Carryover Basis/GST Exemption Form 8939 Due January 17, 2012

January 6, 2012

For the estates of decedents who died in 2010, January 17, 2012, is the due date for filing IRS Form 8939 (Allocation of Increase in Basis for Property Acquired From a Decedent) if the executor chooses to elect out of the 2010 federal estate tax into the “modified carryover basis” rules that had been applicable for 2010 before Congress enacted the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the 2010 Tax Act”) in December 2010. Although we have observed that executors’ work on preparing and finalizing the Forms 8939 to be filed is well underway, a few last-minute reminders and warnings may prove helpful.

The January 17 Due Date is Very Strict. There is no “automatic” six-month extension of time to file Form 8939, as we have become accustomed to in the case of the federal estate tax return. And the IRS will not grant extensions of the January 17 due date. The IRS (in Notices 2011-66 and 2011-76) has stated that an executor may quite freely amend Form 8939 at any time within six months of the due date – that is, through July 17, 2012. That would include such things as updating the identity, description, character, value, acquisition date, basis, and recipient of assets and making or changing allocations of basis increase to those assets. Even more time is allowed in some cases to allocate the special basis increase allowed for property passing to the decedent’s spouse.

But no such amended Form 8939 may make or revoke the election out of the estate tax (called the “Section 1022 Election” after the section of the Internal Revenue Code that deals with carryover basis); the decision to make the Election must be made and reported on Form 8939 by January 17. In addition, no amendments of any kind will be allowed unless a Form 8939 is filed timely – that is, no later than January 17.

Therefore, even when information for the Form 8939 is incomplete and supplementation by July 17 might be needed, the executor (including a trustee, if there is no court-appointed executor) must file a Form 8939, completed as fully as possible, by January 17. Failure to do so may expose the estate to federal estate tax.

Unlike the instructions for the federal estate tax return, the instructions for Form 8939 do not explicitly state that it is sufficient for only one of several co-executors to sign the Form 8939. It is not clear if that omission is significant.

Even Executors of Some Small Estates Should Make the Section 1022 Election. Obviously, executors of estates larger than the $5 million estate tax exemption should seriously consider a Section 1022 Election in order to avoid the higher estate tax rate, even at the cost of additional capital gains taxes when the decedent’s assets are sold by the executor, trustee, or beneficiaries. Not so obviously, executors of some smaller estates should also make the election. For example, if the “estate” consists of a QTIP trust of which the decedent was the beneficiary as surviving spouse and in which the assets declined in value, plus cash and modest other assets (perhaps less than the $1.3 million basis increase that can be allocated to those assets), then the election might be considered in order to preserve the higher basis of the assets in the QTIP trust (because that basis would be stepped down under Section 1014 if the estate tax applied).

Example: Peter (the predeceased spouse) died in 2007, and his wife Susan (the surviving spouse) died in 2010. At the time of her death, Susan owned assets with a value of $1,000,000 and a basis of $400,000. Susan was also the beneficiary of a QTIP trust created at Peter’s death, which had a value of $5,000,000 when Peter died in 2007, but, as with many investments, had declined to a value of $3,000,000 at the time of Susan’s death in 2010, but with no change in its assets except for value.

Because Susan’s gross estate for federal estate tax purposes would be $4,000,000 (her assets worth $1,000,000 plus the QTIP trust assets of $3,000,000), there would be no federal estate tax, and there seems to be no reason to elect out of an estate tax that would be zero. But, although the $400,000 basis of Susan’s assets would be stepped up to the date-of-death value of $1,000,000, the $5,000,000 basis of the assets of the QTIP trust would be stepped down to the date-of-death value of $3,000,000. If the QTIP trust assets go up in value in the future, an additional $2,000,000 might be subject to a capital gains tax because of that loss of basis.

On the other hand, if Susan’s executor elects out of the estate tax, the $400,000 basis of Susan’s assets will still be increased to $1,000,000 by the $1,300,000 basis increase, but the basis of the assets of the QTIP trust, to which the carryover basis rules do not apply, will still be $5,000,000. The $2,000,000 loss of basis and resulting potential increased capital gains tax are avoided.

