Fiduciary Income Tax Planning Utilizing the § 645 Election
By Lance Lvovsky, Supervisor, Tax & Business Services
A revocable living trust becomes irrevocable at the death of the grantor. This necessitates the requirement for an income tax return, Form 1041 (U.S. Income Tax Return for Estates and Trusts). This is in addition to the general requirement for an estate to file an income tax return, Form 1041. (Note: the requirement for filing an estate tax return, Form 706, is not discussed in this article).
Given the possibility of having to file an income tax return for both the estate and the trust, a unique opportunity presents itself to utilize the Internal Revenue Code (IRC) § 645 election to combine the trust and estate into one entity for tax purposes. This eliminates one tax return filing requirement (see discussion below for implications upon election termination).
A qualified revocable trust or QRT is any trust that is a grantor trust under IRC § 676 on date of the decedent’s death. The trustee of a and the executor of the estate can elect to treat the trust as a part of the estate rather than as a separate trust for federal income tax purposes. If the election is made, trust income and expenses will be reported by the estate on the estate’s income tax return, and the trust will be treated as part of the estate. Only one Form 1041 (for the estate) is required if the § 645 election is made, even though legally, the trust, rather than the estate, continues to hold the assets. Certainly, the income and expenses of the estate continue to be reported by the estate on the estate’s income tax return.
There are a number of income tax advantages to being classified as an estate rather than a trust, including:
- Estates are allowed to select a fiscal year, which creates income-shifting and tax-deferral opportunities. Trusts are required to adopt a calendar tax year. Example: Decedent dies on December 2, 2018. Decedent’s QRT would ordinarily file an income tax return for the year ending December 31, 2018, and pay any income tax due by April 15, 2019. If the executor and the trustee utilize the 645 election to combine the trust and estate into one entity for tax purposes, the executor can elect a fiscal year ending November 30, 2019. The same income would now be deferred and not due until March 15, 2020.
- Estates are allowed a charitable income tax deduction under IRC § 642(c)(2) for amounts permanently “set aside” for charitable purposes, whereas trusts generally can only deduct the amounts that are paid to charities in the current year.
- For two (2) years after the owner’s death, the active participation requirement under the passive loss rules, which allows up to $25,000 in passive losses, is waived in the case of estates. This requirement is not waived for trusts.
- An estate is allowed to own S corporation stock for a longer time period than it would by reporting as a trust. A revocable trust is permitted to continue to be an S shareholder only for the two-year period beginning on the date of the decedent’s death, whereas an estate is allowed to be an S shareholder for the period of administration.
- Estates have a $600 personal exemption. Trusts have an exemption of $100 or $300.
- Estates are not required (and as such not subject to underpayment penalties) to make estimated tax payments until the tax year ending two years following the decedent’s death. By this time, most estates have concluded administration, all assets distributed, and filed a final income tax return.
The IRC § 645 election is irrevocable once made. The election must be made on IRS Form 8855 (Election to Treat a Qualified Revocable Trust as Part of an Estate) by the due date, including extensions, of the estate’s initial income tax return. A taxpayer identification number must be obtained by both the electing QRT and the related estate. Both the executor and the trustee must sign Form 8855. Keep in mind, the estate and trust are treated as separate shares for allocating distributable net income (DNI). As such, it is imperative that the estate and trust continue to keep separate books and records.
In practice, it is almost always beneficial to utilize the 645 election given the various planning opportunities discussed above.
Termination of Election Period
The 645 election period does not continue indefinitely. The election termination date is based on a complex set of rules and differs on whether or not an estate tax return (Form 706) was filed. Upon election termination, the electing Trust will have to begin filing a separate income tax return. The short period for the Trust return begins on the date after the termination date and ends on December 31. Keep in mind that trusts must file on a calendar year basis. The estate can continue to file an income tax return on a fiscal year schedule, assuming a fiscal year election was made initially. Given the intricacies of the rules surrounding an election termination, it is highly recommended that you consult with your tax advisor.
In summary, a 645 election can be a very powerful planning tool. The tax planning opportunities can be beneficial, but one must also be mindful of the tax implications when the 645 election is terminated.
For further guidance and tax planning discussions, please consult with your Marcum tax professional.