Separate Share Rules Applicable to Estates

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-114841-98]

RIN 1545-AW57

Separate Share Rules Applicable to Estates

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 that provide that

substantively separate and independent shares of different

beneficiaries are to be treated as separate estates for purposes of

computing the distributable net income. These proposed regulations also

provide that a surviving spouse's statutory elective share of a

decedent's estate is a separate share. Further, a revocable trust that

elects to be treated as part of a decedent's estate is a separate

share. Section 1307 of the Taxpayer Relief Act of 1997 amended section

663 of the Internal Revenue Code by extending the separate share rules

to estates. These proposed regulations affect estates of decedents.

This document also provides notice of a public hearing on these

proposed regulations.

DATES: Written and electronic comments must be received by April 6,

1999. Outlines of topics to be discussed at the public hearing

scheduled for April 22, 1999, at 10 a.m. must be received by April 1,

1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-114841-98), 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-

114841-98), 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 regulations, Laura

Howell, (202) 622-3060; concerning submissions of comments, the

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

hearing, Michael L. Slaughter, Jr., (202) 622-7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

Prior to amendment by Section 1307 of the Taxpayer Relief Act of

1997, Pub. L. 105-34, August 5, 1997, (TRA 1997), section 663(c) of the

Internal Revenue Code (Code) provided that, for the purpose of

determining the amount of distributable net income in the application

of sections 661 and 662, in the case of a single trust having more than

one beneficiary, substantially separate and independent shares of

different beneficiaries (or classes of beneficiaries) of the trust

shall be treated as separate trusts. The application of the separate

share rule is mandatory where separate shares exist. Section 1.663(c)-

1(d) and H.R. Conf. Rep. No. 2014, 105th Cong. 1st Sess. 712-13 and fn.

18.

Section 1307 of TRA 1997 amended section 663(c) of the Code by

extending the separate share rule to estates. Prior to this amendment,

a distribution to an estate beneficiary in the ordinary course of

administration often resulted in the beneficiary being taxed on a

disproportionate share of the estate's income. The extension of the

separate share rule to estates promotes fairness by more rationally

allocating the income of the estate among the estate and its

beneficiaries thereby reducing the distortion that may occur when a

disproportionate distribution of estate assets is made to one or more

estate beneficiaries in a year when an estate has distributable net

income. Under the separate share rule, a beneficiary is taxed only on

the amount of income that belongs to that beneficiary's separate share.

In addition, section 1305 of TRA 1997 added section 645 to the Code

(originally enacted as section 646 and redesignated as section 645 by

the Internal Revenue Service Restructuring and Reform Act of 1998).

Under section 645, both the executor (if any) of an estate and the

trustee of a qualified revocable trust may elect to treat the revocable

trust as part of the decedent's probate estate for income tax purposes.

The legislative history for section 1305 provides that the separate

share rule applicable to estates will apply when a qualified revocable

trust elects to be treated as part of the decedent's estate.

Explanation of Provisions

The proposed regulations conform the current regulations to the

statutory changes. In addition, the proposed regulations address two

specific matters involving separate share treatment of interests in

estates: the treatment of the spousal elective share and the treatment

of an electing revocable trust under section 645 of the Code.

General Separate Share Rule

If an estate has multiple beneficiaries, substantially separate and

independent shares of different beneficiaries (or classes of

beneficiaries) are to be treated

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as separate estates only for purposes of computing distributable net

income. There are separate shares in an estate when the governing

instrument of the estate and applicable local law create separate

economic interests in one beneficiary or class of beneficiaries such

that the economic interests of those beneficiaries (e.g., rights to

income or gains from specified items of property) are not affected by

the economic interests accruing to another separate beneficiary or

class of beneficiaries. Thus, there are separate shares in an estate

when a beneficiary or class of beneficiaries has an interest in a

decedent's estate (whether corpus or income, or both) that no other

beneficiary or class of beneficiaries has in the decedent's estate. The

application of the separate share rule to estates is mandatory where

separate shares exist. The separate share rule requires that the

estate's income and deductions be allocated among the separate shares

as if they were separate estates. The section 661 deduction to the

estate and the section 662 inclusion in the gross income of the

beneficiary are limited by the distributable net income allocable to

each separate share.

These proposed regulations do not change the rules involving

specific gifts and bequests described in section 663(a).