Therefore, Susan’s executor should elect out of the federal estate tax, even though there would have been no federal estate tax on Susan’s estate.

GST Exemption Must Be Allocated on Form 8939, Even to QTIP Trusts and Some Other Preexisting Trusts Not Otherwise Addressed on Form 8939. In addition to the carryover basis reporting and allocations, Form 8939 is used to allocate GST exemption to trusts as to which there could be generation-skipping transfers (taxable distributions or taxable terminations) in the future. The GST exemption allocations will be made on Schedule R of Form 8939. The automatic allocation rules will apply if the executor files a Form 8939 without attaching a Schedule R, or to the extent the Schedule R does not allocate all of the decedent’s available GST exemption.

The Schedule R for Form 8939 is very similar to the Schedule R that accompanies Form 706. But there is a hugely significant way in which this Schedule R differs in its relationship to the rest of the Form 8939. Executors accustomed to preparing estate tax returns will generally use Schedule R to calculate GST tax and allocate GST exemption with respect to transfers reported on the estate tax return. That is also true in the case of the Form 8939. But in the case of the Form 8939, there may be trusts of which the decedent is treated as the transferor for GST tax purposes that are exempt from carryover basis and therefore not otherwise reported or addressed on Form 8939 at all.

The most typical example might be a QTIP trust of which the decedent was the surviving spouse and lifetime beneficiary. Often such QTIP trusts will have been divided at the predeceased spouse’s death into “exempt” and “non-exempt” trusts for GST tax purposes, with the exempt trust designed and funded to absorb the predeceased spouse’s available GST exemption under an actual or deemed “reverse QTIP election.” The Form 8939 is the occasion for allocating GST exemption to any non-exempt QTIP trust at the surviving spouse’s death.

In the preceding example of Peter and Susan, if the entire $3,000,000 QTIP trust were a non-exempt trust that continued for Peter’s and/or Susan’s descendants, Susan’s executor should use Schedule R to allocate $3,000,000 of GST exemption to the QTIP trust, as well as up to $1,000,000 of GST exemption to generation-skipping trusts created by Susan.

In addition to QTIP trusts, other trusts to which GST exemption might be allocated but which are not otherwise reported on Form 8939 include some grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs) that are not treated as acquired from the decedent for purposes of the carryover basis rules.

When there is only one generation-skipping trust or the total of such trusts is no greater than the available GST exemption (as in Susan’s case), this is not so crucial, because the automatic allocation rules will fully allocate GST exemption to the generation-skipping trust or trusts. But in the larger estates that are the more typical candidates for the Section 1022 Election and the use of Form 8939, it could be more important that the executor make an intentional allocation of GST exemption, just as in the case of estate tax returns for large estates in years other than 2010. If the GST exemption is not allocated, or not completely allocated, the automatic allocation rules of Section 2632(e) of the Internal Revenue Code will allocate the available GST exemption, first pro rata to direct skips and then pro rata to trusts with generation-skipping potential.

In allocating GST exemption, the executor is able to take into account the true generation-skipping potential of a trust, and might, for example, make no allocation or a smaller allocation to a trust for which there is a greater likelihood of substantial distributions to non-skip persons like the decedent’s surviving children (or children of a deceased child). The automatic allocation rules are not as strategic or discriminating as the executor’s affirmative allocation of GST exemption might be.

Moreover, it is not even clear, as the IRS has made it clear in the case of 2010 inter vivos gifts, that there would be no automatic allocation of GST exemption to an outright direct skip, which would be a complete waste of GST exemption in the 2010 world of a zero GST tax rate.

All of these considerations highlight the need for a timely filed Form 8939 to report the executor’s affirmative GST exemption allocations, which, in turn, take into account all trusts the value of which would have been included in the decedent’s gross estate under estate tax rules, not just trusts otherwise mentioned on the Form 8939.

Further background on the 2010 Tax Act is in The 2010 Tax Act’s Impact on Estate Planning and Administration: Making Sense out of the Confusion, A McGuireWoods White Paper for Clients and Their Advisors. An update on Form 8939 and related carryover basis and GST tax issues is on pages 37-48 of Estate Tax Changes Past, Present and Future.

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