In general, for an interest to qualify for the marital deduction under IRC Sec. 2056, the interest must be includible in the decedent's gross estate and pass to the surviving spouse.

The Net Value Rule

Implicit in the passing requirement is the limitation of the deduction to the "net value" passing to the surviving spouse, as determined under IRC Sec. 2056(b)(4). This usually relates to encumbrances such as mortgages on real property passing to a surviving spouse. The value of the residence, clearly must be reduced by any mortgage or other encumbrance. Also, in the absence of specific direction in the will of the decedent, most states embrace the concept of "equitable apportionment" of the burden of death taxes. If the interest passing to the spouse must bear a portion of the Federal estate tax or state death tax imposed on the decedent's estate, the net value of the marital deduction will be further reduced.

The U.S. Court of Appeals reversed an earlier decision by the U.S. Tax Court in the case of the Estate of Gordon P. Street v. Commissioner of Internal Revenue |(U.S. Court of Appeals for the Sixth Circuit, No. 91- 2230, September 8, 1992, affirming in part, reversing in part and remanding the decision of the U.S. Tax Court, 56 TCM 774, CCH Dec. 45,201(M).

In this case, the Commissioner, in examining the estate tax return of a decedent, reduced the claimed marital deduction by the amount of administration expenses that had been deducted on the estate's fiduciary income tax returns. The IRS also sought to reduce the marital deduction by the amount of post death interest that had accrued on unpaid Federal and state death taxes. The estate filed a petition on May 30, 1986, seeking a redetermination of the Commissioner's proposed adjustments. The parties had agreed by stipulation that the only issues that should be resolved by the Tax Court was whether the amount of the marital deduction must be decreased by the administrative expenses and by interest accruing on the Federal estate tax and state inheritance tax deficiencies.

The Tax Court Relies on Richardson

The Tax Court held in favor of the estate. The Tax Court stated that if the administrative expenses and interest payable on the Federal and state taxes were chargeable to income, they would not reduce the marital deduction. Relying on Estate of Richardson v. Commissioner (CCH Dec. 44,388), 89 T.C. 1193 (1987), the Tax Court held that the interest payable on state inheritance and Federal estate tax was chargeable to income under Tennessee law and the terms of the will. The Tax Court likewise found that other administrative expenses were charged against income of the estate and would not reduce the marital deduction. The Commissioner appealed, arguing that Reg. Sec. 20.2056(70)-4(a) requires that, when valuing the spouse's marital deduction, all administrative and interest expenses paid, or payable, out of income must be subtracted from the amount properly deductible. In response, the U.S. Court of Appeals said ".....The Commissioner argues that the Tax Court erred in failing to reduce the marital deduction available to petitioner by the amount of administrative and interest expenses incurred by the estate." The Tax Court held that because these expenses were chargeable to income and not to the principal of the estate, the amount which passes from decedent to the spouse would remain unchanged, and therefore there need not be any adjustment to the amount of the marital deduction.

Court of Appeals Cries "Foul"

The U.S. Court of Appeals believed the Tax Court reached an improper result. Federal estate tax is imposed on "the transfer of the taxable estate" |26 U.S.C. Par. 2001 (a). The taxable estate is computed by subtracting, from the value of the gross estate, deductions enumerated in IRC Sees. 2053 through 2056. These include, inter alia, deductions for administrative expenses and for claims against the estate..." in general, IRC Sec. 2056(a) provides a marital deduction for "an amount equal to the value of any interest in property which passes...from the decedent to his surviving spouse" |26 USC Par. 2056(a). The value of such interest which may be deducted is, however, qualified by the language of IRC Sec. 2056(b)(4)(b), the regulations of which attempt to clarify the meaning of this provision as follows: An example of a case in which this rule may be applied is a bequest of property in trust for the benefit of the decedent's spouse where the income from the property from the date of the decedent's death until distribution of the property to the trustee is to be used to pay expenses incurred in the administration of the estate |Regulations 20.2056 (b) - 4(a).