Surviving Spouse's Elective Share

Most non-community property states have some form of elective share

statute which replaces common law dower and curtesy (the common law

protection for surviving spouses). Generally, an elective share statute

gives the surviving spouse the right to claim a share of the deceased

spouse's estate if the surviving spouse is disinherited or dissatisfied

with what the spouse would have received under the will or otherwise.

In most states the elective share consists of a fraction, ranging from

one-fourth to one-half of the decedent's estate. Elective share

statutes vary as to when the share vests and whether the share includes

a portion of the estate income, as well as whether the share

participates in the appreciation or depreciation of the estate's

assets.

Rev. Rul. 64-101 (1964-1 C.B. 77) addresses the Florida statutory

dower interest which, at the time of the revenue ruling, entitled the

widow to the dower interest and mesne profits thereon. The ruling holds

that the value of assets transferred to the widow as dower is not a

distribution to a beneficiary subject to sections 661(a) and 662(a) of

the Code. Instead, the transfer of assets is governed by section 102.

Rev. Rul. 71-167 (1971-1 C.B. 163) modifies Rev. Rul. 64-101 by

holding that the amount distributed to the widow representing mesne

profits is subject to sections 661(a) and 662(a) of the Code.

Therefore, an amount corresponding to the allowable deduction to the

estate under section 661(a) is includible in the gross income of the

widow under section 662(a).

Recently, two cases, Deutsch v. Commissioner, TCM 1997-470, and

Brigham v. United States, 983 F. Supp. 46, (D. Mass. 1997), have

addressed how to treat payments to the surviving spouse in satisfaction

of the spouse's elective share amount. In Deutsch, the surviving spouse

elected to take against the decedent's will as provided by the Florida

elective share statute. Under the statute, the surviving spouse was

entitled to 30 percent of the net estate based upon date of death

values, but was not entitled to any income of the estate, and did not

participate in appreciation or depreciation of the estate assets. The

Tax Court, noting Rev. Rul. 64-101, held that payments to the surviving

spouse in satisfaction of her elective share amount were not subject to

sections 661(a) and 662(a). Rather, the payments were governed by

section 102.

In Brigham, the surviving spouse elected to take against the

decedent's will as provided by the New Hampshire elective share

statute. Under the statute, the surviving spouse was entitled to one-

third of the personalty and one-third of the real estate. The court

held that the payments made to the surviving spouse in satisfaction of

her elective share amount were subject to sections 661(a) and 662(a).

Thus, the court held that all of the estate's distributable net income

was taxable to the surviving spouse because she was the only

beneficiary to receive a distribution for the year in question and her

distribution exceeded the amount of the estate's distributable net

income.

In light of the uncertainty concerning the proper treatment of

payments in satisfaction of a surviving spouse's elective share, and

also given that Rev. Ruls. 64-101 and 71-167 are outdated because dower

has been replaced by elective share statutes in most states, the

Internal Revenue Service and Treasury have concluded that regulatory

guidance is needed to provide uniform treatment.

These proposed regulations provide that the surviving spouse's

elective share constitutes a separate share of the estate for the sole

purpose of determining the amount of distributable net income in

application of sections 661(a) and 662(a). Therefore, only the income

that is (1) allocable to the surviving spouse's separate share for a

taxable year, and (2) distributed to the surviving spouse in

satisfaction of the elective share will be treated as a distribution

subject to sections 661(a) and 662(a). This approach results in the

surviving spouse being taxed on the estate's income earned during

administration only to the extent of the surviving spouse's right to

share in the estate's income under state law. Comments are requested on

whether there are situations in which an elective share or dower

interest would not be a separate share under the separate economic

interest test set forth in the proposed regulations.

Electing Revocable Trust To Be a Part of Estate

These proposed regulations provide that a qualified revocable trust

that elects to be treated as part of the decedent's estate constitutes

a separate share for the sole purpose of determining the amount of

distributable net income in the application of sections 661 and 662. A

separate proposed regulation project will provide further guidance

concerning qualified revocable trusts that are treated as part of an

estate.

Proposed Effective Date

These regulations apply to estates of decedents dying after the

date that the Treasury decision adopting these rules as final

regulations is published in the Federal Register.

Effect on Other Documents

When these regulations are finalized, Rev. Rul. 64-101 (1964-1 C.B.

77) and Rev. Rul. 71-167 (1971-1 C.B. 163) will be obsolete.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12886. 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 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.

