Docstoc

SPECIAL PROBLEMS IN ADMINISTERING ESTATES AND

Document Sample
SPECIAL PROBLEMS IN ADMINISTERING ESTATES AND Powered By Docstoc
					              SEPARATE SHARE RULES AND SECTION 645 ELECTING TRUSTS

                                                                   By

                                                    W. Birch Douglass, III
                                                    McGuireWoods LLP
                                                     Richmond, Virginia

                                                         September 2001

I.         INTRODUCTION ...................................................................................................... 1

      A.      Revocable Trusts as Will Substitutes...................................................................... 1
      B.      Overview of Separate Share Rules. ........................................................................ 2
      C.      Summary of Election to Treat QRTs as Part of Estate. .......................................... 2
      D.      Impact of 2001 Act. ................................................................................................ 4

II.        STATUTORY PROVISIONS AND STATUS OF REGULATIONS ....................... 4

      A.      Section 663(c). ........................................................................................................ 4
      B.      Final Regulations under Section 663. ..................................................................... 5
      C.      Section 645.............................................................................................................. 5
      D.      Proposed Regulations under Section 645. .............................................................. 6

III. SECTION 663 FINAL REGULATIONS ................................................................... 7

      A.      Definition of Separate Shares. ................................................................................ 7
      B.      Creation, Valuation, and Allocation. ...................................................................... 8
      C.      Spouse's Elective Share. ......................................................................................... 9
      D.      Qualified Revocable Trusts ("QRTs"). ................................................................... 9
      E.      Pecuniary Formula Bequests................................................................................... 9
      F.      Income in Respect of a Decedent.......................................................................... 10
      G.      Effective Date Rules. ............................................................................................ 10

IV. SECTION 645 PROPOSED REGULATIONS ........................................................ 10

      A.      The Election. ......................................................................................................... 10
      B.      Definition of a QRT. ............................................................................................. 10
      C.      Required Written Statement. ................................................................................. 11
      D.      Tax Identification Numbers ("TINs") and Forms 1041. ....................................... 12
      E.      Application of the Separate Share Rule. ............................................................... 13
      F.      Duration of the Election. ....................................................................................... 13
      G.      Treatment on Termination of the Election. ........................................................... 14
      H.      Effective Date Rules. ............................................................................................ 14

V.         SUBCHAPTER J SEPARATE SHARE RULE IN OPERATION .......................... 14

      A.      Basic Rules............................................................................................................ 14


                                                                     i
  B.   Typical Applications. ............................................................................................ 15
  C.   Marital Deduction Planning. ................................................................................. 19
  D.   Disclaimers. .......................................................................................................... 23
  E.   Generation-Skipping Planning. ............................................................................. 24
  F.   S Corporations. ..................................................................................................... 24
  G.   Effect of Rate Compression. ................................................................................. 26

VI. DISCUSSION OF SECTION 645 AND ITS APPLICATION ................................ 27

  A.   Definition of a Qualified Revocable Trust ("QRT"). ............................................ 27
  B.   Duration of Election Period. ................................................................................. 30
  C.   Effect of Election .................................................................................................. 32
  D.   Use of Fiscal Year Other than Calendar Year. ..................................................... 34
  E.   Distributable Net Income ("DNI"). ....................................................................... 34
  F.   Charitable Set-Aside Deduction. .......................................................................... 36
  G.   S Corporation Election. ......................................................................................... 36
  H.   Passive Loss Active Participation Rules. .............................................................. 38
  I.   GST Separate Share Rule...................................................................................... 38
  J.   Other Special Situations, Advantages, and Disadvantages.. ................................. 39
  K.   Filing of Returns. .................................................................................................. 40
  L.   Absence of Estate. ................................................................................................. 42

VII.   MAKING THE SECTION 645 ELECTION DECISION .................................... 42

  A.   Factors to Consider. .............................................................................................. 42
  B.   Tax Considerations. .............................................................................................. 43
  C.   Effect on Beneficiaries. ......................................................................................... 44
  D.   Practical Aspects. .................................................................................................. 44
  E.   Guidelines if No Probate Estate. ........................................................................... 45
  F.   Guidelines for Partially Funded QRT with Complete Pour Over. ........................ 46
  G.   Guidelines if Not a Complete Pour Over. ............................................................. 46
  H.   Taking Full Advantage of the Election Period. .................................................... 48
  I.   Administration of Entities Following Termination of Election. ........................... 48




                                                             ii
     SEPARATE SHARE RULES AND SECTION 645 ELECTING TRUSTS

                                      By

                            W. Birch Douglass, III
                            McGuireWoods LLP
                             Richmond, Virginia

I.   INTRODUCTION

     A.   Revocable Trusts as Will Substitutes.

          1.     The Taxpayer Relief Act of 1997, P.L. 105-34 (the "1997 Act")
                 made certain changes that increase the attractiveness of funded
                 revocable trusts as will substitutes. These changes are found in
                 sections 645 and 663 of the Internal Revenue Code of 1986, as
                 amended (the "Code") [Hereafter, references to a "section" means
                 a section of the Code or regulations thereunder, as the case may
                 be.]

          2.     Among their many advantages, revocable trusts are popular as
                 testamentary substitutes in place of wills as a means of avoiding or
                 minimizing probate, particularly in jurisdictions with burdensome
                 probate costs and procedures. In addition, during lifetime such
                 trusts provide a convenient vehicle to manage a person's assets
                 and, in the event of incapacity, a less expensive alternative to a
                 guardianship or conservatorship.

          3.     Estates and formerly revocable trusts (sometimes referred to as
                 "postmortem trusts" but called "QRTs" in the proposed regulations
                 under section 645) have historically been treated as separate
                 taxable entities, subject to slightly different income tax treatment.
                 The election to treat the two as a combined entity under section
                 645 narrows these differences.

          4.     The Code treats the separate and independent shares of different
                 beneficiaries as separate shares for purposes of calculating
                 distributable net income ("DNI") and for certain other, but not all,
                 purposes.

          5.     Most revocable trusts are silent regarding the handling of an
                 "administrative" trust following the grantor's death and until the
                 trust is divided and any subtrusts are funded. The IRS has
                 provided no specific guidance in this matter. Most trustees treat
                 the undivided trust as a complex trust and defer accounting for the
                 separate interests or subtrusts until funding actually begins, after
                 which compensating distributions, allocations, and adjustments


                                       1
            may be made as appropriate to reflect the situation that would have
            resulted had the trust actually been divided, and the subtrusts
            funded, as of the grantor's death in accordance with the terms of
            the trust instrument.

B.   Overview of Separate Share Rules.

     1.     There are three separate share rules to be aware of in administering
            trusts and estates.

            a.     The subchapter J rule.

            b.     The subchapter S rule.

            c.     The GST rule.

     2.     The subchapter J separate share rule found in section 663(c)
            requires that the separate and independent shares of different
            beneficiaries in the same estate or trust be treated as separate
            shares or trusts in determining the DNI allocable to the respective
            beneficiaries.

     3.     The subchapter S separate share rule found in section 1361(d)(3)
            provides that separate shares are treated as separate trusts for
            purposes of determining permitted S corporation shareholders.

     4.     The GST rule found in section 2654(b)(2) applies the same
            separate share concepts in identifying trusts for generation-
            skipping transfer tax purposes.

     5.     Until the 1997 Act, the section 663(c) separate share rule applied
            only to trusts and not to estates. This allowed personal
            representatives to time distributions in such a manner as to carry
            out DNI in the most favorable way to the estate and its
            beneficiaries. It also meant that one beneficiary or class of
            beneficiaries could be taxed on income payable to, or accruing to,
            a separate beneficiary or class of beneficiaries.

     6.     The 1997 Act imposes the separate share rule of section 663(c) on
            estates of decedents, thereby minimizing the planning
            opportunities through the use of a probate estate instead of a
            postmortem trust.

C.   Summary of Election to Treat QRTs as Part of Estate.

     1.     Before the 1997 Act, the lifetime advantages of revocable trusts
            frequently were offset by the disadvantages of certain income tax



                                   2
     rules applicable to such trusts following the grantor’s death as
     compared to those applicable to probate estates.

2.   The 1997 Act eliminated many, but not all, of the previous
     disparities in the income tax rules between postmortem trusts and
     estates. In acknowledgment of the fact that revocable trusts are
     used as testamentary substitutes for nontax reasons, Congress
     significantly reduced the differences in the income tax treatment
     between the two types of postmortem entities by permitting an
     election to treat trusts that were revocable by a decedent during life
     as a part of the decedent’s estate for income tax purposes.

3.   No separate share rule exists for purposes of section 645. This
     means the entire QRT (and not simply one or more separate shares
     of the QRT) will be subject to the election.

4.   If the decision is made not to make the election in spite of the
     income tax benefits (because of anticipated administrative
     difficulties, for instance), the reasons for that decision should be
     documented in the fiduciaries' files.

5.   From the drafting perspective, the practitioner should consider
     whether a general authorization to make postmortem elections will
     suffice, or whether it is appropriate to add to the will and trust
     specific authority for the fiduciaries of both to make the section
     645 election. The practitioner should also consider whether such
     authority should be conditioned upon agreements between the
     fiduciaries regarding equitable adjustments and the allocation of
     the tax liability. Similarly, one should consider whether specific
     exculpatory language should be added to exonerate the fiduciaries
     from liability for the consequences of making, or not making, the
     section 645 election.

6.   Most of the questions, both substantive and procedural, raised in
     this outline would not arise if the election were for treatment of the
     QRT as an estate rather than for treatment as part of an estate.
     There seems to have been no tax policy reason to have conditioned
     the substantive income tax treatment of a postmortem trust, or the
     procedural requirements for such treatment, on the existence or the
     dispositive terms of a concurrent estate. Concerns about “multiple
     trust abuse” could easily be addressed by requiring all electing
     trusts to share one personal exemption and one set of tax brackets,
     and by allocating dollar amounts (such as the section 469(i)(2)
     passive activity loss deduction limitation) to each such trust
     proportionately. As currently enacted, the section 645 election
     effectively requires a merger with any existing estate for income
     tax purposes, with the resulting uncertainties noted below.


                            3
      D.   Impact of 2001 Act.

           1.     The many uncertainties in, and possible future of, The Economic
                  Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16
                  (the "2001 Act"), will raise additional complexities in determining
                  how to fund separate shares (for example, because of carryover
                  basis) and whether to make the section 645 election (for example,
                  because the gross estate is below the filing level).

           2.     The "cover all contingencies" and formula drafting that will be
                  used by some lawyers may make it difficult to determine the
                  existence of separate shares.

           3.     If interim planning involves the use of disclaimer provisions, the
                  personal representative and trustee may not know until the end of
                  the nine months what dispositve scheme will be in place. This
                  makes postmortem planning more difficult.

           4.     For QRTs that otherwise would have to file returns or pay
                  estimated income taxes before the expiration of the disclaimer
                  period, the section 645 election may be beneficial if for no other
                  reason than to give the fiduciaries more time to engage in
                  postmortem planning.

           5.     In some situations where disclaimers will be part of the
                  postmortem planning, a section 645 election may cause
                  unnecessary complexity.

II.   STATUTORY PROVISIONS AND STATUS OF REGULATIONS

      A.   Section 663(c).

           1.     The following new sentence was added to section 663(c) by the
                  1997 Act:

                         Rules similar to the rules of the preceding provisions of this
                         subsection shall apply to treat substantially separate and
                         independent shares of different beneficiaries in an estate
                         having more than 1 beneficiary as separate estates.

