The 645 Election: Just What the Doctor Ordered
Tim Harden discusses the requirements, timing, and benefits of this income tax election
ABOUT THE AUTHOR: Tim Harden is a CPA with Gatto, Pope & Walwick, LLP who works with estates, trusts, and individuals to provide tax saving strategies and compliance services. He has an extensive background in the field of trust, estate, and gift tax, including the areas of probate, asset protect, and complex trust and estate planning with tax compliance, including roughly 16 years as an attorney in this area prior to changing his focus to public accounting.
Table of Contents
Intro to a Use Case
Gibby Utterson has been engaged as the attorney for the estate of Robert Stephenson. Right off the bat, complications have arisen between the fiduciaries involved. Currently, he is trying to convince the Executor of the probate estate, Ed Hide, to get along with Henry Jackal, the Trustee, and to make a 645 Election to streamline the administration of their friend Robert's estate. The problem lies in their wildly differing approaches to life and how to make a convincing case to each of them taking their idiosyncratic viewpoints into account. Hide is the easier one. He is concerned about protecting any funds he might receive from the estate, so if he can save some money with the election, he most likely will go along. Nevertheless, Utterson knows he must make sure the savings are significant, because Hide does have a perversely disagreeable nature. He may well argue contrary to Jackal just to be difficult. Jackal, on the other hand, takes his fiduciary duties seriously. He is punctilious to a fault, so Utterson will have to be prepared to explain the minutiae of the election in excruciating detail.
They agree to hear out Utterson on the pros and cons of the election before deciding. To start, Hide wants to get to the good stuff - the benefits - but Jackal makes them go through the laborious steps of analyzing what kind of trust can make it, who is authorized, how it's done, and how long it lasts before they go into the benefits. But first, Utterson provides some background to lay the groundwork for their later decision.
What is the Election?
Like many tax elections, this one is named after the Code Section that created it: Internal Revenue Code Section 645. Simply, it provides a "general rule": "…if both the executor (if any) of an estate and the trustee of a qualified revocable trust elect the treatment provided in this section, such trust shall be treated and taxed as part of such estate (and not as a separate trust) for all taxable years of the estate ending after the date of the decedent's death and before the applicable date." This Code Section was enacted by the Taxpayer Relief Act of 1997, P. L. 105-34, § 1305(a).
The reason why Utterson has broached this subject is immediately obvious to both Hide and Jackal. One of them is an executor and the other a trustee. Under this statute, they can combine their required filings into one. Even the two of them can agree that simplifying things is often better. However, they are both aware that tax law is complicated and there are likely more considerations at issue than what is immediately obvious to both. In addition, the tightly drafted wording of the statute hides several possible landmines. For instance, what are a "qualified revocable trust" and the "applicable date"? What is the required timing for making the election? And what, specifically, are the advantages and disadvantages of making the election?
These questions are particularly important because the 645 Election is irrevocable once made.
Utterson proceeds to delve into these questions, by looking at both the statute and its regulations.
Qualified Revocable Trust
The Regulations provide a definition of a qualified revocable trust, or "QRT". Under Treasury Regulation Section 1.645-1(b)(1), it is any trust that the decedent had the power to revoke as of the date of death. As a result of this, a testamentary trust cannot be a QRT, because it did not come into existence until the decedent's death. In this case, Utterson explains, Stephenson had several bank accounts and business interests in his trust as of the date of death. This means that he had changed the title of these assets from his personal name to that of his trust, the Robert L. Stephenson Revocable Living Trust. However, as suggested by its name, it was a "revocable living trust", meaning that he had the power to make changes to the trust while he was alive, including simply revoking it entirely. Now that he has passed, it is no longer revocable. It is this trust of which Mr. Jackal is the trustee. Because the trust was revocable at Stephenson's death, it qualifies as a QRT under the Regulation. In answer to a question from Jackal, Utterson gives an example of a trust that would not qualify as a QRT. If Stephenson had created a dynasty trust to benefit future generations of his descendants, this would not qualify as a QRT, because it would be irrevocable prior to death and already be a separate entity for tax purposes. This is in contrast to a revocable trust, which is not treated as a separate taxable entity. All tax items are simply reported on the grantor's individual tax return.
Jackal and Hide are both satisfied with this explanation and are ready for the next are of consideration.
