Estate Portability: Sowers Reap Unexpected Harvest in Estate of Sower v. Commissioner

In 2010, Congress introduced into the tax code the concept of portability for certain estates. Each estate has an applicable exclusion amount. Under portability, the executor of the estate of a deceased spouse may elect to give the surviving spouse that deceased spouse’s unused applicable exclusion amount (DSUE).¹ Although the normal statute of limitations for estates is three years,² the Code permits the IRS to audit the first deceased spouse’s return without to regard to the expiration of the statute applicable to that return to determine if the DSUE has been calculated correctly.³ In the recent case of Estate of Sower v. Commissioner,⁴ the Tax Court provided some guidance on the audit of the return of the first deceased spouse.

I. The Facts

Frank Sower passed away in February 2012. Before his death, Frank and his wife Minnie gave gifts of approximately $998,000 each. Those gifts were reported on properly filed gift tax returns.⁵ Frank’s executor, however, did not list Frank’s gifts on his estate tax return but rather included them on a subsidiary schedule. Frank’s estate did not owe any tax. As a result of the non-reporting of the gifts, Frank’s estate had a DSUE of approximately $1.2 million. In November 2013, Frank’s estate received a standard IRS letter, accepting the return as filed.⁶

Minnie Sower died in August 2013. Her estate claimed the $1.2 million DSUE from Frank’s estate on the estate’s tax return.⁷ As part of an audit of Minnie’s estate tax return, the IRS examined the DSUE calculation on Frank’s return. During that examination, the IRS discovered that Frank’s gifts were not reported⁸ and were not taken into account in the calculation of Frank’s DSUE. That DSUE was therefore calculated incorrectly. Accordingly, as part of its examination of Frank’s return, the IRS reduced the DSUE from $1.2 million to approximately $300,000.⁹ As a result of that change, the inclusion of Minnie’s lifetime gifts, and other minor adjustments, Minnie’s estate tax liability increased by approximately $800,000.

The estate filed a timely petition for redetermination. In that petition, the estate disputed the entire adjustment based on a number of different arguments.¹⁰ First, the estate argued that the first closing letter received by the executor of Frank’s estate should be treated as a closing agreement under section 7121 and that the Commissioner should be estopped from examining that estate. Second, the estate argued that the examination which resulted in the change in the estate’s DSUE was an improper second examination. Third, the estate argued that the effective date of section 2010(c)(5)(B) (and its regulations) prevented the Commissioner from adjusting the DSUE from Frank’s estate due to pre-2010 gifts. Finally, the estate argued that the Commissioner’s application of section 2010(c)(5)(B) is contrary to Congress’s intent to allow portability and is unconstitutional because of lack of due process in that the statute of limitations under section 6501 was overridden.¹¹

II. The Court’s Holding

The court found that the Commissioner is authorized to enter into written agreements as to any person’s tax liability. The court also concluded that the Commissioner generally follows strict rules regarding such agreements, requiring that the agreements be set out on Form 866 or Form 906.¹² In very rare cases, courts have found there to be a closing agreement without a writing confirming the agreement. In such cases there are generally clear signs of an agreement, such as a negotiation followed by an offer and acceptance.¹³ The court found no such clear signs in this case. No negotiation took place between the Commissioner and the executor of Frank’s estate. Furthermore, there was no offer and acceptance. Accordingly, the court rejected the claim that there was a closing agreement.¹⁴

The court next examined the estate’s contention that the Commissioner was estopped from examining Frank’s estate return. The court concluded that estoppel is applied only with great caution in such cases.¹⁵ A taxpayer must establish four elements to prevail in estopping the Commissioner: (1) there must be a wrongful misleading silence or a false representation by the Commissioner; (2) this silence or representation must be as to a statement of fact. not as to a statement of law or opinion; (3) the taxpayer must be ignorant of the facts; and (4) the taxpayer must be adversely affected by the misleading silence or false representation.¹⁶ The court found that none of the four elements were present in this case. There was no false representation or misleading silence by the Commissioner, and the issues are matters of law, not fact. Both parties were aware of the facts, and the estate had not been adversely affected in a manner that justified estoppel.¹⁷

Next, the court considered the estate’s contention that the review of Frank’s estate’s DSUE computation constituted a disallowed second examination. Congress limited the Commissioner’s authority to conduct a second examination in those situations in which new information is obtained.¹⁸ Here, no additional information was requested. The Commissioner simply used information already available regarding Frank’s estate.¹⁹ Further, the limitations on second examinations apply only to the examined party, not to a third-party examination. The court found that the limitation did not apply here, since the examination of Frank’s estate was an examination of a third party as to Minnie’s estate.²⁰

Moreover, the court rejected the estate’s claim that gift tax regulations allow the Commissioner to examine the return of a deceased spouse only if the DSUE is used on a gift tax return and not when used on an estate tax return.²¹ The court noted temporary regulations that permit the Commissioner to examine a deceased spouse’s DSUE when the DSUE is used with respect to any transfer by the surviving spouse and found that there are regulations supporting the Commissioner’s actions.²²

Furthermore, the estate argued that section 2010’s effective date establishing the DSUE precluded an examination of pre-2010 gifts since those gifts added back in were made before the effective date of the DSUE statute. The estate argued that no adjustment could be made for those gifts.²³ The court explained that effective dates vary in their application. In this case, the effective date for estates was for decedents dying after December 31, 2010. The gift tax effective date has no relevance to the issue, the court stated, because this is an estate tax matter.²⁴

Finally, the estate argued that the application of section 2010(c)(5)(B) in this case was contrary to Congress’s intent to create portability and lacked due process because it overrode the statute of limitations.²⁵ The court disagreed. The statutory language is the best indication of congressional intent, and Congress specifically gave the Commissioner the authority to examine the returns of deceased spouses. Therefore, the Commissioner’s application of section 2010(c)(5)(B) was not contrary to congressional intent.²⁶ Furthermore, the court found that section 2010(c)(5)(B) did not override the statute of limitations. The statute of limitations applies to the assessment of tax, but there was no assessment of tax against Frank’s estate. There was only an examination of the computation of the DSUE. Therefore, there was no violation of due process.²⁷

The court held that the Commissioner had acted in accord with the law in all these matters. ²⁸

III. Conclusions

This is an interesting case that is undoubtedly decided correctly on the narrow issue of examining the computation of the earlier-deceased spouse’s DSUE when prior gifts were given. The case suggests, however, that the Commissioner has the authority to audit any valuation affecting the computation of the DSUE.

Assume a decedent leaves his entire estate, except for a piece of land, to his spouse. The land is left to his son. The valuation of that piece of land affects the computation of the DSUE. Therefore, if the surviving spouse in this example passed away twenty years after her deceased spouse, the IRS could audit the valuation of the land twenty years after the death of the first spouse. Further, if the executor of that estate has also passed away, the second spouse’s estate’s executor would have to defend a valuation of which he or she may have had little or no knowledge. This puts a significant burden on the second spouse’s estate’s executor.

Congress should correct this by placing a time limitation on the Commissioner’s ability to examine valuation issues in an earlier estate return in connection with a later estate return. For example, a ten-year limitation would permit the Commissioner to examine the earlier return if the first spouse had passed away within the ten-year period preceding the death of the second spouse, but not if earlier than that. Arithmetic corrections, such as the one in this case, would be exempt from the ten-year rule. ■