           2.     The General Explanation says the following concerning the
                         reasons for the change:

                         The Congress understood that estates typically do not have
                         separate shares. Nonetheless, where separate shares do
                         exist in an estate, the inapplicability of the separate share
                         rule to estates may result in one beneficiary or class of
                         beneficiaries being taxed on income payable to, or


                                        4
                    accruing to, a separate beneficiary or class of
                    beneficiaries. Accordingly, the Congress believed that a
                    more equitable taxation of an estate and its beneficiaries
                    would be achieved with the application of the separate
                    share rule to an estate where, under the provisions of the
                    decedent's will or applicable local law, there are separate
                    shares in the estate.

     3.     In describing the provision, the General Explanation states:

                    The Act extends the application of the separate share rule
                    to estates. There are separate shares in an estate when the
                    governing instrument of the estate (e.g., the will and
                    applicable local law) creates separate economic interests
                    in one beneficiary or class of beneficiaries such that the
                    economic interests of those beneficiaries (e.g., rights to
                    income or gains from specified items of property) are not
                    affected by economic interests accruing to another separate
                    beneficiary or class of beneficiaries. For example, a
                    separate share in an estate would exist where the
                    decedent's will provides that all of the shares of a closely-
                    held corporation are devised to one beneficiary and that
                    any dividends paid to the estate by that corporation should
                    be paid only to that beneficiary and any such dividends
                    would not affect any other amounts which that beneficiary
                    would receive under the will. As in the case of trusts, the
                    application of the separate share rule is mandatory where
                    separate shares exist.

B.   Final Regulations under Section 663.

     1.     Final regulations (T.D. 8849) regarding the 1997 Act change to
            section 663(c) were published on December 28, 1999 at 64 F.R.
            72540.

     2.     The final regulations clarify the definition of separate shares and
            narrow the application of the separate share rules for estates as had
            been set forth in the proposed regulations.

C.   Section 645.

     1.     The 1997 Act added new section 646, which was then redesignated
            as section 645 by the Internal Revenue Service Restructuring and
            Reform Act of 1998, P.L. 105-206. Under the new section, an
            election may be made to treat QRTs as part of a decedent’s estate
            for income tax purposes.



                                  5
     2.     Section 645 provides:

                   (a) GENERAL RULE. — For purposes of this subtitle, 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.

                   (b) DEFINITIONS. — For purposes of subsection (a) —

                          (1) QUALIFIED REVOCABLE TRUST. — The
                          term “qualified revocable trust” means any trust
                          (or portion thereof) which was treated under
                          section 676 as owned by the decedent of the estate
                          referred to in subsection (a) by reason of a power in
                          the grantor (determined without regard to section
                          672(e)).

                          (2) APPLICABLE DATE. — The term “applicable
                          date” means —

                                    (A) if no return of tax imposed by chapter
                                    11 is required to be filed, the date which is 2
                                    years after the date of the decedent’s death,
                                    and

                                    (B) if such a return is required to be filed,
                                    the date which is 6 months after the date of
                                    the final determination of the liability for tax
                                    imposed by chapter 11.

                   (c) ELECTION. — The election under subsection (a) shall
                   be made not later than the time prescribed for filing the
                   return of tax imposed by this chapter for the first taxable
                   year of the estate (determined with regard to extensions)
                   and, once made, shall be irrevocable.

D.   Proposed Regulations under Section 645.

     1.     Proposed regulations (REG-106542-98) under section 645 were
            published on December 18, 2000 at 65 F.R. 79015. The IRS
            cancelled the scheduled April 11, 2001 hearings on the proposed
            regulations, as no requests were made to speak at the hearing.




                                    6
            2.     The written comments of The American College of Trust and
                   Estate Counsel dated April 6, 2001 are attached to this outline as
                   Exhibit A. The written comments of certain members of the
                   Postmortem Income Tax Planning Committee of the American Bar
                   Association's Section of Real Property, Probate and Trust law
                   dated April 9, 2001 are attached as Exhibit B.

            3.     Issuance of final regulations by June 30, 2002 is on the 2001
                   Priority Guidance Plan was issued by the IRS and the Treasury
                   Department.

            4.     Prior to the promulgation of the proposed regulations, the IRS
                   issued Rev. Proc. 98-13, 1998-4 I.R.B. 21, setting forth the
                   requirements for making the election.

                   a.     The criteria of the required written statement to effect the
                          election are similar to those contained in the proposed
                          regulations.

                   b.     In most situations Rev. Proc. 98-13 requires an electing
                          QRT to obtain a tax identification number ("TIN") and file
                          a Form 1041 for the QRT's short taxable year beginning
                          with the decedent's death and ending December 31 of that
                          year. However, the proposed regulations give the option
                          not to obtain a TIN or file a Form 1041 for the QRT.

                   c.     The proposed regulations, when finalized, will replace Rev.
                          Proc. 98-13.

            5.     In Notice 2001-26, 2001-13 I.R.B. 942, the IRS announced that
                   estates and QRTs of decedents dying after December 31, 1999 and
                   before the effective date of the final section 645 regulations may
                   choose to use either the election and reporting procedures set forth
                   in Rev. Proc. 98-13 or those set forth in the proposed regulations.

III.   SECTION 663 FINAL REGULATIONS

       A.   Definition of Separate Shares.

            1.     The final regulations reflecting the 1997 Act changes were
                   promulgated on December 28, 1999 and apply the provisions to
                   estates of decedents dying after that date.

            2.     The regulations clarify the definition of separate shares and narrow
                   the application of the separate share rules for estates as set forth in
                   the proposed regulations that were published in January 1999.




                                          7
     3.     A separate share ordinarily exists if the economic interests in one
            beneficiary or class of beneficiaries neither affect nor are affected
            by economic interests accruing to another beneficiary or class of
            beneficiaries.

     4.     A separate share generally exists only if it includes both corpus
            and the income attributable thereto and is independent from any
            other share.

     5.     Bequests of specific property and specific sums of money
            described in section 663(a)(1) are not separate shares.

     6.     The income on bequeathed property is a separate share if the
            recipient of the specific bequest is entitled to such income.

B.   Creation, Valuation, and Allocation.

     1.     Separate shares come into existence upon the earliest moment that
            a fiduciary may reasonably determine, based upon the known facts,
            that a separate economic interest exists.

     2.     The fiduciary must use a reasonable and equitable method to
            determine the value of each separate share and in calculating the
            DNI allocable to each share.

            a.     This gives the fiduciary flexibility, within limits, in
                   applying the separate share rules.

            b.     Redeterminations in value of the separate shares must be
                   taken into account.

     3.     In computing DNI for each separate share, the portion of gross
            income that is income within the meaning of section 643(b) must
            be allocated among the separate shares in accordance with the
            amount of income each share is entitled to under the terms of the
            governing instrument or applicable local law.

            a.     Similar allocation rules are provided for the amount of
                   gross income that is not attributable to cash received by the
                   trust or estate.

            b.     This includes original issue discount, the distributive share
                   of partnership tax items and the pro rata share of S
                   corporation tax items.

     4.     Any expense or loss that is applicable solely to one separate share
            is not available as a deduction to any other share.



                                  8
     5.     Interest imposed by state law on a pecuniary bequest or delayed
            estate distribution is a payment of interest by the estate and not a
            distribution for purposes of section 661 and 662.

C.   Spouse's Elective Share.

     1.     The elective share of a surviving spouse constitutes a separate
            share of the estate.

     2.     An elective share that is entitled to income and shares in
            appreciation or depreciation is a separate share under the general
            rules.

     3.     Under a special rule in the final regulations, an elective share that
            is not entitled to income and does not share in appreciation or
            depreciation is also treated as a separate share.

D.   Qualified Revocable Trusts ("QRTs").

     1.     QRTs are subject to the separate share rules.

     2.     A QRT that elects under section 645 to be treated as part of the
            decedent's estate for income tax purposes is always a separate
            share of the estate.

     3.     Nonelecting QRTs are also subject to the separate share rules
            applicable to estates and not to the rules that apply to separate
            share trusts.

     4.     An electing QRT itself may have two or more separate shares.

E.   Pecuniary Formula Bequests.

     1.     Pecuniary formula bequests constitute separate shares of the estate.

     2.     Any pecuniary formula bequest that is entitled to income and
            shares in appreciation or depreciation is a separate share under the
            general rules.

     3.     Under a special rule in the final regulations, a pecuniary formula
            bequest that is not entitled to income and does not share in
            appreciation or depreciation is also treated as a separate share as
            long as the governing instrument does not provide that it is to be
            paid or credited in more than three installments.




                                   9
      F.   Income in Respect of a Decedent.

           1.     Income in respect of a decedent (IRD) is allocated among the
                  separate shares that could potentially be funded with the IRD
                  irrespective of whether a share is entitled to receive any income
                  under the terms of the governing instrument or applicable local
                  law.

           2.     The amount allocated to each share is based upon the relative
                  values of the shares that could potentially be funded with the IRD.

      G.   Effective Date Rules.

           1.     The final regulations are applicable to estates and qualified
                  revocable trusts of decedents dying after December 28, 1999.

           2.     For estates and QRTs of decedents who died after August 5, 1997
                  but before December 28, 1999, the IRS will accept any reasonable
                  interpretation of the separate share provisions. Presumably, the
                  IRS will accept the same approach for a decedent who died on
                  December 28, 1999.

           3.     For trusts other than QRTs regulation section 1.663(c)-2 of the
                  regulations is applicable for taxable years of such trusts beginning
                  after December 28, 1999.

IV.   SECTION 645 PROPOSED REGULATIONS

      A.   The Election.

           1.     If an election is filed for a QRT, the QRT will be treated and taxed
                  for all purposes of subtitle A as a part of its related estate (and not
                  as a separate trust) during the election period.

           2.     Once made, the election is irrevocable.

           3.     To be valid, the required written statement must be attached to a
                  timely filed Form 1041 for the first taxable year of the related
                  estate or the QRT, depending upon the existence of a personal
                  representative for the related estate.

      B.   Definition of a QRT.

           1.     A QRT is any trust (or portion thereof) that on the date of death of
                  the decedent was treated as owned by the decedent under section
                  676 by reason of a power held by the decedent (determined
                  without regard to section 672(e)).



                                        10
     2.     The proposed regulations take the position that the trust is not a
            QRT if it was treated as owned by the decedent under section 676
            by reason of a power that was exercisable by the decedent only
            with the approval or consent of another person.

     3.     The proposed regulations also take the position that a section 645
            election for a QRT must result in a domestic estate.

C.   Required Written Statement.

     1.     If there is a personal representative, the written statement must

            a.     Identify the election as an election under section 645.

            b.     Contain the name, address, date of death, and TIN of the
                   decedent.

            c.     Contain the name and address of the QRT and, if a TIN has
                   been obtained after the death of the decedent, the TIN of
                   the QRT.

            d.     Contain the name, address, and TIN of the related estate.

            e.     Provide a representation that the trust for which the election
                   is being made meets the definition of a QRT under section
                   645 and the regulations.

            f.     Contain a statement from the personal representative,
                   signed and dated under the penalties of perjury, stating

                   (i)     The personal representative elects to treat the QRT
                           as part of the related estate under section 645.

                   (ii)    The personal representative understands that the
                           personal representative is required to make a timely
                           return of income for the combined related estate and
                           QRT on Form 1041 and to pay timely any tax due
                           thereon.

     2.     If there is no personal representative, the written statement must

            a.     Identify the election as an election under section 645.

            b.     Contain the name, address, date of death, and TIN of the
                   decedent.




