As part of our tax and estate planning practice in Connecticut and New York we do a lot of planning and estate administration. Part of the estate documents we and many other planners put together include terminology regarding “Portability”. In 2010, Congress introduced into the tax code with Internal Revenue Code (I.R.C.) § 2010(c)(2) the concept of portability for certain estates. Each estate has an applicable exclusion amount that it will not pay any estate tax. Federally in 2018 this amount is $11.2 million, and Connecticut is $2.6 million, but increasing over the next several years until it matches the federal exemption 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). Although the normal statute of limitations for estates is three years, 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. In the recent case of Estate of Sower v. Commissioner, 147 T.C. No. 11 (2017), the Tax Court provided some guidance on the audit of the return of the first deceased spouse.
In the recent Sower case, Mr. Sower passed away in February 2012. Before his death, Mr. Sower and his wife gave gifts of approximately $998,000 each. Those gifts were reported on properly filed gift tax returns. Mr. Sower’s executor, however, did not list Mr. Sower’s gifts on his estate tax return but rather included them on a subsidiary schedule. Mr. Sower’s estate did not owe any tax. As a result of the non-reporting of the gifts, Mr. Sower’s estate claimed a DSUE of approximately $1.2 million, which was overstated due to the failure to include the taxable gifts made. In November 2013, Mr. Sower’s estate received a standard IRS letter, accepting the return as filed.
Mrs. Sower died in August 2013. Her estate claimed the $1.2 million DSUE from Mr. Sower’s estate on the estate’s tax return. As part of an audit of Mrs. Sower’s estate tax return, the IRS examined the DSUE calculation on Mr. Sower’s return. During that examination, the IRS discovered that Mr. Sower’s gifts were not reported and were not taken into account in the calculation of Mr. Sower’s DSUE. That DSUE was therefore calculated incorrectly. Accordingly, as part of its examination of Mr. Sower’s return, the IRS reduced the DSUE from $1.2 million to approximately $300,000. As a result of that change, the inclusion of Mrs. Sower’s lifetime gifts, and other minor adjustments, Mrs. Sower’s estate tax liability increased by approximately $800,000.
The court disagreed. 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. 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 Mr. Sower’s estate. There was only an examination of the computation of the DSUE. Therefore, there was no violation of due process.
The court held that the Commissioner had acted in accord with the law in all these matters. In fact, this case is in-line with how the IRS can act in other cases when something in an earlier filed tax return effects a current return, such as net operating losses. In those instances, even though the earlier year may be closed, the IRS can examine those item that impact the current year return under Examination. If adjustments are determined to be appropriate, the examiner can adjust the carry-forward amount accordingly, though they cannot adjust or collect moneys owed from the adjustments on those closed years.