Only with an understanding of the foregoing issues can one properly proceed to analyze the estate and gift tax consequences of transfers of property interests under plans of deferred compensation.
IRC §2039(a) is the operative statute taxing annuities or other payments (other than life insurance) under a plan or contract which are receivable by a beneficiary “by reason of surviving the decedent” if the amounts were payable to the decedent during life or the decedent possessed the right to receive the payment either for his life or for any period not ascertainable without reference to death. IRC §2039 deserves a careful reading. It was designed to apply where other estate tax sections of the IRC (particularly §§2036, 2037, 2038, and 2041) would not apply.
§2039(b) limits inclusion under §2039(a) to the decedent’s proportionate contribution toward the purchase of the benefit. For this purpose a contribution by the “decedent’s employer” is considered as being made by the decedent, “if made by reason of his employment.”
IRC §2039(c)-(e), as variously designated and redesignated, formerly exempted from federal estate taxation in the participant’s estate benefits payable under a qualified plan or IRA, and also exempted from taxation in the nonparticipant spouse's estate, the spouse’s interest in the participant's qualified plan or IRA arising solely by virtue of the community property laws. Each of these exemptions were repealed over the course of the even number years from 1982-1986, subject, however to some important transition rules.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, generally repealed the unlimited exclusion applicable to participants in plans and IRAs, but retained an unwieldy estate tax exclusion for up to $100,000 in benefits. This awkward exception went the way of the old orphan’s deduction (which some of you will remember), and was repealed by The Deficit Reduction Act of 1984 (DEFRA), Pub. L. No. 98-369.[1] Finally, the exception for the community property interest of the nonparticipant spouse was repealed by TRA ’86, Pub. L. No. 99-514 on the erroneous assumption (clearly stated in various Committee Reports and even in the Blue Book) that it was no longer necessary.
Sec. 245(a) of TEFRA, Pub. L. No. 97-248, added §2039(g), which limited the application of 2039(c) and (e) to $100,000. 2039(c) previously provided an unlimited estate tax exclusion for a participant’s interest in a qualified plan: 2039(e) had a similar exclusion for IRAs. This change was made effective “for estates of decedents dying after 12/31/82, except that such amendments shall not apply to the estate of any decedent who was a participant in any plan, who was in pay status on 12/31/82, and irrevocably elected before 1/1/83.”
Sec. 525(a) of DEFRA, Pub. L. No. 98-369, repealed §2039(c),(e) and (g) and redesignated (d) as (c), effectively revoking the estate tax exclusion for IRAs and qualified plans altogether, except for the community property interest of the nonparticipant spouse, which was retained as redesignated 2039(c) (it was formerly 2039(d)).
Sec. 1852(e)(1)(A) of the 1986 Tax Reform Act, Pub. L. No. 99-514, repealed §2039(c), which used to be 2039(d), and which, at the time of its repeal read, in part:
(c) Exception of certain annuity interests created by community
property laws.
“(1) In general. In the case of an employee on whose behalf contributions or payments were made by his employer or former employer under a trust, plan, or contract to which this subsection applies, if the spouse of such employee predeceases such employee, then notwithstanding any provision of law, there shall be excluded from the gross estate of such spouse the value of any interest of such spouse in such trust, plan, or contract, to the extent such interest –
“(A) is attributable to such contributions or payments, and
“(B) arises solely by reason of such spouse's interest in community income under the community property laws of a State. . . .”
This section was thought to no longer be necessary, but alas, its demise was premature. An extended discussion of this issue is found later in this treatise, where we explore the question of whether 2039 causes the nonparticipant’s community property interest in the participant’s qualified plan or IRA to be subject to estate tax in the first place, and if so, whether a marital deduction for it is allowable.
The bottom line, the path to which is explained below, is that if (1) the decedent was both a participant in the plan and in pay status on December 31, 1984, and the decedent irrevocably elected the form of the benefit before July 18, 1984, or (2) if the decedent separated from service before January 1, 1985, and did not change the form of benefit before death, then up to $100,000 of plan benefits may be excluded from the estate tax.
Further, if (3) the decedent was both a participant in the plan and in pay status on December 31, 1982, and the decedent irrevocably elected the form of the benefit before January 1, 1983, or (4) the decedent separated from service before January 1, 1983, and did not change the form of benefit before death, there is an unlimited exclusion from estate tax.[2]
The instructions to the Form 706 clearly imply that either test (1) or (2) must be met before moving on to test (3) or (4). This is an interesting way of putting it, and may be true as a matter of logic. If test (4) is met, then test (2) would automatically be met. So the only implication is that if test (3) is relied upon, then either test (1) or test (2) must also be met. The decedent will pass test (1) if still a participant on December 31, 1984. If the decedent was not still a participant on December 31, 1984, then presumably the decedent would have separated from service before January 1, 1985, thereby passing test (2), provided the form of benefit was not changed before death, which would be the case if test (3) was relied upon since the form of benefit had to be irrevocable. All this leads me to conclude, somewhat tentatively, that passing test (3) or (4) is sufficient without further analysis.
This is not an exercise I would have gone through if the instructions to the Form 706 did not make it seem that there could be a circumstance under which one could pass test (3) or (4) and yet fail (1) or (2), thus losing the exclusion. There may be, but I haven’t found it yet.
What is the source of these four tests? See the following.
