Sometimes misfortune piles on. In a case that shows why it can be far better to have a corporate trustee, two Virginia trust beneficiaries got mugged first by their father serving as trustee -- and then by the Internal Revenue Service. Estate of Hester, slip copy, 2007 WL 703170 (W.D.Va. March 2, 2007).

Wendell Hester was the sole trustee and income beneficiary of a trust created by his deceased wife, Dorothy. The couple's children were the remainder beneficiaries of the trust. The trust assets consisted of $3.2 million in cash and a promissory note held by Dorothy's estate with a face amount of $1.25 million. In February of 1998, Wendell transferred the entirety of the trust to his individual brokerage account (which also contained Wendell's own assets and was worth over $4 million.)

Wendell then embarked on several months of day trading with the commingled assets in the brokerage account. The result: more than $2 million in losses.

To make matters worse, Wendell also withdrew over $450,000 in cash, collected $280,000 on the promissory note, and pledged the commingled assets in the brokerage account as security for margin losses.

According to the court, at the time of Wendell's death in October of 1998, the extent of his commingling was so complex that it was impossible to determine which interests in the commingled assets belonged to Wendell and which to his children. Wendell's children did not assert a claim against Wendell's estate regarding the misappropriation and commingling of the trust assets. The likely reason probably was that they were also the beneficiaries of Wendell's estate and trust, so filing a claim would only have succeeded in diverting assets from another trust of which the children were also the beneficiaries.)

The estate tax return filed by the executor of Wendell's estate included as part of the gross estate all of the remaining misappropriated funds. The return did not claim any deduction for possible claims belonging to Wendell's children as remainder beneficiaries of the trust. After an audit, Wendell's estate paid over $2.7 million. Then, the estate claimed an estate tax refund for two alternative reasons: (1) because the misappropriated assets shouldn't have been included in Wendell's gross estate, as Wendell had no an interest in those assets but rather, because of his various breaches of fiduciary duty, he held the misappropriated assets in constructive trust for his children; or (2) if the IRS determined that the misappropriated assets were includible in Wendell's gross estate, the estate should receive an offset deduction equal to the amount of said assets for claims against the estate (pursuant to Internal Revenue Code Section 2053(a)(3)) or for indebtedness with respect to property that is included in the gross estate (under IRC Section 2053(a)(4).)

The IRS denied the refund request. Wendell's estate filed suit.

The Virginia district court held that the misappropriated assets were includible in Wendell's gross estate, emphasizing that Wendell had treated those assets as his own property by exercising "dominion and control" over them without recognizing any duty to repay the trust. Moreover, the court said, the estate was not entitled to any offsetting deduction under IRC Section 2053(a)(3) because Wendell's children had never filed a claim against his estate and no claim was reasonably expected to be forthcoming. The court also noted that even if one could anticipate an actual claim arising, it was too late. By the time the Virginia District Court was deciding the case, such a claim for misappropriation of trust assets was barred by the Virginia statute of limitations.

The court also held that the estate could not take a deduction under IRC Section 2053(a)(4) for indebtedness with respect to property included in the gross estate because Wendell's misappropriation of the trust assets in violation of his fiduciary duties as trustee did not create an indebtedness. The court distinguished the concept of Wendell's estate being "liable" and it being "indebted," noting that neither Wendell nor the estate "had an unconditional and legally enforceable obligation for the payment of money."

Talk about a double whammy. Dad blows through $2 million of the trust funds, then subjects the remainder to an estate tax that should have avoided at his death.

What could the children have done?

Wendell's children could have asked for regular accountings while he was alive. That might have helped. But it looks like the losses and commingling occurred during a relative brief period -- just eight months before Wendell left his mortal coil.

Obviously, filing a claim against the probate estate would have helped. Indeed, the day could have been saved by a probate court order approving a rough justice accounting as to what belonged in the trust and what the estate should be surcharged for breach of fiduciary duty. Even if the parties believed they had a duty to disclose the issue on the decedent's federal estate tax return, the IRS generally accepts state law pronouncements as to property ownership.

(See David A. Handler's note on the recent decision in Thompson, below ad.)

The U.S. Court of Appeals for the Second Circuit in its Thompson decision has given the Internal Revenue Service and taxpayers incentive to be extremely careful when proposing valuations.

In Estate of Thompson v. Commissioner, No. 06-0815-ag, decided Aug. 23, 2007, the issue was the valuation of certain stock in a closely held publishing company for estate tax purposes.

Under Internal Revenue Code Section 7491(a)(1), if "a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer . . . the Secretary shall have the burden of proof with respect to such issue."

In Thompson, the parties stipulated that the estate submitted "credible evidence" in support of its valuation, shifting the burden of proof to the IRS. After the Tax Court rejected the IRS' methodology and conclusions regarding the value of the stock, the estate argued that IRC Section 7491 required the court to adopt the estate's valuation.

But the Second Circuit ruled that when the Tax Court rejects the IRS' methodology in valuing an estate, it's not required to adopt the estate's valuation method. "Notwithstanding the enactment of § 7491, it remains the case that [as the court said in Silverman v. Commissioner, 538 F.2d 927 (2d Cir. 1976), the 'Tax Court is not bound by the formulas or opinions proffered by expert witnesses. It may reach a determination of value based upon its own analysis of all the evidence in the record.'"

Because the court found both valuations to be "deficient and unpersuasive," it undertook its own valuation.