                                   11
           c.     Contain the name and address of the QRT and, if a TIN has
                  been obtained after the death of the decedent, the TIN of
                  the QRT.

           d.     Provide a representation that the trust for which the election
                  is being made meets the definition of a QRT under section
                  645 and the regulations.

           e.     Provide a representation that there is no personal
                  representative and to the trustee's knowledge and belief,
                  one will not be appointed.

           f.     Contain the TIN obtained by the trust to file as an estate
                  under Regulation section 301.6109-1(a)(4)(ii)(B).

           g.     Contain a statement from the trustee of the QRT, signed
                  and dated under the penalties of perjury, stating

                  (i)     The trustee elects to treat the QRT as part of the
                          related estate under section 645.

                  (ii)    The trustee understands that the trustee is required
                          to make a timely return of income for the QRT on
                          Form 1041 taking into account the section 645
                          election and to pay timely any tax due thereon.

D.   Tax Identification Numbers ("TINs") and Forms 1041.

     1.    If there is a personal representative, a TIN must be obtained for the
           related estate, but the QRT is not required to obtain a TIN in its
           own name.

     2.    All payors of an electing QRT shall be furnished a Form W-9
           showing

           a.     The name of the related estate as the primary name on the
                  form.

           b.     The name of the electing QRT as the secondary name.

           c.     The TIN of the related estate.

           d.     The address of the trustee

     3.    If there is no personal representative, the trustee must obtain a TIN
           to file as an estate, and there is no requirement to obtain a TIN for
           the electing QRT, and Forms W-9 would be furnished in the usual
           fashion using that TIN.


                                12
     4.     The fiduciaries may treat the QRT as an electing trust from the
            decedent's date of death until the due date for the section 645
            election, and no Form 1041 is required for the QRT for the short
            taxable year from the date of death until December 31.

     5.     If a section 645 election is made after a Form 1041 is filed by the
            QRT, the trustee must amend the Form 1041. However, the
            amended return cannot itself effect a valid section 645 election.

E.   Application of the Separate Share Rule.

     1.     The separate share rule of section 663(c) treats an electing QRT
            and its related estate as separate shares for purposes of computing
            DNI and applying the distribution provisions of sections 661 and
            662.

     2.     If a distribution is made by an electing QRT or its related estate,
            the DNI of the share making the distribution must be determined
            and the distribution provisions of sections 661 and 662 must be
            applied using the separately determined DNI applicable to the
            distributing share.

F.   Duration of the Election.

     1.     The election period begins on the date of the decedent's death and
            terminates on the day before the applicable date. The election does
            not apply to successor trusts.

     2.     If a Form 706 is required to be filed for the decedent's estate, the
            applicable date is the day that is six months after the date of final
            determination of liability for estate tax.

     3.     Solely for purposes of determining the applicable date under
            section 645, the date of final determination of liability is the
            earliest day on which any of the following has occurred:

            a.      The issuance by the IRS of an estate tax closing letter,
                    unless a claim for refund of estate tax is filed within six
                    months thereafter;

            b.      The final disposition of a claim for refund, unless suit is
                    instituted within six months thereafter;

            c.      The issuance of a decision, judgment, etc. resolving the
                    liability of the estate tax, unless a notice of appeal or
                    petition for certiorari is filed within 90 days thereafter; or




                                  13
                 d.      The expiration of the period of limitations for assessment
                         of the estate tax provided in section 6501.

     G.   Treatment on Termination of the Election.

          1.     On the close of the last day of the election period, the combined
                 related estate and electing QRT (or just the QRT if there is no
                 related estate) is deemed to distribute the share or shares
                 comprising the electing QRT to a new trust in a distribution to
                 which section 661 and 662 apply.

          2.     The new trust must include such distribution in gross income to the
                 extent required under section 662.

     H.   Effective Date Rules.

          1.     The regulations are to apply on or after the date the final
                 regulations are published in the Federal Register.

          2.     As noted above, Notice 2001-26 allows estates and QRTs of
                 decedents dying after December 31, 1999 and before the effective
                 date of the final regulations to choose to use either the election and
                 reporting procedures set forth in Rev. Proc. 98-13 or those set forth
                 in the proposed regulations.

V.   SUBCHAPTER J SEPARATE SHARE RULE IN OPERATION

     A.   Basic Rules.

          1.     The separate share rule only applies if a single trust or estate has
                 multiple beneficiaries and those beneficiaries have substantially
                 separate and independent shares.

          2.     The rule is mandatory and not elective.

          3.     The rule does not apply to the beneficial interests in simple trusts,
                 discretionary "sprinkling" or "spray" trusts, or separate trusts that
                 may have been created under the same trust instrument even
                 though such trusts themselves may be treated as separate shares.

          4.     A separate share may itself have multiple beneficiaries with equal,
                 disproportionate, or indeterminate interests; and the same person
                 may be a beneficiary of more than one separate share.

          5.     When separate and independent shares exist, the DNI allocation
                 rules are applied separately to each independent share as if it were
                 a separate trust or estate. This means one beneficiary could receive



                                       14
            amounts in excess of the trust's or estate's total DNI yet only be
            taxable on a ratable portion of the DNI.

     6.     The separate share rule does not permit the treatment of separate
            shares as separate trusts under subchapter J for any purpose other
            than allocation of DNI. A trust with separate shares will continue
            to be treated as one trust for all other purposes, including the
            following:

            a.     TINs.

            b.     Tax return filing requirements.

            c.     Income tax payments, including estimated taxes.

            d.     Personal exemption.

            e.     Excess deductions, unused net operating losses, and capital
                   loss carryovers on termination of the trust.

     7.     If there are three or more separate shares and income of at least
            two of the shares is accumulated, the taxes payable by the trust are
            calculated based on the accumulated income from all shares. Thus,
            the total taxes attributable to the separate shares could exceed what
            would have been payable had true separate trusts been created.
            The compression of income tax rates creates more situations in
            which this could be a potential problem.

     8.     Any deduction or loss that is attributable solely to one separate
            share must be used in calculating the DNI for that share and is not
            available to any other separate share.


B.   Typical Applications.

     1.     Even for a relatively simple estate the separate share rule will
            come into play.

                   Situation 1. Father’s will leaves S Corp. stock to Son and
                   residue equally to Son, Daughter 1, and Daughter 2. Under
                   local law, Son is entitled to all S Corp. dividends received
                   by the estate. Because of financial needs of Daughter 2, a
                   partial distribution of the residue is made to her during the
                   same fiscal year S Corp. pays a dividend in order to provide
                   the estate with funds to pay the income taxes on the S Corp.
                   K-1 income reportable by the estate.




                                  15
     As a result of the 1997 Act, the separate share rule applies in this
     example, creating four separate shares. Although the bequest of
     the S Corp. stock itself is not a separate share by reason of section
     663(c)(1), the income (dividends) is a separate share. The interests
     of Son, Daughter 1, and Daughter 2 are also separate shares.
     Assuming no other income, the partial funding would not carry out
     any of the DNI resulting from the K-1 income. Were there to be
     income from sources other than S. Corp., only one-third of the
     residue’s separate share DNI would carry out to Daughter 2 with
     the principal distribution to her. When the S Corp. stock is
     ultimately distributed to Son, along with an amount equal to all
     dividends paid during the period of administration, the DNI to be
     carried out to him would not exceed the K-1 income for the year of
     distribution (taking into account any application of the 65-day rule
     that now applies to estates as well as trusts).

2.   Events outside the control of the fiduciary can bring the separate
     share rule into play.

            Situation 2. The facts are the same as in Situation 1 except
            that instead of leaving a specific bequest of S Corp. stock to
            Son, Father’s will gives Son the right to have S Corp. stock
            allocated to his one-third of the residue.

     Assuming Son has not exercised his right to have the S Corp. stock
     allocated to his share at the time the partial distribution is made to
     Daughter 2, it seems that one-third of the S Corp. K-1 income
     should be taken into account in determining Daughter 2’s share of
     DNI. Presumably the result would be different if Son had already
     filed a paper with the personal representative electing to have the S
     Corp. stock allocated to his share, as the regulations state that
     separate shares come into existence at the earliest moment that a
     fiduciary may reasonably determine that separate shares exist.
     Does it make a difference when such election is made during the
     fiscal year? What if made after the distribution to Daughter 2?

3.   Although the nature of the rights of surviving spouses to elective
     shares varies from state to state, the final regulations treat all
     elective shares the same.

            Situation 3. Father, who lives in a Uniform Probate Code
            type of state, leaves his residence and a cash bequest to
            Wife who is not the mother of Children. Father leaves
            balance of his assets to Children by beneficiary designation
            and by will. Wife timely claims an elective share of the
            augmented estate. The estate promptly pays its portion of
            the elective share using part of the income earned by the


                           16
            estate since Father's death but not using any part of the
            deferred compensation received by the estate from Father's
            former employer.

     Wife's elective share is a separate share. Because there is no
     prohibition on using IRD to fund the estate's portion of the elective
     share, a ratable share of the gross income includible in DNI that is
     IRD (the deferred compensation) must be allocated to the elective
     share of Wife, whether or not actually paid to Wife. However,
     because Wife is not entitled to any income earned by Children or
     the estate pending payment of the elective share, no part of the
     other gross income includible in DNI is allocated to Wife even
     though a part of the elective share was in fact paid out of such
     income. If the state's elective share statute provides for interest to
     be paid by the persons paying the elective share, the interest will
     be includible in Wife's gross income under section 61 (and not
     under section 662) and treated as a nondeductible personal interest
     expense by the estate or Children pursuant to section 163(h).

4.   Wills that pour over to funded revocable trusts are quite common
     as a probate avoidance technique whether or not there is a
     surviving spouse.

            Situation 4. Mother's will leaves an annuity for five years
            to Jane, a former household employee, and pours the
            residue over to revocable trust created by Mother and
            funded during her life with all of her portfolio assets. Trust
            assets are distributable outright to Children. Executor and
            Trustee decide not to make the election under section 645.

     Jane's annuity is a separate share as is the residue of the estate.
     Further, the revocable trust is a separate share and may itself have
     two or more separate shares.

5.   In the trust setting, the most common application of the separate
     share rule is in trusts whose income either is payable in fixed
     shares to designated beneficiaries or may be accumulated for their
     future benefit.

            Situation 5. Mother's will creates a trust under which half
            of the income is payable quarterly to Daughter who is age
            27. The other half of the income may be paid out or
            accumulated in Trustee's discretion for Son who is age 22.
            Once Son reaches age 25, his half of the income is payable
            in the same fashion as Daughter's. The trust terminates
            when Son attains age 35. Son is in graduate school, and
            Daughter is married to an entrepreneur with significant


                           17
             nonpassive tax losses. The trust assets consist of a
             portfolio of securities, several closely held stocks, a vacant
             lot on which Daughter wishes to build a new principal
             residence, and an undivided interest in a mountain cabin
             used by Son and his cousins on hunting trips.

     The separate share rule applies in Situation 5 and produces logical
     results. If Son is paid his half of the income, DNI will be allocated
     equally to Son and Daughter. Alternatively, if Trustee withholds
     and accumulates all or part of Son's half of the income, half of DNI
     will reported to Daughter and Son's accumulation will be taxed to
     the trust (perhaps with an equitable adjustment made so that Son's
     half of the trust bears the income tax costs).

6.   In trusts that authorize principal distributions, the results can
     surprise the beneficiaries.

             Situation 6. The facts are the same as in Situation 5 except
             that Trustee is authorized to make advancements out of
             principal to Son or Daughter. Trustee distributes the
             interest in the cabin to Son, in part to minimize Trustee's
             potential liability for hunting accidents. Trustee does not
             distribute all of Son's half of the income.

