Marital Deduction; Valuation of Interest Passing to Surviving Spouse

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 20

[REG-114663-97]

RIN 1545-AV45

Marital Deduction; Valuation of Interest Passing to Surviving

Spouse

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

effect of certain administration expenses on the valuation of property

which qualifies for the estate tax marital or charitable deduction. The

proposed regulations define estate transmission expenses and estate

management expenses and provide that estate transmission expenses, but

not estate management expenses, reduce the value of property for

marital and charitable deduction purposes. This document also provides

notice of a public hearing on these proposed regulations.

DATES: Written comments must be received by February 16, 1999. Outlines

of topics to be discussed at the public hearing scheduled for April 21,

1999, at 10 a.m., must be received by March 31, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-114663-97), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

114663-97), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in Room 2615, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Deborah Ryan (202) 622-3090; concerning submissions of comments, the

hearing, and/or to be placed on the building access list to attend the

hearing, LaNita Van Dyke (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On March 18, 1997, the Supreme Court of the United States issued

its decision in Commissioner v. Estate of Hubert, 520 U.S. 93 (1997)

(1997-32 I.R.B. 8), in which it considered the proper interpretation of

Sec. 20.2056(b)-4(a) of the Estate Tax Regulations. On November 24,

1997, the IRS issued Notice 97-63 (1997-47 I.R.B. 6), requesting

comments on alternatives for amending Sec. 20.2056(b)-4(a) in light of

the Supreme Court's Estate of Hubert decision. Section 2056(b)(4)

provides that, in determining the value of an interest in property

which passes from the decedent to the surviving spouse for purposes of

the marital deduction, account must be taken of any encumbrance on the

property or any obligation imposed on the surviving spouse by the

decedent with respect to the property. Section 20.2056(b)-4(a) of the

Estate Tax Regulations amplifies this rule by providing that account

must be taken of the effect of any material limitations on the

surviving spouse's right to the income from the property. The

regulation provides, for example, that there may be a material

limitation on the surviving spouse's right to the income from marital

trust property where the income is used to pay administration expenses

during the period between the date of the decedent's death and the date

of distribution of the assets to the trustee.

The facts in Estate of Hubert are similar to a common fact pattern

wherein the decedent's will provides for a residuary bequest to a

marital trust which qualifies for the marital deduction and also

provides that estate administration expenses are to be paid from the

residuary estate. Further, the will (or state law) permits the executor

to use the income generated by the residuary estate (otherwise payable

to the marital trust) to pay administration expenses, and the executor

does so. The issue before the Supreme Court in Estate of Hubert was

whether the executor's use of the income to pay estate administration

expenses was a material limitation on the surviving spouse's right to

the income which would reduce the marital deduction under

Sec. 20.2056(b)-4(a).

The issue in Estate of Hubert also involved the estate tax

charitable deduction, and the proposed regulations relate to the

valuation of property for both marital and charitable deduction

purposes. However, for simplicity and clarity, this discussion focuses

on the provisions of the estate tax marital deduction.

In Estate of Hubert, the Commissioner argued that the payment of

administration expenses from income is, per se, a material limitation

on the surviving spouse's right to income for purposes of

Sec. 20.2056(b)-4(a), and, therefore, the value of the marital bequest

should be reduced dollar for dollar by the amount of income used to pay

administration expenses. The Court agreed that the value of the marital

bequest should be reduced if the use of income to pay administration

expenses is a material limitation on the spouse's right to income. The

Court found, however, that the regulation does not define material

limitation and that the Commissioner had not argued that the use of

income in this case was a material limitation. Thus, the Court held for

the taxpayer.

In Notice 97-63 (November 24, 1997), the IRS requested comments on

possible approaches for proposed regulations in light of the Estate of

Hubert decision. Notice 97-63 suggested three alternative approaches

for determining when the use of income to pay administration expenses

constitutes a material limitation on the surviving spouse's right to

income. One approach distinguished between administration expenses that

are properly charged to principal and those that are properly charged

to income and provided that there is a material limitation on the

surviving spouse's right to income if income is used to pay an estate

administration expense that is properly charged to principal. A second

approach provided a de minimis safe harbor amount of income that may be

used to pay administration expenses without constituting a material

limitation on the surviving's spouse's right to income. A third

approach provided that any charge to income for the payment of

administration expenses constitutes a material limitation on the

spouse's right to income.

