Bar Report Seeks Withdrawal of Proposed Regs on Postdeath Events, Taxable Estate Values

On the premise that the courts' inconsistency and a split in authority caused problems regarding deductions dealing with post-death events, on April 23, 2007, the IRS rejected decisions of the Supreme Court and a majority of the Circuit Courts of Appeal and issued proposed regulations under IRC § 2053, including Treasury Regs. § 20.2053-4. The new proposed regulations limit the availability of any deduction on the estate tax return to amounts actually paid by the estate. In essence, if no payment is made, no deduction is permitted.

Since many such expenses and claims remain pending at the time the statute of limitations for assessment and collection of the estate tax is due to expire, under the proposed regulations, in lieu of being allowed to claim a deduction on the estate tax return (Form 706), the executor will need to file a protective claim for refund to preserve its right to claim any such deduction under IRC § 2053(a), outlining the reasons why actual payment has not been made. The IRS will then act on that claim only after it has been paid and any and all contingencies have been resolved. The new, additional filing requirements, disclosures and payments (any/all of which can adversely affect the fiduciary's liability exposures and litigation positions with respect to the underlying claims) contemplated under the proposed regulations impose an unreasonable hardship on fiduciaries.

Finally, the proposed regulations will not work properly with certain elections and estate planning clauses.

Based on the foregoing, the authors suggest that these proposed regulations be withdrawn.

IRC § 2053(a)(3) states, in relevant part, that, "[f]or purposes of [the federal estate tax], the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts . . . for claims against the estate . . . as are allowable by the law of the jurisdiction . . . under which the estate is being administered."³

Interestingly, while § 2053(a)(3) is silent as whether and, to what extent, if any, post-death events should be considered for purposes of determining the validity and/or value of claims against an estate, the Treasury regulations under that section, which have not been amended since 1958, provide guidance. Treasury Reg. § 20.2053-4 states, in relevant part, that "[t]he amounts that may be deducted as claims against a decedent's estate are such only as represent personal obligations of the decedent existing at the time of his death, whether or not then matured . . . "⁴ This regulation further states that "[o]nly claims enforceable against the decedent's estate may be deducted;" and that "[l]iabilities imposed by law or arising out of torts are deductible."⁵

Treasury Reg. § 20.2053-1(b)(3) allows deductions attributable to claims even though the exact amount of any such claim is not known on the date the estate tax return is filed, provided it was ascertainable with reasonable certainty at that time and will be paid.⁶

While Treasury Reg. § 20.2053-4 contains a temporal reference in the words "at the time of his death," the "reasonable certainty" and "will be paid" provisions of Treasury Reg. § 20.2053-1(b)(3) appear to allow post-death events to be considered. These regulatory provisions have contributed to the unsettled nature of this issue.

Over the years, two lines of case law have developed with respect to the analysis of whether and to what extent, if any, post-death events should be considered in determining the validity and/or value of claims under § 2053. One line of cases, following Jacobs v. Commissioner,⁷ concludes that post death events are relevant and only amounts actually paid are deductible. The other, better reasoned, more widely accepted line, which follows Ithaca Trust Co. v. U.S,⁸ concludes that post death events are irrelevant and deductions under § 2053 should be based on the value of the pertinent claims at the date of death, rather than being based on those amounts which actually happen to have been paid before the estate tax return (or a claim for refund with respect thereto) is filed.

Ignoring the fact that the Supreme Court has addressed the issue, the IRS suggests that the 50 year old regulations under § 2053 needed amendment because of a purported split in authority. Contrary to the IRS' assertion, however, the majority of the circuits (Fifth, Seventh, Ninth, Tenth and Eleventh¹³) apply the principles the Supreme Court adopted in Ithaca Trust -- that valuation of claims against an estate is to be determined at date of death, post-death events are not to be considered.¹⁴ The only cases the authors could find adopting the rule that only amounts actually paid are deductible are cases in the Eighth Circuit and the Court of Claims.¹⁵