     If the value of the undivided interest in the cabin in Situation 6 is
     greater than the accumulated income for the year, half of the DNI
     will be reported to Daughter and half to Son because the principal
     distribution carried out all of his separate share DNI. Thus, DNI
     would be reported equally by Son and Daughter even though
     distributions during the year to Son and Daughter were not equal.
     Had the trust been a sprinkling one, DNI would be allocated to Son
     and Daughter based on the ratio the distributions (income and
     principal) to each bear to total distributions from the trust.

7.   Another commonly encountered situation is when non-pro rata
     terminating distributions cover more than one taxable year.


             Situation 7. The facts are same as in Situation 5 and upon
             the termination date Trustee distributes all cash on hand
             equally to Son and Daughter, distributes the vacant lot to
             Daughter, and distributes the undivided interest in the cabin
             to Son. The portfolio securities and closely held stocks are
             not distributed until the next taxable year because Son and
             Daughter could not decide who was to get which closely
             held stocks.



                           18
            Because of the separate share rule, only half of the DNI in
            Situation 7 will be taxed to Daughter in the first year even though
            she may have received more than half in value of the distributions
            made during the taxable year.

     8.     For trusts not subject to the separate share rule, the distribution
            deduction rules allocate DNI to the beneficiaries pro rata based on
            all distributions made during the year.

                   Situation 8. Mother creates trust for Daughter and Son and
                   gives Trustee the authority to sprinkle income and principal
                   among Daughter and Son. Son is in graduate school, and
                   Trustee distributes all income to Son for educational
                   purposes. No principal distributions are made.

            Because the separate share rule does not apply in Situation 8, 100
            percent of the DNI is taxed to Son for the year.

     9.     When the separate share rule applies and part of the income is
            accumulated, the DNI taxable to the trust may be taxed at rates
            higher than the beneficiaries' rates. If one of the trusts created at
            death is a charitable remainder trust, avoidance of the separate
            share rule would allow non-pro rata funding distributions to be
            made to that trust in order to reduce overall income taxes through
            the use of the tax-exempt status of the charitable remainder trust.

C.   Marital Deduction Planning.

     1.     The most common form of marital deduction planning today in
            many parts of the country is a pour-over will to a revocable trust,
            with a fractional formula division into a unified credit-type bypass
            trust and a QTIP marital trust. The revocable trust is frequently
            funded during lifetime to facilitate the management of assets or to
            avoid probate expenses. Physical division of the trust assets and
            funding are generally delayed for some period of time following
            the grantor's death.

     2.     Because the separate share rule now applies to estates, many of the
            questions posed apply to marital deduction-type wills as well as
            revocable trust arrangements.

     3.     Following the grantor's death, the revocable trust is referred to as
            the "trust before division" or the "administrative trust," and only
            rarely are there specific provisions concerning its administration
            pending funding.




                                   19
4.   This raises the question whether the interim income should be
     taxed under a "two-pocket" or "three-pocket" approach. That is,
     should the trust before division be disregarded (the two-pocket
     approach) and treated as only two trusts or should the trust before
     division be counted (the three-pocket approach) and treated as a
     third trust.

     a.     Superimposing the separate trust rule in the analysis adds
            further complexity in determining the proper treatment of
            DNI during the interim period following death, particularly
            where IRD is involved.

     b.     The existence of a section 645 election may add additional
            complexity.

5.   The final regulations in response to the 1997 Act change come into
     play in a number of ways.

     a.     It is now clear that separate shares come into existence
            upon the earliest moment that a fiduciary may reasonably
            determine, based upon the known facts, that a separate
            economic interest exists. This makes it difficult to argue
            that there is only one share (the trust before division) and
            that the marital and bypass trusts can be disregarded as
            separate shares until actual funding occurs.

     b.     The final regulations state that a qualified revocable trust is
            a separate share and may itself contain two or more
            separate shares.

     c.     The special rules on the treatment of IRD take on added
            significance because many marital deduction/unified credit
            formulas restrict or direct the allocation of items subject to
            the income tax.

6.   Under the two-pocket approach, the marital and bypass trusts are
     treated as successor trusts coming into existence immediately upon
     the grantor's death for purposes of determining how trust income is
     taxable. The three-pocket approach treats the original trust as
     continuing for a reasonable period of administration as a complex
     trust, much like an estate in administration, before being divided
     into the marital and bypass trusts.

            Situation 9. Husband's will pours over to a revocable trust
            that divides, according to a fractional formula, into a QTIP
            trust and a bypass trust with all income of both trusts
            payable by Trustee to Wife for life. Distribution of the
            estate and funding of the trusts will be deferred until the


                          20
            estate has been fully administered and a closing letter has
            been received from the IRS.

     Income accumulated by the estate in Situation 9 will be taxed to
     the estate. Income distributed to Wife will be taxable to Wife,
     whether the two-pocket or three-pocket approach is used and
     whether or not the separate share rule applies.

     In Situation 9, the proper treatment of any income distributed by
     the estate to the revocable trust and retained by the trust before
     division is problematic. If the income is accumulated and the two-
     pocket approach is followed, such income will be taxed to Wife, as
     both the marital trust and the bypass trust are simple trusts, and the
     separate share rule is therefore not particularly relevant.

7.   Under the three-pocket approach, the proper treatment of DNI may
     depend upon the application of the separate share rule.


            Situation 10. The facts are the same as in Situation 9
            except that the bypass trust is a sprinkling trust for the
            benefit of children.

     If all income received by the trust before division is accumulated
     in Situation 10 and the two-pocket approach is applied, the portion
     of the accumulated income attributed to the QTIP trust would be
     regarded as currently distributable to Wife and would be taxed to
     her even though not actually distributed. The remaining income
     would be taxed to the bypass trust as a complex trust.

     Using the three-pocket approach in Situation 10, all accumulated
     income would be "trapped" and taxed to the trust before division as
     a complex trust even though the beneficial interests in the trust
     may be separate shares within the meaning of the separate share
     rule.

8.   Should Trustee make a non-pro rata distribution under the facts in
     Situation 10 of all or part of the income to Wife, with no
     distributions to the children, the tax results are dictated by the
     separate share rule.

     a.     Assuming the separate share rule applies in the three-
            pocket setting under the "earliest moment" test, the non-pro
            rata distribution to Wife will be treated as a principal
            distribution to the extent the distribution is in excess of the
            QTIP trust's pro rata share of DNI for the year, and the
            balance of the DNI will be taxed at the trust level. Note


                           21
             that this is the same result as under the two-pocket
             approach, except that the trust before division instead of the
             bypass trust is the taxpayer.

      b.     Were the separate share rule not to apply at this stage (as
             had been thought by many practitioners in the past), all of
             the DNI would be allocated to Wife under this approach so
             she could pay all of the income taxes, and no DNI would be
             taxed at the trust level.

9.    Avoiding the separate share rule could mean a slight tax savings
      for the family if Wife's marginal federal income tax rate is less
      than the trust’s.

10.   Rate compression and the required use of calendar years by trusts
      substantially eliminates the ability to defer income taxes through
      the use of staggered taxable years. Most opportunities to make
      "trapping" distributions may now have been extinguished by the
      final regulations because of the rule that separate shares come into
      existence at the earliest moment the fiduciary may reasonably
      determine.

11.   Before the extension of the separate share rule to estates,
      practitioners were inconsistent in applying the separate share rule.

      a.     Some practitioners took the position that the separate share
             rule was inapplicable because the trust before division was
             much like an estate. Cases and rulings do not discuss the
             application of the separate share rule to a trust before
             division.

      b.     Other practitioners said the separate share rule must apply
             to a trust or estate before division because the marital and
             bypass trusts (the separate shares) are to be funded by a
             formula based on facts, circumstances, and values
             determined as of the deceased grantor's death, and only the
             mechanical calculation of the size of each trust that
             remains. Further, because the separate share rule applies to
             a trust between its termination date and actual distribution,
             it follows that the rule should apply on the front end
             between its creation and its funding.

      c.     The third choice was to apply the separate share rule to the
             trust or estate before division only for taxable years
             beginning after all information is available to determine the
             size and proportion of both the marital trust and the bypass
             trust.



                           22
     12.    The final regulations provide some guidance in this area. Absent
            governing instrument language to the contrary, the separate share
            rule should apply to all trusts and estates before division,
            particularly those involving marital deduction/unified credit or
            GST formula funding. In the S corporation setting, as discussed
            below, having the subchapter S separate share rule apply can be
            particularly helpful when each continuing trust would be a
            permitted S shareholder.

     13.    The issue remains as to whether the separate share rule as now
            written has the effect of forcing the marital and bypass trusts to be
            recognized for DNI purposes before actual funding of those trusts.

D.   Disclaimers.

     1.     A qualified disclaimer by a beneficiary may focus attention on the
            separate share rule in situations where applications of the rule
            would otherwise be inconsequential.

                    Situation 11. The facts are the same as in Situation 9,
                    except that Wife disclaims all of her interest in the bypass
                    trust so it will pass outright to Children.

            Without the disclaimer, the trust income would either be taxed all
            to Wife under the two-pocket approach or, under the three-pocket
            approach, taxed to her to the extent of her DNI, which in turn
            depends on whether the separate share rule applies. But the
            disclaimer in Situation 11 could change the situation.

     2.     If the planner adopts the use of the two-pocket approach,
            Children’s interest in Situation 11 should be viewed as a complex
            trust with none of the income currently distributable to Children,
            and they would be taxable only to the extent of actual distribution
            of DNI.

     3.     Under the three-pocket approach, regardless of whether the
            separate share rule applies, Children’s share of income would be
            taxable to the trust.

     4.     If principal as well as income distributions, which are to be
            charged against the marital share, are made to Wife from the trust
            before division and before the disclaimer with respect to the bypass
            trust, it is not clear how the DNI should be allocated. If all DNI
            could be taxed to Wife, this would effectively increase the ultimate
            benefits of the children by relieving them of the income tax
            burden.




                                  23
E.   Generation-Skipping Planning.

     1.     Because the typical GST-planned estate frequently involves the
            creation of three trusts (QTIP, reverse QTIP, and bypass), the
            various planning aspects discussed above are even more relevant.
            It is important for the planner to consider whether a "four-pocket"
            approach is appropriate.

                   Situation 12. The facts are same as in Situation 8, and in
                   addition the QTIP share is to be divided into a regular
                   QTIP trust and a reverse QTIP trust.

            Using a trust before division and not applying the separate share
            rule below that level at the outset would allow Trustee in Situation
            12 to make a non-pro rata trapping distribution to the QTIP trust.
            Therefore, a subsequent funding of the reverse QTIP and bypass
            trusts might attract less income tax and result in more value
            ultimately passing to the grandchildren.

     2.     Although the separate share rule generally does not overlap with
            the multiple trust rule of section 643(f), some potential exists for
            overlap in the GST-planning context where the division of one
            trust into separate trusts is commonplace.

                   Situation 13. Grandfather creates a $1.5 million sprinkling
                   trust under his will for the equal benefit of his
                   grandchildren. Executor allocates the full $1,030,000 GST
                   exemption to the trust. Trustee then divides the trust into
                   two trusts, one for $1,060,000 having a zero inclusion ratio
                   and a second for $440,000 having an inclusion ratio of one.

            For the multiple trust rule to apply and treat the trusts as one, a
            principal purpose of the trusts must be the avoidance of income
            taxes. In Situation 13, was the only motivating factor the
            avoidance of a GST tax? Because rate compression has taken
            away most of the incentive for multiple trusts, income taxes likely
            would not be viewed as a principal purpose for the division, and
            the IRS would respect the separateness of the trusts in Situation 13.
            Under the multiple trust rule, it would first operate to treat the
            trusts as one solely for income tax purposes, and then be applied to
            determine how the DNI is allocated.