Notice 97-63 also asked for comments on whether the test for

materiality should be based on a comparison of the relative amounts of

the income and the expenses charged to the income; whether materiality

should be based on projections as of the date of death rather than on

the facts that develop afterwards; and whether present value principles

should be applied.

In response to Notice 97-63, several commentators suggested that

local law should be determinative of whether an expense is a proper

charge to income or principal. If the testamentary document directs the

executor to charge expenses to income, and the charge is allowed under

applicable local law, then the charge to income should not be treated

[[Page 69249]]

as a material limitation on the spouse's right to income.

This approach was not adopted because statutory provisions relating

to income and principal may vary from state to state, and this would

result in disparate treatment of estates that are similarly situated

but governed by different state law. Moreover, in states that have

adopted some form of the Uniform Principal and Income Act, the

definitions of principal and income, and the allocation of expenses

thereto, can be specified in the will or trust instrument and given the

effect of state law. Thus, simply following state law was thought to be

too malleable to protect the policies underlying the marital and

charitable deductions.

Several commentators agreed with the de minimis safe harbor

approach whereby a certain amount of income could be used to pay

administration expenses without materially limiting the surviving

spouse's right to the income. Under this approach, the safe harbor

amount is determined in two steps: first, the present value of the

surviving spouse's income interest for life is determined using

actuarial principles and, second, the resulting amount is multiplied by

a percentage, for example, 5 percent.

The proposed regulations do not adopt this approach. Although a de

minimis safe harbor approach would provide a bright line test for

determining materiality in the context of the marital deduction, it is

unclear how this approach would apply for charitable deduction purposes

because there is no measuring life for valuing the income interest.

One commentator suggested that, consistent with the plurality

opinion in Estate of Hubert, the test for materiality should be

quantitative, based upon a comparison between the amount of income

charged with administration expenses and the total income earned during

administration. The commentator, however, considered the requirement

that projected income and expenses be presently valued to be

impractical, complex, and uncertain. Another commentator considered a

quantitative test to be impractical. A third commentator suggested that

a quantitative test would require a factual determination in each case

and, as a result, the period of estate administration would be greatly

prolonged.

Because these tests for materiality appear to be complex and

difficult to administer, the proposed regulations adopt neither a

quantitative test nor a test based on present values of projected

income and expenses.

Many commentators opposed an approach in which every charge to

income is a material limitation on the spouse's right to income. Two

commentators contended that adoption of this approach would effectively

overrule the result in Estate of Hubert.

One commentator suggested the approach adopted in the proposed

regulations, a description of which follows, and two commentators

suggested similar approaches.

Explanation of Provisions

After carefully considering the comments, the Treasury and the

Internal Revenue Service have determined that a test based on what

constitutes a material limitation would prove too complex and would be

administratively burdensome. For this reason, the proposed regulations

eliminate the concept of materiality and, instead, establish rules

providing that only administration expenses of a certain character

which are charged to the marital property will reduce the value of the

property for marital deduction purposes. It is anticipated that these

rules will have uniform application to all estates, will be simple to

administer, and will reflect the economic realities of estate

administration. These same rules will also apply for purposes of the

estate tax charitable deduction.