Thus, the proposed regulations are clearly adopting a "bright line" test that, if no payment is made, no deduction is allowed. Unfortunately, among the problems associated with making claims deductible only when paid is the statute of limitations. If the claim remains unresolved when the statute of limitations is due to expire, the executor may, under the proposed regulations, file a protective claim for refund to preserve the right to claim a deduction under Treasury Reg. § 20.2053-4(b). In this claim for refund, the executor must explain the reasons and contingencies delaying actual payment. The IRS will only act on the claim after the executor notifies them that the contingency has been resolved and payment has been made. The estate must also notify the IRS and pay additional taxes or file a refund claim for overpaid taxes if, after the filing of the estate tax return, the estate receives a tax refund or other adjustment to a paid claim.¹⁶

Proposed Treasury Reg. § 20.2053-4(b)(4) goes on to establish "a rebuttable presumption that claims by a family member of a decedent, a related entity, or a beneficiary of the decedent's estate or revocable trust are not legitimate and bona fide and therefore are not deductible."

If the pertinent code section is ambiguous or silent, regulatory review must then focus on the issue of whether the proposed regulation is based on a permissible construction of the statute. A permissible construction must be reasonable. Hence, the regulation must be rejected if it is unreasonable, arbitrary, capricious or manifestly contrary to the statute.¹⁸ In other words, the proposed regulation cannot embellish the statute, make law, or add something that Congress has overlooked.

For the reasons outlined in the analysis below, the recently proposed regulations on the treatment of claims against the estate under § 2053 are not valid.

II. ANALYSIS OF PROPOSED TREASURY REGULATIONS SECTION 20.2053-4.

No court has declared IRC § 2053 to be ambiguous. Thus, the IRS has no discretion to issue regulations contrary to the statutory intent.

The Supreme Court has clearly stated that valuation is to be determined as of the date of death. In Ithaca Trust Co.,²⁴ the Supreme Court refused to consider post-death events in the valuation of the estate's deduction for a charitable bequest (a sum certain based on the applicable actuarial calculations), opting to value the charitable remainder interest after a surviving spouse's life estate based on the appropriate actuarial factors instead of recognizing that the widow actually died before the filing of the decedent's estate tax return. Significantly reducing the amount of the charitable deduction allowable to the decedent's estate, the Ithaca Trust Court stated: "[t]empting as it is to correct uncertain probabilities by the now certain fact, we are of the opinion that it cannot be done . . . "²⁵ Thus, as a matter of law, the Ithaca Trust holding requires sum certain claims that are valid and enforceable at the time of the decedent's death to be valued without consideration of post-death events.

In Propstra v. U.S.,²⁶ the Ninth Circuit analyzed, in great detail, the 1954 amendment to IRC § 2053(a) which changed the language authorizing a deduction for claims "allowed by the laws of the jurisdiction" to the current "allowable by the laws of the jurisdiction." The Propstra court concluded "that enforceability was to be determined at date of death . . . [and] claims based on legally recognized and enforceable rights were deductible; claims that were unenforceable because they lacked legal foundation were not deductible, even if actually paid. Congress lent support to this . . . construction when . . . it replaced "allowed" with "allowable." [ Id. at 1254-1255.] Precluding consideration of post-death events in valuing a lien that was attached to one of the decedent's real properties on the decedent's date of death, even though the decedent's estate had the lien extinguished for a lesser amount, Propstra followed the Ithaca Trust approach: "we think that various indicia show that Congress intended that post-death events be disregarded when valuing the claims against the estate." [ Id. at 1254.] As Propstra ruled on Congressional intent when § 2053 was amended, the IRS cannot issue regulations contrary to that expression of Congressional intent. As the proposed regulations are contrary to that expression of Congressional intent, they are invalid.

