The U. S. Tax Court recently upheld the right of the IRS to adjust the amount of the unused estate tax exemption left by the predeceased spouse, when computing the federal estate tax owed by the estate of the surviving spouse

This is one of the first reported decisions to discuss the issues created by the “portability” of the federal estate tax exemption between spouses, which first became part of the law effective beginning in 2011. Under that law, if the first spouse to die of the married couple does not use all of his or her federal estate tax exemption, the unused portion can be transferred to the surviving spouse, to be added to his or her own federal gift and estate tax exemption. In order to make this transfer, the law requires the estate of the predeceased spouse to file a Federal estate tax return reporting its assets and deductions and credits, as well as the amount of unused exemption.

In this case, the estate of the predeceased spouse did file a Federal estate tax return transferring unused exemption to the surviving spouse. However, in computing how much exemption had been used, and therefore how much was left to be transferred, the estate of the predeceased spouse failed to take into account the total lifetime taxable gifts that the predeceased spouse had made. These gifts had used up a portion of the Federal gift and estate tax exemption of the predeceased spouse, leaving his estate with less exemption to transfer to the surviving spouse.

When the surviving spouse died, her estate filed a Federal estate tax return reporting her taxable estate, and applying the unused exemption of the first spouse to die. Upon audit, the IRS reviewed the return of the predeceased spouse, and caught the error in calculating the unused exemption caused by failing to reduce for the predeceased spouse’s lifetime taxable gifts. As a result of this adjustment, the predeceased spouse had less unused federal estate tax exemption to transfer to his surviving spouse. With less exemption transferred from the predeceased spouse, the estate of the surviving spouse was then forced to pay additional estate tax.

The estate of the surviving spouse protested this adjustment on several grounds. Included was the fact that the estate of the first spouse had received a “closing letter” from the IRS accepting the Federal estate tax return as filed. The surviving spouse’s estate also argued that the adjustment constituted an improper second examination of the predeceased spouse’s estate tax return, and that the IRS was estopped from taking action regarding the predeceased spouse’s estate. Finally, the surviving spouse’s estate argued that the IRS could not adjust the value of gifts made before 2010, the year in which the portability election was enacted.

All these arguments were unsuccessful. Section 2010 of the Internal Revenue Code gives the IRS the power to examine the return filed by the estate of the predeceased spouse to determine the unused exemption amount. The IRS regulations expressly give the IRS the authority to examine the return with respect to each transfer by the surviving spouse to which unused exemption of the first spouse has been applied. The Tax Court had little trouble in finding that this Code provision and regulation give the IRS authority to review the return of the predeceased spouse in order to determine whether his unused exemption had been properly calculated. Under this express statutory and regulatory authority, the IRS was not making an improper second audit of the predeceased spouse’s return, and there was no reason to find the IRS estopped. Nor did the fact that the predeceased spouse’s taxable gifts had been made before 2010 provide any defense.

This is not a surprising result under the law. It is important to file the Federal estate tax return for the first spouse in a proper manner, even though no tax is due and the sole purpose of filing the return is to transfer unused federal estate tax exemption to a surviving spouse. The case illustrates the clear ability of the IRS to review the predeceased spouse’s Federal estate tax return in connection with the audit of the surviving spouse, no matter how long after the predeceased spouse’s death. Though not a factor in this case, it highlights the need for good record keeping, as the death of a surviving spouse can be many years, if not decades, after the first spouse’s death.

This Tax Court decision was issued as a Regular opinion, so it can be cited as a legal precedent.

Estate of Sower, 149 T. C. No. 11 (9-11-17)