[[Page 792]]

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any electronic and written comments (a

signed original and eight (8) copies) that are submitted timely to the

IRS. The IRS and Treasury specifically request comments on the clarity

of the proposed regulation and how it may be made easier to understand.

All comments will be available for public inspection and copying. We

especially request comments concerning the treatment of pecuniary

bequests (including formula pecuniary bequests) as separate shares.

A public hearing has been scheduled for April 22, 1999, beginning

at 10 a.m. The hearing will be held in room 2615, 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 or

electronic comments by April 6, 1999, and submit an outline of topics

to be discussed and the time to be devoted to each topic (a signed

original and eight (8) copies) by April 1, 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 regulations is Laura Howell of the

Office of 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 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

entries in numerical order to read as follows:

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

Section 1.663(c)-1 also issued under 26 U.S.C. 663(c).

Section 1.663(c)-2 also issued under 26 U.S.C. 663(c).

Section 1.663(c)-3 also issued under 26 U.S.C. 663(c).

Section 1.663(c)-4 also issued under 26 U.S.C. 663(c).

Section 1.663(c)-5 also issued under 26 U.S.C. 663(c).

Section 1.663(c)-6 also issued under 26 U.S.C. 663(c). * * *

Par. 2. Section 1.663(c)-1 is amended as follows:

1. The section heading is revised.

2. The first sentence of paragraph (a) is amended by removing the

language ``trust'' and adding the language ``trust (or estate)'' in its

place and removing the language ``trusts'' and adding the language

``trusts (or estates)'' in its place. The second sentence of paragraph

(a) is amended by removing the language ``trusts'' and adding the

language ``trusts (or estates)'' in its place.

3. Paragraph (b)(2) is removed.

4. Paragraphs (b)(3) and (b)(4) are redesignated as paragraphs

(b)(2) and (b)(3).

5. Paragraph (b) introductory text, is amended by removing the

language ``trusts'' and adding the language ``trusts (or estates)''

each place it appears.

6. Paragraph (c) and the last sentence of paragraph (d) are amended

by removing the language ``trust'' and adding the language ``trust (or

estate)'' in its place.

The revision reads as follows:

Sec. 1.663(c)-1 Separate shares treated as separate trusts or as

separate estates; in general.

* * * * *

Par. 3. Section 1.663(c)-2 is revised to read as follows:

Sec. 1.663(c)-2 Computation of distributable net income.

The amount of distributable net income for any share under section

663(c) is computed for each share as if each share constituted a

separate trust or estate. Accordingly, any deduction or any loss which

is applicable solely to one separate share of the trust or estate is

not available to any other share of the same trust or estate.

Par. 4. Section 1.663(c)-3 is amended by revising the section

heading and removing paragraph (f) to read as follows:

Sec. 1.663(c)-3 Applicability of separate share rule to trusts.

* * * * *

Sec. 1.663(c)-4 [Redesignated as Sec. 1.663(c)-5]

Par. 5. Section 1.663(c)-4 is redesignated as Sec. 1.663(c)-5 and a

new Sec. 1.663(c)-4 is added to read as follows:

Sec. 1.663(c)-4 Applicability of separate share rule to estates.

(a) General rule. The applicability of the separate share rule to

estates provided by section 663(c) will generally depend upon whether

the governing instrument and applicable local law create separate

economic interests in one beneficiary or class of beneficiaries of the

decedent's estate such that the economic interests of the beneficiary

or class of beneficiaries are not affected by economic interests

accruing to another beneficiary or class of beneficiaries. A separate

share should be allocated only the share of the estate's income and

deductions that the beneficiary (or beneficiaries) of such separate

share is (or are) entitled to (if any) under the terms of the governing

instrument or local law. The separate share rule does not affect rules

under section 663(a) concerning specific gifts and bequests.

(b) Examples of separate shares. Separate shares include--

(1) A surviving spouse's elective share;

(2) A revocable trust that elects to be part of the decedent's

estate under section 645;

(3) The residuary estate, or some portion of the residuary estate,

if the requirements of paragraph (a) of this section are met; and

(4) A gift or bequest of a specific sum of money or of specific

property that is paid or credited in more than three installments, if

the requirements of paragraph (a) of this section are met.