F.   S Corporations.

     1.     Because only certain types of trusts are allowed to be shareholders
            in an S corporation, careful planning is critical to avoid accidental


                                  24
     loss of subchapter S status by having the S stock held by or
     distributed to an impermissible shareholder.

2.   An estate can hold S stock indefinitely as long as administration is
     not unduly prolonged, and an electing QRT can hold S stock
     throughout the election period. The typical revocable grantor trust
     can hold S stock for two years after the grantor's death. For trusts
     meeting the qualified subchapter S trust (QSST) requirements, the
     income beneficiary can make an election to have the S stock
     portion of the trust treated as a grantor trust and thus be a permitted
     S shareholder with the beneficiary as the deemed owner. An
     electing small business trust (ESBT) election may be available for
     trusts not meeting the QSST requirements or for other trusts
     preferring ESBT treatment over QSST treatment.


3.   For QSST qualification and election purposes as well as trust
     identification purposes, trusts having multiple deemed owner
     beneficiaries with substantially separate and independent shares
     within the meaning of section 663(c) are treated as separate trusts
     by reason of section 1361(d). That same section also provides that
     a successive beneficiary of the trust is automatically treated as
     having made a QSST election unless such beneficiary affirmatively
     refuses to consent to such election.

            Situation 14. Husband created trust for Wife with S stock.
            Wife made QSST election, and Executor made a partial
            QTIP marital deduction election. Wife has just died, and
            the trust is to terminate and go equally to three children.
            Because of the partial QTIP, Trustee will not distribute the
            trust assets until Wife's estate receives a closing letter from
            the IRS.

     The facts in Situation 14 are those found in Private Letter Ruling
     9212031 in which the IRS held that the interests of the children in
     the trust pending distribution were subject to the separate share
     rule, that each of the three separate shares was an individual QSST,
     and that under the successive beneficiary rule the QSST election
     made by Wife would automatically be treated as made by each
     child.

     The same result occurs in the case of a trust before division when
     the separate share rule applies and the grantor makes a QSST
     election before death as in Private Letter Ruling 9422041. Simply
     making a QSST election does not mean the S election is
     necessarily safe. If any of the separate trusts are not simple trusts,
     the trustee of the trust before division must actually distribute


                           25
            currently all of the income of each separate trust to its beneficiary.
            Failure to distribute the income in this manner violates the
            subchapter S requirements and can create many problems for
            counsel for the estate or corporate counsel in giving tax and legal
            opinions for loan transactions and sales transactions involving the
            stock or corporate assets.

     4.     Because the DNI rules are inapplicable to the S income of an
            ESBT, the separate share rule is only relevant to the non-S income,
            if any, of the ESBT. Section 641(d).

G.   Effect of Rate Compression.

     1.     The top federal income tax rate of 39.6 percent is reached in 2001
            once a trust has $8,900 of taxable income. If the separate share
            rule applies in a situation where all or substantially all of the
            income has been distributed to one beneficiary or trust instead of
            pro rata to all beneficiaries and trusts, the excess over that to which
            the recipient beneficiary was entitled would be subject to tax at the
            trust level.

                   Situation 15. Grandfather creates a $1 million separate
                   share trust for his five teenage grandchildren who otherwise
                   have no taxable income. DNI for the year 2001 is $30,000.
                   Trustee disburses $10,000 for Grandchild One's education
                   and accumulates the remaining $20,000. Grandchild One is
                   taxed on $6,000 (1/5th of the DNI) and pays $600 of tax at
                   his 10% federal income tax rate. The trust pays almost
                   $8,400 in taxes on the remaining $24,000 at its higher rate.
                   Total taxes are about $9,000.

            Alternatively, had Grandfather in Situation 15 created the trust as a
            sprinkling one, Grandchild One would have paid tax of $1,000 on
            $10,000 of DNI, and the trust's taxes would have been reduced to
            about $6,900, for total taxes of approximately $7,800 which means
            a savings of about $1,200 over the taxes in Situation 15.

            Further savings would have been possible had Grandfather created
            a separate $200,000 trust for each grandchild earning $6,000
            annually. The $10,000 disbursed for Grandchild One out of his
            trust would result in $6,000 of DNI being taxed to him and cause
            $600 of tax. Each other trust would itself report $6,000 and pay
            taxes of about $1,500. Total taxes would be approximately $6,600,
            representing overall savings of $2,500 over Situation 15.




                                   26
           2.     Although the tax differences in these scenarios as a result of rate
                  compression are not major, the planner cannot overlook them when
                  planning for the client.

VI.   DISCUSSION OF SECTION 645 AND ITS APPLICATION

      A.   Definition of a Qualified Revocable Trust ("QRT").

           1.     To be a QRT, the trust must have been treated under section 676 as
                  owned by the decedent by reason of a power held by the decedent,
                  without regard to section 672(e).

                  a.     A section 645 election may be made with respect to more
                         than one QRT.

                  b.     If the decedent's power was only over a portion of the trust,
                         such portion is itself a QRT, and the section 645 election
                         may be made over such portion.

                  c.     It is not clear how things should be handled if the "portion"
                         of the trust over which the decedent had a power of
                         revocation was a horizontal slice (for example, the income
                         portion or the principal portion of the trust) or over a
                         specific asset in the trust (for example, the stock in an S
                         corporation).

           2.     Section 676(a) relates to revocable trusts and provides:

                         (a) GENERAL RULE — The grantor shall be treated as
                         the owner of any portion of a trust, whether or not he is
                         treated as such owner under any other provision of this
                         part, where at any time the power to revest in the grantor
                         title to such portion is exercisable by the grantor or a non-
                         adverse party, or both.

           3.     Section 672(e)(1) deals with powers deemed held by the grantor
                  and provides:

                         (e)(1) IN GENERAL — For purposes of this subpart, a
                         grantor shall be treated as holding any power or interest
                         held by —

                                 (A)     any individual who was the spouse of the
                                 grantor at the time of the creation of such power or
                                 interest, or

                                 (B)    any individual who became the spouse of the
                                 grantor after the creation of such power or interest,


                                       27
                    but only with respect to periods after such
                    individual became the spouse of the grantor.

4.   A trust that is revocable by the grantor’s spouse is not a QRT even
     though such a power would make the trust a grantor trust under
     section 676. Section 645 specifically provides that powers held by
     a spouse that usually are attributed to the grantor under section
     672(e) are not attributed to the decedent for QRT purposes.

5.   In addition, the Conference Report confirms that “trusts that are
     treated as owned by the decedent solely by reason of a power in a
     nonadverse party would not qualify.” H.R. Conf. Rep. No. 105-
     220, at 711.

6.   It is not clear at this time whether a trust revocable by the grantor
     with the consent of a nonadverse party would qualify for the
     section 645 election.

            Situation 16. Grantor is an elderly widower, and Children
            as well as his attorney are concerned that he might be
            influenced to make large gifts to his caregivers. Attorney
            drafts revocable trust requiring the written consent of
            Attorney or a member of Attorney's law firm in order for
            Grantor to amend or revoke the trust.

     This type of situation is not uncommon. Similarly, the consent of
     an unrelated third party is sometimes used with regard to trusts
     created by wealthy individuals in advance of entering into second
     marriages, particularly in states whose rules on marital property,
     elective shares, and renunciation rights are less than clear as to the
     treatment of revocable trust assets

     Under the proposed regulations, the trust in Situation 16 would not
     qualify as a QRT so as to participate in a section 645 election.
     There appears to be no policy reason, or statutory basis, for the
     position taken in the proposed regulations.

     If the final regulations allow the consent of a nonadverse party, be
     aware that because section 672(e) does not apply (that is, because
     the spouse’s power to revoke will not be attributed to the
     decedent), a revocation power exercisable by the grantor only with
     the spouse’s consent may not qualify where the spouse is an
     adverse party.

7.   The typical revocable trust used as a will substitute should
     generally qualify as a QRT.




                           28
8.    The typical joint trust used in community property states, under
      which each spouse may unilaterally revoke his or her own share of
      the trust estate, should also meet the QRT requirements because
      the decedent’s share of the trust estate will satisfy the section 676
      requirement that a “trust (or portion thereof)” was “treated under
      section 676 as owned by the decedent.”

9.    Under a joint trust, the deceased grantor's share will usually consist
      of the deceased grantor's separate property and half of any
      community property owned by the grantors. The surviving
      grantor's share typically consists of the remaining property that
      will be held in a separate trust that will continue to be revocable by
      the surviving spouse.

10.   If a joint trust is revocable only by action of both spouses, the trust
      may not qualify as a QRT, as the spouse is likely to be an adverse
      party. However, at the second death, any “portion” of an originally
      joint trust which remained subject to the surviving spouse’s sole
      power of revocation would qualify for the election.

11.   A trust that is includible in the decedent's gross estate under
      section 2041 because the decedent held a testamentary general
      power of appointment or an unlimited power of withdrawal is not a
      QRT and does not qualify for the election. Being treated as the
      owner for income tax purposes under section 678 does not make
      the trust a QRT. Also, a QTIP trust includible in the gross estate
      under section 2044 is not a QRT.

12.   Similar to an estate, most revocable trusts will require a “winding
      up” period before being distributed to the beneficiaries.

      a.     Before distribution of a revocable trust following the
             grantor's death, administration expenses and estate taxes
             must be determined and paid. The administration of the
             revocable trust (or, in the case of a joint trust in a
             community property state, the decedent’s share of the trust)
             will continue at least until these functions are completed.
             Thereafter, the trust may terminate, continue on different
             terms, or divide into multiple trusts or shares, as directed by
             the trust agreement.

      b.     Even though the terms of a revocable trust may direct that
             it be divided into separate trusts or separate shares "on the
             date of the grantor’s death," typically the trust cannot
             actually be divided and distributed until years after the date
             of the grantor's death when the deceased grantor’s debts,
             expenses, and estate tax liabilities have been determined.


                            29
            c.     Because of the difficulty in determining debts, expenses,
                   and taxes, such a trust will often function as a single,
                   undivided entity for several years following the grantor's
                   death and until the trustee is in a position to make
                   distributions.

            d.     Customarily, the trustee of a such a postmortem revocable
                   trust would treat the trust as an “administrative trust”
                   during the winding up period, that is, as a separate tax
                   entity that holds and administers the decedent’s trust (or
                   share of a joint trust) until the typical bypass and marital
                   trusts, or separate trusts for children (the “subtrusts”) are
                   actually funded.

            e.     Alternatively, the trustee could treat the subtrusts as
                   coming into existence immediately upon the death of the
                   grantor so that postmortem income is not taxed to a
                   temporary “administrative trust.” Although nothing in the
                   statute specifically precludes such subtrusts from qualifying
                   and making the section 645 election themselves, it seems
                   doubtful that they can. Where the election is to be made,
                   the use of an administrative trust is advisable, especially at
                   the first death where assets were held in a joint trust. The
                   administrative trust will clearly constitute the decedent’s
                   “portion” which is entitled to make the section 645
                   election.

            f.     The section 663 separate share final regulations make clear
                   that separate shares come into existence at the earliest
                   moment that a fiduciary may reasonably determine, based
                   upon the known facts, that a separate economic interest
                   exists. These separate share rules apply to all QRTs,
                   whether or not the section 645 election is made.

B.   Duration of Election Period.

     1.     Generally, it appears that the election is intended to apply to a
            reasonable period for administration of the decedent’s estate and
            winding up of the QRT.

     2.     If the election is made, the election period will begin on the date of
            the grantor’s death.

     3.     The election period cannot extend indefinitely; nevertheless, it is
            not entirely clear when the election period ends.