Estate of Smith v. Commissioner,²⁷ the leading Fifth Circuit case, also follows the Ithaca Trust line of cases with respect to contingent liabilities and other claims for amounts uncertain as of the decedent's date of death. The Smith case involved a lawsuit against the decedent brought by an energy company over disputed royalty payments. The claim was eventually settled by the executors of the decedent's estate for significantly less than the amount of the original claim. Notwithstanding this fact, the Fifth Circuit held that the claim must be valued as of the date of death and, ". . . must [be] appraised on information known or available up to (but not after) that date."²⁸

In response to the IRS' "no pay, no deduction" approach, the Fifth Circuit, stated, "[w]e decline the Commissioner's invitation to rewrite the law."²⁹ In remanding the case to the Tax Court, the Fifth Circuit prohibited the consideration of post-death evidence and analogized the valuation of the claim to that of an interest in a closely-held business in which each party presents "evidence of pre-death facts and occurrences supporting the value of the [claim] advocated by that party."³⁰

The Tenth and Eleventh Circuits also follow the Ithaca Trust line of cases and cite Propstra in refusing to consider post-death events for purposes of determining the amount of the § 2053 deduction. The leading cases in these circuits, respectively, are Estate of McMorris v. Commissioner³¹ and Estate of O'Neal v. U.S.³² The Tenth Circuit's Estate of McMorris decision is notable for its thorough examination of the cases and promotion of the virtues of certainty for the taxpayer and the taxing authority alike. It also recognizes that any resulting benefits to be derived from refusing consideration of post-death events are dependent upon the facts of each particular case.³³ Thus, a rule refusing to consider post-death events does not, per se, favor either party.

In Estate of McMorris, the Tenth Circuit refused to consider post-death events that reduced an estate tax deduction for income tax liabilities after independent events caused the income taxes in question to become refundable to the decedent's estate. The Tenth Circuit focused on whether the deduction was properly calculated as of the date of death, and did not place reliance on the enforceability issue in its holding. It found that the deduction was properly calculated because the post-death events that triggered the refund were of independent origin and not relevant. Hence, the full amount of the originally claimed deduction was allowed.

In Estate of O'Neal, an Eleventh Circuit case following the Ithaca Trust holding, the claim was enforceable, but the amount of the claim was uncertain as of the date of death. The Estate of O'Neal court ultimately valued the claim under the strict date of death approach adopted by the Smith court. It refused to consider post-death events or allow such facts to be determinative of the IRC § 2053 deduction.

In Kyle Estate v. Commissioner,³⁴ the Tax Court made a clear distinction between the issues of valuation and enforceability of a claim. In Kyle, the claim at issue was filed post-death against the decedent's estate and, like the Smith case, was unresolved at the time of her death. The Kyle court determined that, in cases where the enforceability of a claim is an issue, post-death events are relevant for purposes of determining the validity/enforceability of the claim.³⁵ Where validity/enforceability is not an issue and the matter is merely one of valuation, post-death events are not considered.³⁶ Based on this case law, Kyle held that post-death events must be considered only in determining whether a claim is valid and enforceable. Thus, the Kyle court denied the estate's § 2053 deduction for a claim that was dismissed because it was not enforceable.

The Eighth Circuit is the only circuit that has taken the position that a deduction is allowed only for amounts actually paid. In Jacobs v. Commissioner,³⁷ the widow of the decedent never enforced her right to receive $75,000 under the terms of an antenuptial agreement with the decedent. Instead, she elected to receive her statutory share of the estate under state law. Thus, the Jacobs court refused to allow a $75,000 deduction for funds otherwise due to the widow under an antenuptial agreement which was enforceable at the time of the decedent's death.

Similarly, in Sachs v. Commissioner,³⁸ the Eighth Circuit denied a deduction under IRC § 2053 because an income tax liability of the decedent (that was paid prior to his death) was reduced post-death as the result of new legislation which resulted in a refund of a portion of the income tax claimed by the decedent's estate. The Sachs court affirmed that, in the Eighth Circuit, the date of death principle of claim valuation set forth in Ithaca Trust does not apply to the deductibility of claims under IRC § 2053. Thus, the estate lost its deduction because, as a legal matter, the claim ceased to exist without regard to whether the nullification of the claim was foreseen.³⁹ However, the Sachs court acknowledged that, in the context of a tort action filed against the decedent after his death, ". . .it would be absurd to deny the estate a deduction for the settlement of the lawsuit on the ground that the decedent was unaware of the potential claim on the date of his death."⁴⁰

Under the case law, which is replete, the courts have routinely found § 2053 to be unambiguous. In fact, numerous courts have stated the Congressional intent is clear. As the proposed regulations are contrary to the unambiguous statutory language, they are invalid.

