PSYCHOLOGICAL FACTORS IN T&E LITIGATION SETTLEMENT

When dealing with clients on evaluating and settling estate and trust litigation, attorneys need to be cognizant of some psychological factors that may inhibit their clients from rationally acting or evaluating the case in their own self-interest. A recent article in the Estate Planning Journal discusses some of these factors. With knowledge of these factors, the attorney can better understand what may be motivating his or her client, and also work to reduce the influence of factors that are distorting client perceptions and evaluations.

1. ENDOWMENT EFFECT. A client under the influence of the endowment effect will exaggerate the value of his or her position simply by reason of ownership of items involved, or by holding such a position for a period of time. That is, things take on more value if they are actually owned or the longer they are held or owned, than would otherwise be the case.

2. PASSIONS. Obviously, client emotions and passions influence judgment. In estate and trust litigation, these passions will include grief, guilt, sibling rivalry and other jealousy, hostility towards second (or subsequent spouses), etc.

3. UNDERVALUE OF COSTS. Litigants tend to overly discount the likely future cost of litigation.

4. SELF-SERVING BIAS. Litigants will tend to view situations in a way that make themselves look correct and as acting from good motives, while viewing opponents as wrong or acting with bad intent.

Pointing out these factors to clients may help them in being more objective and to help diffuse the impact of such distortions. The author also notes that in regard to self-serving bias, bringing this to the attention of a litigant may not be enough. In that case, the author believes that asking the client to list the weaknesses in his or her own case will help reduce the impact of this bias.

Helsinger, Howard M., Advising the Trust or Estate Litigant: When to Raise or Fold, Estate Planning Journal (WG&L, July 2010)

OVERPAYMENT AND UNDERPAYMENT RATES – 4TH QUARTER 2010

ESTATE SETTLEMENT RECIPIENTS LOSE A CHUNK TO THE IRS

Two brothers brought suit against their step-siblings and the estate of their step-mother for a share of ownership of real properties that were devised to them by their step-mother, but which were transferred out of the step-mother's death in the months before her death. A settlement agreement was reached that provided for cash payments to the brothers. The attorney for the brothers received a contingency fee, and that was that. Well, until the IRS came a-knocking.

The estate had deducted the brothers' settlement payments as claims against the estate for federal estate tax purposes. On audit, this claim was denied, and thus additional estate taxes, penalties, and interest were imposed. By this time, the estate had already distributed all of its assets. The IRS came after the brothers for the amounts due, under Code Section 6901 transferee liability.

The brothers raised a number of well thought-out reasons why transferee liability did not apply. Unfortunately, the Tax Court rejected them all. These issues are instructive, and thus are summarized below:

a. The brothers asserted that they did not receive "property of a decedent," which is a requirement for transferee liability. They based this argument on their having sued their step-siblings, and that the settlement funds were thus paid by the step-siblings and not the decedent's estate. The court rejected this because the actual funds were paid to them from the estate and because the estate was a co-defendant. But the court went on to address what would be the case if the payments had in fact been paid by the step-siblings directly. The court noted that if the step-siblings received property from the estate, and then paid the brothers from their own funds, transferee liability would still apply since a "transferee of a transferee" is still liable.

b. The brothers argued that they were not "transferees" because they received their settlement proceeds not as beneficiaries but in exchange for a waiver of their right to sue to enforce the terms of the will. However, the court characterized the settlement proceeds as a substitute for the real property devised to them, which was thus received as transferees.

c. The brothers argued that the portion of the settlement that was paid to their attorney for his contingency fee was not property received by them for transferee liability purposes. The court rejected this, acknowledging that such fees were authorized and attributable to the brothers, and thus deemed received by them before the attorney was paid.

Note that Code Section 6901 does not independently create transferee liability. Instead, a transferee must first have liability for the estate taxes under applicable State law or state equity principles. In this case, as in most such settlement circumstances, this is not much of a hurdle to the IRS since under the law of most (if not all) States, a beneficiary will be liable for estate obligations to the extent of distributions received by the beneficiary.

While not addressed in the opinion, the brothers perhaps may be able to sue and collect from the other estate beneficiaries who received estate assets to the extent that a portion of the estate tax liability is apportioned to them under the applicable State law and their shares were not previously charged with their apportioned liability. Also, perhaps the fiduciaries of the estate may have some liability to the brothers for the penalties that were incurred attributable to estate issues.

