Most taxpayers would breathe a sigh of relief when getting an IRS letter stating that their spouse’s estate tax return had been accepted as filed. However, a recent Tax Court case has made it clear that the earlier estate return can be brought back from the dead! What keeps the earlier estate alive? The use by the second spouse of the estate tax exclusion that was transferred up the first spouse’s death.
The tax law allows spouses to share each other’s unused exclusion amounts. This is referred to as “portability.” When a spouse dies, any unused estate tax exclusion amount of the deceased spouse transfers over to the surviving spouse. The portability election must be made by an executor on Form 706, the estate tax return of the first spouse to die. Portability is a huge tax benefit for large estates. The 2017 estate tax exclusion amount is $5,490,000 per person, or $10,980,000 for a married couple. Exclusion amounts are adjusted yearly for inflation.
If two taxpayers are married, and Wife dies first using only $2 million of her $5,490,000 exclusion, her remaining $3,490,000 will be usable by the Husband’s estate when he dies. He also gets his own exclusion of $5,490,000 (or a possible higher amount depending on inflation adjustments). For a married couple to share exclusions, portability must be elected on the estate tax return of the first spouse to die.
In Estate of Sower v. Commissioner, a Husband died in 2012 and did not use all of his estate tax exclusion. So, the Husband’s estate made a portability election to allow the Wife’s estate to take the unused exclusion amount of $1,256,033. The IRS sent an Estate Tax Closing Document to the Husband’s estate indicating no estate tax liability.
The Wife died in 2013 and her estate claimed the unused exclusion of the Husband. When evaluating the Wife’ estate tax return, the IRS examined the Husband’s earlier estate tax return and reduced the amount of the Husband’s exclusion that could be used by the Wife. The exclusion reduction was based on the earlier failure of Husband to report lifetime taxable gifts on his estate tax return. The loss of a portion of the transferred exclusion increased the Wife’s estate tax liability by $788,165.
The Wife’s estate petitioned the Tax Court for review of the deficiency, arguing that the IRS’s letter accepting the Husband’s estate amounted to a closing agreement that the IRS could not renege on. The estate also argued that the IRS was barred by the statute of limitations from opening up the Husband’s estate tax liability.
Back from the Dead
The Tax Court rejected the estate’s position and allowed the IRS to revisit the predeceased spouse’s return. The Court reasoned that the statute of limitations does bar the IRS from examining the Husband’s earlier return to validate the correct amount of a couple’s unused exclusion. The Court also found that the Estate Tax Closing Document was not a closing agreement because no negotiation had taken place between the IRS and the Husband’s estate and there was no offer and acceptance, as is required for valid contracts. Closing agreements must be negotiated settlements, the Court noted. In other words, the Estate Tax Closing Document was not binding on the IRS and did not preclude the IRS’s reexamination of the Husband’s estate.
Maximizing a married couple’s estate tax exclusion is a key strategy in estate planning. This strategy can only be used if you effectively file a portability election, a technical process that must meet all IRS requirements. The take-away from this case is that applying a portable estate tax exclusion can open up the earlier estate to IRS scrutiny. It is important that you get professional advice when you are faced with these complicated estate tax issues.