     4.     The general rule of section 645(a) provides that the election period
            ends on the “applicable date.”


                                    30
5.   Where no estate tax return is required to be filed, under section
     645(b)(2)(A) the applicable date is clearly two years after the date
     of death (which may not be two full taxable years).

     a.     Under the 2001 Act, this rule takes on more importance.
            For example, in the year 2009, the gross estate would have
            to be in excess of $3,500,000 for the estate to be able to
            take advantage of section 645 treatment for more than two
            years after death.

     b.     Because the 2001 Act did not change section 645 and, for
            decedents dying after December 31, 2009, replaces existing
            section 6018 (estate tax return filing requirements) with
            new section 6018 (return reporting allocation of basis
            increase), it appears that an estate and QRT of a decedent
            dying after repeal takes effect could only use section 645
            for the two years no matter how large or complicated the
            estate and trust may be.

6.   Where an estate tax return is required to be filed, section
     645(b)(2)(B) defines the “applicable date” as “the date which is 6
     months after the date of the final determination of the liability for
     [estate] tax.”

7.   The term “final determination” is not defined in the statute. The
     proposed regulations take a practical approach and provide that the
     "final determination" is the earliest day on which a number of
     events might occur.

     a.     Under the proposed regulations, the "final determination"
            will often occur before the expiration of the statute of
            limitations.

     b.     Because the personal representative has no control over the
            receipt of a closing letter and no way of knowing the date
            on which it might be issued, planning for the final year of
            the election period may be difficult.

            (i)     The receipt of a "closing letter" does not constitute
                    evidence of "final determination of estate tax
                    liability." See Rev. Proc. 83-19, 1983-1 C.B. 677

            (ii)    See Estate of Brocato v. Commissioner, T.C. Memo
                    1999-424, and Estate of Bommer v. Commissioner,
                    T.C. Memo 1995-197, holding that a closing letter
                    does not estop the IRS from continuing an audit and
                    suggesting that only a "formal closing agreement" is
                    a bar to further adjustments.


                           31
            c.       If a section 6166 election is made, the statute of limitations
                    on collection of tax is suspended and refunds may be
                    claimed within two years of each installment payment.
                    This does not necessarily constitute an extension of time to
                    assess liability. In addition, under section 6511(a) refunds
                    may be claimed within two years of each installment
                    payment.

            d.      If litigation is instituted, the section 6503(a)(1) statute of
                    limitations on assessments is extended until 60 days after a
                    decision becomes final.

            e.      Because the applicable date does not occur until after the
                    final determination of estate tax liability, delaying the
                    settlement of an estate tax audit by the personal
                    representative can provide the trustee of the electing QRT
                    with additional time for postmortem planning.

     8.     Because the applicable date is unlikely to coincide with the end of
            a calendar month or quarter, extra work will be required with
            respect to allocations and adjustments.

     9.     The trustee may terminate the election early by distributing all of
            the trust's assets.

            a.      This can minimize the number of fiduciary returns.

            b.      More importantly, this allows the trustee to time the end of
                    the election period to coincide with the end of a calendar
                    month or quarter instead of waiting for the applicable date
                    to arrive.

            c.      The estate would continue its administration using its same
                    tax identification number.

            d.      Unfortunately, most QRTs designed as will substitutes are
                    not in a position to be distributed before receipt of the
                    closing letter.

C.   Effect of Election

     1.     Making the election generally will result in favorable treatment for
            the QRT. However, where the beneficiary of the estate is not
            simply the revocable trust (a pure “pour over” plan), and
            particularly where the fiduciaries of the entities are not identical,
            the personal representative should consider carefully any
            differential effect on the beneficiaries of the estate that the election
            may have before consenting to make it.


                                  32
2.   All items of income, deduction, and credit for the estate and the
     QRT will be reported on a single Form 1041 during the election
     period, combining the activities of both (or all qualifying
     consenting) entities.

3.   Questions have arisen whether an electing QRT is "treated ... as
     part of [the] estate" for purposes other than income tax reporting
     purposes. For example, if an IRA is payable to an electing QRT,
     does the section 645 election mean the related estate is treated as
     the beneficiary of the IRA, thereby resulting in the application of
     the less favorable rules that apply to estates as opposed to the
     extended payout rules provided for trusts treated as "designated
     beneficiaries."

4.   The proposed regulations do not address the treatment of sales or
     other transactions between an electing QRT and its related estate or
     between two electing QRTs.

            Situation 17. Each of Estate, QRT 1, and QRT 2 own
            stock in Family Corp. Estate pours over to QRT 1. QRT 2
            is a dynasty trust, and all parties wish it to own 100 percent
            of Family Corp. Assuming there has been appreciation
            since death or death occurred in 2010 after the arrival of the
            carryover basis rules, will the gain be recognized by Estate
            and QRT 1? What if an installment note is used, and
            payments are made after the election period ends?

     These questions are perhaps best answered by looking at the
     treatment of distributions from one entity to the other. By analogy
     to those rules and to other rules in the Code treating multiple
     persons as one for tax purposes (for example, husband and wife,
     grantor trusts, and single-member LLCs), these transactions would
     be disregarded. The IRS is aware of the need for guidance in this
     area, and perhaps the final regulations will address these matters.

     Bear in mind that the distribution of an installment note generally
     accelerates the balance of the unrecognized gain. If the deemed
     distribution by the QRT at the end of the election period would be
     an acceleration event, can the problem be avoided by distributing
     the asset to be sold to the successor trust or beneficiaries? It is
     unlikely the application of the separate share rule would avoid the
     problem because its only function is to determine DNI. If and
     when carryover basis arrives, this concern will take on more
     importance.




                          33
D.   Use of Fiscal Year Other than Calendar Year.

     1.     Since 1987 most trusts (including QRTs) have been required to use
            a calendar year as provided in section 644(a). Technically, this
            remains the case for an electing QRT. Nevertheless, because all of
            its income, deductions, and credits are reported on the estate’s
            return during the election period rather than on its own, the
            practical effect is that the trust assets are treated as if they are part
            of the estate, which may select a fiscal year other than the calendar
            year.

     2.     An estate may select a taxable year ending up to 12 months
            following the date of the decedent's death. In situations where
            there is no estate — and thus the electing QRT is the only
            postmortem entity — the trustee will be the fiduciary selecting the
            fiscal year, based on the same factors traditionally considered by a
            personal representative or administrator. If a year ending with the
            month preceding death is selected, the beneficiaries’ tax liability
            often can be postponed.

                    Situation 18. Grantor died June 1, 2001 with a QRT, and
                    distributions have been since that date to the beneficiaries
                    of the QRT. The first year of the QRT will end December
                    31, 2001 if no section 645 election is made. If a section
                    645 election is made, the first fiscal year of the QRT could
                    end as late at May 31 2002.

            Absent a section 645 election, the distributions made in 2001 from
            the QRT will be taxed to the beneficiaries on calendar year 2001
            returns (to the extent of DNI) and that tax will be due April 15,
            2002.

            If a section 645 election is made, the 2001 distributions, as well as
            those made on or before May 31, 2002 will be includible by the
            beneficiaries in their calendar year 2002 returns, and the tax on
            those distributions will not be due until April 15, 2003.

E.   Distributable Net Income ("DNI").

     1.     The separate share rules of section 663(c) treat an electing QRT
            and its related estate as separate shares for purposes of computing
            DNI and applying the distribution provisions of sections 661 and
            662.

     2.     If a distribution is made by an electing QRT or its related estate,
            the DNI of the share making the distribution must be determined
            and the distribution provisions of sections 661 and 662 must be



                                   34
     applied using the separately determined DNI applicable to the
     distributing share.

3.   A distribution from one share to another share to which sections
     661 and 662 would apply if made to a beneficiary other than
     another share of the combined related estate and electing QRT may
     affect the computation of the DNI of the share making the
     distribution and the share receiving the distribution.

     a.     As a result, the proposed regulations provide that (i) the
            share making the distribution must reduce its DNI by the
            amount of the distribution deduction that it would be
            entitled to under section 661 had the distribution been made
            to another beneficiary and (ii) solely for purposes of
            calculating DNI, the share receiving the distribution must
            increase its gross income by the same amount.

     b.     The distribution has the same character in the hands of the
            recipient share as in the hands of the distributing share.

4.   A QRT and its related estate are treated as separate shares for DNI
     purposes even if no section 645 election is made.

            Situation 19. Estate under a pour-over will has no taxable
            income or DNI (for example, because administration
            expenses are claimed on Form 1041 instead of Form 706),
            but Electing QRT has substantial DNI (for example,
            because large IRA payments or other IRD items are
            received by Electing QRT). Estate makes a "bypass"
            distribution to Beneficiary of Electing QRT.

     If the governing instruments or state law authorize bypass
     distributions, the distribution should be treated as made directly
     from Estate to Beneficiary and should not carry out DNI. If
     neither the governing instruments nor state law authorizes the
     bypass distribution, it will likely be treated as a constructive
     distribution to Electing QRT followed by a constructive
     distribution to Beneficiary and would carry out DNI of Electing
     QRT.

     If Estate had some DNI and the bypass distribution were to be
     treated as a constructive distribution, the distribution would reduce
     Estate's DNI and increase the gross income of Electing QRT for
     DNI purposes.

     If Estate has DNI and Electing QRT has no DNI, the IRS might
     argue that, as to bypass distributions, Beneficiary is treated as
     having a separate share interest in Estate for DNI purposes


                          35
F.   Charitable Set-Aside Deduction.

     1.     Under section 642(c), only an estate, and not a nonelecting QRT, is
            entitled to a charitable deduction for amounts of income
            “permanently set aside” for charitable purposes. A nonelecting
            QRT must actually pay the amount to charity in the taxable year
            for which it is deducted or by the end of the following taxable year
            as provided in sections 642(c)(1) and (2).

     2.     Section 642(c) itself has not been changed, but now distributions
            from a QRT that elects section 645 treatment also will be eligible
            for the set-aside deduction, which will be taken on the estate’s
            return. This should facilitate planning for distributions to
            charitable beneficiaries from an electing QRT.

                   Situation 20. QRT provides for various pecuniary gifts to
                   individuals and the balance of its assets for certain
                   charitable purposes, but because of ambiguities and
                   uncertainties with respect to the names and tax status of
                   named organizations and lack of accurate knowledge as to
                   the magnitude of estate taxes, Trustee is unwilling to make
                   distributions until these matters have been resolved.

            Without a section 645 election, Trustee must pay income taxes on
            the income received and accumulated pending distribution to the
            charitable beneficiaries at some future date.

            If a section 645 election is made, a section 642(c) set-aside
            deduction should be available even though the ultimate recipients
            have yet to be determined.

     3.     Section 681 disallows a section 642(c) deduction for trusts having
            income that would be classified as unrelated business income if the
            trust were a tax-exempt entity. This rule, however, does not apply
            to estates. An electing QRT will be able to avoid this section 681
            disallowance because the deduction will be taken on the estate’s
            return. This will be helpful where the QRT owns an interest in a
            passthrough business entity or a sole proprietorship.

G.   S Corporation Election.

     1.     Although making the election will provide some advantage to a
            QRT that holds S corporation stock, the failure of Congress to
            modify the provisions of section 1361 to conform to the intent to
            equalize the treatment of estates and QRTs continues to result in
            different treatment of S corporation stock held by the two types of
            entities.



                                 36
2.   Section 1361(c)(2)(A)(ii) permits a funded QRT to continue to be
     an S corporation shareholder only for the two-year period
     beginning on the day of the decedent owner’s death. An estate,
     however, may be an S corporation shareholder throughout a
     reasonable period of administration (including the deferral period
     where section 6166 treatment is elected). See section
     1361(b)(1)(B); section 1.641(b)-3(a); and Rev. Rul. 76-23, 1976-1
     C.B. 264. Therefore, where an estate tax return will be filed for
     the estate and an audit is likely, a QRT may continue as an S
     corporation shareholder for a potentially longer qualifying period if
     it makes the section 645 election. The election could be helpful in
     cases where the ultimate distributee is not a qualified S corporation
     shareholder, or where there is a need to retain the stock in the QRT
     for more than two years.

