)(ii) sets forth simplified reporting for particular assets on Form 706, which allows for good faith estimates. The simplified reporting rules apply to estates that do not otherwise have a filing requirement under IRC §6018(a). This means that if the gross estate exceeds the basic exclusion amount ($5.49 million in 2017), simplified reporting is not applicable.

Simplified reporting is only available for marital and charitable deduction property (under IRC §§2056, 2056A, and 2055) but not to such property if certain conditions apply.  Treas. Reg. §20.2010-2(a)(7)(ii)(A).

Assets reported under the simplified method are to be listed on the applicable Form 706 schedule without any value entered in the column for "Value at date of death."  The sum of the asset values included in the return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10 and 23 of part 5 of Form 706 (as assets subject to the special rule of Treas. Reg. §20.2010-2(a)(7)(ii)).

In addition to listing the assets on the appropriate schedules, the regulations require that certain additional information must be provided for each asset.  Treas. Reg. §20.2010-2(a)(7)(ii)(A).

Availability.  The inherited DSUE amount is available to the surviving spouse as of the date of the deceased spouse's death. It is applied to gifts and the estate of the surviving spouse before their own exemption is used. Accordingly, the surviving spouse may use the DSUE amount to shelter lifetime gifts from gift tax or to reduce the estate tax liability of the surviving spouse's estate at death.  Treas. Reg. §20.2010-3(b)(ii).

The regulations allow the surviving spouse to use the DSUE before the deceased spouse’s return is filed (and before the amount of the DSUE is established). Treas. Reg. §20.2010-3(ii).  However, the DSUE amount is subject to audit until the statute of limitations expires on the surviving spouse’s estate tax return.  Temp. Treas. Regs. §§20.2010-3T(c)(1) and 25.2505-2T(d)(1).  However, the regulations do not address whether a presumption of survivorship can be established. Thus, there is no guidance on what happens if both spouses die at the same time and the order of death cannot be determined and it is not known whether the IRS would respect estate planning documents that include a provision for simultaneous deaths.

Statute of Limitations – IRS Audits

The statute of limitations for assessing additional tax on the estate tax return is the later of three years from the date of filing or two years from the date the tax was paid. However, the IRS can examine the DSUE amount at any time during the period of the limitations for the second spouse as it applies to the estate of the first spouse. Treas. Reg. §20.2010-2(d) allows the IRS to examine the estate and gift tax returns of each of the decedent's predeceased spouses. Any materials relevant to the calculation of the DSUE amount, including the estate tax (and gift tax) returns of each deceased spouse, can be examined. Thus, a surviving spouse needs to retain appraisals, work papers, documentation supporting the good-faith estimate, and all intervening estate and gift tax returns to substantiate the DSUE amount.

New Case On The Audit Issue 

Facts.  In Estate of Sower v. Comr., 149 T.C. No. 11 (2017), the decedent died in August of 2013 as the surviving spouse.  Her predeceased spouse died in early 2012.  His estate reported no federal estate tax liability on its timely filed Form 706.  His estate also reported no taxable gifts although he had made $997,920 in taxable gifts during his life.  However, his estate did include $845,420 in taxable gifts on the worksheet provided to calculate taxable gifts to be reported on the return.  His estate reported a deceased spouse unused exclusion (DSUE) amount of $1,256,033 and a portability election of the DSUE was made on his estate’s Form 706 to port the DSUE to the surviving spouse. 

The decedent’s estate filed a timely Form 706 claiming the ported DSUE of $1,256,033 and paid an estate tax liability of $369,036, and then an additional $386,424 of tax and interest to correct a math error on the original return.  The decedent’s estate also did not include lifetime taxable gifts (of which there were $997,921) on the return, simply leaving the entry for them blank.  About two months later, the IRS issued an estate tax closing letter to the husband’s estate showing no estate tax liability and noting that that the return had been accepted as filed. 

IRS audit.  In early 2015, the IRS began its examination of the decedent’s return.  In connection with that exam, the IRS opened an exam of the husband’s estate to determine the proper DSUE to be ported to the decedent’s estate.  As a result of this exam, the IRS made an adjustment for the amount of the pre-deceased spouse’s lifetime taxable gifts and issued a second closing letter and also reducing the DSUE available to port to the decedent’s estate of $282,690.  The IRS also adjusted the decedent’s taxable estate by the amount of her lifetime taxable gifts and reduced it for funeral costs.  The end result was an increase in federal estate tax liability for the decedent’s estate of $788,165, and the IRS sent the decedent’s estate a notice of deficiency for that amount and the estate disputed the full amount by filing a petition in Tax Court. 

Estate’s arguments.  The estate claimed that the IRS was estopped from reopening the estate of the predeceased spouse after the closing letter had been initially issued to that estate.  The estate also claimed that the IRS was precluded from adjusting the DSUE for gifts made before 2010.  The estate additionally claimed that I.R.C. §2010(c)(5)(B) (allowing IRS to examine an estate tax return to determine the correct DSUE notwithstanding the normal applicable statute of limitations) was unconstitutional for lacking due process because it overrode the statute of limitations on assessment contained in I.R.C. §6501. 

Tax Court opinion.  The Tax Court disagreed with the estate on all points.  The court noted that I.R.C. §2010(c)(5)(B) gave the IRS the power to examine the estate tax return of the predeceased spouse to determine the correct DSUE amount.  That power, the court noted, applied regardless of whether the period of limitations on assessment had expired for the predeceased spouse’s estate.  This, the Tax Court noted, was bolstered by temporary regulations in place at the time of the predeceased spouse’s (and the decedent’s) death.  I.R.C. §7602, the Tax Court noted, also gave the IRS broad discretion to examine a range of materials to determine whether a return was correct, including estate tax returns. 

The Tax Court also determined that the closing letter did not amount to a closing document under I.R.C. §7121, which required a Form 866 and Form 906, and there had been no negotiation between the IRS and the estate.  The Tax Court also held that the decedent’s estate had not satisfied the elements necessary to establish equitable estoppel against the IRS.  The IRS had not made a false statement or had been misleadingly silent that lead to an adverse impact on the estate. 

Also, the Tax Court noted that there had not been any second examination.  No additional information had been requested from the pre-deceased spouse’s estate and no additional tax was asserted.  The effective date of the proposed regulation was for estates of decedent’s dying after 2010 and covered gifts made by such estates irrespective of when those gifts were made. 

There was also no due process violation because adjusting the DSUE did not amount to an assessment of tax against the estate of the pre-deceased spouse.  Consequently, the Tax Court held that the IRS properly adjusted the DSUE and the decedent’s estate had to include the lifetime taxable gifts in the estate for estate tax liability computation purposes. 

Conclusion

Because the election to utilize portability allows the IRS an extended timeframe to question valuations, the use of a bypass/credit shelter trust that accomplishes the same result for many clients may be a preferred approach.  However, in those situations, it should be a routine practice for practitioners to obtain a signed acknowledgement and waiver from the executor of the first spouse’s estate that the potential benefit of portability in the surviving spouse’s death has been explained fully and has been waived. 

As the Tax Court points out, the IRS has the power to audit the first spouse’s estate tax return and can add any increased tax to the surviving spouse’s estate tax return – no matter how many years have passed since the first spouse’s death.  That means it should also be routine practice for practitioners to make sure that Form 706 for the first spouse’s estate is prepared with absolute perfection.