Applicable Date
Since they are dealing with a QRT and an estate, the next question is what the "applicable date" means. This turns out to be a more complicated question than whether a trust can qualify as a QRT. It is important, because it is the endpoint for the period of the 645 Election, which begins as of the date of death. There are two scenarios, which are laid out in Treasury Regulation Section 1.645-1(f)(1) and (2).
The first, under (f)(1) is fairly simple. If there is no Form 706 to be filed for the decedent, then the "applicable date" is the day which is two years after the date of death. Unfortunately for Jackal and Hide, a Form 706 is anticipated to be filed for Stephenson.
The second scenario, which is covered under (f)(2), is more complicated. Under this section, the applicable date is the later of two years after the date of death or the day that is six months after the "date of final determination of liability for estate tax." This latter is a term defined as the earliest of five possible dates:
Six months after the IRS issues an estate tax closing letter, unless the estate files a claim for refund within 12 months of the issuance of the closing letter.
Piggybacking off the prior, when the claim for refund is finally disposed of, unless suit is instituted within six months of that date.
Signing a settlement agreement with the IRS that determines estate tax liability.
The date a court issues a decision to resolve the liability, unless this decision is appealed by proper means within 90 days.
The date the statute of limitations for assessment of estate tax under Code Section 6501 expires (generally three years after the return is filed).
Finally, the Regulation provides a definition for the final disposition of a claim for refund under (2) above. It says that this occurs when "all items have been either allowed or disallowed." In addition, if a waiver relating to a disallowance is filed before the item is actually disallowed, then the date of the waiver is what counts.
Obviously, the determination of the applicable date is very fact intensive and is not subject to easy generalizations. The Regulation does provide three examples to help provide clarity. In the first, the date of death is October 20, 2002, and no 706 is required to be filed. This falls under (f)(1), and therefore the applicable date is two years after the date of death, or October 20, 2004. It is important to note that this means the last day of the period to which the 645 Election applies is October 19, 2004. Starting the next day, the trust is no longer taxed together with the estate.
In the second example, with the same date of death, the IRS issues a closing letter on March 15, 2005. This falls under (1) above, which means that the applicable date is six months after the issuance of the closing letter, unless the estate files a claim of refund within twelve months. In the example, it does not, so the date of final determination of liability is six months after the issuance of the closing letter, or September 15, 2005. Therefore, the applicable date is six months after that or March 15, 2006.
In the third and final example, the same date of death is used, but now the Form 706 is audited, a notice of deficiency is issued, and then a petition is filed in Tax Court. The Tax Court's decision, which is issued December 14, 2005, is not appealed. That means the date of final determination of liability is that date, and the applicable date is six months after that, or June 14, 2006.
The question of the applicable date is a lot to take in for Jackal and Hide, but Utterson explains that basically they will file the Form 706 for the estate and then see what happens from there. The 645 Election will last until six months after the estate tax liability is determined, so now that they are aware of the events that trigger that determination, they will have to be on the lookout and plan accordingly.
Timing
With all this talk of dates and timing, Jackal asks a pertinent question - when does the election actually have to be made? This is important, because although not as complicated an issue as the determination of the applicable date, it is easily missed. Under subsection (c) of the Regulation, the election must be made by the time of the filing of the Form 1041 for the first taxable year of the related estate, including extensions. However, this applies even if there is not enough income to necessitate the filing of a return. Thus, if the initial year passes with no return being filed, the election form must be filed separately, or the opportunity is lost.
Form 8855
The discussion of the timing confuses Hide. How can the election be filed without a return being filed? Utterson has an easy answer for that one: The election is made by completing and filing Form 8855. In fact, even if there is a return being filed, the Form 8855 is done separately, because it is mailed in to the IRS to one of two different service centers, depending on the state the decedent was located in. However, it should be noted that there is a box in Section G on page one of the 1041 that needs to be checked to show that a 645 Election has been made.
Although for Jackal and Hide it is straightforward, in some situations there could be a question as to who signs the 8855. First, if there is both an executor and a trustee, then both executor and the trustee sign the form. In doing so, they are agreeing to be bound by the election, to allocate the tax burden appropriately, and to timely provide information to each other. In addition, they are affirming that they will ensure that the tax is timely paid.