The lesson from this case is that every plaintiff in estate litigation needs to determine what the federal estate tax exposure is of the plaintiff upon success or settlement. More particularly, counsel for such plaintiffs need to think about whether tax, penalties and interest will be apportioned to their clients. If yes, should this be varied by agreement? If yes, how can their clients monitor estate tax compliance and audit activity to protect their interests? If yes, should other parties be burdened with the penalties or interest? If yes, how can their clients be sure the other parties will pay their respective shares in case the IRS comes after only their clients for any deficiency?

We can't tell from the opinion whether the brothers knew of the risk of estate taxes being imposed on them by reason of the settlement, but I suspect the answer is no. This is doubly so as to the penalty portions of the liability.

Carl M. Upchurch, et al. v. Commissioner, TC Memo 2010-169,

APPLICABLE FEDERAL RATES – SEPTEMBER 2010

NEW TAX ACT PROVISIONS

On August 10, the Education Jobs and Medicaid Assistance Act was signed into law. The new law contains several new provisions relating to the foreign tax credit.

First, new Code §909 is added to the Internal Revenue Code. Without getting bogged down in the details, the new provision delays the foreign tax credit or deduction for a taxpayer until the foreign income that gives rise to the foreign tax is taken into account by the taxpayer – if this never happens, then the credit or deduction is lost for good. The delay is triggered by a “splitting” transaction which is when the related income is taken into account by related entities or persons to the taxpayer who seeks the credit or deduction. Congress was concerned that some taxpayers were engaging in tax structuring so that foreign income was incurred by related persons or entities that are not currently subject to U.S. tax while still allowing the income to generate U.S. foreign tax credits that can be used to offset U.S. tax on other foreign income. The deferment of the credit or deduction will also apply for deemed paid credits under Code §§902 and 960.

Another new provision is Code §901(m), which acts to disallow a portion of the foreign tax credit or deduction for actual or deemed asset acquisitions that arise in certain circumstances (referred to as “covered asset acquisitions”). The genesis of this provision is a concern that U.S. taxpayers were obtaining basis step-ups in foreign assets in transactions that did not result in a basis step-up for foreign purposes. Thus, such assets could generate more income or gain or less depreciation in foreign jurisdictions than is arising in the U.S., giving rise to more foreign tax and less U.S. tax. The new provision, again in a complex manner, targets this extra foreign income tax and denies foreign tax credits and deductions for it. Covered asset acquisitions include (a) Section 338 qualified stock purchases that are treated as asset acquisitions, (b) other transactions which are treated as asset acquisitions fore U.S. tax purposes but are treated as stock acquisitions or are disregarded for purposes of the foreign income taxes of the relevant foreign jurisdiction (e.g., the purchase of shares of a corporation that is disregarded for U.S. tax purposes), and (c) acquisitions of partnership interests for which a Code §754 election is in place. Again, the common denominator in these acquisitions is a basis step-up in assets for U.S. purposes, but not foreign tax purposes.

Lastly, new language under Code §904(d)(6) seeks to restrict the availability of foreign tax credits and deductions for taxpayers that have income which would be treated as U.S. source but which is instead characterized as foreign source under a treaty. The concern is that this increase in foreign source income under a treaty, which is often of a type that is lightly taxed by the foreign jurisdiction, creates more foreign source income than is appropriate (which foreign source income allows for greater taxpayer credits and deductions). The new provision effectively creates separate baskets for each such item of income, thus allowing only the foreign taxes imposed on each such item to be creditable or deducted. Thus, each item of income must be separately tracked and analyzed.

COMMENTS: The foreign tax credit is already a complex area, that is little understood beyond those that often deal with it. The foregoing provisions address legitimate concerns of the government. However, the remedies further complicate the area, and will result in additional taxpayer compliance costs and frustration. Taxpayers would like to understand the laws applicable to them, and would also not like to have to pay substantial fees to advisors and accountants to have them explained and applied. The complexity of these new provisions indicates the total disregard for these taxpayer concerns by Congress.

UPDATED TABLE ON FLORIDA HOMESTEAD RESTRICTIONS ON TRANSFER

Several years ago I posted my summary table on Florida’s homestead restrictions on transfer. As those who have dealt with these restrictions know, they can be difficult to both remember and correctly apply.

I have now updated the table for the new election available to a surviving spouse on a bad devise to obtain a 50% tenancy in common interest in lieu of a life estate.

The table is available here.

