Estate of Bates v. Comm’r, T.C. Memo. 2012-314, 2012 WL 5445778 (U.S.Tax Ct. Nov. 7, 2012)

While we know what the federal estate tax rules are until the end of 2012, what happens in 2013 and beyond is anyone’s guess. Under current law the estate tax exemption is scheduled to drop significantly from $5,120,000 in 2012 to $1,000,000 in 2013, and the top estate tax rate is scheduled to jump from 35% to 55%.

At a top rate of 55%, the federal estate tax automatically makes the IRS the single largest creditor for most large estates. That’s the bad news. Here’s the good news: as I’ve previously explained here and here, with a reasonable amount of sensitivity to the tax issues looming in the background of every taxable estate, litigation can often be shaped to create win-win opportunities by mining the tax code for "free money" to settle cases.

Consider the economics of the settlement agreement reached in the Tax Court case linked-to above. In this case the estate settled a will/trust contest by paying the challenger approximately $500,000 to drop his claims. The decedent in this case died in 2005, when the top estate tax rate was 47%. If the $500,000 settlement is a tax deductible expense, the heirs get a 47% deduction = to $235,000. Bottom line, if done right a $500,000 settlement payment "costs" the heirs only $265,000 after taxes. This is the kind of math that gets deals done and makes probate litigators look like geniuses . . . or not.

When the estate filed its estate tax return, instead of characterizing the $500,000 settlement payment as a validly deductible creditor claim under IRC § 2053, the exact opposite was done. The payment was characterized as a NON-deductible payment to an estate beneficiary as follows:

FUNDS PAID TO REGGIE LOPEZ IN EXCESS OF BEQUEST BY DECEDENT IN SETTLEMENT OF TRUST CONTEST LAWSUIT TO SETTLE TITLE TO BENEFICIARIES

As explained by the Tax Court, there’s no way this kind of payment was ever going to fly as an estate tax deduction.

The estate contends that the settlement payment to Mr. Lopez is deductible. Pursuant to section 2053(a)(3), a claim against an estate is deductible if it is supported by adequate consideration and not attributable to the testator’s testamentary intent. See sec.2053(c)(1)(A); Estate of Huntington v. Commissioner, 100 T.C. 313, 316, 1993 WL 99962 (1993), aff’d, 16 F.3d 462 (1st Cir.1994); Estate of Lazar v. Commissioner, 58 T.C. 543, 553, 1972 WL 2476 (1972); Estate of Pollard v. Commissioner, 52 T.C. 741, 745, 1969 WL 1656 (1969). The settlement payment to Mr. Lopez is not deductible because the payment lacked adequate consideration and was consistent with decedent’s testamentary intent. See sec.2053(c)(1)(A); Estate of Huntington v. Commissioner, 100 T.C. at 316; Estate of Lazar v. Commissioner, 58 T.C. at 553; Estate of Pollard v. Commissioner, 52 T.C. at 745.

In support of his determination, respondent cites Estate of Huntington and Estate of Lazar, where the Court concluded that settlement payments to beneficiaries were not deductible. The estate contends that these cases are distinguishable because the settlement payments were paid to family members. While the settlement payments in these cases were to family members, the Court’s reasoning is equally applicable to cases involving nonfamily members. Decedent had a longstanding and extremely close relationship with Mr. Lopez, expressly provided that he would receive estate assets, and memorialized her testamentary intent in both the First Trust and the Second Trust. In addition, the superior court resolved the amount of estate assets that Mr. Lopez was entitled to receive, and the settlement payment was paid in full satisfaction of any claim relating to the First Trust or the Second Trust. Furthermore, on the estate tax return, the estate reported that Mr. Lopez was a beneficiary and the settlement payment was paid to settle title to beneficiaries. During decedent’s lifetime Mr. Lopez was paid for the services he rendered, and no part of the settlement payment related to a claim for unpaid services. In short, Mr. Lopez’s claim represented a beneficiary’s claim to a distributive share of the estate rather than a creditor’s claim against the estate. See Estate of Lazar v. Commissioner, 58 T.C. at 552. 

Lesson learned?

If you’re dealing with a taxable estate, it’s imperative that every decision made by the parties and their lawyers with respect to how they characterize and prosecute their trust/probate claims is considered against this backdrop. Whether a dispute is resolved through litigation or settlement, the nature of the underlying action determines the proper tax consequences. The taxability of a settlement is controlled by the nature of the litigation. The nature of the litigation is in turn controlled by the origin and character of the claim that gave rise to the litigation. And it’s the parties – not the IRS – that ultimately control this initial link in the causal chain.

Is it possible to frame the same set of facts as either a creditor claim against the estate or a will contest? If the answer is yes, one type of case is tax deductible (creditor claim), the other isn’t (will contest). Did the contestant’s lawyer only prosecute the challenger’s individual interests or did this lawyer help the estate properly administer the estate for everyone’s benefit? If it’s the former, no tax deduction; if it’s the latter, challenger’s legal fees may be tax deductible (think more free money to settle). Get these questions right, everyone wins. Get them wrong . . . not so good.