Taxpayer Relief Act of 1997
The 1997 Act imposed the separate share rule of § 663(c) on estates of decedents dying after August 5, 1997, by adding this new sentence to Code§ 663(c):
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.
The legislative history indicates that Congress did not believe this statutory change would affect many estates:
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 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.
Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), Dec. 17, 1997, at p. 404.
The 1999 Final Regulations
Final regulations issued on December 28, 1999 (T. D. 8849), 65 Fed. Reg. 16317, explain how the separate share rule applies in the estate context. The final regulations are applicable to estates and qualified revocable trusts of decedents dying on or after December 28, 1999. For estates and qualified revocable trusts 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. For trusts other than qualified revocable trusts, the rules of administration apply for taxable years of such trusts beginning after December 28, 1999.
The regulations describe rules for determining the existence of separate shares and contain certain new rules of administration that also apply to all trusts.
Separate Share Rule Basics
The separate share rule applies only if a single trust or estate has multiple beneficiaries and those beneficiaries have substantially separate and independent shares. A separate share generally exists only if it includes both corpus and the income attributable thereto and is independent from any other share or, in other words, if the economic interests in one beneficiary or class of beneficiaries neither affect nor are affected by the economic interests accruing to another beneficiary or class of beneficiaries. The rule is mandatory and not elective. 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. 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.
• Specific bequests. Bequests of specific property and specific sums of money described in Code § 663(a)(1) are not separate shares. But the income on bequeathed property is a separate share if the recipient of the specific bequest is entitled to such income.
• Spouse’s elective share. The elective share of a surviving spouse constitutes a separate share of the estate. An elective share that is entitled to income and shares in appreciation or depreciation is a separate share under the general rules. 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.
• Qualified revocable trusts. Qualified revocable trusts, as defined in Code § 645, are subject to the separate share rules. A qualified revocable trust that elects to be treated as part of the decedent’s estate for income tax purposes is always a separate share of the estate. Qualified revocable trusts are subject to the separate share rules applicable to estates and not to the rules that apply to separate share trusts, whether or not an election is actually made under Code § 645 to be part of the estate. An electing revocable trust itself may have two or more separate shares.
• Pecuniary formula bequests. Pecuniary formula bequests constitute separate shares of the estate. Any pecuniary formula bequest that is entitled to income and shares in appreciation or depreciation is a separate share under the general rules. If the pecuniary formula bequest shares in appreciation or depreciation but not income, the bequest is not a separate share. 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. On the other hand, if the bequest is to be paid in four or more installments, it is not a separate share.
Limited Scope of Separate Share Rule
The separate share rule does not permit the treatment of separate shares as separate trusts or estates under subchapter J for any purpose other than allocation of DNI. A trust or estate with separate shares will continue to be treated as one trust or estate for all other purposes, including the following:
• tax identification numbers;
• tax return filing requirements;
• income tax payments, including estimated taxes;
• personal exemption; and
• excess deductions, unused net operating losses and capital loss carryovers on termination of the trust or estate.
Creation, Valuation and Allocation of DNI of Separate Shares
Separate shares come into existence on the earliest moment that a fiduciary may reasonably determine, based on the known facts, that a separate economic interest exists. 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. This gives the fiduciary flexibility, within limits, in applying the separate share rules. Redeterminations in value of the separate shares must be taken into account.
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. In computing DNI for each separate share, the portion of gross income that is income within the meaning of Code § 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. One beneficiary could receive amounts in excess of the trust or estate’s total DNI yet only be taxed on a ratable portion of the DNI. Interest imposed by state law on a pecuniary bequest or delayed estate distribution is a nondeductible payment of interest by the estate and not a distribution for purposes of Code §§ 661 and 662.
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 or estate are calculated based on the accumulated income from all shares. Thus, in the case of trusts, 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.
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.
• Income in respect of a decedent. Income in respect of a decedent (IRD) is allocated among the separate shares that potentially could 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. The amount allocated to each share is based on the relative values of the shares that potentially could be funded with the IRD.
• Gross income not attributable to cash. Gross income not attributable to cash but included in DNI is allocated among the separate shares in the same proportion as Code § 643(b) income from the same source would be allocated. This provision relates to S corporation K-1 income items, partnership K-1 income items and original issue discount.
