For Tax Professionals  
REG-114663-97 December 16, 1998

Marital Deduction; Valuation of
Interest Passing to Surviving Spouse

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 20 [REG-114663-97] RIN 1545-
AV45

TITLE: Marital Deduction; Valuation of Interest Passing to Surviving
Spouse

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to the
effect of certain administration expenses on the valuation of
property which qualifies for the estate tax marital or charitable
deduction. The proposed regulations define estate transmission
expenses and estate management expenses and provide that estate
transmission expenses, but not estate management expenses, reduce
the value of property for marital and charitable deduction purposes.
This document also provides notice of a public hearing on these
proposed regulations.

DATES: Written comments must be received by February 16, 1999.

Outlines of topics to be discussed at the public hearing scheduled
for April 21, 1999, at 10 a.m., must be received by March 31, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-114663-97), room
5226, Internal Revenue Service, POB 7604, Ben Franklin.2 Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to:

CC:DOM:CORP:R (REG-114663-97), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue, NW., Washington, DC.

Alternatively, taxpayers may submit comments electronically via the
Internet by selecting the "Tax Regs" option on the IRS Home Page, or
by submitting comments directly to the IRS Internet site at
http://www.irs.ustreas.gov/prod/tax_regs/comments.html. The public
hearing will be held in Room 2615, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Deborah Ryan (202) 622-3090; concerning submissions of
comments, the hearing, and/or to be placed on the building access
list to attend the hearing, LaNita Van Dyke (202) 622-7190 (not
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On March 18, 1997, the Supreme Court of the United States issued its
decision in Commissioner v. Estate of Hubert, 520 U.S.
93 (1997) (1997-32 I.R.B. 8), in which it considered the proper
interpretation of 20.2056(b)-4(a) of the Estate Tax Regulations.

On November 24, 1997, the IRS issued Notice 97-63 (1997-47 I.R.B.
6), requesting comments on alternatives for amending 20.2056(b)-4(
a) in light of the Supreme Court's Estate of Hubert decision.

Section 2056(b)(4) provides that, in determining the value of an
interest in property which passes from the decedent to the surviving
spouse for purposes of the marital deduction, account must be taken
of any encumbrance on the property or any obligation imposed on the
surviving spouse by the decedent with respect to the property.
Section 20.2056(b)-4(a) of the Estate Tax Regulations amplifies this
rule by providing that account must be taken of the effect of any
material limitations on the surviving spouse's right to the income
from the property. The regulation provides, for example, that there
may be a material limitation on the surviving spouse's right to the
income from marital trust property where the income is used to pay
administration expenses during the period between the date of the
decedent's death and the date of distribution of the assets to the
trustee.

The facts in Estate of Hubert are similar to a common fact pattern
wherein the decedent's will provides for a residuary bequest to a
marital trust which qualifies for the marital deduction and also
provides that estate administration expenses are to be paid from the
residuary estate. Further, the will (or state law) permits the
executor to use the income generated by the residuary estate
(otherwise payable to the marital trust) to pay administration
expenses, and the executor does so. The issue before the Supreme
Court in Estate of Hubert was whether the executor's use of the
income to pay estate administration expenses was a material
limitation on the surviving spouse's right to the income which would
reduce the marital deduction under 20.2056(b)-4(a).

The issue in Estate of Hubert also involved the estate tax
charitable deduction, and the proposed regulations relate to the
valuation of property for both marital and charitable deduction
purposes. However, for simplicity and clarity, this discussion
focuses on the provisions of the estate tax marital deduction.

In Estate of Hubert, the Commissioner argued that the payment of
administration expenses from income is, per se, a material
limitation on the surviving spouse's right to income for purposes of
20.2056(b)-4(a), and, therefore, the value of the marital bequest
should be reduced dollar for dollar by the amount of income used to
pay administration expenses. The Court agreed that the value of the
marital bequest should be reduced if the use of income to pay
administration expenses is a material limitation on the spouse's
right to income. The Court found, however, that the regulation does
not define material limitation and that the Commissioner had not
argued that the use of income in this case was a material
limitation. Thus, the Court held for the taxpayer.