In addition, many statutory elections will not work under the proposed regulations. For example, to determine whether an estate qualifies for installment payments under IRC § 6166, deductions allowable under § 2053 must be considered. As IRC § 2057 has a similar requirement for qualified family owned businesses, certain estates could be precluded from utilizing these special relief provisions, further thwarting Congressional intent.

The statute of limitations, which was intended to clearly delineate the timeframe within which an audit and assessment would be allowed, can become virtually inconsequential in situations where a protective claim has to be filed as the protective claim must, necessarily, effectively extend the statute, at least until the date the claim is resolved. When a claim for refund is filed and the statute of limitations has expired, the IRS can review the whole estate tax return and make new determinations on previously reported items. If the IRS determines there should be an increase in valuation, that increase in valuation can be used to offset any claimed deduction. While a deficiency cannot be assessed, the refund can be denied, effectively leaving the estate open to litigation with the IRS for years longer than contemplated by the current statute of limitations framework.

Other complexities and unreasonable difficulties created by the proposed regulations relate to the use of "formula clauses" for purposes of establishing values to be funded into marital trusts and/or credit trusts under certain estate planning documents. Because there will be no ability to determine what can/should be funded into any marital trust or credit trust until resolution of the final amount of a claim, the proposed regulations simply do not work with certain formula clauses (or, alternatively, they impose yet another delay in attempting to administer the estate in a timely fashion). One could argue that this issue just extends funding and taxation until the "second death". But, if one (still) cannot ascertain the marital deduction amount on the second death, determination of the taxable estate and/or filing of an estate tax return on the second spouse's death would appear to be an administrative impossibility.

Notwithstanding all of the above, assuming a reviewing court could determine (i) that § 2053 is ambiguous; (ii) that no court has stated that the statute is clear; and (iii) that the proposed regulations are not difficult or impossible to administer, the proposed regulations under § 2053 should not be upheld because they are unreasonable, arbitrary and capricious. The following examples from a recent article in the California Trusts & Estates Quarterly illustrate why the proposed regulations are unreasonable or arbitrary and capricious:

Example 1, Claim Against All Assets, Generally: Jane files a lawsuit against Jon, alleging that Jon owes Jane $1 million. Jane and Jon die the next day, and the sole asset of Jane's estate is the claim and Jon's estate owns one asset worth $1 million. Assume further that no other deductions or assets exist, the value of Jane's claim at date of death is $500,000, and ignore each decedent's applicable exclusion amount. Assume that at the time of the filing of the estate tax return, the claim is still pending.

Example 2, Claim to a Particular Asset: Assume the same facts as Example 1, except that Jane alleged that Jon stole a particular asset worth $1 million and that asset is the sole asset of Jon's estate.

Example 3, Claim as Business Liability: Assume the same facts as Example 1 except Jon's sole asset is an interest in a wholly owned business and Jane's suit named Jon and that business as co-defendants.

In all three examples, Jane's estate is subject to tax on the value of the claim as of the date of death [see IRC § 2031] and Jane's taxable estate would be $500,000. By contrast, the tax on Jon's estate changes in each of these three examples.

In Example 1, under these proposed regulations, $1.5 million would be subject to estate tax because Jane would have a taxable estate of $500,000 and Jon would have a taxable estate of $1 million and Jon's estate would have no deduction for the contingent claim.

In Example 2, only $1 million would be subject to estate tax because Jane would have a taxable estate of $500,000 and Jon would have a taxable estate of $500,000, because the fair market value of the $1 million asset would be reduced by the $500,000 contingent liability to Jane's estate. [See Id.]

In Example 3, by contrast, on Jon's death, the business would be subject to the claim for $500,000, and Jon's estate would value that business, and thus the estate's interest in that business, subject to its share of the liability under the claim. [See Id.] Thus, in Example 3, under these proposed regulations something less than $1.5 million but more than $1 million would be subject to estate taxes.

Logically, the results in Example 1 and Example 2 and Example 3 should be the same -- the type of Jane's claim and the type of Jon's assets should not determine the estate tax consequences. Nothing in the IRC provides any basis to conclude that the taxes should change based on the nature of the claim or the nature of the estate-defendant's assets. Rather, § 2053 provides a deduction for "claims" without any qualifications; so all claims should be treated equally.