COVENANT NOT TO COMPETE DEFEATS PERSONAL GOODWILL CLAIM

Dr. Howard was the sole shareholder, officer, and director of his personal service corporation. Back in 1980, he entered into an employment agreement and a covenant not to compete with the corporation.

In 2002, the corporation sold the practice. In the sale, $549,900 of the purchase price was paid to Dr. Howard as a sale of his personal goodwill in the practice (instead of such amount being paid to the corporation for its goodwill). Dr. Howard reported the sale of the goodwill on his individual return, as capital gain.

The IRS challenged the sale, claiming the goodwill belonged to the corporation.

The court acknowledged that the “essence of goodwill is the expectancy of continued patronage, for whatever reason…the probability that old customers will resort to the old place without contractual compulsion.” As such, the court also recognized that a professional that works for a personal service corporation can have personal goodwill. Unfortunately, in this circumstance, the goodwill that was sold was held to be corporate goodwill, and not goodwill belonging to Dr. Howard.

What did in Dr. Howard was the employment agreement and the covenant not to compete that he had with the corporation. Relying on prior case law, the court determined that the personal relationships with the patients became the property of the corporation by reason of those agreements. Absent such agreements, the court would likely have ruled differently.

The sad part of the case is that Dr. Howard really did not need an employment agreement nor a covenant not to compete, since he was the sole shareholder. Those items generally protect the corporation vis-a-vis its employees, but as a practical matter Dr. Howard was protecting himself (as shareholder) from himself (as employee).

A curious part of the case is that the IRS and the court converted the payment to Dr. Howard to a taxable dividend to him. One would think that the proper tax accounting would have been income to the corporation, followed by either a dividend (or liquidating distribution if applicable) to Dr. Howard.

Howard v. U.S., 106 AFTR2d 2010-xxxx (7/30/2010)

KEY MAY 2010 FLORIDA PROBATE LAW CHANGES [FLORIDA]

The following summarizes the interesting recent changes made to Florida’s Probate Code.

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1. Fla.Stats. § 655.935 - Safe Deposit Boxes

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1.1 Lessor may have obligation to gather information and copies regarding items removed from the decedent's safe deposit box.

1.2 COMMENT: Helpful to avoid cases of "disappearing dispositive documents."

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2. Fla.Stats. § 731.110 - Caveats

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2.1 Provides noncreditors may file caveats prior to death, subject to 2 year expiration period.

2.2 COMMENT: A procedural break to noncreditors.

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3. Fla.Stats. § 731.201 - Notice

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3.1 Clarification of formal and informal notice definitions by reference to particular Probate Rules.

3.2 COMMENT: Clarification is always a good thing.

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4. Fla.Stats. § 732.401 - Surviving Spouse Interest in Homestead

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4.1 In lieu of receiving a life estate in homestead that is improperly or not devised, the surviving spouse may elect to receive a 50% tenants in common interest (with the other 50% vesting in the decedent's descendants).

4.2 6 month election period.

4.3 Election filed in real property records.

4.4 Disclaimer of surviving spouse's interest in homestead will not act to divest statutory remaindermen of their interest.

4.5 Fla.Stats. § 732.4015 directs that disclaimed spousal interest passes in accordance with Chapter 739 (Fla.Stats. § 732.4015).

4.6 COMMENT: Useful method to reducing conflicts between surviving spouse and decedent's descendants, especially if descendants are not lineals of the surviving spouse.

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5. Fla.Stats. § 732.4017 - Lifetime Homestead Transfers

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5.1 Irrevocable inter vivos transfers will be respected as such and will not be treated as testamentary transfers subject to restrictions on devises.

5.2 Such transfers include transfers in trust, and transfers when transferor retains rights in the property or transfers are subject to contingencies.

5.3 COMMENT: Useful in avoiding arguments that irrevocable inter vivos transfers will not be subject to testamentary homestead restrictions.

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6. Fla.Stats. § 732.805 - Marriage Obtained by Fraud, Duress, or Undue Influence

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6.1 Surviving spouse will not have listed marital rights, including rights under the Probate Code.

6.2 COMMENT: Having seen too many instances of fraudulent marriages of elder persons, this is a good thing. The litigators will like this, too.

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7. Fla.Stats. § 733.1051 - Revisions of Wills for 2010 Decedents

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7.1 Provides a procedure for court review and revision of Wills with dispositive provisions that are affected by repeal of estate tax in 2010.

7.2 COMMENT: I preferred some of the other approaches that treated the decedent as having died on 12/31/09. This one requires litigation, and may require having draftsman declare their own errors to obtain relief.