Internal Revenue Code Section 645 was enacted in 1997 because of the increasing use of revocable trusts as will substitutes to avoid probate in many states. While in some states like New Jersey and Texas, probate isn’t terribly expensive or difficult, an increasing number of individuals are designing their estate plans with revocable trusts for non-probate purposes. During the grantor’s life, they may be used for streamlined asset management and a less expensive alternative to guardianships in the event of incapacity. After death, trusts provide increased privacy as well as ease of administration when it comes to out-of-state property and possible inheritance tax freezes that can delay the availability of cash to administer an estate. By making an IRC Section 645 election, clients can treat certain trusts as part of their estate. Here are some of the benefits of doing that.
Statutory Requirements
Section 645 sets forth the statutory requirements for making the election to treat certain trusts as part of an estate. The Internal Revenue Service issued final regulations on Dec. 4, 2002.
Section 645 provides in pertinent part that if both the executor (if any) of an estate and trustees of a qualified revocable trust elect the treatment provided in Section 645, such trust shall be treated and taxed as part of such estate (and not a separate trust) for all taxable years of the estate ending after the date of the decedent’s death and before the applicable date.
To use the 645 election, the client must have a qualified revocable trust under Treasury Regulations Section 1.645-1(b).
Section 645 Tax Implications
A revocable living trust becomes irrevocable at the death of the grantor and causes the trust to require separate income tax reporting for any income attributable to it. For example, if a decedent died on Sept. 15, the following income tax returns need to be prepared for the year of the decedent’s death are:
- Final Form 1040 for the decedent’s last year alive (income from Jan. 1 – Sept. 15)
- Form 1041 for the estate of the decedent (income from Sept. 15 – Dec. 31)
- Form 1041 for the (now irrevocable) revocable trust (income from Sept 15 – Dec. 31)
A Section 645 election can be used to combine the trust and estate into one entity for tax purposes, allowing only one Form 1041 to be filed. If the election is made, trust income and deductible expenses will be reported by the estate on the estate’s income tax return, and the trust will be treated as part of the estate, even though the trust, rather than the estate, continues to hold the assets.
Six Additional Benefits
In addition to streamlining the administrative burden of preparing and filing two tax returns, there are a number of other potential advantages to using Section 645 elections to treat the trust as part of the estate for tax purposes:
- Availability of a fiscal tax year under IRC Section 644. Without the Section 645 election, trusts are required to adopt a calendar tax year. Estates, on the other hand, may select a fiscal year. This allows deferral of the trust’s income tax burden from one reporting year to another. For example, if a decedent dies on Dec. 1, 2019, without a Section 645 election, the decedent’s trust would file an income tax return for the year ending Dec. 31, 2019 (the decedent’s year of death) and pay the income tax due by April 15, 2020. With a Section 645 election, for tax purposes, the trust and estate are combined into one entity. The executor may elect a fiscal year ending Nov. 30, 2020. The same trust income tax would now be deferred until March 15, 2021;
- Limited tax obligations. There’s no estimated tax obligations for two years after the decedent’s death;
- Entitlement to c charitable deduction. The electing trust would be entitled to a charitable deduction for any amounts permanently set aside for charity without the requirement that the amount be actually paid under Section 642(c)(2);
- Eligible to hold S corporation stock. The trust would be eligible to hold S corporate stock for an extended period of time;
- Increased exemption amount. Trusts have an income tax exemption of $100 (simple trust) or $300 (complex trust), whereas estates have an exemption of $600. Because a Section 645 election combines the trust with the estate for tax purposes, the trust combined with the estate would have the increased exemption of $600; and
- . Extended payment deadlines. A Section 645 election allows the trust to have extended payment deadlines. Though they still must timely file, estates don’t need to make estimated income tax payments until the tax year ending two years following the decedent’s death. Estates also aren’t subject to underpayment penalties during this time. This isn’t the case for trusts.