Assume that a taxpayer is sued for $10 million in a breach of contract claim two weeks before his death. Four years later, the lawsuit is settled for $1 million. But long before that, say nine months after the date of death, the executor of the decedent's estate needs to file the estate tax return and is forced to decide how much can be deducted as a claim against the estate — $10 million, $5 million, $1 million, $0?

For estates located just about anywhere in the country, an executor may claim the full $10 million deduction, even if many years later, the litigation is settled for pennies on the dollar. It's a great taxpayer windfall. But this is not the case if the estates are in the jurisdictions of the U.S. Court of Appeals for the Second or Eighth Circuits.

Recent litigation highlights a split among the circuits: Some calculate the deduction based on facts known on the date of death. The Second and Eighth Circuits consider post-mortem facts to determine the claim's value. Obviously, there's a need for more consistency — one workable set of rules to guide taxpayers, the Internal Revenue Service and courts in determining claims that may be deducted against the estate.

CODE, REGS, CASES

Internal Revenue Code Section 2053(a)(3) provides that “the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts … for claims against the estate … as are allowable by the laws of the jurisdiction, whether within or without the United States under which the estate is being administered.” Meanwhile, the Treasury regulations tell us that we should make a reasonably certain assessment of an enforceable claim's worth at the date of death. Specifically, Treasury Regulation Section 20.2053-1(b)(3) says, “An item may be entered on the return for deduction though its exact amount is not then known, provided it is ascertainable with reasonable certainty, and will be Regulation Section 20.2053-4, which specifically addresses claims against estates, provides that “the amounts that may be deducted as claims against a decedent's estate are such only as represent personal obligations of the decedent existing at the time of his death, whether or not then matured, and interest thereon which had accrued at the time of death…Only claims enforceable against the decedent's estate may be deducted.”

The leading case in this area is Ithaca Trust Co., decided in 1929. 1In Ithaca Trust, a decedent created a testamentary charitable remainder trust for the benefit of his wife, but she died within a year of her husband's death. The estate deducted the amount that was actually passing to charity, valuing the charitable remainder interest based upon the spouse's premature death, rather than the amount determined by referring to actuarial tables. The U.S. Supreme Court found, “The estate so far as may be is settled as of the date of the testator's death…The tax is on the act of the testator not the receipt of the property by the legatees…Therefore the value of the thing to be taxed must be estimated as of the time when the act is done.”2 The high court ruled that, notwithstanding the certainty of the s paid. No deduction may be taken upon the basis of a vague or uncertain estimate.” In addition, Treasuryurviving spouse's premature death, the value of the charitable deduction must be determined at the decedent's date of death, based on applicable actuarial tables prescribed by the regulations.

Unfortunately, over the years a split developed among the circuits that have considered the effect of post-mortem facts on the deductibility of claims against the estate. The Second and Eighth have largely rejected Ithaca Trust's “date of death” approach, while the Fifth, Ninth, Tenth and Eleventh circuits generally have followed it. The question remains unanswered in other circuits. Even within the two camps, there is little agreement on appropriate tests for deductibility. When analyzing these cases, it is useful to parse the issue into four categories: the validity of the claim, the certainty of the claim, claims that are actuarially determinable and claims that require valuation.

VALIDITY OF CLAIM

First, a claim must be valid. This the Eighth Circuit made clear in both Jacobs and Sachs.3 In Jacobs, the decedent entered into an antenuptial agreement that provided for the payment of $75,000 to his wife upon his death. In his will, he gave his wife an election to receive, in lieu of the $75,000; $250,000 to be held in trust for her lifetime. The widow chose to take the life income interest in trust. Nevertheless, the estate took a deduction for the $75,000 as a claim against the estate. The court held that the only claims that could be deducted as “claims against the estate” were those that are presented to and allowed or otherwise determined as valid against the estate and actually paid or to be paid.4 The Eighth Circuit noted the “widow never claimed anything from the estate under the antenuptial contract, and the gross estate was not decreased one single cent by reason of the [fixed amount] stipulated in the antenuptial contract.”5 The court reconciled its holding with the Supreme Court's ruling in Ithaca, by stating that the Supreme Court “has not said that claims against the estate must be determined solely by the facts and conditions existing on the day of the decedent's death.” Moreover, said the Eighth Circuit, “[W]e are confident that the Court will never say so.”6Jacobs is based on pre-1954 law and requires both that the claim be allowed (as opposed to allowable under current law) and actually paid.

Similarly, in Sachs, the IRS sought to disallow the estate's deduction for income tax liability that had been paid, but subsequently forgiven by the Tax Reform Act of 1984. The Sachs court, following Jacobs, held that the application of the date-of-death rule does not apply to claims against an estate deducted under Internal Revenue Code Section 2053(a)(3). The court explained: “[W]e hold that an estate loses its §2053(a)(3) deduction for any claim against the estate which ceases to exist legally, regardless of whether the nullification of the claim could have been foreseen.”7

In 1960, the Treasury Department adopted this validity-of-claim analysis in Revenue Ruling 60-247, 8which provides that no deduction is allowed for claims against an estate if the creditor waives payment, fails to file a claim or fails to enforce a claim.

