Tax Considerations in Will Contests
December 12, 2013
The period following someone’s death can be an emotional time. Unfortunately, the period of administration of the decedent’s estate can be just as emotional, though for different reasons. As the intended disposition of the decedent’s assets becomes “public,” the estate’s beneficiaries, and others, may challenge such disposition. The manner in which these challenges are resolved can have significant tax and economic consequences for the decedent’s estate.
The estate tax is imposed upon the transfer of the assets comprising a decedent’s estate. The taxable estate is determined by subtracting from the value of the gross estate certain deductions authorized by the Internal Revenue Code. Under various conditions and limitations, deductions are allowable for administration expenses, charitable transfers, and transfers to a surviving spouse. Once the taxable estate has been ascertained, the estate tax rates are applied to arrive at the gross estate tax (before authorized credits).
In theory, the process of compiling the necessary information for determining the tax is straightforward. In practice, however, it can become challenging. The fiduciary must: identify and “collect” the decedent’s assets; determine the decedent’s outstanding liabilities; and dispose of the decedent’s estate.
The starting point for directing the disposition of the decedent’s assets, including the identification of deductible transfers, is the decedent’s last will or revocable trust. These instruments may provide for an outright transfer of property to the decedent’s spouse or a charity. In some cases, they will grant the fiduciary authority to select a charitable recipient. Rather than an outright transfer, the instrument may create a split-interest trust for the benefit of the spouse or a charity, and certain non-marital and non-charitable beneficiaries (usually from the decedent’s family).
What happens, however, when the validity of the will or trust, or of the dispositions of property provided therein, are challenged? The fiduciary will certainly incur additional legal, accounting and other fees and expenses in defending the instrument. As a result of the legal proceedings, the disposition of the decedent’s assets may change – either by court decision or through a settlement by the parties – and, consequently, the value of the taxable estate. For example, it may be determined that an asset does not belong to the estate, or that a disposition under the will should not have been made to a specific charity.
These determinations have estate tax and other tax consequences of which the fiduciary should be aware because they impact the economic result of the settlement. Frequently, however, not enough attention is paid to the tax treatment of the settlement and, consequently, the economic cost may become more expensive than it otherwise could have been.
Estate Tax Return and Payment
The timing of the will contest raises a number of tax considerations. In general, the estate tax return must be filed, and the estate tax paid, within nine months after the decedent’s date of death. If a timely extension application is made, the estate will have an additional six months to file the return. Extensions of time to pay the tax are granted less frequently, and require a showing of good cause.
In the event the will contest cannot be resolved before the due date for the return, the fiduciary should disclose the nature of the dispute on the return, since the resolution thereof will likely affect the amount of estate tax owed by the estate. Similarly, the fiduciary will have to determine how much estate tax to remit while the contest is pending. This necessitates consideration of the merits of the claims and of the expected litigation costs. In the case of an “overpayment,” the fiduciary must be mindful of the possibility of claiming a refund. If it appears that the litigation will continue beyond the limitation period for a refund, the fiduciary should consider filing timely a protective refund claim.
Will the IRS respect the Settlement?
Whether the IRS will respect the settlement is an issue characterized by the intersection of state property law and federal tax law.
The determination of the federal estate tax is based upon the respective property rights of the decedent (what assets did he own at his death), of his creditors (what liabilities do the decedent and/or his estate owe), and of the beneficiaries of his estate (to whom do the decedent’s assets pass after the satisfaction of these liabilities). These various property rights arise under state law. In the case of a will contest, the adversarial nature of the proceeding is an important factor in determining the federal tax consequences of the settlement, though it may not be determinative; the IRS is generally free to review the applicable state law for the purpose of determining whether the terms of the settlement are, in fact, consistent with the property rights of the parties under such state law. It is important to bear in mind that the IRS may not be bound by a settlement agreement.
Administration expenses are those that are actually and necessarily incurred in the administration of the decedent’s estate; for example, for the collection of assets, payment of debts, and distribution of property. These may include legal fees incurred by the fiduciary, which are usually deductible for estate tax purposes. However, expenditures that are not essential to the settlement of the estate, but that are incurred for the individual benefit of the decedent’s heirs, may not be taken as deductions. For the expenditure to be allowable as an administration expense, it must have benefited the estate as a whole, as contrasted with the personal benefit of a beneficiary. This distinction is often difficult to make.
A settlement may establish the amount of a claim or expense for tax purposes, provided that the expenditure is allowable under local law, the settlement resolves a bona fide issue in a genuine contest, and it is the product of arm’s-length negotiations by parties having adverse interests with respect to the claim or expense. No deduction will be allowed for amounts paid in settlement of an unenforceable claim. A consent decree should be accepted as fixing a claim when the consent was a bona fide recognition of the validity of the claim – not a mere “cloak” for a gift to a family member – and was accepted by the court as satisfactory evidence upon the merits. However, if a local court does not adjudicate the merits of a claim, its decision as to its deductibility will not necessarily be accepted by the IRS.
The foregoing assumes that the settlement payment represents an expense. A review of the underlying claim may indicate otherwise. For example, if a payment is made by the estate to someone claiming a share of the estate as a beneficiary, it is likely that the payment will not be deductible as an expense for estate tax purposes (though it may qualify for the marital or charitable deduction).