Ever wonder why we don’t spend much time thinking about the income tax consequences of an inheritance? Well, there’s a simple reason for that. According to IRC § 102(a), “the value of property acquired by gift, bequest, devise, or inheritance” is excluded from gross income, which means it’s not subject to income tax.
On the other hand, IRC § 102(b) tells us the income I receive on inherited property (as opposed to the underlying property itself) is subject to income tax. For example, income distributions from a trust are taxable income, but the value of the trust’s underlying principal isn’t.
These income tax rules are simple enough, and in most cases no one gives them much thought. Where things get muddy is in the litigation context, especially when cases settle (and they almost always settle). The reason for that “muddiness” is that while everyone sitting around the negotiating table is focused on the future and “who’s” getting “what” and “when,” the tax treatment of these payments turns on a backward-looking question no one’s interested in when cases settle: the nature of the underlying claims way back when the lawsuit was initially filed.
What’s the “origin of the claim” doctrine?
At today’s top marginal rate of 37%, income taxes can be significant. And it’s a tax that applies no matter how large or small the sums involved might be, as opposed to the estate tax, which is limited exclusively to large inheritances; impacting an infinitesimally small share of the population (think less than 0.1%).
In the estate litigation context, whether a settlement payment is subject to income tax — or not — depends on one critical question: what’s the settlement payment being paid “in lieu of”? In other words, if the settlement payment’s in lieu of a claim for inheritance, no tax. But if it’s in lieu of a claim for some kind of taxable income, it’s taxable.
The legal test determining these outcomes is referred to as the “origin of the claim” doctrine. Here’s how this doctrine’s defined in an excellent user-friendly article entitled Tax Issues When Settling a Trust or Estate Dispute: A Guide for the Litigator, by California attorneys Brian G. Fredkin and Ryan J. Szczepanik:
The “origin of the claim” test was applied by the U.S. Supreme Court in Hort v. Commissioner (1941) 313 U.S. 28, and later articulated in U.S. v. Gilmore (1963) 372 U.S. 39. As stated by the court in Alexander v. IRS (1stCir. 1995) 72 F.3d 938, 942, under the “origin of the claim” doctrine, it is a “well-settled rule that the classification of amounts received in settlement of litigation is to be determined by the nature and basis of the action settled,” and that “amounts received in compromise of a claim must be considered as having the same nature as the rights compromised.”
Why should trusts and estates litigators care?
Framing your lawsuit at its inception as a claim for non-taxable inheritance rights means your settlement is going to be non-taxable. Overlooking this point at the front end of your case makes it impossible to reverse course at the back end when it’s settled and everyone finally wakes up to the looming tax issues.
For an excellent discussion of how this particular tax issue can play out in the estate context, and how the “origin of the claim” doctrine’s used to work through those cases where the tax results are murky, you’ll want to go back to the Fredkin and Szczepanik article. Here’s an excerpt:
The “origin of the claim” doctrine requires that tax consequences be based upon the facts presented. The IRS has explained that the initial pleading is the most persuasive evidence of the tax treatment of an amount subsequently recovered by way of settlement. Therefore, in preparing the initial pleading, the attorney should rely on the strongest theory under state law that supports the client’s claim and achieves favorable tax results.
A trust or estate’s distribution of property is excluded from gross income under section 102(a) of the Code as property acquired by gift, bequest, devise, or inheritance. The same exclusion applies to settlement amounts paid to contesting beneficiaries in compromise of a claim as an heir. Thus, if possible, the claim should be pled for a portion of the estate as an heir, for instance, through a contest to a trust or will.
Example No. 1: Non-Taxable Claim = Non-Taxable Settlement
Again, framing your lawsuit at its inception as a claim for a non-taxable payment means your settlement is going to be non-taxable. Here are two such examples from the Fredkin and Szczepanik article:
In Marcus v. Commissioner, the tax court gave significant weight to the IRS’s admission in its pleadings that an agreement to pay the taxpayer from the net proceeds from the sale of property was a substitute for a bequest of property. The taxpayer received the proceeds in settlement of claims against her stepfather’s estate. The court held this amount to be excluded from gross income as an inheritance. …
A settlement agreement that resolves a party’s claim as an heir should state that the settlement proceeds are “in lieu and instead of” any inheritance. The tax court in Vincent v. Commissioner, held that settlement proceeds in a dispute between the stepmother and her stepson as to the ownership of real property were excluded from gross income under section 102(a) of the Code as property acquired by gift, bequest, devise, or inheritance. The tax court noted that the settlement agreement stated the payment was “in lieu and instead of any inherited interest,” thereby suggesting that language in the settlement agreement will be respected by the courts.
Example No. 2: Taxable Claim = Taxable Settlement
On the other hand, if your claims are framed as seeking payments that are subject to tax, your settlement’s also going to be taxable. Here’s an example of that kind of claim from the Fredkin and Szczepanik article:
If, in contrast, the claim as pled is for compensation for services rendered to a decedent, the tax character likely will be income to the recipient and thus taxable. In Green v. Commissioner, for example, a woman filed suit against her boyfriend’s estate for the value of “wifely” services she rendered to him during his lifetime. The court held that the settlement amount she received was compensation and thus taxable. If the claim as pled is for income from property, the tax character also likely will be income and thus taxable.
Example No. 3: Mixed Claims
And then there are those cases where it’s somewhere in between; it’s a mix of taxable and non-taxable claims. When these cases settle, whether you win or lose the tax argument isn’t going to turn on any one court filing or deposition transcript, it’ll be a “totality of the circumstances” kind of inquiry that’s much more likely to break your way if you’ve been conscious of the tax issues at every step of the case vs. accidentally backing into the right set of facts when it’s all said and done. Here’s an example of a “mixed” claim, again from the Fredkin and Szczepanik article:
Some lawsuits implicate both income and amounts in compromise of a claim as an heir. For example, in Getty v. Commissioner, the court held that a $10 million lump-sum settlement to the eldest son of J. Paul Getty was excluded from gross income under section 102(a) of the Code as property acquired by gift, bequest, devise, or inheritance. The eldest son, J. Ronald Getty, was an income beneficiary under the trust instrument. J. Paul Getty assured his eldest son that he would make him a co-equal income beneficiary with his brothers under the trust, but he never did so. After J. Paul Getty’s death, J. Ronald Getty asserted a claim against the remainder beneficiary, the J. Paul Getty Museum, seeking a constructive trust over an amount equal to the amount J. Ronald Getty would have received from the trust had his father carried out his promise. In holding that the $10 million settlement payment was excludable from gross income, the court reasoned that had J. Paul Getty performed his promise to remedy the inequality, he probably would have done so by a bequest of property. The court explained that when contesting a deficiency determined by the Commissioner of Internal Revenue, the taxpayer must show the merits of his claim by a preponderance of the evidence. The taxpayer need not prove the proceeds are “clearly classifiable” as either property or income from property.