In Notice 97-63 (November 24, 1997), the IRS requested comments on
possible approaches for proposed regulations in light of the Estate
of Hubert decision. Notice 97-63 suggested three alternative
approaches for determining when the use of income to pay
administration expenses constitutes a material limitation on the
surviving spouse's right to income. One approach distinguished
between administration expenses that are properly charged to
principal and those that are properly charged to income and provided
that there is a material limitation on the surviving spouse's right
to income if income is used to pay an estate administration expense
that is properly charged to principal. A second approach provided a
de minimis safe harbor amount of income that may be used to pay
administration expenses without constituting a material limitation
on the surviving's spouse's right to income. A third approach
provided that any charge to income for the payment of administration
expenses constitutes a material limitation on the spouse's right to
income.

Notice 97-63 also asked for comments on whether the test for
materiality should be based on a comparison of the relative amounts
of the income and the expenses charged to the income; whether
materiality should be based on projections as of the date of death
rather than on the facts that develop afterwards; and whether
present value principles should be applied.

In response to Notice 97-63, several commentators suggested that
local law should be determinative of whether an expense is a proper
charge to income or principal. If the testamentary document directs
the executor to charge expenses to income, and the charge is allowed
under applicable local law, then the charge to income should not be
treated as a material limitation on the spouse's right to income.

This approach was not adopted because statutory provisions relating
to income and principal may vary from state to state, and this would
result in disparate treatment of estates that are similarly situated
but governed by different state law.

Moreover, in states that have adopted some form of the Uniform
Principal and Income Act, the definitions of principal and income,
and the allocation of expenses thereto, can be specified in the will
or trust instrument and given the effect of state law. Thus, simply
following state law was thought to be too malleable to protect the
policies underlying the marital and charitable deductions.

Several commentators agreed with the de minimis safe harbor approach
whereby a certain amount of income could be used to pay
administration expenses without materially limiting the surviving
spouse's right to the income. Under this approach, the safe harbor
amount is determined in two steps: first, the present value of the
surviving spouse's income interest for life is determined using
actuarial principles and, second, the resulting amount is multiplied
by a percentage, for example, 5 percent.

The proposed regulations do not adopt this approach.

Although a de minimis safe harbor approach would provide a bright
line test for determining materiality in the context of the marital
deduction, it is unclear how this approach would apply for
charitable deduction purposes because there is no measuring life for
valuing the income interest.

One commentator suggested that, consistent with the plurality
opinion in Estate of Hubert, the test for materiality should be
quantitative, based upon a comparison between the amount of income
charged with administration expenses and the total income earned
during administration. The commentator, however, considered the
requirement that projected income and expenses be presently valued
to be impractical, complex, and uncertain. Another commentator
considered a quantitative test to be impractical. A third
commentator suggested that a quantitative test would require a
factual determination in each case and, as a result, the period of
estate administration would be greatly prolonged.

Because these tests for materiality appear to be complex and
difficult to administer, the proposed regulations adopt neither a
quantitative test nor a test based on present values of projected
income and expenses.

Many commentators opposed an approach in which every charge to
income is a material limitation on the spouse's right to income. Two
commentators contended that adoption of this approach would
effectively overrule the result in Estate of Hubert.

One commentator suggested the approach adopted in the proposed
regulations, a description of which follows, and two commentators
suggested similar approaches.

Explanation of Provisions

After carefully considering the comments, the Treasury and the
Internal Revenue Service have determined that a test based on what
constitutes a material limitation would prove too complex and would
be administratively burdensome. For this reason, the proposed
regulations eliminate the concept of materiality and, instead,
establish rules providing that only administration expenses of a
certain character which are charged to the marital property will
reduce the value of the property for marital deduction purposes. It
is anticipated that these rules will have uniform application to all
estates, will be simple to administer, and will reflect the economic
realities of estate administration.

These same rules will also apply for purposes of the estate tax
charitable deduction.