Under the proposed regulations, a reduction is made to the date of

death value of the property interest which passes from the decedent to

the surviving spouse (or to a charitable organization described in

section 2055) for the dollar amount of any estate transmission expenses

incurred during the administration of the decedent's estate and charged

to the property interest. Such a reduction is proper because these

expenses would not have been incurred but for the decedent's death. No

reduction is made for estate management expenses incurred with respect

to the property and charged to the property because these expenses

would have been incurred even if the death had not occurred. However, a

reduction is made for estate management expenses charged to the marital

property interest passing to the surviving spouse if the expenses were

incurred in connection with property passing to someone other than the

surviving spouse and a person other than the surviving spouse is

entitled to the income from that property. Estate transmission expenses

are all estate administration expenses that are not estate management

expenses and include expenses incurred in collecting estate assets,

paying debts, estate and inheritance taxes, and distributing the

decedent's property. Estate management expenses are expenses incurred

in connection with the investment of the estate assets and with their

preservation and maintenance during the period of administration.

Proposed Effective Date

These regulations are proposed to be effective for estates of

decedents dying on or after the date the regulations are published in

the Federal Register as final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It also has

been determined that section 553(b) of the Administrative Procedure Act

(5 U.S.C. chapter 5) does not apply to these regulations, and, because

the regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, this

notice of proposed rulemaking will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for April 21, 1999, beginning

at 10 a.m. in Room 2615 of the Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who

wish to present oral comments at the hearing must submit written

comments and an

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outline of the topics to be discussed and the time to be devoted to

each topic (signed original and eight (8) copies) by March 31, 1999. A

period of 10 minutes will be allotted to each person for making

comments. An agenda showing the scheduling of the speakers will be

prepared after the deadline for receiving outlines has passed. Copies

of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Deborah Ryan,

Office of the Assistant Chief Counsel (Passthroughs and Special

Industries). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 20

Estate taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 20 is proposed to be amended as follows:

PART 20--ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16,

1954

Paragraph 1. The authority citation for part 20 continues to read

in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In Sec. 20.2055-1, paragraph (d)(6) is added to read as

follows:

Sec. 20.2055-1 Deduction for transfers for public, charitable, and

religious uses; in general.

* * * * *

(d) * * *

(6) For the effect of certain administration expenses on the

valuation of transfers for charitable deduction purposes, see

Sec. 20.2056(b)-4(e). The rules provided in that section apply for

purposes of both the marital and charitable deductions. This paragraph

(d)(6) is effective for estates of decedents dying on or after the date

these regulations are published in the Federal Register as final

regulations.

Par. 3. Section 20.2056(b)-4 is amended by:

1. Removing the last two sentences of paragraph (a).

2. Adding paragraph (e).

The addition reads as follows:

Sec. 20.2056(b)-4 Marital deduction; valuation of interest passing to

surviving spouse.

* * * * *

(e) Effect of certain administration expenses--(1) Estate

transmission expenses. For purposes of determining the marital

deduction, the value of any deductible property interest which passed

from the decedent to the surviving spouse shall be reduced by the

amount of estate transmission expenses incurred during the

administration of the decedent's estate and paid from the principal of

the property interest or the income produced by the property interest.

For purposes of this subsection, the term estate transmission expenses

means all estate administration expenses that are not estate management

expenses (as defined in paragraph (e)(2) of this section). Estate

transmission expenses include expenses incurred in the collection of

the decedent's assets, the payment of the decedent's debts and death

taxes, and the distribution of the decedent's property to those who are

entitled to receive it. Examples of these expenses include executor

commissions and attorney fees (except to the extent specifically

related to investment, preservation, and maintenance of the assets),

probate fees, expenses incurred in construction proceedings and

defending against will contests, and appraisal fees.

(2) Estate management expenses--(i) In general. For purposes of

determining the marital deduction, the value of any deductible property

interest which passed from the decedent to the surviving spouse shall

not be reduced by the amount of estate management expenses incurred in

connection with the property interest during the administration of the

decedent's estate and paid from the principal of the property interest

or the income produced by the property interest. For marital deduction

purposes, the value of any deductible property interest which passed

from the decedent to the surviving spouse shall be reduced by the

amount of any estate management expenses incurred in connection with

property that passed to a beneficiary other than the surviving spouse

if a beneficiary other than the surviving spouse is entitled to the

income from the property and the expenses are charged to the deductible

property interest which passed to the surviving spouse. For purposes of

this subsection, the term estate management expenses means expenses

incurred in connection with the investment of the estate assets and

with their preservation and maintenance during the period of

administration. Examples of these expenses include investment advisory

fees, stock brokerage commissions, custodial fees, and interest.

