Marital Deduction Relief

By Robert S. Barnett

The proliferation of recent Private Letter Rulings concerning improper reporting of the marital deduction indicates that there remains much confusion in this area. Preparers using Form 706 must be familiar with the requirements of reporting on Schedule M for the appropriate marital deduction.

A Preparer’s Mistake

Consider a husband and wife with a combined estate of $5 million and an estate plan with a will containing trust provisions for both tax and family purposes. Their will first includes a credit shelter, or bypass, trust to utilize the applicable exclusion amount in the estate of the first spouse. The remainder, or the residuary estate, passes to the surviving spouse either outright or in the form of a QTIP (qualified terminable interest property) trust. This arrangement will minimize estate taxes and provide maximum protection for the family.

Assume that the husband has died and his Form 706 properly reported all of his property, assets, liabilities, and deductions on the relevant schedules. Assume also that the preparer listed all assets on Schedule M in order to claim the marital deduction. Although the large marital deduction resulted in no estate taxes, this filing places a greater tax burden on the wife’s estate.

The tax return preparer failed to recognize that this simple error ruined the decedent’s plan for allocating the $1 million exemption equivalent to the estate of the first spouse to die.

By including all items on Schedule M, the preparer effectively eliminated the first decedent’s bypass trust and lost $1 million of the husband’s exemption. Apparently, this is a common occurrence, because the IRS has recently issued guidance on the topic.

Making the QTIP Election

At the center of the confusion lies Schedule M. Schedule M used to have a “check-the-box” provision to elect for qualified terminal interest property. The tax code allows an estate tax marital deduction for any interest in property passing from a decedent to a surviving spouse. Under IRC section 2056(b)(7), an estate will be entitled to a marital deduction for certain terminable interests that are treated as passing from the decedent to the surviving spouse. Generally these rules require that no part of the property may pass to any person other than the surviving spouse during that spouse’s lifetime, and that the surviving spouse must have a qualifying income interest for life. The IRS has held that the check-the-box election must be made affirmatively to obtain the marital deduction. Reporting the proper items on Schedule M would not suffice if the check-the-box requirement were not met.

As a result of several rulings that disallowed the marital deduction, the instructions to Form 706 and Schedule M were changed to provide an automatic QTIP election for items which were listed and reported on Schedule M as qualifying for the marital deduction. This new change has greatly reduced the confusion and controversy surrounding the mechanics of the election, but apparently estate tax practitioners are still incorrectly preparing the form. The new error is made by reporting too many assets on Schedule M and thereby increasing the marital deduction at the expense of the credit shelter.

If the combined assets of the husband and wife were below the taxable threshold ($1 million for 2003), no harm is done by claiming too much of the marital deduction. It is only when the combined estates exceed the exemption equivalent that this error will cause the credit shelter available to the first estate to be lost. Once the QTIP election is made, it becomes irrevocable.

The excess election has transfer tax consequences for the surviving spouse. IRC section 2044 generally provides that the gross estate of the surviving spouse must include the value of any property for which the prior decedent was allowed a deduction under the QTIP election. In addition, the surviving spouse will generally be treated as the transferor of the property for generation-skipping transfer tax purposes under IRC section 2652(a).

By increasing the QTIP marital deduction election in the first estate, the return preparer has created a taxable estate when the surviving spouse dies. Revenue Procedure 2001-38, 2001-1 C.B. 1335, provides relief in situations where an estate has made an unnecessary QTIP election. The revenue procedure may be implied to correct an improper QTIP election if the taxable estate (before allowance of the marital deduction) was less than the applicable exclusion amount under IRC section 2010(c). In such cases, the QTIP election was unnecessary because no estate tax would have been imposed regardless of whether the QTIP election was made.

The revenue procedure applies only to QTIP elections that were improperly made under IRC section 2056(b)(7). Relief will be available if an election was made to treat property as QTIP where the election was not necessary based on the values as finally determined for federal estate tax purposes. Certain formula elections and partial elections are not covered by the revenue procedure.

The IRS Response

The good news is that for many estates where such mistakes are made, the IRS will now disregard the QTIP election and treat it as null and void. This will save substantial estate taxes in the estate of the second spouse to die, because the property for which the election is disregarded will not be includible in the gross estate of the surviving spouse under IRC section 2044. Additionally, the spouse will not be treated as making a gift if the spouse disposes of the interest with respect to such property, and the surviving spouse will not be treated as the transferor of such property for generation-skipping transfer tax purposes.

In order to take advantage of the revenue procedure, a taxpayer must produce sufficient evidence that the election fits within the scope and requirements of the procedure as previously described. The procedure does not establish any formal requirements for this purpose, but gives certain examples that provide a basis for advice. The taxpayer should produce a copy of the estate tax return filed by the predeceased spouse’s estate and clearly show that the election was not necessary to reduce the estate tax liability to zero. If a closing letter has been received, transmittal of the closing letter will show the values as finally determined for estate tax purposes.

A copy of the last will and testament and trust documents should also be included, clearly showing the estate plan and providing evidence of the testator’s intent to create a credit shelter trust rather than an outright marital deduction for the entire estate. The revenue procedure also suggests including an explanation as to why the election should be treated as void. A letter written by the tax preparer should indicate that the error was an inadvertent misreading of the last will and testament and not the result of a contrary directive on the part of the testator. This information should be submitted either with the Form 706 filed for the surviving spouse’s estate, or with a request for a private letter ruling submitted prior to the filing of the Form 706.

On November 29, 2002, the Office of Chief Counsel issued advice (Chief Counsel Advice 8200248007) on whether an estate may adjust the amount of the marital deduction for QTIP property after Form 706 has been filed. The purpose of the adjustment was to more accurately reflect the value of property passing to the marital trust. The decedent’s will divided the estate into three separate trusts, designated the survivor’s trust, the exemption trust, and the marital trust. The will specifically stated that the exemption trust should consist of the pecuniary amount equal to the maximum applicable exclusion or the credit shelter amount. The decedent’s Form 706 included the entire value of all three trusts on Schedule M of the return. Of course, only the marital trust should have been subject to the QTIP election and listed on Schedule M. After discovering the error, the estate’s accountant filed a “supplemental information” Form 706, changing the value of the QTIP election. However, the accountant again made an error on the amount stated on the supplemental form.

The advice stated that the estate’s accountant made a valid QTIP election on the original Form 706. Nevertheless, the accountant incorrectly reported the amount of the QTIP deduction. Without mentioning Revenue Procedure 2001-38, the Chief Counsel apparently based its decision upon the decedent’s intent as expressed in the estate plan as well as the description on Schedule M. The Chief Counsel concluded that only the marital trust qualified for the QTIP Election. The Chief Counsel allowed the estate to adjust and reduce the marital deduction for the excess election claimed, and thereby reinstate the credit shelter trust as an exempt trust, passing tax-free at the death of the surviving spouse. This advice is consistent with Revenue Procedure 2001-38 and the various Private Letter Rulings (2002-43030; 2002-36021; 2002-26020) that have recently been issued following the revenue procedure.

Rather than relying on these new corrective provisions, it is better to properly prepare Schedule M and the various other sections of Form 706. Nonetheless, it is good to know that the IRS is now recognizing that inadvertent errors should not defeat an otherwise sound estate plan.

Robert S. Barnett, CPA, Esq., is counsel to Capell & Vishnick LLP, Lake Success, N.Y.