CERTAIN AND ENFORCEABLE CLAIMS

There's another line of cases that focuses on whether a certain and enforceable claim existed on the date of death. In Propstra v. United States, 9the decedent owned two parcels of real estate that were encumbered by liens in favor of the Salt River Valley Water User's Association for past due assessments and penalties totaling $202,000. During his lifetime, the decedent tried to negotiate a waiver or reduction of the liens, but the association's bylaws denied it the power to adjust claims. Twenty-two months after the estate tax return was filed, the association's bylaws were amended and the outstanding claim was settled for $135,000. The IRS Commissioner issued a notice of deficiency, stating the estate was entitled to deduct only the $135,000 actually paid.

The Ninth Circuit first focused on whether the claim was disputed or contested. The court found that on the date of death, the estate had no defense to the claims, and the claimant did not have the ability to compromise the claim. Consequently, the court found that the claims were certain and enforceable, holding that “as a matter of law, when claims are for sums certain and are legally enforceable as of the date of death, post-death events are not relevant in computing the permissible deduction.”10

Following the Ninth Circuit's lead, the Tenth Circuit found in favor of the taxpayer in Estate of McMorris v. Commissioner.11 In McMorris, the decedent's estate claimed deductions for 1991 federal and state income tax liabilities. In connection with the audit of the decedent's estate, the decedent's income tax liability was reduced when the basis of an asset giving rise to the income tax liability was adjusted. The IRS argued that the prior estate tax deductions for the income tax liability should be reduced to the amount actually paid. The Tenth Circuit held in favor of the taxpayer, stating that “the date-of-death valuation rule announced in Ithaca Trust applies to a deduction for a claim against the estate under section 2053(a)(3). As a result, in this circuit, events which occur after the decedent's death may not be considered in valuing that deduction.”12 The court cited “sound policy reasons” for its adherence to the date-of-death valuation principle for Section 2053(a)(3) deductions, including a “bright line rule which alleviates the uncertainty and delay in estate administration which may result if events occurring months or even years after a decedent's death could be considered in valuing a claim against the estate.”13

ACTUARIAL CERTAINTY

There are several cases, including Ithaca Trust, in which a claim can be actuarially determined on the date of death. Surprisingly, notwithstanding the Supreme Court's mandate in Ithaca Trust, the circuits are split in their adherence to the date-of-death principle in cases that have actuarial certainty of the claim on the date of death.

Commissioner v. Shively's Estate,14 is factually most analogous to Ithaca Trust. Yet the Second Circuit's conclusion is contrary to Ithaca Trust's rationale and result. But the Ninth Circuit, in Estate of Van Horne v. Commissioner,15 is consistent with Ithaca Trust's adherence to date-of-death valuation principles, especially with regard to the use of actuarial tables to value an annuity or income interest. In the Second Circuit's Shively, the decedent was required to make spousal support payments of $40 per week to his ex-wife, Marie Shively. The actuarial value of these payments on the date of his death was about $27,000. Marie died shortly after the decedent, but before the filing of the decedent's estate tax return.

The Second Circuit held that the deduction was to be limited to the amount actually paid to Marie, because former IRC Section 812(b) (predecessor to the current IRC Section 2053(a)(3)) permits a deduction only of those claims against the estate as are allowed by the laws of the jurisdiction under which the estate is being administered. The court reasoned that Marie did not present a claim for the present value of her right to continuing weekly support payments. The court held that “where, prior to the date on which the estate tax return is filed, the total amount of a claim against the estate is clearly established under state law, the estate may obtain under Section 812(b)(3) no greater deduction than the established sum, irrespective of whether this amount is established through events occurring before or after the decedent's death.”16 Interestingly, Shively appears to extend the period for consideration of post-mortem facts to the date of filing of the federal estate tax return.

Adhering to the date-of-death valuation principle, the Ninth Circuit in Van Home used actuarial tables to calculate an undisputed spousal support obligation. The ex-spouse died after receiving only four monthly payments, and the support obligations were terminated. The IRS argued that the spousal support obligations were not a “sum certain” and therefore should not be governed by Propstra. The Ninth Circuit disagreed, stating, “legally enforceable claims valued by reference to an actuarial table meet the test of certainty for estate tax purposes.”17

VALUING CLAIMS

Even circuits that adhere to Ithaca Trust's date-of-death rule use some sort of valuation to determine inchoate claims. In the Fifth Circuit's Estate of Smith v. Commissioner,18 the decedent was party to a suit filed by Exxon Corporation when she died. Exxon initially claimed $2.5 million from the decedent's estate, but settled 15 months later for $681,840. The Fifth Circuit reversed the Tax Court's ruling that the estate's deduction was limited to the $681,840 actually paid, and instructed the Tax Court, on remand, “[n]either to admit nor consider evidence of post-death occurrences when determining the date-of-death value of Exxon's claim.”19 The court further observed that, “as the [IRS] Commissioner has recognized in the context of valuing closely-held businesses, [a] determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases…A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”20 The court concluded that “like a closely-held business, every lawsuit is unique; thus it is incumbent on each party to supply the Tax Court with relevant evidence of pre-death facts and occurrences supporting the value of the Exxon claim advocated by that party.”21