(c) Shares with multiple beneficiaries and beneficiaries of

multiple shares. A share may be considered as separate even though more

than one beneficiary has an interest in it. For example, two

beneficiaries may have equal, disproportionate, or indeterminate

interests in one share which is economically separate and independent

from another share in which one or more beneficiaries have an interest.

Moreover, the same person may be a beneficiary of more than one

separate share.

Par. 6. Newly designated Sec. 1.663(c)-5 is amended by:

[[Page 793]]

1. Revising the section heading and introductory text.

2. Redesignating the ``Example.'' as ``Example 1.'' and

redesignating paragraphs (a), (b), (c), (d), and (e) in newly

designated Example 1 as paragraphs (i), (ii), (iii), (iv), and (v).

3. Adding Example 2, Example 3, and Example 4.

The revisions and addition read as follows:

Sec. 1.663(c)-5

Examples.

Section 663(c) may be illustrated by the following examples:

Example 1. * * *

Example 2. (i) Facts. (A) Testator died domiciled in State X on

January 30, 1999, leaving an estate of $40,000,000 after debts,

expenses, and estate taxes, and survived by a spouse and three adult

children from a previous marriage. Testator's will directed the

executrix to pay the surviving spouse $1,000,000 in cash and divide

the residue, after payment of debts, expenses, and estate taxes,

equally among Testator's three children.

(B) The surviving spouse filed an election under State X's

elective share statute. The court determined that the surviving

spouse's election was valid and ordered the executrix to pay the

elective share. Under State X's elective share statute, a surviving

spouse is entitled to one-fourth of a decedent's estate after debts,

expenses, and estate taxes if the decedent had children. Further,

the surviving spouse is entitled to a proportional amount of the

estate net income and participates proportionally in appreciation or

depreciation of the estate's assets.

(C) The executrix elected the calendar year for the estate. On

June 30, 1999, the executrix distributed $5,000,000 to the surviving

spouse in partial satisfaction of the elective share. During the

1999 taxable year, the estate received dividend income of $2,000,000

and paid expenses of $50,000. For the 1999 taxable year, the value

of the estate neither appreciated nor depreciated. The executrix

made no other distributions during the 1999 taxable year.

(ii) Holding. Separate share treatment applies to each of the

three residuary bequests, and to the surviving spouse's elective

share.

(iii) Application. (A) After determining the income and expenses

for the estate, the executrix allocated a portion of the income and

expenses to each separate share based upon each share's percentage

of the estate. Thus, while the surviving spouse's elective share

initially constituted 25% of the estate, after the partial

distribution of $5,000,000 made on June 30, 1999, the elective share

constituted a smaller percentage of the estate. Accordingly, the

percentage of the estate's income and expenses allocated to the

elective share after June 30, 1999, was correspondingly reduced in

accordance with the executrix's determination of the proper

allocation of income and expenses to the elective share.

(B) For the 1999 taxable year, the estate is treated as having

distributed to the surviving spouse the distributable net income

that was allocated to the elective share. In accordance with section

662, the surviving spouse must include in gross income for the 1999

taxable year an amount equal to the distributable net income

allocated to the surviving spouse's separate share and distributed

to the surviving spouse for the 1999 taxable year. The estate will,

accordingly, be allowed a deduction under section 661 for the amount

of distributable net income allocated to the elective share and

distributed to the surviving spouse.

Example 3. (i) Facts. (A) Assume the same facts as in Example 2

except that Testator died domiciled in State Y leaving an estate of

$60,000,000 after debts, expenses, and estate taxes. Under State Y's

elective share statute, the surviving spouse is entitled to the date

of death value of one-third of the decedent's estate after debts,

expenses, and taxes. The statute also provides that the surviving

spouse is not entitled to any of the estate's income and does not

participate in appreciation or depreciation of the estate's assets.

Further, under the statute, the surviving spouse is entitled to

interest on the elective share from the date of the court order

directing the executrix to make payments.

(B) The executrix elected the calendar year for the estate.

During the 1999 taxable year, the estate received dividend income of

$3,000,000, and paid administration expenses of $60,000 and paid the

surviving spouse $1,000,000 of interest payments on the elective

share. Also, during the 1999 taxable year, the executrix distributed

$5,000,000 to the surviving spouse in partial satisfaction of the

elective share. The executrix made no other distributions during the

1999 taxable year.

(ii) Holding. Separate share treatment applies to each of the

three residuary bequests and to the surviving spouse's elective

share.