Moreover, the proposed regulations benefit Jane's estate and are detrimental to Jon's estate. The representative of Jane's estate would know that under the regulations, Jon's estate has to pay estate taxes currently, without deducting the uncertain claim. If the representative of Jane's estate knew that Jon's estate needed to take advantage of the tax deduction currently, instead of waiting possibly years, the representative of Jane's estate could use that information to bargain for a larger, earlier settlement. Also, Jane's estate could take that deduction into account when settling its claim, because in essence Jon's estate is saving, roughly, 45 cents in taxes on every dollar paid in the settlement. [See IRC § 2001(c)(2)(B).] Thus, these proposed regulations provide an artificial incentive for Jon's estate to pay more than actually is owed or due, and to settle claims prematurely, just to take advantage of an estate tax deduction.⁴³

Webster's Third New International Dictionary defines arbitrary and capricious as follows:

III. CONCLUSION.

The proposed regulations under IRC § 2053 cause multiple problems. They are contrary to express statutory language; they do not interplay well with the estate tax provisions of the IRC; and they are unreasonable, arbitrary and capricious. Furthermore, they are in direct conflict with rulings from the Supreme Court and the Fifth, Seventh, Ninth, Tenth and Eleventh Circuit Courts of Appeal. Finally, implementation of the proposed regulations places unreasonable burdens and uncertainties on fiduciaries, a result which is, itself, contrary to Congressional intent. For these reasons, the proposed regulations should be withdrawn. Alternatively, they should be rewritten to conform with the United States Supreme Court's Ithaca Trust decision and the conclusions of the vast majority of the Circuit Courts of Appeal which have addressed the issues of whether and to what extent, if any, post-death events should be considered in determining the validity and/or value of claims under § 2053.

² Although the participants on the project might have clients affected by the rules applicable to the subject matter of this paper and have advised such clients on applicable law, no such participant has been specifically engaged by a client to participate on this project.

³ I.R.C. § 2053(a).

⁴ Treasury Reg. § 20.2053-4 (emphasis added).

⁵Id.

⁶ Treasury Reg. § 20.2053-1(b)(3).

⁷Jacobs v. Commissioner, 34 F.2d 233 (8^th Cir. 1929), cert. den'd 280 U.S. 603 (1929).

⁸Ithaca Trust Co. v. United States (1929) 279 U.S. 151.

⁹ 72 F.R. 20080.

¹⁰Id. at 20081.

¹¹Id.

¹²Id.

¹³Commissioner v. Lyne 90 F.2d 745 (1st Cir. 1937); Commissioner v. State Street Trust Company 128 F.2d 618 (1st Cir. 1942); Helvering v. O'Donnell 94 F.2d 852 (2d Cir. 1938); Estate of Shivley 276 F.2d 372 (2d Cir. 1960); Estate of Smith 198 F.3d 515 (5th Cir. 1999); Commissioner v. Strauss 77 F.2d 401 (7th Cir. 1935); Helvering v. Northwest National Bank & Trust Company of Minneapolis 89 F.2d 553 (8th Cir. 1937); Propstra v. United States 680 F.2d 1248 (9th Cir. 1982); Estate of McMorris 243 F.3d 1254 (10th Cir. 2001); Estate of O'Neal 258 F.3d 1265 (11th Cir. 2001); Fehrs v. United States 45 AFTR 2d (RIA) 1695 (Ct. Cl. 1979); Estate of Sachs 88 T.C. 769, rev'd on other grounds , 856 F.2d 1158 (8^th Cir. 1988); Estate of Lester 57 T.C. 503 (1972); Estate of Theile 9 T.C. 473 (1947); Russell v. United States 260 F.Supp. 493 (N.D. Ill. 1966); Greene v. United States 447 F.Supp. 885 (N.D. Ill. 1978); Wilder v. Commissioner 581 F.Supp. 86 (N.D. Oh. 1983).

¹⁴Ithaca Trust Co. v. United States 279 U.S. 151 (1929).