Under the proposed regulations, a reduction is made to the date of
death value of the property interest which passes from the decedent
to the surviving spouse (or to a charitable organization described
in section 2055) for the dollar amount of any estate transmission
expenses incurred during the administration of the decedent's estate
and charged to the property interest. Such a reduction is proper
because these expenses would not have been incurred but for the
decedent's death. No reduction is made for estate management
expenses incurred with respect to the property and charged to the
property because these expenses would have been incurred even if the
death had not occurred. However, a reduction is made for estate
management expenses charged to the marital property interest passing
to the surviving spouse if the expenses were incurred in connection
with property passing to someone other than the surviving spouse and
a person other than the surviving spouse is entitled to the income
from that property. Estate transmission expenses are all estate
administration expenses that are not estate management expenses and
include expenses incurred in collecting estate assets, paying debts,
estate and inheritance taxes, and distributing the decedent's
property. Estate management expenses are expenses incurred in
connection with the investment of the estate assets and with their
preservation and maintenance during the period of administration.

Proposed Effective Date

These regulations are proposed to be effective for estates of
decedents dying on or after the date the regulations are published
in the Federal Register as final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required.

It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations, and, because the regulations do not impose a
collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Internal Revenue Code, this notice of
proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its
impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed
original and eight (8) copies) that are submitted timely to the IRS.
All comments will be available for public inspection and copying.

A public hearing has been scheduled for April 21, 1999, beginning at
10 a.m. in Room 2615 of the Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the 10th Street entrance, located
between Constitution and Pennsylvania Avenues, NW. In addition, all
visitors must present photo identification to enter the building.
Because of access restrictions, visitors will not be admitted beyond
the immediate entrance area more than 15 minutes before the hearing
starts.

For information about having your name placed on the building access
list to attend the hearing, see the "FOR FURTHER INFORMATION
CONTACT" section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit
written comments and an outline of the topics to be discussed and
the time to be devoted to each topic (signed original and eight (8)
copies) by March 31, 1999. A period of 10 minutes will be allotted
to each person for making comments. An agenda showing the scheduling
of the speakers will be prepared after the deadline for receiving
outlines has passed. Copies of the agenda will be available free of
charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Deborah Ryan,
Office of the Assistant Chief Counsel (Passthroughs and Special
Industries). However, other personnel from the IRS and Treasury
Department participated in their development.

List of Subjects in 26 CFR Part 20

Estate taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations Accordingly, 26 CFR part 20
is proposed to be amended as follows:

PART 20--ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16,
1954

Paragraph 1. The authority citation for part 20 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In 20.2055-1, paragraph (d)(6) is added to read as follows:

20.2055-1 Deduction for transfers for public, charitable, and
religious uses; in general.

* * * * *

(d) * * *

(6) For the effect of certain administration expenses on the
valuation of transfers for charitable deduction purposes, see
20.2056(b)-4(e). The rules provided in that section apply for
purposes of both the marital and charitable deductions. This
paragraph (d)(6) is effective for estates of decedents dying on or
after the date these regulations are published in the Federal
Register as final regulations.

Par. 3. Section 20.2056(b)-4 is amended by:

1. Removing the last two sentences of paragraph (a).

2. Adding paragraph (e).

The addition reads as follows:

20.2056(b)-4 Marital deduction; valuation of interest passing to
surviving spouse.

* * * * *

(e) Effect of certain administration expenses--(1) Estate
transmission expenses. For purposes of determining the marital
deduction, the value of any deductible property interest which
passed from the decedent to the surviving spouse shall be reduced by
the amount of estate transmission expenses incurred during the
administration of the decedent's estate and paid from the principal
of the property interest or the income produced by the property
interest. For purposes of this subsection, the term estate
transmission expenses means all estate administration expenses that
are not estate management expenses (as defined in paragraph (e)(2)
of this section). Estate transmission expenses include expenses
incurred in the collection of the decedent's assets, the payment of
the decedent's debts and death taxes, and the distribution of the
decedent's property to those who are entitled to receive it.
Examples of these expenses include executor commissions and attorney
fees (except to the extent specifically related to investment,
preservation, and maintenance of the assets), probate fees, expenses
incurred in construction proceedings and defending against will
contests, and appraisal fees.