(iii) Application. The distributable net income of each child's

residuary bequest is $980,000 (a 33.33% share of estate income less

a 33.33% share of estate expenses). Because the surviving spouse was

not entitled to any estate income under state law, no income is

allocated to the spouse's separate share. The distribution in

satisfaction of the spouse's elective share does not consist of any

distributable net income and is not included in the spouse's gross

income under section 662. The $1,000,000 of interest payment to the

surviving spouse must be included in gross income of the spouse

under section 61. Therefore, the estate is treated as having

distributed to the surviving spouse $5,000,000 of amounts other than

1999 estate income. Accordingly, the estate is not allowed a

deduction under section 661 for the distribution made to the

surviving spouse. The taxable income of the estate for the 1999

taxable year is $2,939,400 ($3,000,000 (dividend income) minus

$60,000 (expenses) and $600 (personal exemption)). The $1,000,000

interest payment is a nondeductible personal interest expense

described in section 163(h).

Example 4. (i) Facts. (A) Testator died domiciled in State Z on

February 14, 1999, survived by a spouse and two children. Testator's

will contains a nonproportional funding fractional formula marital

bequest for the surviving spouse with a residuary credit shelter

trust for the lifetime benefit of the surviving spouse, and

remainder to the two children on the surviving spouse's death. The

date of death value of the estate is $1,650,000.

(B) The executrix elected the calendar year for the estate.

Under the fractional formula, the marital bequest constitutes 60% of

the estate and the credit shelter trust constitutes 40% of the

estate. Accordingly, the executrix claims a marital deduction of

$990,000 on the estate tax return for the amount passing to the

spouse under the fractional formula. On December 31, 1999, the

executrix made a partial proportionate distribution of $1,000,000,

$600,000 to the surviving spouse outright and $400,000 to the credit

shelter trust. As of December 31, 1999, prior to the distribution,

the value of Testator's estate had appreciated to $2,000,000.

(C) During the 1999 taxable year, the estate made no other

distributions, received dividend income of $20,000, and paid

expenses of $8,000.

(ii) Holding. Separate share treatment applies to the fractional

formula marital bequest and the credit shelter trust.

(iii) Application. (A) Because Testator provided for a

fractional formula marital bequest in the will, the income and any

appreciation in the value of the estate assets is proportionately

allocated between the marital bequest share and the credit shelter

trust share. Therefore, the distributable net income must be

allocated 60% for the marital separate share and 40% for the credit

shelter separate share.

(B) The distributable net income allocable to the marital share

is $7,200 (60% of estate income less 60% of estate expenses).

Correspondingly, the distributable net income allocable to the

credit shelter share is $4,800 (40% of estate income less 40% of

estate expenses). Because the $600,000 amount distributed in partial

satisfaction of the marital bequest exceeds the distributable net

income of $7,200 allocated to the marital share, the estate is

treated as having distributed to the surviving spouse $7,200 of 1999

distributable net income and $592,800 of other amounts. Similarly,

because the $400,000 distributed in partial satisfaction of the

amount payable to the credit shelter trust exceeds the distributable

net income of $4,800 allocated to the credit shelter trust share,

the estate is treated as having distributed to the credit shelter

trust $4,800 of 1999 distributable net income and $395,200 of other

amounts. Accordingly, the estate is allowed a deduction of $12,000

under section 661 for the 1999 taxable year. The taxable income of

the estate is $0, computed as follows:

Dividends.......................................... $20,000

Deductions:

Distribution to surviving spouse share........... $7,200

Distribution to credit shelter trust share....... 4,800

Expenses......................................... 8,000

[[Page 794]]

Personal exemption............................... 600

20,600

----------

(600)

(C) In accordance with section 662, the surviving spouse must

include in gross income for the 1999 taxable year an amount equal to

the distributable net income of the marital bequest share ($7,200)

that was distributed to the surviving spouse. The credit shelter

trust must include in gross income for the 1999 taxable year an

amount equal to the distributable net income of the credit shelter

trust share ($4,800) that was distributed to the credit shelter

trust.

Par. 7. Section 1.663(c)-6 is added to read as follows:

Sec. 1.663(c)-6 Effective date.

Sections 1.663(c)-1 through 1.663(c)-5 concerning the application

of the separate share rules to estates apply to estates of decedents

dying after the final regulations are published in the Federal

Register.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-176 Filed 1-5-99; 8:45 am]

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