3.   Section 1361(c)(2)(A)(iii) provides that a trust that receives S
     corporation stock pursuant to the terms of a decedent’s will is an
     eligible shareholder for the two-year period beginning on the day
     that the stock is transferred to it.

     a.     If an electing QRT transfers S corporation stock to a
            subtrust that is not itself a qualified S corporation
            shareholder, the subtrust probably will not be an eligible
            shareholder for the additional two-year period, because
            section 1361(c)(2)(A)(iii) refers to shares received
            "pursuant to the terms of the a will" rather than received
            "from an entity treated for income tax purposes as a
            decedent’s estate."

     b.     Thus, despite the availability of the section 645 election, it
            may continue to be advantageous in certain circumstances
            (for example, a nonresident alien beneficiary) to arrange for
            a decedent’s S corporation stock to be distributed under the
            will (perhaps requiring a probate administration) rather
            than under a QRT. Perhaps the use of a "pour-back"
            provision in the QRT to get the S stock in the hands of the
            estate could be advantageous.

4.   The proposed regulations under section 645 make it clear that an
     electing QRT can hold S stock during the election period without
     the need for any S shareholder election. At the end of the election
     period, it unclear whether the QRT will have the usual amount of
     time to make a QSST or ESBT election. Although the proposed
     regulations deem the QRT to be a new trust created at the end of
     the election period, they do not specifically mention S elections but
     only say the QRT is a "new trust...to which sections 661 and 662



                          37
            apply." Careful practitioners will want to make any necessary S
            election at the earlier possible time.

H.   Passive Loss Active Participation Rules.

     1.     Section 469(i)(4) already extends the exemption from the passive
            activity loss rules for “active participation” rental real estate
            activities to the active participant’s estate for a period of two years
            following death. The exemption is capped at $25,000, reduced by
            the amount deducted by the decedent’s surviving spouse.

     2.     This provision now applies as well to rental real estate held in a
            QRT that elects to be treated as (part of) an estate.

     3.     Presumably the dollar limitation of section 469(i)(2) will apply
            each year to the activities of both entities together and will be
            allocated between the estate and the QRT if both entities in fact
            hold such assets.

     4.     An issue may arise where both entities hold such assets and the
            amount of the exemption otherwise available to the estate may be
            reduced if the QRT is permitted to make the election.

     5.     A personal representative may refuse to make the election unless
            the trustee agrees that the estate will not lose any portion of its
            otherwise available deduction.

I.   GST Separate Share Rule.

     1.     Where the separate share rule of regulation section 26.2654-1(b) is
            not satisfied, making a section 645 election can avoid the need to
            allocate the decedent’s GST exemption to the entire QRT.

     2.     Regulation section 26.2654-1(b) permits the separate allocation of
            the decedent’s GST exemption to a subtrust funded on a pecuniary
            basis only if certain requirements are met:

            a.      The pecuniary amount must be satisfied either by using
                    date of distribution values or by funding the subtrust in a
                    manner that fairly represents net appreciation or
                    depreciation in the value of the assets of the postmortem
                    trust and “appropriate interest” (as defined in regulation
                    section 26.2642-2(b)(4)(i)) must be paid at the time of
                    distribution.

            b.      If these requirements are not met, a subtrust is not
                    recognized as a separate share for GST purposes and the
                    decedent’s GST exemption must be allocated to the value


                                  38
                   of the entire QRT in order for the allocation to apply to the
                   subtrust.

     3.     Note that this GST separate share rule applies only to QRTs and
            not to estates.

     4.     Qualified disclaimers or court reformation proceedings are often
            used to remedy drafting errors and produce the desirable separate
            share treatment. Electing section 645 treatment offers a simpler
            and less disruptive approach. Because section 2654(b) specifically
            provides that a QRT is treated as a part of it related estate during
            the election period, the GST separate share rule will not apply to
            the QRT during the period of the section 645 election.

J.   Other Special Situations, Advantages, and Disadvantages.

     1.     An electing QRT loses its own personal exemption of $100.
            However, where there is no estate, and the QRT is the only
            postmortem entity, it will have the benefit of the $600 personal
            exemption of an estate under section 642(b).

     2.     Presumably an electing QRT will not be subject to the requirement
            to pay estimated income taxes for any taxable year ending before
            the date two years after the date of the decedent’s death, even if the
            trust would not otherwise qualify under section 6654(l)(2)(B).
            However, section 6654 is not part of Subtitle A and technically is
            not within the section 645 language of "for purposes of this
            subtitle."

     3.     One disadvantage of the election is the loss of separate income tax
            bracket “runs” where the electing trust is treated as “part of” an
            estate. The merged entity will be taxed at a single set of rates.
            However, as a result of the compressed income tax rates applicable
            to estates and trusts, this disadvantage is of limited significance.

     4.     For burden of proof purposes, a QRT is treated in the same manner
            as an estate, whether or not the section 645 election is made, for
            the period for which the election is (or, in the case of a nonelecting
            QRT, would have been) effective.

     5.     Section 267(b) (disallowance of losses on transactions between
            related persons) and section 1239 (disallowance of capital gains
            treatment on sales of depreciable property to related persons)
            contain a significant exception for the sale or exchange of property
            in satisfaction of pecuniary gifts by the personal representative of
            an estate.




                                  39
            a.      The same exceptions will apply to the satisfaction of
                    pecuniary gifts by the trustee of a QRT that has made the
                    section 645 election, as such losses and sales will be
                    reported on the estate’s return under the rules governing
                    estates.

            b.      If a pecuniary bequest from an electing QRT is satisfied
                    with depreciated property, any realized loss can be
                    recognized. Also, a pecuniary bequest from an electing
                    QRT satisfied with appreciated property should result in the
                    recognition of long-term capital gain under section
                    1223(11).

     6.     In the case of qualified timber property, the section 194 deduction
            available to individuals and estates with respect to the amortization
            of the amortizable basis attributable to reforestation expenditures
            will be available to an electing QRT.

     7.     Section 72(u) generally limits the deferral of tax on increases in the
            value of annuity contracts to those held by a natural person.
            Section 72(u)(3)(A) provides an exception for contracts acquired
            by an estate by reason of the decedent’s death. This exception to
            section 72(u) should now apply to contracts held by an electing
            QRT as well.

K.   Filing of Returns.

     1.     Because the estate may elect a fiscal year and the QRT must have a
            calendar year, it is possible that the QRT’s first income tax return
            following the grantor’s death will be due before that of the estate.

            a.      If the QRT files its first income tax return without making
                    the election, the election can nevertheless still be made on
                    the estate’s first income tax return if it has not yet been
                    filed.

            b.      Under these circumstances, the QRT must file an amended
                    Form 1041 excluding the items of income and deduction
                    since the grantor’s date of death (which are of course
                    required to be included on the estate’s Form 1041) and
                    attach a copy of the required written statement to the
                    amended return.

            c.      Because the amended return must be marked as a "final
                    return," confusing could result when the QRT
                    recommences filing its own returns after the election period
                    terminates. Obtaining a new TIN at that time may be wise.



                                  40
2.   If the estate’s first income tax return is filed without the required
     written statement, any possibility of making the election is
     foreclosed unless section 9100 relief is available.

3.   The QRT is not required to file a return for its first year if it does
     not have sufficient income to require it to file or if it meets specific
     requirements enumerated in Rev. Proc. 98-13. These requirements
     are:

     a.      If the QRT’s first return is not due until after the estate’s
             first return;

     b.      The QRT's items attributable to the decedent are reported
             pursuant to regulation section 1.671-4 (b)(2)(i)(A) or (B);
             and

     c.      The “entire trust is a qualified revocable trust.”

4.   Based on these requirements, it does not appear that the exception
     is available

     a.      For the portion of a joint revocable trust attributable to the
             first spouse to die; or

     b.      Where a QRT’s first taxable year ends before the date the
             personal representative selects for the end of the estate’s
             fiscal year if the QRT has sufficient income to require the
             filing of a return.

5.   However, the proposed regulations provide that the QRT is not
     required to file a Form 1041 for the short taxable year beginning
     with the decedent's death if a section 645 election will be made and
     if the fiduciaries will treat the QRT as an electing trust from the
     decedent's date of death.

6.   Because the QRT is required to use a calendar year until the
     election is made, ideally the consideration of whether to make the
     election should be completed by April 15 of the year after the
     grantor’s death. In the event this is not possible (or overlooked),
     the election may nevertheless be made through the date of the
     statutory deadline, that is, the extended due date for filing the
     estate’s Form 1041 (which may be almost a year later than the
     QRT’s filing due date in the case of a grantor who dies in
     December).

7.   Regardless of which return is filed first, the required written
     statement is to be attached to the estate’s return and a copy
     attached to the QRT’s return, if any.


                           41
       L.   Absence of Estate.

            1.     Where the QRT holds all the decedent’s assets at death and there is
                   no probate, the trustee alone may make the election. It will still be
                   necessary to obtain a tax identification number for the estate.

            2.     If the personal representative for the related estate is not appointed
                   until after the trustee has made a valid section 645 election, the
                   personal representative is deemed to agree to the election and to
                   accept the associated responsibilities unless, within 60 days of
                   appointment, the personal representative notifies the trustee in
                   writing of the personal representative's refusal to agree to the
                   election.

                   a.     If the personal representative refuses to agree to the
                          election, the election period terminates the day before the
                          effective date of the personal representative's appointment.

                   b.     If the personal representative and the trustee are the same
                          person, the personal representative cannot refuse to agree to
                          the election.

                   c.     Assuming the election continues, amended Forms 1041
                          must be filed.

                   d.     If the election terminates, the personal representative must
                          obtain a new TIN for the related estate and file returns for
                          the estate, but the QRT is not required to amend any returns
                          filed by it during the election period.

VII.   MAKING THE SECTION 645 ELECTION DECISION

       A.   Factors to Consider.

            1.     As with most other estate administration tax matters, the question
                   of whether to elect to treat a QRT as part of the estate must be
                   made on a case-by-case basis after considering all relevant factors.

            2.     The factors to be considered generally fall into three separate
                   categories to be addressed in deciding whether to make the section
                   645 election.

                   a.     Tax considerations.

                   b.     Effect on beneficiaries.

                   c.     Practical aspects.



                                         42
     3.     Guidelines can be helpful in starting the decision-making process.

     4.     Once the decision has been made to make the election, a plan
            should be developed to take full advantage of the election and to
            deal with matters at the time the election terminates.

     5.     The estate and electing QRT will share liability for the payment of
            tax owed by the combined entity. Without special income tax
            allocation language in the governing instruments or a separate
            agreement, allocation would presumably be prorated based on the
            ratio of the separate income tax liabilities, with each fiduciary
            making any needed equitable adjustments (for example, to take
            into account a capital loss).

B.   Tax Considerations.

     1.     The trustee and the personal representative should determine
            whether the benefits available from making the election are likely
            to yield a significant tax advantage to the trust and estate.

     2.     Questions to be asked.

            a.     Can the trust benefit from the selection of a fiscal year by
                   the estate?

            b.     Does the trust have charitable beneficiaries?

            c.     Does the trust own S corporation stock?

            d.     Are any IRA or other qualified retirement benefits payable
                   to the trust?

            e.     Does the trust expect to receive real estate passive activity
                   losses?

            f.     Does the trust own qualified timber property?

            g.     Are any GST trusts created under the trust instrument?

            h.     Does the trust anticipate funding pecuniary bequests in
                   kind? If so, will gain or loss likely be required to be
                   recognized?

            i.     What will the effect of the election be with regard to state
                   income taxation?

            j.     Will the election create additional complexities with regard
                   to any separate share calculations?



