Merging a Revocable Trust at Death With an Estate – Tax Consequences

Overview

A revocable trust is a popular estate planning tool that is utilized as a will substitute.  Some people view it as a good alternative to a will for several reasons, including privacy and probate avoidance.  Unfortunately, some believe that a revocable trust will also save estate taxes compared to a properly drafted will.  It will not.  The very nature of the revocability of the trust means that the trust property is included in the decedent’s estate at death. 

While estate tax savings are not an issue with a revocable trust, it’s important to understand the income tax issues that can occur when the grantor of the trust dies and the trust assets become part of the grantor’s estate.  There’s a special tax election involved for a “qualified revocable trust” (QRT) and it has particular accounting and income tax consequences.  It can also provide some tax planning opportunities.

The tax and accounting rules surrounding the election to treat a QRT as an estate – it’s the topic of today’s post.

The I.R.C. §645 Election

The issue.  When the grantor of a revocable trust dies, the trust becomes irrevocable.  For tax purposes, the trust will have a calendar year – a short tax year from the date of death through December 31.  In addition, the trust will be a complex trust if the trustee is not required to make immediate distributions.  In that case, depending on the assets in the trust, the trust may earn income that will be taxed in accordance with the rate brackets applicable to a trust.  For 2020, the top rate of 37 percent is reached at $12,951 of trust income.  Of course, one possible solution to this problem is for the trustee to distribute the trust income to the beneficiaries so that it can be taxed at their (likely lower) tax rates.  But, if that additional income has not been planned for it could create tax issues for the beneficiaries such as underpayment penalties. 

Another option may be for the trustee/executor to make the I.R.C. §645 election for a QRT.

Mechanics.  A QRT is a domestic trust (or portion thereof) that is treated as owned by a decedent (a grantor trust) on the date of the decedent’s death by reason of a power to revoke that was exercisable by the decedent or with the consent of the decedent’s spouse.  I.R.C. §645(b)(1).  For a QRT, the executor of the decedent’s estate, along with the trustee, can make an election to have the QRT taxed as part of the decedent’s estate for income tax purposes instead of as a separate trust.  I.R.C. §645(a).  In other words, a joint election by both the trust and the estate’s executor is required. 

Without the election, the revocable trust becomes irrevocable upon the decedent’s death and requires a separate income tax return (Form 1041) to report trust income (using a calendar year-end) that is earned post-death.  The merger of the trust and the estate for income tax purposes applies only to tax years that end before the date six months after the final determination of estate tax, or, if there is no estate tax return that is filed (Form 706), two years after the date of death.  I.R.C. §645(b)(2). 

If an executor is not appointed for the estate, the trustee files the election with an explanatory statement that no executor is being appointed for the estate.  The election is made by completing Form 8855 and attaching a statement to Form 1041 providing the name of the QRT, its taxpayer identification number and the name and address of the trustee of the QRT.

Once made, the election causes the trust to be treated for income tax purposes as part of the decedent’s estate for all applicable tax years of the estate ending after the date of the decedent’s death.  Id.  The electing QRT need not file an income tax return for the short year after the date of the decedent’s death.  Instead, the trustee of the electing QRT only need file one Form 1041 for the combined trust and estate under the estate’s TIN, and all income, deductions and credits are combined. 

The election allows a fiscal year-end to be utilized, ending at the end of a month not to exceed one-year after the decedent’s death.  The utilization of a fiscal year for income tax purposes can allow the estate executor to more effectively time the reporting of income and expense to achieve a more advantageous tax result.  For example, assume that an election is made for a QRT resulting in a tax year of December 1, 2020 through November 30, 2021.  A beneficiary receives a distribution on December 23, 2020.  As a result of the election, the beneficiary won’t have to report any income triggered by the distribution until 2021 and will have until April 15, 2022 to file the return that reports the income from the distribution.  Without the election, the distribution would have been taxed to the beneficiary in 2020 and reported on the 2020 return filed on or before April 15, 2021.   

The election can also allow for the loss recognition when a pecuniary bequest is satisfied with property having a fair market value less than basis.  I.R.C. §267(b).  One $600 personal exemption is allowed; the QRT can deduct amount paid to, or permanently set aside for charity; and up to $25,000 in passive real estate losses can be deducted.  I.R.C. §§642(b); 642(c); 469(i)(4).

Once the election is made, it is irrevocable.

Implications.  The I.R.C. §645 election, while resulting in one tax return for purposes of reporting income and expense on Form 1041, the trust and the estate are still treated as separate shares for purposes of calculating the distributable net income (DNI) deduction.  Treas. Reg. §1.645-1(e)(2)(iii).  The election does not combine the estate and trust for purposes of computing the DNI deduction. Thus, distributions can result in different allocation to beneficiaries and different amounts of income tax paid by the estate/trust. 

To illustrate, assume that an estate has $20,000 of income with no distributions made to the trust which, as typical, is the estate’s sole beneficiary.  The trust has $40,000 of income and made a $60,000 distribution to a beneficiary.  The income reported on Form 1041 is $60,000.  Under the Treas. Reg., the estate’s DNI is calculated separately from that of the trust.  In the example, the estate’s share of DNI is $20,000, but it gets no DNI deduction due to the lack of distributions during the tax year.  Conversely, the trust’s share of DNI is $40,000 and the trust’s DNI deduction is the lesser of the total cash distributed or the DNI.  Here, the DNI was less than the actual cash distributed resulting in a DNI deduction of $40,000.  The filed Form 1041 recognizes the $20,000 of taxable income and the beneficiary has $40,000 of income reported on the beneficiary’s individual return. 

Now assume that the estate distributes $20,000 to the trust, the trust’s share of income is $60,000 ($40,000 plus the $20,000 from the estate).  The full $60,000 of income is DNI of the trust, and the $60,000 distribution to the beneficiary causes the full $60,000 to be taxed at the beneficiary’s level.  There is no tax at the trust level to be taxed at the compressed bracket rates applicable to trusts and estates.  This all means that separate accounting for the trust and the estate must be done while the estate is being administered. 

When the election period ends or when the assets of the original trust are distributed to another trust, the new trust will file returns on a calendar year basis.  Thus, a filing will be required for the timeframe from the end of the fiscal year to the end of the calendar year after the termination.  In that instance, the beneficiaries could end up with two K-1s and the benefit of income deferral could be eliminated depending  on the tax bracket that the beneficiary is in.

Conclusion

Clearly there are several things to consider before making an I.R.C. §645 election.  For individuals that die late in the year, the election can allow estate administration to perhaps be completed before a tax return must be filed.  Thus, the first tax return could end up being the final tax return for the estate if the estate is fully administered by the time the return is due.  That would save administrative costs.  Also, the election can provide the ability to shift income into a later tax year; allow funds to be set aside for charity and receive a deduction but not have to distribute the funds until a later time; eliminate the need for estimated tax payments; and hold S corporate stock during the period of estate administration – an advantage over a trust if administration extends beyond two years.  But the separate share rule can complicate the accounting.  The trust and the estate are not combined for calculating the DNI deduction.  Separate accounting for the trust and estate is needed while the estate is being administered.

More things to think about when a decedent dies with a revocable trust.