(2) Estate management expenses--(i) In general. For purposes of
determining the marital deduction, the value of any deductible
property interest which passed from the decedent to the surviving
spouse shall not be reduced by the amount of estate management
expenses incurred in connection with the property interest during
the administration of the decedent's estate and paid from the
principal of the property interest or the income produced by the
property interest. For marital deduction purposes, the value of any
deductible property interest which passed from the decedent to the
surviving spouse shall be reduced by the amount of any estate
management expenses incurred in connection with property that passed
to a beneficiary other than the surviving spouse if a beneficiary
other than the surviving spouse is entitled to the income from the
property and the expenses are charged to the deductible property
interest which passed to the surviving spouse. For purposes of this
subsection, the term estate management expenses means expenses
incurred in connection with the investment of the estate assets and
with their preservation and maintenance during the period of
administration. Examples of these expenses include investment
advisory fees, stock brokerage commissions, custodial fees, and
interest.

(ii) Special rule where estate management expenses are deducted on
the federal estate tax return. For purposes of determining the
marital deduction, the value of the deductible property interest
which passed from the decedent to the surviving spouse is not
increased as a result of the decrease in the federal estate tax
liability attributable to any estate management expenses that are
deducted as expenses of administration under section 2053 on the
federal estate tax return.

(3) Examples. The following examples illustrate the application of
this paragraph (e). In each example, the decedent, who dies after
2006, makes a bequest of shares of ABC Corporation stock to the
decedent's child. The bequest provides that the child is to receive
the income from the shares from the date of the decedent's death.
The value of the bequeathed shares, on the decedent's date of death,
is $3,000,000. The residue of the estate is bequeathed to a trust
which satisfies the requirements of section 2056(b)(7) as qualified
terminable interest property. The value of the residue, on the
decedent's date of death, before the payment of administration
expenses and estate taxes, is $6,000,000. Under applicable local
law, the executor has the discretion to pay administration expenses
from the income or principal of the residuary estate. All estate
taxes are to be paid from the residue. The state estate tax equals
the state tax credit available under section 2011. The examples are
as follows:

Example 1. During the period of administration, the estate incurs
estate transmission expenses of $400,000, which the executor charges
to the residue. For purposes of determining the marital deduction,
the value of the residue is reduced by the federal and state estate
taxes and by the estate transmission expenses. If the transmission
expenses are deducted on the federal estate tax return, the marital
deduction is $3,500,000 ($6,000,000 minus $400,000 transmission
expenses and minus $2,100,000 federal and state estate taxes). If
the transmission expenses are deducted on the estate's income tax
return rather than on the estate tax return, the marital deduction
is $3,011,111 ($6,000,000 minus $400,000 transmission expenses and
minus $2,588,889 federal and state estate taxes).

Example 2. During the period of administration, the estate incurs
estate management expenses of $400,000 in connection with the
residue property passing for the benefit of the spouse. The executor
charges these management expenses to the residue. For purposes of
determining the marital deduction, the value of the residue is
reduced by the federal and state estate taxes but is not reduced by
the estate management expenses. If the management expenses are
deducted on the estate's income tax return, the marital deduction is
$3,900,000 ($6,000,000 minus $2,100,000 federal and state estate
taxes). If the management expenses are deducted on the estate tax
return rather than on the estate's income tax return, the marital
deduction remains $3,900,000, even though the federal and state
estate taxes now total only $1,880,000. The marital deduction is not
increased by the reduction in estate taxes attributable to deducting
the management expenses on the federal estate tax return.

Example 3. During the period of administration, the estate incurs
estate management expenses of $400,000 in connection with the
bequest of ABC Corporation stock to the decedent's child.

The executor charges these management expenses to the residue.

For purposes of determining the marital deduction, the value of the
residue is reduced by the federal and state estate taxes and by the
management expenses. The management expenses reduce the value of the
residue because they are charged to the property passing to the
spouse even though they were incurred with respect to stock passing
to the child and the spouse is not entitled to the income from the
stock during the period of estate administration. If the management
expenses are deducted on the estate's income tax return, the marital
deduction is $3,011,111 ($6,000,000 minus $400,000 management
expenses and minus $2,588,889 federal and state estate taxes). If
the management expenses are deducted on the estate tax return rather
than on the estate's income tax return, the marital deduction
remains $3,011,111, even though the federal and state estate taxes
now total only $2,368,889. The marital deduction is not increased by
the reduction in estate taxes attributable to deducting the
management expenses on the federal estate tax return.

(4) Effective date. This paragraph (e) is effective on the date
these regulations are published in the Federal Register as final
regulations.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue


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