On remand, the Tax Court22 limited the deduction to $681,840. Notwithstanding the Fifth Circuit's instruction to put on evidence of the value of the claim, the estate presented no new evidence at the trial. The estate asserted it had met its burden under the “law of the case” doctrine, because the parties agreed Exxon was claiming $2.5 million from the decedent at her death. The Tax Court rejected the estate's argument, citing the Fifth Circuit's instruction that the amount of the estate's deduction depended on the fair market value of Exxon's claim as of the decedent's death. The Tax Court therefore found in favor of the IRS and the Fifth Circuit affirmed.23

Like the Fifth Circuit, the Eleventh Circuit uses pre-death valuation for inchoate claims. In Estate of Elizabeth O'Neal v. Commissioner,24 the decedent's estate deducted claims by the decedent's children and grandchildren. The children and grandchilden were seeking reimbursement of their tax liabilities arising from gifts made to them by the decedent during her lifetime. The IRS initially assessed the deficiency at $9.4 million, but ultimately settled for $563,314.

On appeal to the Eleventh Circuit, the court found that the district court erred when it considered the $563,314 post-death settlement. Yet the appeals court also stated there was no authority for using the date-of-death value of $9.4 million for the deduction. The Eleventh Circuit therefore remanded the case to the district court for an evidentiary hearing on the valuation of the claim and instructed the district court not to consider evidence of post-death events, but rather to determine the value based on relevant evidence of pre-death facts and occurrences supplied by each party.

On remand, the district court relied on expert testimony to find that the value of the donees' claim, at the date of the decedent's death, was $5.835 million.25 In so holding, the district court accepted the testimony of the estate's expert, Judge Sam C. Pointer, Jr., the recently retired chief judge of the U.S. District Court for the Northern District of Alabama. The expert went through an extensive analysis of the donees' transferee tax liability and identified four possible outcomes of the transferee tax litigation. In addition, the expert analyzed the likelihood that the donees would prevail, under applicable state (Alabama) law, with their restitution claims against the decedent or her estate. He concluded that the donees' claims had a value of $5.835 million as of the date of the decedent's death.

The split among the circuits creates opportunities for some taxpayers to exploit the date-of-death valuation rule by claiming expenses that exist on the date-of-death are later compromised or reduced. Given the right jurisdiction, a taxpayer's estate can experience a windfall. At least that's the way things stand now. Naturally, the IRS and Treasury have noticed these inconsistencies among the jurisdictions and have put this item on their agendas for 2003-2004. So expect proposed regulations or a revenue ruling in the near future. For estate planners who seek certainty, this area sorely needs guidance; be it in the form of new legislation, regulation, or a Supreme Court ruling.

Whichever branch of the government addresses the issue, it should weigh the need to stop taxpayer windfalls against the need for estates to be administered in a timely and orderly manner. One way to achieve a balance would be to sort claims into two categories. First, if a claim is valid, certain and determinable, and enforceable, such as in Propstra, it would be deductible under IRC Section 2053. But, if it were contested, such as in Smith and O'Neal, the contested amount would be valued and that valued amount would be the deduction. If the amount actually paid turns out to be greater than the deduction, the taxpayer can claim a refund. This solution adheres to the date-of-death premise of estate taxation, while providing a mechanism for the valuation of unmatured, inchoate claims that are not ripe on the date of death.

Endnotes

  1. 279 U.S. 151 (1929).
  2. Ibid. at 155.
  3. 34 F. 2d 233 (8th cir. 1929); 856 F.2d 1158 (8th Cir. 1988).
  4. 34 F.2d at 235.
  5. Ibid.
  6. Ibid at 236.
  7. 856 F.2d at 1161.
  8. 1960-2, C.B. 272, 273.
  9. 680 F.2d 1248 (9th Cir. 1982).
  10. Ibid. at 1254.
  11. 243 F.3d 1254 (10th Cir. 2001).
  12. Ibid. at 1261.
  13. Ibid.
  14. 276 F.2d 372 (2nd Cir. 1960).15. 720 F.2d 1114 (9th Cir. 1983).
  15. Ibid at 374.
  16. Id. at 1117.18. 198 F.3d 515 (5th Cir. 1999), nonacq., AOD 2000-04.
  17. Ibid at 526.
  18. Ibid.
  19. Ibid.
  20. T.C. Memo 2001-303.
  21. 90 AFTR2d 2002-7445 (2002).
  22. 258 F.3d 1265 (11th Cir. 2001).
  23. 228 F. Supp.2d 1290 (Dist. Ct. Al 2002).

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