                                 43
C.   Effect on Beneficiaries.

     1.     If a benefit may accrue from the election, it will be necessary to
            determine to whom the benefit will ultimately accrue and whether
            different beneficiaries will be affected differentially if the election
            is and is not made.

     2.     Questions to ask.

            a.      Will there be a probate estate?

            b.      Is the trust the sole beneficiary of the will?

            c.      If not, are the beneficiaries of the will and the trust
                    identical?

            d.      Are any equitable adjustments likely to be made?

D.   Practical Aspects.

     1.     The questions regarding whether the election is likely to be
            practical must be considered.

            a.      Will the estate and the trust be administered by the same
                    persons?

            b.      If not, is it likely that the trustee and personal
                    representative can work effectively together to take full
                    advantage of the election?

            c.      Will time and expense be saved by eliminating the need to
                    file a Form 1041 for the QRT?

            d.      If no estate tax return is required to be filed, is it likely that
                    the administration can be completed within two years of the
                    grantor’s death?

            e.      If an estate tax return is required to be filed, is it likely that
                    the administration will be completed prior to the final
                    determination of the estate tax liability?

            f.      How will the income tax burden be allocated between the
                    estate and the QRT and is it likely that disputes will arise
                    regarding such allocation?

            g.      How much confusion will result from the requirement of
                    the proposed regulations that the TIN of the related estate
                    be furnished to all of the electing QRT's payors?



                                   44
                   (i)     What is the penalty if the electing QRT obtains a
                           TIN and uses it with its payors?

                   (ii)    If a TIN is not obtained for the QRT, what problems
                           will arise in tracing the income of the two entities?

                   (iii)   How will the payors react to the requirement of the
                           proposed regulations that the Forms W-9 they will
                           receive regarding the electing QRT's assets have the
                           related estate's name and TIN first, the actual owner
                           (the electing QRT) and its address listed thereafter,
                           but signed by the personal representative of the
                           related estate (which is not the owner of the account
                           or asset).

                   (iv)    When the election period ends, how difficult will it
                           be to have the payors take the related estate's TIN
                           off the account and begin using the TIN of the
                           QRT?

                   (v)     How much confusion will result if the payors foul
                           up the 1099s and K-1s?

E.   Guidelines if No Probate Estate.

     1.     Generally, where there is no probate estate, the analysis of whether
            to make the election will be fairly straightforward and will usually
            result in a determination to make the election, unless it is likely a
            personal representative will be appointed in the future who will
            refuse to agree to the election.

     2.     If the QRT is the only postmortem entity because it was fully
            funded at death, no issues arise with regard to the allocation of the
            income tax liability, and the ability to use a fiscal year should
            facilitate the administration and allow some opportunity for
            income tax deferral.

     3.     Before making the election, state law should be reviewed to
            determine the effect of the election for state law income taxation
            purposes. Unexpected results may be obtained under state law.

     4.     In nonconforming states, making the election for federal income
            tax purposes will generally require two sets of records and
            calculations, and two potentially very different returns for each
            year the election is in effect. At a minimum, if the trustee does not
            select a calendar year for federal purposes, the state will likely
            require the trust to report on a calendar year basis



                                  45
     5.     Even in states that have enacted conforming legislation, it is
            prudent to “think through” the results of the election for state law
            purposes. For example, states may apply different rules for
            purposes of taxing testamentary trusts and those created under inter
            vivos trusts. The election may affect which set of rules will apply.

F.   Guidelines for Partially Funded QRT with Complete Pour Over.

            a.     Advantages should flow from making the election if the
                   QRT has a charitable beneficiary, rental real estate,
                   qualified timber property, anticipated (or already realized,
                   by the time the election is to be made) losses, S corporation
                   stock, an annuity contract, or a GST problem as described
                   above.

            b.     At a minimum, only one fiduciary income tax return,
                   instead of two, will need to be prepared for all years other
                   than perhaps the first.

            c.     A possible disadvantage could be the elimination of the
                   opportunity to defer the taxation of income through the
                   estate's selection of a noncalendar fiscal year. For example,
                   if the estate selects a fiscal year ending in February and
                   makes distributions to a nonelecting QRT during January,
                   the trust will not be required to report the income until
                   April 15 of the following year. It may be possible to
                   minimize this disadvantage by carefully timing
                   distributions from an electing QRT to its subtrusts (for
                   example, the bypass and marital trusts).

G.   Guidelines if Not a Complete Pour Over.

     1.     Where the will does not pour over to the QRT, or where
            distributions from the will are also made to beneficiaries other than
            the QRT), the decision of whether to elect will require careful
            consideration.

     2.     Under the separate share rule, the estate and QRT will be treated as
            separate shares. Thus, the income of the estate and the income of
            the QRT will not be aggregated for purposes of determining the
            amount of DNI carried out in distributions from either the estate or
            the trust (unless bypass distributions are deemed to be constructive
            distributions to the other entity). Both the personal representative
            and the trustee (if they are not the same person) must determine
            whether including the QRT with the estate as a combined entity
            will impact negatively on benefits otherwise available to either
            entity alone (for example, the limitation on passive activity losses).



                                  46
3.   Where the fiduciaries of the estate and QRT are not identical, and
     especially where their beneficiaries are adverse, either fiduciary
     may decide the likely benefits do not outweigh the potential
     problems. For example,

     a.     Will the trustee be comfortable if the personal
            representative has primary responsibility for filing what
            will be a “consolidated” return?

     b.     At the least, the fiduciaries will have to determine an
            equitable method for allocating the income tax liability
            among the entities. Although the separate share rule
            addresses the allocation of DNI among the beneficiaries of
            the estate and the trust, apparently the personal
            representative and trustee may allocate the payment of the
            tax due on the consolidated entity as they determine.
            Presumably, each fiduciary should only be responsible for
            paying the pro rata portion of income taxes allocable to the
            entity for which that fiduciary is responsible, particularly
            where the beneficiaries of the entities are not the same.

            (i)     For instance, the estate may have a net gain and the
                    QRT a net loss. It would seem unfair for the QRT’s
                    losses to offset the estate’s gains for tax purposes, to
                    the benefit of the beneficiaries of the estate, without
                    an equitable adjustment between the two entities.

            (ii)    When drafting a pour-over estate plan, consider
                    addressing the issue of allocation of payment of
                    taxes from the two entities if a section 654 election
                    is made.

     c.     Fiduciaries have personal liability for unpaid taxes if
            distributions are made before tax liabilities are satisfied. A
            fiduciary’s liability should be limited to the tax allocable to
            the entity the fiduciary controls and to the distributions
            actually made from that entity.

            (i)     Where the persona representative has filed a
                    combined return for the two entities, if the trustee
                    distributes assets to trust beneficiaries without
                    reserving sufficient funds for audit adjustments, the
                    trustee (or the distributee), and not the personal
                    representative, should be the one personally liable
                    for the deficiency.




                          47
                   (ii)    In the absence of clarifying legislation, the
                           fiduciaries should enter into an agreement to this
                           effect at the time they make the election.

H.   Taking Full Advantage of the Election Period.

     1.     Although administration of the QRT may unavoidably extend
            beyond the termination of the election period, taking advantage of
            the benefits of the election should not be delayed. A trustee of an
            electing QRT should pay particular attention to a number of issues:

     2.     Where a charitable bequest is from the electing QRT rather than
            from the estate, such amounts should be sure to be “set aside”
            while the election is still in effect. (If an amount set aside is later
            paid to charity from a QRT after the election terminates, regulation
            section 1.642(c)-1(a)(1) would presumably deny a second
            deduction, even though the estate rather than the QRT was the
            entity previously allowed the deduction for the set-aside.)

     3.     If pecuniary bequests from the QRT may be satisfied with
            depreciated assets, these bequests should be made from the QRT
            during, rather than after, the election period in order to preserve the
            use of the loss under section 267(b).

     4.     If a GST trust created under the QRT will be funded on a
            pecuniary basis, the trustee should be certain that, if it would not
            meet the GST separate share rule, it is funded while the election is
            still in effect to maximize the benefit of the GST exemption
            allocation.

     5.     If S corporation stock is held by the QRT, the trustee should
            distribute the stock to a qualified shareholder in time to avoid
            losing the S corporation election. If the section 645 election will
            terminate before the estate’s administration is complete,
            distribution of the stock from the trust to the estate (if authorized
            under a “pour-back” provision in the trust instrument) may keep
            the S corporation election in effect longer.

I.   Administration of Entities Following Termination of Election.

     1.     A number of significant questions remain regarding how the
            “unwinding” of the combined entity will occur upon the
            termination of the election.

     2.     If the estate is closed before the applicable date and the
            administration of the QRT continues, the QRT will continue to
            report on the same fiscal year basis, and the tax attributes



                                  48
     applicable to an estate will continue to apply to the electing trust
     until the election terminates.

3.   Conversely, where the QRT administration is completed before the
     applicable date but the estate remains open, the estate simply
     continues its administration under the same TIN.

4.   In the case of both taxable and nontaxable estates, the
     administration of both the QRT and the estate may not be
     completed by time the election terminates. Under these
     circumstances, the estate and QRT would resume separate
     reporting for income tax purposes.

     a.     The QRT begins reporting as a separate trust, with its new
            taxable year beginning on the day after the election
            terminates (and, under redesignated section 644(a), ending
            at the end of that calendar year).

     b.     The estate continues as a taxable entity, using its same
            fiscal year and TIN, filing a single return for that fiscal
            year, and including the QRT’s income for the period of that
            fiscal year in which the election was in effect.

     c.     Any distributions made from the estate to the QRT from
            that point forward, under the pour-over provision of the
            will, would carry out DNI of the estate. At that point the
            same income tax issues to be considered in timing
            distributions from a single entity must be considered in
            coordinating distributions from the two.

5.   The Form 1041 for the related estate for the taxable year in which
     the election terminates shall include:

     a.     The income, deductions, and credits of the QRT through
            the last day of the election period;

     b.     The income, deductions, and credits of the related estate for
            its taxable year; and

     c.     A deduction for the deemed distribution of the share or
            shares comprising the electing QRT to the new trust.

6.   No guidance is provided regarding the methods to follow in
     allocating the income and deductions of the QRT between the
     election portion of the year and the balance of the year or how
     installment sales are to be treated.




                           49
            Situation 21. Electing QRT sells appreciated asset in
            exchange for a promissory note, with the gain to be
            reported on the installment method. Before the note is
            paid, the election period ends.

     Under the proposed regulations, the combined entity is deemed to
     distribute the QRT share to a new trust. It appears this would be a
     disposition of the installment obligation that would trigger the gain
     under section 453. This would be income to the related estate.
     Because the related estate is not closing, the gain would not appear
     to become part of DNI and would not pass out to the QRT as part
     of the distribution deduction allowable to the estate on termination
     of the election.

7.   It is not clear how unused loss carryovers and excess deductions on
     termination under section 642(h) are to be allocated and treated
     following termination of the election. Likewise, it is not clear
     what will be considered the “final year” of each entity, not only for
     that purpose but also to determine whether the year’s capital gains
     will be included in DNI pursuant to the regulations under section
     643.

8.   Confusion is likely to result regarding income tax overpayments
     and refunds for the election period and the crediting of the same to
     the income tax liabilities later payable by the separate entities.




                          50

				
DOCUMENT INFO
Shared By:
Categories:
Stats:
views:29
posted:3/6/2010
language:English
pages:52