If there is no executor, the trustee can still make the election and signs the form on his own. However, by submitting the form in this manner, he is making the assertion that no executor will be appointed. If plans change, and an executor is appointed later, then a revised election form must be filed within 90 days of the appointment of the executor. If the executor does not consent, then the election is revoked.
Finally, if there is more than one QRT, then all of the trustees must sign the Form 8855. Below is a snippet of the top of the form. Form 8855 is fairly simple - most of the work is done in the analysis of the advisability and timing of the election.
Tax Advantages to the 645 Election
By now, Hide is impatient. They have reviewed many technical details and even looked at part of a tax form, and he is still does not know what he will gain from making the election. Therefore, Utterson proceeds to lay out the potential benefits:
Single return. Only one return would need to be filed, rather than one for the estate and one for the trust. This would save on fees and paperwork.
Larger exemption. Trusts, depending on their type, get either a $100 or $300 exemption deduction, but when the 645 Election is made, the $600 exemption deduction for estates applies. This is not a huge savings, obviously, but can help save tax, especially for returns near the beginning or end of the administration when there is not a lot of income generated.
Fiscal year. Generally, trusts must file on a calendar year basis. However, the 645 Election allows the combined return to be filed on a fiscal year basis. This can be helpful in two scenarios. First, if the person died near the end of the year, then choosing a fiscal year could extend the time for filing the first return. This could help just in terms of ease of administration, or even enable one return to be filed for the entire administration. For example, if the date of death was December 15, 2025, then a fiscal year end of November 30th would mean the first return would not be due until three and a half months from November 30, 2026, or March 15, 2027. Second, this could be a benefit under the same set of facts if the estate had significant income, choosing the fiscal year end of November 30th could delay paying taxes on that income for over a year. Third, it can just be a general administrative help. People sometimes die with their financial affairs in disarray, so extending the due date for filing the return can provide some much needed breathing room to sort through the decedent's assets, liabilities, and paperwork.
Charitable Set Aside Deduction. Generally, a trust can only take a charitable deduction for amounts actually paid to a charity. However, if the 645 Election is made, then an electing trust is allowed to follow the rule for estates and take an income tax deduction for amounts "permanently set aside" for charity. This adds flexibility and could be beneficial depending on the situation of the trust.
S Corporation Shareholder. S corporation shareholder eligibility is carefully defined by statute. A revocable trust is an eligible shareholder during the lifetime of the grantor without any other action having to be taken. However, when the grantor dies, and it becomes irrevocable, within two years of death, the trust either has to distribute the shares to an eligible shareholder or make a QSST or ESBT election. Without getting too much into the details of those elections, the trust must have the appropriate provisions to allow it to make either of these elections. Unlike a trust, an estate is automatically an eligible S corporation shareholder. The 645 Election extends this status to the electing trust, providing another benefit of making the election.
Estimated Taxes. This is another area where extending the rule for estates benefits a trust. An estate does not have to pay estimated taxes for two years following the decedent's death. The 645 Election applies this same rule to the electing trust.
Active Participation. This is a rule that pertains to passive activities. In most cases, passive losses can only be used to offset passive income. However, if the taxpayer is a real estate professional under the Code, then up to $25,000 of otherwise passive real estate losses can be used against active income. This is all relevant because the Code allows an estate to step into the shoes of the decedent for the two years after the decedent's death. Similar to the other rules above, the 645 Election applies this to a trust as well.
Reforestation Deduction. A lesser used Code Section allows estates to amortize reforestation expenditures, and the 645 Election applies this to electing trusts as well.
Foreign Trusts and Estates. One interesting wrinkle for the 645 Election is when it is applied to foreign trusts and estates. Typically, they are required to file a Form 1040-NR, U.S. Nonresident Alien Income Tax Return. However, the Regulations do not require a QRT to be a domestic trust, so if a foreign trust joins in a 645 Election, it can report its income on the return with the regularly filed 1041. This is another instance of the savings in administrative time and expenses that the 645 Election can provide. It should be noted that other foreign information reporting requirements may apply to the foreign trust.
Conclusion
In the end, the 645 Election is too enticing in terms of the benefits provided for Hide and Jackal to pass up, despite their contentious relationship. There are too many benefits to forgo, and they trust Utterson to handle the paperwork correctly.