It’s not uncommon for a trusts and estates litigator to wake up the morning after reaching a settlement wondering if she or he overlooked a significant tax issue. Why? Because virtually every action taken in this kind of case, from the drafting of the complaint to the settling of the lawsuit has some kind of transfer tax or income tax ramification. These tax issues can be significant, but are often a secondary focus for the parties and attorneys involved. That’s a mistake.
For example, assume you have a case in which the decedent’s estate is subject to estate tax, and you negotiated a settlement in which your clients receive $3 million from the estate based on the decedent’s contract to make a will that’s enforceable under F.S. 732.701. Depending on how that claim is framed, either your clients are going to receive their money income-tax free under the exception for gifts and inheritances found in IRC 102, or the estate’s going to receive an estate-tax deduction under IRC 2053 for “claims against the estate.” Either way, the top marginal tax rate is going to be 40% or close to it, which means how this $3 million payment is treated for tax purposes may translate into one side or the other getting a tax bill of over $1 million or a tax deduction of over $1 million. So yeah, the stakes are high.
Is the settlement subject to income tax?
From an income-tax perspective, the test for determining if your clients are going to pay income tax on their settlement payment is the “origin of the claim” doctrine. If you represent the claimants and you want to make sure they get their money tax free, you need to draft your complaint with this tax issue in mind. As explained in Tax Issues When Settling a Trust or Estate Dispute: A Guide for the Litigator:
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.
Is the settlement deductible for estate tax purposes?
From an estate-tax perspective, whether your estate’s going to receive a deduction for a settlement payment is usually governed by the “claims against the estate” test found in IRC 2053. If the settlement arises out of a claim based on the decedent’s contractual obligation to leave an inheritance, getting a tax deduction is far from certain.
The case everyone used to rely on in this scenario is Estate of Kosow v. Commissioner, 45 F.3d 1524 (11th Cir. 1995), in which the court held that a contract to leave property to a particular person pursuant to a divorce settlement can cause the entire balance of the decedent’s estate to be deductible for transfer tax purposes as long as the consideration for the promise to ultimately leave property to that person was full and adequate compared to the property rights given away pursuant to the contract. The problem with Kosow is that it involved an usual set of facts that may not provide much guidance for future tax payers. As explained in this wide-ranging article summarizing all of the potential tax traps lurking underneath even the simplest estate litigation settlement agreement:
Kosow arose in an unusual setting. In that case, the executor of the estate subject to the divorce obligation was able to establish, many years after the divorce, the nature and extent of the property rights relinquished, their relative value to the inheritance rights established years earlier, and, therefore, the likelihood of full and adequate consideration for the agreed bequest occurring many years later. While that theoretical possibility usually exists in marital settlement cases, it would be a mistake to conclude that any such promise, particularly when made in favor of a third-party beneficiary who is a natural object of the decedent’s bounty, will always support a claim that effectively causes the promisor’s estate to be exempt from estate tax. Moreover, while not raised in Kosow, where one party agrees to accept a lesser amount in a divorce in exchange for a promise by the other party to leave property to children or others, the party accepting less will presumably have made a gift of the forgone amount (or of the value of the future gift) to the children or other persons at the time of the divorce. See, e.g., Rev. Rul. 79-363, 1979-2 CB 345.
Kosow was decided almost thirty years ago. We now have a new case to dissect when trying to unravel this tax knot. It’s the Spizzirri case, and the news is not good for those hoping for a repeat of the tax deduction allowed in Kosow.
Case Study
This case involved a $3 million payment made to the decedent’s stepchildren pursuant to the terms of a marital agreement he entered into with his spouse. The stepchildren filed claims against the estate seeking this payment, and based on that claim the estate paid them and deducted the payment under IRC 2053 as a “claim” against the estate. The IRS denied the deduction and the tax issue was litigated. Underscoring the you-can’t-have-it-both-ways nature of this tax issue, the 11th Circuit went out of its way to note — twice! — that there was no evidence that the claimants paid income tax on the payment.
The estate did not call any of Spizzirri’s stepchildren as witnesses, nor did it introduce any evidence that they had reported the payments as taxable income. … The estate also failed to call the stepchildren as witnesses though it could have asked them whether they reported the payments as income.
In other words, if this payment was a valid claim against the estate that’s deductible for estate tax purposes, then someone should have paid income tax on it. If no one paid income taxes that fact is going to weigh heavily against an estate tax deduction. You can’t have it both ways.
Is a contractually required inheritance payment deductible for estate tax purposes? NO
Against this backdrop, the 11th Circuit made short work of the estate’s claimed tax deduction, noting that all five factors listed in the Treasury Regulations for cases involving inheritance payments made pursuant to contracts involving “family” transfers weighed against allowing the claimed tax deduction. So sayeth the 11th Circuit:
The “bona fide” requirement in section 2053(c)(1)(A) bars a deduction for a claim “to the extent it is founded on a transfer that is essentially donative in character (a mere cloak for a gift or bequest).” Treas. Reg. § 20.2053-1(b)(2)(i) (2009). In transactions between family members, “a testator is mo[re] likely to be making a bequest … than repaying a real contractual obligation.” Huntington, 16 F.3d at 466. So we “subject [those transactions] to particular scrutiny, even when they apparently are supported by monetary consideration.” Id. Because Spizzirri’s stepchildren were “lineal descendants of … [his] spouse,” we apply the same “particular scrutiny” to the estate’s payments to the stepchildren that we do to transactions between family members. See Treas. Reg. § 20.2053-1(b)(2)(iii)(A) (defining “[f]amily members” as including the “spouse of the decedent” and “lineal descendants” of “the decedent’s spouse”).
To guide our evaluation of intrafamily transfers, the Treasury Regulations list five factors that suggest a transfer was contracted bona fide. Id. § 20.2053-1(b)(2)(ii). First, “[t]he transaction underlying the claim … occurs in the ordinary course of business, is negotiated at arm’s length, and is free from donative intent.” Id. § 20.2053-1(b)(2)(ii)(A). Second, the claim “is not related to an expectation or claim of inheritance.” Id. § 20.2053-1(b)(2)(ii)(B). Third, the claim “originates pursuant to an agreement between the decedent and the family member.” Id. § 20.2053-1(b)(2)(ii)(C). Fourth, “[p]erformance by the claimant” stems from “an agreement between the decedent and the family member.” Id. § 20.2053-1(b)(2)(ii)(D). Fifth, “[a]ll amounts paid in satisfaction or settlement of a claim or expense are reported by each party for Federal income and employment tax purposes … in a manner that is consistent with the reported nature of the claim or expense.” Id. § 20.2053-1(b)(2)(ii)(E).
Each factor weighs against finding that the payments to Spizzirri’s stepchildren were contracted bona fide.
What’s the takeaway?
If you’re involved in a case based on a contract claim for an inheritance payment, you need to keep in mind that just because this is a creditor “claim” subject to Florida’s ultra-short limitations periods for probate creditor claims, doesn’t mean it’s also a “claim” for federal estate-tax deduction purposes under IRC 2053. This distinction between the definition of the word “claim” for state probate law purposes and the definition of same word for federal tax law purposes is a huge trap for the unwary. Don’t fall victim to this trap. Forewarned is forearmed. And there’s no better case for teasing out these state-vs-federal law distinctions then the 11th Circuit’s opinion in Spizzirri. This case is a must read for trusts and estates litigators.