In a recent U.S. District Court case from the Southern District of California, the court ruled on several motions to dismiss relating to the IRS' attempt to impose liability on a surviving spouse for estate taxes on the estate of her decedent husband, even though the property received by the surviving spouse was eligible for the marital deduction. The IRS attempted various approaches. Some of the more interesting approaches are discussed below, along with the court's resolution.
The facts are somewhat lengthy. Boiling them down to the key aspects, Allen Paulson (the decedent) entered into a prenuptial agreement with his spouse-to-be, Madeleine Pickens. The agreement included obligations for Mr. Paulson to make certain gifts to Ms. Pickens when he died. Mr. Paulson's living trust made provisions for Ms. Pickens, but gave her the ability to elect to receive either under the prenuptial agreement or the living trust provisions. The living trust provided for substantial gifts to a marital trust.
After Mr. Paulson's death, the IRS granted an extension of time to file the Form 706 and to pay estate taxes. When filed, the Form 706 reported a total gross estate of $187,729,626, a net taxable estate of $9,234,172, and an estate tax liability of $4,459,051, and this tax amount was assessed on November 26, 2001. The estate elected to pay $706,296 in tax and deferred the remaining tax under Code §6166.
The estate tax return was selected for audit. During the audit, disputes arose between the estate and trust fiduciaries, Ms. Pickens, and some beneficiaries. Under a 2003 settlement, Ms. Pickens gave up the distributions provided under both the prenuptial agreement and the living trust, instead choosing to receive direct distributions from the living trust of two residences and stock in a country club. These amounts were paid to Ms. Pickens as trustee of a trust bearing her name, the Madeleine Anne Paulson Separate Trust (or so it appears, since the trust bears both her first name and her married last name).
The IRS proposed a deficiency of almost $38 million in estate taxes. A Tax Court determination, based on the stipulation of the parties, resulted in an increase in the estate taxes of $6,669,447. The estate elected to add this to its Code §6166 deferred payment obligation.
In 2010, the IRS rescinded Code §6166 treatment due to missed installment obligation payments. This rescission was affirmed by the Tax Court in 2011 after a taxpayer challenge.
Additional litigation between interested parties resulted in the resignation of the executor in 2013. As of 2015, the estate tax liability stood at $10,261,217. The U.S. filed a complaint seeking judgment against the estate and various persons in their fiduciary and individual capacities, including Ms. Pickens. Various cross-claims were also filed between the parties. What follows below are some of the more interesting defenses raised by Ms. Pickens and the court's rulings on them.
Statute of Limitations on Collections. Ms. Pickens claimed that a portion of the tax being sought relates to the 2001 assessment, and is thus time barred by the ten-year statute of limitations. The U.S. argued that the 2001 assessed taxes were previously paid, and that the remaining tax relates to the 2006 post-audit assessment. Thus, applying a first-in, first-out approach to the taxes, this left all of the remaining taxes available for collection within the ten-year window. The court ruled in favor of the U.S.
Liability for Tax as Statutory Executor. The U.S. sought to hold Ms. Pickens responsible, in her representative capacity, for the tax as the executor of the estate under Code §2002. Ms. Pickens was never appointed and never served as the executor of the estate. Recall that the estate had an executor, but he resigned in 2013. The U.S. argued that Ms. Pickens is a statutory executor, subject to this liability, because she now owns property that formerly belonged to the decedent. Code §2203 defines an executor for these purposes as "the executor or administrator of the decedent, or, if there is no executor or administrator appointed, qualified, and acting within the United States, then any person in actual or constructive possession of any property of the decedent." The court noted that since there was no executor at the current time, the Code §2202 claim against her can proceed.
Transferee Liability as a Fiduciary of the Marital Trust. The government sought to impose transferee liability on Ms. Pickens under Code §6324(a)(2) as trustee of the Marital Trust. The court noted "it is unclear how Plaintiff can plausibly articulate a claim for relief against Ms. Pickens based on a role that she never assumed by virtue of the Marital Trust never being funded" and dismissed the Code §6324(a)(2) claim relating to trustee status.
