Section 2053 of the Internal Revenue Code allows for the deduction of funeral expenses, administration, claims against the estate, and certain indebtedness of a deceased in computing federal estate tax. Under the estate tax, the value of assets against which the estate tax is applied is measured on the date of death (or under the alternative date election, 6 months after the date of death.) Likewise, the amount of deductions is generally computed as of the date of death. However, some deductions clearly arise after death (e.g., funeral expenses and administrative expenses) so these are not fixed as of the date of death. Further, the question of what post-death events can be considered in determining the deductible amount of a claim against an estate has been the subject of numerous (and inconsistent) pronouncements by the courts and the IRS.
What happens with claims against an estate that are contested, contingent, unenforceable, become unenforceable after the decedent's death, or are not in fact presented for payment? How much can an estate deduct on its return? Oftentimes, a fair amount of speculation and guesswork goes into such determinations (both by taxpayers and the IRS). Further, if the IRS does not agree with the amount claimed, expensive and time consuming administrative proceedings and court cases result.
In an effort to bring more certainty to the deduction question, and to limit disagreements between the IRS and taxpayers, the IRS has issued proposed regulations that radically vary the current procedures. Under the proposed regulations, for claims against an estate arising in contract or tort, an estate may not deduct such a claim under Section 2053 UNTIL THE CLAIM IS PAID BY THE ESTATE. The regulations specifically provide that post-death events are thus considered.
A principal effect of these rules will be that for claims not paid by the time the estate tax return is filed, no deduction will be initially allowed, and thus tax may be overpaid. If the claim is later paid, a claim for refund can then be filed based on the deduction that is then allowable. If the statute of limitations for filing for a refund has expired, the estate is generally out of luck – however, it can file to extend the statute of limitations by filing a protective refund claim before the statute of limitations expires (if the protective claim is not timely filed, the later refund claim will not be allowed) to allow for a later claim.
If a claim becomes unenforceable, and it is paid after that, no deduction will be allowed. The regulations also provide for a presumption against the validity of claims to related parties and entities. The proposed regulations also provide rules when a court decree can be relied upon to fix a deduction amount, and when a settlement of a claim will be respected for this purposes.
These new rules would be a mixed blessing for taxpayers. On the plus side, taxpayers would have more certainty in regard to what should be reported as deductible claims, and will also spend less time and money fighting with the IRS on those issues. They can also avoid the problem of underestimating a claim and thus not getting a full deduction if the final claim amount is not determined until after expiration of the statute of limitations for refund. On the negative side, and this is a big negative, estates must first pay estate taxes without a deduction for contested or uncertain claims, and then later ask for taxes back once the claim is paid. This can have significant cash flow implications to estates.
The proposed regulations are not yet effective, and will not be until final regulations are actually issued.