(ii) Special rule where estate management expenses are deducted on

the federal estate tax return. For purposes of determining the marital

deduction, the value of the deductible property interest which passed

from the decedent to the surviving spouse is not increased as a result

of the decrease in the federal estate tax liability attributable to any

estate management expenses that are deducted as expenses of

administration under section 2053 on the federal estate tax return.

(3) Examples. The following examples illustrate the application of

this paragraph (e). In each example, the decedent, who dies after 2006,

makes a bequest of shares of ABC Corporation stock to the decedent's

child. The bequest provides that the child is to receive the income

from the shares from the date of the decedent's death. The value of the

bequeathed shares, on the decedent's date of death, is $3,000,000. The

residue of the estate is bequeathed to a trust which satisfies the

requirements of section 2056(b)(7) as qualified terminable interest

property. The value of the residue, on the decedent's date of death,

before the payment of administration expenses and estate taxes, is

$6,000,000. Under applicable local law, the executor has the discretion

to pay administration expenses from the income or principal of the

residuary estate. All estate taxes are to be paid from the residue. The

state estate tax equals the state tax credit available under section

2011. The examples are as follows:

Example 1. During the period of administration, the estate

incurs estate transmission expenses of $400,000, which the executor

charges to the residue. For purposes of determining the marital

deduction, the value of the residue is reduced by the federal and

state estate taxes and by the estate transmission expenses. If the

transmission expenses are deducted on the federal estate tax return,

the marital deduction is $3,500,000 ($6,000,000 minus $400,000

transmission expenses and minus $2,100,000 federal and state estate

taxes). If the transmission expenses are deducted on the estate's

income tax return rather than on the estate tax return, the marital

deduction is $3,011,111 ($6,000,000 minus $400,000 transmission

expenses and minus $2,588,889 federal and state estate taxes).

Example 2. During the period of administration, the estate

incurs estate management expenses of $400,000 in connection with the

residue property passing for the benefit of the spouse. The executor

charges these management expenses to the residue. For purposes of

determining the marital deduction, the value of the residue is

reduced by the federal and state estate taxes but is not reduced by

the estate management expenses. If the management expenses are

deducted on the estate's income tax return, the marital deduction is

$3,900,000 ($6,000,000 minus $2,100,000 federal and state estate

taxes). If the management expenses are deducted on the estate tax

[[Page 69251]]

return rather than on the estate's income tax return, the marital

deduction remains $3,900,000, even though the federal and state

estate taxes now total only $1,880,000. The marital deduction is not

increased by the reduction in estate taxes attributable to deducting

the management expenses on the federal estate tax return.

Example 3. During the period of administration, the estate

incurs estate management expenses of $400,000 in connection with the

bequest of ABC Corporation stock to the decedent's child. The

executor charges these management expenses to the residue. For

purposes of determining the marital deduction, the value of the

residue is reduced by the federal and state estate taxes and by the

management expenses. The management expenses reduce the value of the

residue because they are charged to the property passing to the

spouse even though they were incurred with respect to stock passing

to the child and the spouse is not entitled to the income from the

stock during the period of estate administration. If the management

expenses are deducted on the estate's income tax return, the marital

deduction is $3,011,111 ($6,000,000 minus $400,000 management

expenses and minus $2,588,889 federal and state estate taxes). If

the management expenses are deducted on the estate tax return rather

than on the estate's income tax return, the marital deduction

remains $3,011,111, even though the federal and state estate taxes

now total only $2,368,889. The marital deduction is not increased by

the reduction in estate taxes attributable to deducting the

management expenses on the federal estate tax return.

(4) Effective date. This paragraph (e) applies to estates of

decedents dying on or after the date these regulations are published as

final regulations in the Federal Register.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 98-33125 Filed 12-15-98; 8:45 am]

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