TEFRA[3] §245 repealed the former unlimited estate tax exclusion and replaced it with a $100,000 exclusion. §245(c) provided that the change would apply to estates of decedents dying after December 31, 1982. DEFRA[4] §525 amended IRC §2039 once again, this time by striking out subsections (c),(d), (e),(f), and (g) and replacing them with new subsections (b) and (c), effective for estates of decedents dying after December 31, 1984. Among other things, the change eliminated the $100,000 estate tax exclusion. More specifically, DEFRA §525(b)(3) amended TEFRA 245(c) to provide that the TEFRA change to IRC §2039 would “not apply to the estate of any decedent who was a participant in any plan who was in pay status on December 31, 1982, and irrevocably elected before January 1, 1983, the form of benefit.” (Emphasis added.)
Employing rather convoluted verbiage, TRA ‘86[5] §1852(e)(3) amended DEFRA §525(b) to do away with both the “irrevocable election” and the “in pay status” requirements if the individual separated from service before January 1, 1983 and does not change the form of benefit before death. In summary, the present rule (after the three effective date amendments) is that if the individual separated from service prior to January 1, 1983, the individual can take advantage of the pre-TEFRA estate tax exclusion rules, as long as the individual does not change the form of benefit before death.
The pre-TRA ’86 DEFRA rule still applies, if the individual was in pay status on December 31, 1982, and irrevocably elected the form of benefit before January 1, 1983. There could be instances in which although the individual was in pay status the individual had not separated from service, in which case, the old rule might apply.
The DEFRA committee reports make it clear that the beneficiary designation need not be irrevocable.[6]
The TRA ‘86 committee reports state that the new law provides that the estate tax exclusion grandfather rule “is also available for individuals who separated from service . . . [before the applicable date], elected a form of benefits to be paid in the future, and who was [sic] not in pay status as of the applicable dates.”[7] It is a shame that words like “pay status” are used without benefit of definition.[8] In any event, the statute requires that, pay status or not, the form of benefit cannot be changed. This is not necessarily the same as “electing a form of benefits to be paid in the future.” What if the participant separated from service, but made no election? See Treas. Reg. §20.2039-1T (T.D. 8073, 1/29/86).
DEFRA §525(b) provided that the former $100,000 estate tax exclusion would continue to apply to plan participants who were in pay status on December 31, 1984 and who had made an irrevocable election by July 17, 1984 as to the form of such benefits. TRA ‘86[9] §1852(e)(3) amended DEFRA §525(b) to do away with both the “irrevocable election” and the “in pay status” requirements if the individual separated from service before January 1, 1985 and does not change the form of benefit before death.
Does a “plan” include an IRA? The DEFRA Committee Reports imply that the exception from estate tax can apply to an IRA.[10] Although an IRA is not generally thought of as a “plan,” Treas. Reg. §20.2039-1T (T.D. 8073, 1/29/86) makes it clear that an IRA can qualify for the exclusion under certain circumstances.
All four of the exceptions require either (1) that an irrevocable election have been in place or (2) that there be a separation from service. Applied to an IRA, that poses problems: Regarding the first condition, it would be a very unusual for an IRA election to have been irrevocable. As to the requirement of a separation from service, this simply has no context in which to operate, unless, perhaps the IRA is a SEP.
On the face of it, the TRA ‘86 changes ought to be applicable to IRAs, if the DEFRA changes were applicable to IRAs, and by publishing Treas. Reg. §20.2039-1T (T.D. 8073, 1/29/86) it would appear that the Service has admitted the latter. However, the TRA ‘86 Blue Book states that the TRA ‘86 change does not apply to IRAs.[11] The only thing in the amendment that could justify this distinction between the original DEFRA rule and the TRA ‘86 amendment to it, is the TRA ‘86 separation from service requirement, which requirement does seem somewhat out of place in the case of an IRA.
The pre-TEFRA IRC 2039 rules are applicable in any event. IRC §2039(e) required that in order for an IRA to be exempt from estate tax the IRA beneficiary must receive the benefit as an “annuity.” For this purpose, an annuity is defined as “an annuity contract or other arrangement providing for a series of substantially equal periodic payments to be made to a beneficiary (other than an executor) for his life or over a period extending for at least 36 months after the date of the decedent’s death.[12]
Under the old rules, if a lump sum distribution[13] was paid or payable with respect to a decedent under a plan described in Treas. Reg. §20.2039-2(b)(1) or (2), the unlimited estate tax exclusion was not available unless the recipient of the distribution made the §402(a)/403(a) taxation election described in Treas. Reg. §20.2039-3(d).[14] The election to forego special averaging in favor of the exclusion is made on the Form 709 or in a request for refund.[15]
The Treasury has published regulations (mentioned above) in the form of three questions and answers concerning the effective date exceptions to the TEFRA limitation of the estate tax exclusion to $100,000 and the DEFRA elimination of the exclusion.[16] The temporary regulations predate the TRA ‘86 changes. Since they are just about the only authority we have interpreting the DEFRA exclusions, the regulations are worth setting forth in detail.
Section 20.2039-1T. Limitations and repeal of estate tax
exclusion for qualified plans and individual retirement plans (IRAs)
(Temporary).
Q-1: Are there any exceptions to the general effective dates of the $100,000 limitation and the repeal of the estate tax exclusion for the value of interests under qualified plans and IRAs described in section 2039(c) and (e)?
A-1: (a) Yes. Section 245 of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) limited the estate tax exclusion to $100,000 for estates of decedents dying after December 31, 1982. Section 525 of the Tax Reform Act of 1984 (TRA of 1984) repealed the exclusion for estates of decedents dying after December 31, 1984.
(b) Section 525(b)(3) of the TRA of 1984 amended section 245 of TEFRA to provide that the $100,000 limitation on the exclusion for the value of a decedent’s interest in a plan or IRA will not apply to the estate of any decedent dying after December 31, 1982,