Transferee Liability as a Beneficiary. The government also sought to impose transferee liability on Ms. Pickens under Code §6324(a)(2), this time as a beneficiary of the living trust. Reading the statute alone, one would likely side with the government on this. It reads: "If the estate tax imposed by chapter 11 is not paid when due, then the spouse, transferee, trustee (except the trustee of an employees' trust which meets the requirements of section 401(a)), surviving tenant, person in possession of the property by reason of the exercise, nonexercise, or release of a power of appointment, or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate under sections 2034 to 2042, inclusive, to the extent of the value, at the time of the decedent's death, of such property, shall be personally liable for such tax." Here we have a "beneficiary" receiving property includible in the gross estate and there being unpaid estate tax.
However, case law has limited the meaning of the term "beneficiary" in Code §6324(a)(2) to mean only the beneficiary of a life insurance policy. The court declined to depart from that limited interpretation and dismissed the U.S.' Code §6324(a)(2) claim relating to beneficiary status.
Transferee Liability as a Fiduciary of the Madeleine Anne Paulson Separate Trust. The government also sought to impose transferee liability on Ms. Pickens under Code §6324(a)(2) as trustee of the Madeleine Anne Paulson Separate Trust. Noting that the settlement assets were paid to Ms. Pickens as trustee of that trust, the court allowed the claim to proceed against her in her individual capacity.
IRS as Third Party Beneficiary. In the 2003 settlement agreement, Ms. Pickens agreed to indemnify other parties to the agreement for estate taxes attributable to assets she received. The IRS sought to piggy-back on those indemnification provisions to collect from Ms. Pickens based on it being a third party beneficiary of the settlement contract. The court allowed the IRS to proceed on that claim.
As to Statutory Executor Argument. One might wonder why the IRS is seeking to hold Ms. Pickens liable in her representative capacity, since if the transfers to her were respected as eligible for the marital deduction (as they opinion indicates they were), one would presume that the tax apportionment provisions of the subject documents and/or state law would direct payment of the estate taxes away from the assets she received. However, while such apportionment provisions may dictate who can sue who for contribution and indemnification, there is no general bar as to the IRS collecting from assets that are eligible for the marital deduction even if the dispositive documents or state law indicate otherwise.
The IRS also may have had a more hidden motive. There is language in the opinion that the IRS is seeking to obtain a judgment against the estate by naming its executor or administrator in a representative capacity so as to reduce the estate tax liability to a judgment under Code §7402, and to extend the statute of limitations for collection of that tax under Code §6502.
Ms. Pickens argued that the IRS' position would render every beneficiary of an estate a statutory executor when the appointed, qualified, and acting executor resigns. An interesting argument, but one that apparently did not impress the court.
As to Transferee Liability as a Beneficiary. The limitation of the term "beneficiary" to a beneficiary of a life insurance trust is a warning to not always take unambiguous statutory language at its face value.
As to Transferee Liability as a Fiduciary of the Madeleine Anne Paulson Separate Trust. Bad luck for Ms. Pickens on this one. Having ruled that Ms. Pickens has no transferee liability as a beneficiary, if the settlement agreement paid the assets directly to Ms. Pickens instead of a trust for her, there probably would be no transferee liability.
As to IRS as Third Party Beneficiary. Taxpayers often include tax indemnification provisions in their settlement and other agreements. The recognition of third party beneficiary rights in the IRS suggests that such agreements be drafted in a manner (if practical and possible) in a manner that eliminates such a third party beneficiary claim. One has to wonder again where the IRS is going with this, since Ms. Pickens indemnification relates only to taxes on the assets she received. As marital deduction property, there should be no taxes and thus no indemnification. The opinion does give mention of other settlement agreement language that perhaps overcomes this limitation.
Overall, the case also demonstrates that the IRS is not immune from the well-known litigation strategy of throwing it all against the wall to see what sticks.
U.S. v. Paulson, Case No. 3:15-cv-02057, U.S. District Court, Southern District of California (September 6, 2016)