¹⁵Jacobs v. Commissioner, 34 F.2d 233 (8^th Cir. 1929), cert. den'd 280 U.S. 603 (1929); Estate of Sachs 856 F.2d 1158 (8th Cir. 1988); Estate of Chesterton 551 F.2d 278 (Ct. Cl. 1977), cert. den'd, 434 U.S. 835 (1977).

¹⁶ Proposed Reg. § 20.2053-4.

¹⁷National Cable & Telecomm. Assn. v. Brand X Internet Servs. (2005) 545 U.S. 967, 982; Chevron USA v. Natural Resources Defense Counsel (1984) 467 U.S. 837, 843; Estate of Gerson (2006) 127 T.C. 139, aff'd 507 F.3d 435 (6^th Cir. 2007).

¹⁸Chevron USA, 467 U.S. at 843.

¹⁹ IRC § 2053(d).

²⁰See US v. Manufacturers Nat'l Bank of Detroit, 363 U.S. at 194.

²¹ See Estate of Smith,198 F.3d at 524; Burnet v. Guggenheim 288 U.S. 280, 285(1933) ("Congress did not mean that the [estate] tax should be paid twice, or partly at one time and partly at another.").

²² Basic accounting method concepts of consistency, certainty and predictability dictate that assets and liabilities must be valued at the same time in order to ensure that any "netting" of the assets less the liabilities fairly reflects the difference. Neither the IRC nor the Treasury regulations define what a "method of accounting" is.

Congress and the Treasury apparently assume that a method of accounting is an understood concept of financial accounting . . . However, certain elements are critical in defining a method of accounting: . . . consistency, certainty, and predictability. *** Once a method of a tax accounting has been adopted, it is assumed that the method will be consistently applied to a taxpayer's activities. Otherwise, there is no "method", only arbitrary procedures whose inconsistent application makes impossible the logical determination of income and expense during any particular period. [Citing Walter H. Potter, 44 TC 159 (1965), acq. 1966-1 CB 3, and Holt Co. v. United States, 368 F2d 311 (5th Cir. 1966).] The use of a method of accounting lends certainty and predictability to the recognition and recording of financial transactions and events. Thus, any particular method of accounting, as opposed to an arbitrary practice, should so be defined that any person applying that method to a particular set of facts will reach the same result. Gertzman, Federal Tax Accounting (1988) § 2.01.

²³Chevron USA v. Natural Resources, supra, 467 U.S. at 844; Boeing Co. v. United States 537 U.S. 437 (2003).

²⁴Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929).

²⁵Id. at 155.

²⁶Propstra v. U.S., 680 F.2d 1248 (9^th Cir. 1982).

²⁷Estate of Smith. Comm'r, 198 F.3d 515 (5th Cir. 1999).

²⁸Id. at 517.

²⁹Id. at 524-525.

³⁰Id. at 526.

³¹Estate of McMorris v. Comm'r., 243 F.3d 1254 (10th Cir. 2001).

³²Estate of O'Neal v. U.S., 258 F.3d 1265 (11th Cir. 2001).

³³Estate of McMorris, 243 F.3d at 1262-63 (10th Cir. 2001), citing Estate of Lester v. Comm'r, 57 T.C. 503, 507 (1972).

³⁴ 94 T.C. 829 (1990).

³⁵Id. at 850.

³⁶Id. at 851.

³⁷Jacobs v. Comm'r., 34 F.2d 233 (8th Cir. 1929), cert. denied, 280 U.S. 603 (1929).

³⁸ 856 F.2d 1158 (8th Cir. 1988).

³⁹Id. at 1160-61.

⁴⁰Id. at 1162.

⁴¹ Proposed Regs. § 20.2053-4(b).

⁴² Compare, for example, the post return-filing obligations imposed under IRC §§ 2013, 2031A, 2053(d), 2057 and 6166.

⁴³ Michael C. Gerson, Trusts & Estates Quarterly, Vol 13, Issue 2, Summer 2007, "You Can Lead the IRS to the Law, But You Can't Make it Think: Why Section 2053 Proposed Regulations are Wrong," pp. 21-30.

⁴⁴ Webster's Third New International Dictionary (1961) p. 110.

⁴⁵ Webster's Third New International Dictionary (1961) p. 333.