CLAIMS BASED ON TESTAMENTARY INTENT ARE NOT DEDUCTIBLE UNDER SECTION 2053 FOR ESTATE TAX PURPOSES

Code 2053(a)(3) allows an estate to deduct claims that are paid in calculating estate taxes. Oftentimes, estate litigation involves disputed claims. Are the payment of those claims deductible?

They can be, but not if the payment is attributable to the testator’s testamentary intent. This was illustrated in a recent Tax Court case.

In the case, a caretaker of the decedent was a $100,000 pecuniary beneficiary under the decedent’s first set of trust documents. Under a second set of documents, the caretaker became a testamentary trust beneficiary. When the decedent died, litigation ensued between the caretaker and members of the decedent’s family. The parties settled, and the caretaker was paid $575,000.

The estate treated the first $100,000 as a bequest to the caretaker. They then sought to deduct the remaining payment as a deductible claim under Code §2053(a)(3).

Not so fast, said the Tax Court. A requirement for deductibility is that the claim is based on adequate consideration. The Court found that the caretaker had been fully paid for his lifetime services, and thus there was no consideration given to the deceased for the payment to him – also, no claim for unpaid compensation had been filed. Further, per the caretaker being a named beneficiary in both the first and second trust documents, it was clear that the payment was in settlement and a substitute for the gifts provided in the trust documents. As such, the payments were attributable to the decedent’s testamentary intent, and thus not deductible.

The estate also sought deductibility under Code §2053(a)(3) per the payment being made to “preserve estate assets.” The Tax Court determined that such grounds did not apply when the payment is attributable to testamentary intent.

Estate of Sylvia E. Bates, TC Memo 2012-314

EMPLOYERS PAY THE FUTA PRICE OF THEIR STATE'S LACK OF FINANCIAL DISCIPLINE

Employers pay federal unemployment tax (FUTA) at a rate of 6.0% on the first $7,000 of covered wages paid to each employee each year. However, employers can offset this tax with credits of up to 5.4% (the “normal credit”)  for amounts paid to a state unemployment fund by January 31 of the subsequent year. Thus, the net FUTA rate for many employers is only 0.6%.

Under federal law, states with financial difficulties can borrow funds from the federal government to pay unemployment benefits. However, if a state defaults on its repayment of the loan for at least 2 years, the normal credit available is reduced. This effectively increases the employer's FUTA tax rate by 0.3% for each year in which the loan isn't repaid. Are there states out there that have defaulted on repayment? Of course.

Is your state on the default list? Here is the list and how much it is costing their employers:

--0.9% credit reduction - Indiana.

--0.6% credit reduction - Arkansas, California, Connecticut, Florida, Georgia, Kentucky, Missouri, Nevada, New Jersey, New York, North Carolina, Ohio, Rhode Island, and Wisconsin.

--0.3% credit reduction - Arizona, Delaware, and Vermont.

APPLICABLE FEDERAL RATES–DECEMBER 2012

WANDRY ROLLER COASTER CONTINUES

I have written several times about the Wandry decision, and its respect for a formula adjustment clause in the gift tax arena. This decision has had its ups and downs, since it came out earlier this year.

Up – the Tax Court issues its decision upholding the clause.

Down – the IRS appeals the decision.

Up – the IRS withdraws its appeal.

Down – the IRS has now issued its nonacquiescence to the Wandry decision.

After the IRS withdrew its appeal, I don’t think that there were too many people out there who read that as an IRS concession that these clauses were valid and effective (although many hoped so). With its nonacquiescence, the IRS has now made clear that it does not believe Wandry is good law.

For more on Wandry, click here.

What exactly is a “nonacquiescence?” The Internal Revenue Bulletin provides that it means, as to a Tax Court decision, that “although no further review was sought, the Service does not agree with the holding of the court and, generally, will not follow the decision in disposing of cases involving other taxpayers.”

AOD in 2012-46 IRB

A DAY OFF!

Thanks to Kelly Greene at the Wall Street Journal, I am taking the day off from this blog today. She did my work for me today by writing her article on Last-Minute Gift Traps. Not only is it a great summary of the potential risks under the 2012 year end gifting tsunamai, but she includes my name and thoughts throughout the article.

It is always nice to see your name in the paper  - unless it is in the obituaries or the criminal news section!

Here is a link to the article on the WSJ website. If the link has expired, you can download a PDF version here. Regular readers here have probably seen most of what is in the article, but it is a good summary and reminder of some of the potential gifting risks.

Last-Minute Gift Traps, Wall Street Journal, November 9, 2012

POLICY LOANS CAN BITE YOU

Life insurance policies can be great vehicles for income tax deferral. Part of this arises from the fact that earnings growth that occurs inside the policy is not subject to current income tax (and may never be taxed if the policy is maintained in force until the death of the insured). Another part of this comes from the ability of an insured to “borrow” from the cash surrender value of the policy, and thus access policy value and growth, without paying a current income tax.