This example demonstrates that the marital deduction is to be reduced where income earned by the estate is burdened with the payment of various administrative expenses. The Court of Appeals agrees with the Commissioner that the facts of this case fit squarely within the example noted in the regulation. The Tax Court, in the proceeding below, failed to cite this regulation, and the Court of Appeals believed that was not correct."

The U.S. Court of Appeals continued: "We must determine, then, what expenses will operate to reduce the marital deduction under IRC Sec. 2056. In the present case, the expenses paid from income fell into two categories: 1) expenses associated with the administration of the estate and 2) interest on taxes which accrued after the date of the decedent's death. We must separately examine each of these items of expense."

Administrative Expenses

The Court of Appeals continued: "Our first inquiry is whether estate income used to pay administrative expenses will have any effect on the marital deduction. Reg. Sec. 20.2056(b)-4(a) unquestionably addresses itself to this issue." The regulation states that where income from property from the date of decedent's death until distribution "is to be used to pay expenses incurred in the administration of the estate," any such amount must be set-off to reduce the marital deduction. Otherwise, the spouse would receive a marital deduction from the estate greater than what was available for distribution. Interest on Estate Taxes

With respect to other items of expense, the Court of Appeals stated that they "are mindful that IRC Sec. 2056 and the accompanying regulations and legislative history should not be read too expansively." "As the above discussion makes clear, IRC Sec. 2056 requires the marital deduction to be diminished by the amount of income used by the estate to pay administrative expenses. Income used to pay interest on inheritance and estate taxes, however, must be accorded different treatment."

Since interest expenses accrue after death, estate income used to pay these expenses would not affect the size of the estate as of the date of the decedent's death. The Tax Court concluded that the marital deduction need not be reduced to reflect these items of expense. The Court of Appeals agreed that the Estate of Richardson correctly decided the effect post-death interest expenses would have on the marital deduction, and believed it should be followed. Which Form to Use

The decision in this case by the U.S. Court of Appeals is a clear limitation on the executor's right of election with respect to administration expenses. Until now, estate planning literature has emphasized the executor's right to choose whether to deduct administration expenses on the Form 706 or on Form 1041, depending on a comparison of the tax brackets and where the greatest savings could be achieved. That is no longer true. In a decedent's estate where there is a claimed marital deduction, prudence would suggest that administration expenses be deducted on the estate tax return (Form 706) under the provisions of IRC Sec. 2503, not on the fiduciary tax returns (Form 1041) trader the provisions of IRC Sec. 642 (g).

CALCULATIONOFDEDUCTIBLERENTALLOSSES

Step1

RentallossesdeductiblebyJanetonthe1991Form1040:

Maximumallowabledeductionforrealestatelosses$25,000

Dividends$10,000

Interest70,000

Wages40,000

ModifiedAGI120,000

Less:Thresholdamount(100,000)

Excess20,000

Phase-out%x50%

Phase-outamount(10,000)

(a)Maximumallowabledeductionafterphase-out$15,000

(b)Actualrentalloss$20,000

Allowableloss,lesserof(a)or(b)$15,000

Step2

RentallossesdeductiblebytheEstateofJohnSmithfortheyearendedApril

30,1992:

Maximumallowabledeductionforrealestatelosses$25,000

Dividends$30,000

Interest80,000

ModifiedAGI110,000

Less:Thresholdamount(100,000)

Excess10,000

Phase-out%x.50%

Phase-outamount(5,000)

Maximumallowabledeductionafterphase-out20,000

Less:Lossallowabletosurvivingspouse

calculatedinStep1(15,000)

(a)Maximumdeductiblelossbytheestate$5,000

(b)Actualrentalloss$40,000

Allowableloss,lesserof(a)or(b)$5,000

Theestate'sunallowedlossof$35,000($40,000minus$5,000)willconstitute

asuspendedpassivelossandcanthusbecarriedforwardtofutureyears.

Joseph S. Saslaw, CPA, Israeloff Trattner & Co.