When an interest in a pass-through entity (for example, S corporation stock) is specifically bequeathed, the income from the entity is ordinarily a separate share. This means the K-1 distributive share income from specifically bequeathed S stock is allocated to that separate share. But if no dividends are distributed by the S corporation to the estate and then from the estate to the legatee during the taxable year, the K-1 income will be taxed to the estate.
Potential disputes may arise when actual Code § 643(b) income (that is, an S corporation dividend) is later paid to the estate and distributed to the legatee in a year where there is no noncash income. State law or the fiduciary’s power to adjust will govern and determine whether the subsequent payment of the dividend income to the legatee will be reduced by the income tax previously paid by the estate. The situation is more complex if the S stock generates no § 643(b) income distributions before the distribution of the S stock itself to the legatee.
Dealing with S Corporation Stock in an Estate
Because only certain types of trusts are allowed to be shareholders in an S corporation, careful planning is critical to avoid accidental loss of subchapter S status by having the S stock held by or distributed to an impermissible shareholder.
An estate can hold S stock indefinitely as long as administration is not unduly prolonged. The typical revocable grantor trust can hold S stock for two years after the grantor’s death, but if a § 645 election has been made the S stock can be held until the § 645 election period terminates—normally six months after issuance of the estate tax closing letter. 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 avail-able for trusts not meeting the QSST requirements or for other trusts preferring ESBT treatment over QSST treatment.
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 state 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 the S Corp. pays a dividend, in order to provide the estate with funds to pay income taxes on the S Corp. K-1 income reportable by the estate.
As a result of the 1997 Act, the separate share rule applies in Situation 1, creating four separate shares. The bequest of the S corporation stock itself is not a separate share by reason of § 663(c)(1), but the income (dividends) is a separate share. The interests of Son, Daughter 1 and Daughter 2 are also separate shares. If there is 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 the S corporation, 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 corporation 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 (subject to any application of the 65 day rule, which now applies to estates as well as trusts).
Events outside the control of the fiduciary can also 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.
If Son has not exercised his right to have the S corporation stock allocated to his share when the partial distribution is made to Daughter 2, it seems that one-third of the S corporation K-1 income should be taken into account in determining Daughter 2’s share of DNI. The result should be different if Son had already filed a paper with the personal representative electing to have the S corporation stock allocated to his share, because the regulations state that separate shares come into existence at the earliest moment that a fiduciary may reasonably determine that separate shares exist. The results could vary, depending on whether Son exercises his right before or after the partial distribution to Daughter 2.
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 Code § 663(c) are treated as separate trusts by reason of Code § 1361(d). That same section also provides that a successive beneficiary of the trust is automatically treated as having made a QSST election unless that beneficiary affirmatively refuses to consent to such election.
Situation 3. Husband created trust for Wife with S Corp. stock. Wife made the 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 election, the trustee will not distribute the trust assets until Wife’s estate receives a closing letter from the IRS.
The facts in Situation 3 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 successive beneficiary rule also comes into play 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 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.
Because the DNI rules are inapplicable to the S income of an ESBT, the separate share rule is relevant only to the non-S income, if any, of the ESBT. Code § 641(d).
Although the concepts of the separate share rule are not new, the extension of the rule to estates adds a new dimension of complexity in both drafting and estate administration. An understanding of the separate share rule and its applications is important for all who practice in the estate planning and estate administration fields.
Applicability or nonapplicability of the separate share rule is frequently a function of how will and trust provisions are drafted. Although there are no required “governing instrument” provisions, the separate share rule can be influenced by the terms of the estate planning documents. Because of the 1997 Act, even drafters of wills not containing testamentary trusts must think about the applicability of the separate share rule.
Maintaining an awareness of the separate share rule will help the practitioner deal with the uncertainties of the rule and provide opportunities to fine-tune the estate plan or the postmortem plan for the client and the client’s beneficiaries.
W. Birch Douglass, III is a partner with McGuireWoods LLP in Richmond, Virginia, and T. Randolph Harris is a partner with McLaughlin & Stern, LLP, in New York, New York. They are Vice Chair and Chair, respectively, of the Committee on S Corporations (C-6) of the Section’s Probate and Trust Division.