However, some insureds learn the hard way that unexpected income tax consequences can arise. A recent Tax Court case illustrates a common trigger for taxable income to an insured policy owner.

The tax principle involved relates to the termination of the policy during the lifetime of the insured. This can happen because the owner ceases to pay premiums, cashes in the policy, or the policy otherwise lapses. In this circumstance, if there are loans against the policy, the loan balance is treated as having been paid to the owner at the termination of the policy (principally by the insurance company applying any remaining cash surrender value towards repayment of the loan balance). If this loan amount exceeds the owner’s “investment in the contract” (generally, the total premiums paid by the owner less distributions made to the owner), the taxpayer has to include that excess in its income.

Thus, borrowing against a life insurance policy opens the door to this income, if the policy is cancelled during the owner’s lifetime before the death of the insured. Of course, if the total loan amount, plus additional cash value returned to the taxpayer, does not exceed the premiums previously paid, such income will not arise.

The problem is that there are two sources of policy loan growth that are not immediately obvious. The first is that if there are loans, interest is charged on the loan balance by the insurance company so that the loan balance increases over time just from interest alone. The second is that if some of the policy cash values are used to pay premiums in whole or in part, these are booked as policy loans. These increases can push the policy loan balance beyond the amount that had been paid into the policy in premiums, and an owner may not even be aware of the growing loan balance.

A secondary problem is that insurance companies may cancel a policy of their own accord when the loan balances approach the cash surrender value of the policy. The company then repays itself from the cash surrender value. This loan repayment is treated as a distribution to the owner, thus triggering the potential income recognition described above.

In White, a Tax Court Memorandum decision, this was painfully illustrated to the taxpayer. In the case, the life insurance company canceled the policy when the loan balance exceeded the cash surrender value. The loan balance came about from premium payments being made from the cash value of the policy. The insurance company applied the cash surrender value to the loan balance, and that amount exceeded the owner’s investment in the policy. Thus, the owner incurred income to the extent of that excess. To make matters worse, this income was “phantom” income – that is, the taxpayer picked up income without receiving any actual dollars, and thus had to pay the tax bill out of other funds.

Note that these problems typically go away at the death of the insured, since the loan balance is effectively paid off from the death benefits without an income tax consequence. It is the earlier termination of the policy before the death of the insured that gives rise to these problems.

White, TC Summary Opinion 2012-108

WHEN IS BAD HEALTH AN EXCLUSE FOR A LATE RETURN?

Late filing of a tax return and payment of taxes is subject to penalty absent reasonable cause, if not due to willful neglect. Code §6651(a)(1). In a recent Claims Court case, the key focus by the court in weighing bad health as an excuse for a late gift tax return filing was was whether the taxpayer’s incapacity from illness was “continuous.”

This is not the first case dealing with serious illness as a reasonable cause excuse. The Supreme Court indicated in Boyle, 55 AFTR 2d ¶ 85-1535 (1985) that serious illness of a taxpayer or a member of his immediate family could constitute reasonable cause, but it did not decide how ill that person must be. In Sanford, 71 AFTR 2d ¶ 93-405 (CA 11 1992), the 11th Circuit Court of Appeals recognized the excuse if the taxpayer was unable to exercise reasonable business care. In Williams, 16 TC 893 (1951), an intermittent period of disability was not enough for penalty relief.

In the current case, the taxpayer made substantial gifts in 2007 and owed approximately $1.8 million in gift taxes. She filed her gift tax returns late, and incurred penalties.  The taxpayer suffered numerous health care problems after the gift, including knee replacement surgery, cataract surgery, thyroid problems, heart palpitations, pneumonia, and other respiratory problems. Despite these problems, the Claims Court found that the taxpayer was not continuously incapacitated at the time when she could have informed her tax advisors of the transactions for reporting purposes.

Probably most troublesome for the court was that the taxpayer completed numerous other financial transactions in 2007 through April 15,2008. These including calling tax attorneys, reviewing deeds for the conveyance of real property, visiting notaries, mailing documents to her tax returns, reviewing her 2007 federal and state income tax returns and estimated tax returns, making out checks, and mailing checks to the tax authorities. By able to do these things, the court felt there was no way she was continuously incapacitated.

Stine, 110 AFTR 2d ¶ 2012-5383 (Claims Ct 2012)

SOME 2013 INFLATION-ADJUSTED NUMBERS

Kiddie Tax Exemption	$2,000
Special Use Valuation Reduction Limit	$1,070,000
Regular Gift Tax Annual Exclusion	$14,000
Increased Annual Exclusion for Gifts to Noncitizen Spouses	$143,000
Reporting Foreign Gifts	$100,000 for gifts from nonresident alien individuals or foreign estates, $15,102 for gifts from foreign corporations and foreign partnerships
Foreign Earned Income Exclusion	$97,600
Social Security Wage Cap	$113,700
401k Limit	$17,500
Defined Contribution Plan Limit	$51,000