Things didn’t turn out so well for the estate of Sylvia E. Bates, a successful real estate owner and investor in California. When Sylvia died in 2005, she left behind two wills. Her first will named her granddaughter, Sheri Beersman, as the executor and trustee of a family trust; provided that estate assets be used to pay expenses; and made bequests to certain individuals. Sylvia also named a family trust as the beneficiary of any remaining assets, directing such assets to be distributed evenly among her three grandchildren. Sylvia’s second, subsequent will designated Reggie Lopez—an individual who assisted Sylvia with a variety of tasks—as executor and trustee; named one grandchild, Scott, as the beneficiary of all of her personal property; and directed trust income to be distributed evenly between Scott and Reggie. At the time of her death, Sylvia also left an insurance policy that named Reggie as the sole beneficiary.
About a week after Sylvia’s death, Sheri submitted the first will to the Orange County Superior Court for probate; a few days later, Reggie submitted the second will for probate. Because Scott was incarcerated and unable to monitor the trust litigation, he hired an investigator to follow it.
Prior to its determination, the superior court suspended Reggie’s trustee powers and prohibited him from taking any action with regard to the family trust. It invalidated the second will and the trust that named Reggie as executor and trustee. The superior court also invalidated the bequest made to Reggie under the first will. The Supreme Court of California, however, vacated the superior court’s rulings, restored a presumption of validity to the second will and Reggie submitted the second will again for probate.
It’s All Settled
Sheri and her brother Kenneth settled all litigation with Reggie in December 2005 and sought approval by the superior court of the settlement. The superior court approved the settlement, invalidated the second will and awarded Reggie $575,000 from the first trust, in satisfaction of any claims relating to any of the trusts. Reggie received $300,000 of the settlement and then surrendered any rights to sue Sheri or Kenneth, individually. He then received the remainder of the settlement.
At no time during the year of Sylvia’s death did Sheri file an estate tax return. Although she consulted with a tax accountant, as well as an individual, Jim Caviola, who had provided legal services to Sylvia, Sheri concluded that she had no authority to file the estate tax return. In 2006, after she was issued permanent general administration orders, Sheri filed the estate tax return and deducted certain expenses as “administration” expenses. The Internal Revenue Service disallowed most of the deductions, sent a notice of deficiency to the estate and determined that the estate was liable for additions to tax for failing to timely file the return and timely pay tax.
No-Go to Administration Expenses
On Jan. 13, 2010, Sheri petitioned the Tax Court, asking it to rule on the deductibility of: 1) the settlement payment to Reggie; 2) the reimbursement to Scott for payment to the investigator to monitor the trust litigation; and 3) the insurance proceeds. Sheri also contended that the estate shouldn’t be liable for additions to tax for failure to timely file a return and pay tax.
Unfortunately for Sylvia’s estate, the Tax Court wasn’t too impressed with Sheri’s arguments. In Estate of Sylvia E. Bates, v. C.I.R (T.C. Memo. 2012-314, Nov. 7, 2012), the court denied most of the requested deductions.
First, the court determined that the settlement payment to Reggie wasn’t a deductible administrative expense, because the payment lacked adequate consideration and was consistent with Sylvia’s testamentary intent. Although Reggie wasn’t a family member, he had a close, longstanding relationship with Sylvia, and she specifically provided that he would receive assets. Thus, Reggie’s claim constituted a beneficiary’s claim to a share of Sylvia’s estate, not a creditor’s claim against an estate. As such, the settlement wasn’t deductible.
Second, the court denied the deduction for payments to Scott, which was for reimbursement for the fees he paid to have an investigator monitor the trust litigation. The court was convinced that the investigator was paid to protect Scott’s interests in the estate; it rejected the estate’s claim that the investigator was paid to look into Sylvia’s oil and gas investments. Relying on a prior Tax Court case, the court stated that expenses incurred by a beneficiary to protect his personal interests aren’t administration expenses. As such, this reimbursement wasn’t deductible. However, the IRS did concede that other expenses, including those relating to Jim Caviola, were deductible.
Third, the court held that the insurance proceeds payable to Reggie weren’t administrative expenses and, as such, weren’t deductible. And, adding insult to injury, the court further ruled that the proceeds should be included in Sylvia’s gross estate, because at the time of Sylvia’s death, she had an incident of ownership. That is, she had the power to change the beneficiaries under the insurance policy, thus, the insurance proceeds should be pulled back into the estate.
Finally, the court agreed with the IRS that the estate was liable for additions to tax for failing to timely file the return and pay tax. Under Internal Revenue Code Sections 6651(a)(1) and (2), a taxpayer is subject to additions to tax unless it shows that such failures were due to reasonable cause and not willful neglect. Although there was confusion surrounding whether Sheri could file the estate tax return, the estate didn’t demonstrate that it exercised the requisite ordinary care and prudence to establish reasonable cause. In fact, the court found unpersuasive Sheri’s argument that she justifiably relied on Caviola’s advice. Rather, the court found that the estate’s failures were due to willful neglect and upheld the IRS’ determination of additions to tax.