A recent case out of the tax court ruled that IRS had the power to examine the estate tax return of a predeceased spouse for the purpose of lowering the DSUE (deceased spousal unused exclusion) claimed by the second-to-die spouse’s estate. The tax court opinion stands for the proposition that there is no limit to the number of years the IRS can go back to review (and correct) a DSUE reported by the estate of the spouse who died first. This lends a bit of uncertainty to the benefit of portability.
The facts were simple. The husband died in 2012 and his estate filed a tax return showing no estate tax liability. The husband's estate reported a DSUE of $1,256,033 and elected portability to allow his surviving spouse to use the DSUE at her death. The IRS issued a Letter 627 (Estate Tax Closing Document) to the husband’s estate, showing no tax liability for the estate and stating that the return had been accepted as filed.
The wife died in 2013. Her estate applied her husband’s DSUE of $1,256,033 and paid $755,460 in estate tax liability (plus some interest). Neither the husband’s nor the wife’s estate tax return properly reported the value of taxable gifts the couple had made during their lifetimes. Each had gifted nearly $1 million and filed proper Form 709s at the time of those gifts.
In 2015, the IRS examined the wife’s estate tax return and discovered the missing gift amount. It then reexamined the husband’s estate tax return (more than three years after it was filed) and reissued a new estate tax closing document adjusting the amount of the husband’s lifetime gifts, but not assessing any liability against the estate. As a result of this second examination, however, the IRS decreased the husband’s DSUE from $1,256,033 to $282,690. The examiners then adjusted the wife’s estate tax return to reflect the decreased DSUE, as well as the amount of the wife’s lifetime gifts. As a result of the adjustments, IRS assessed a $788,165 estate tax deficiency against the wife’s estate.
The wife’s estate made a number of arguments against the assessment, but the tax court rejected them all.
The court ruled that the IRS has the power under IRC § 7602 to examine all relevant “books, papers, records, or…data” to determine the correctness of an estate tax return. Here, that included the husband’s estate tax return. The court also ruled that IRC § 2010(c)(5)(B) allowed IRS to adjust the amount of the DSUE, even after the limitations period passed for examining that return. The IRS did not adjust the tax liability of the husband's estate. The court also found that the Estate Tax Closing Document was not a “closing agreement” under IRC § 7121 that would prevent IRS from reexamining the husband’s return. Nor were there facts to support a claim of estoppel.
The court also ruled that the reexamination of the husband’s estate tax return was not an impermissible “second examination” prohibited by IRC § 7605(b) because IRS obtained no new information from the estate. Even so, the IRS would not have been in violation of § 7605(b) as to the wife’s estate. Only the examined party (the husband's estate) was protected from an improper second examination.
Finally, the tax court rejected the wife’s estate’s argument that IRC § 2010(c)(5)(B) was “unconstitutional for want of due process of law in that there is no statute of limitations.” The court found no due process violation because no tax was being imposed more than three years outside the time the tax was due. The court also found that Congress clearly intended that IRS could examine the return of a predeceased spouse and adjust the DSUE under § 2010(c)(5)(B) without running afoul of the statute of limitations in IRC § 6501. The court noted that the regulations also make this point:
The IRS’s authority to examine returns of a deceased spouse applies with respect to each transfer by the surviving spouse to which a DSUE amount is or has been applied. Upon examination, the IRS may adjust or eliminate the DSUE amount reported on such a return [of a deceased spouse]; however, the IRS may assess additional tax on that return only if that tax is assessed within the period of limitations on assessment under section 6501 applicable to the tax shown on that return. Treas. Reg. § 20.2010-3(d); Temp. Regs. § 20.2010-3T.
And so the wife's estate was liable.
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