INCOME TAX CONSIDERATIONS IN THE …tcba31.wildapricot.org/resources/Pictures/4b Income Tax...income tax considerations in the settlement of estate and ... income tax considerations

INCOME TAX CONSIDERATIONS IN THE SETTLEMENT OF ESTATE AND TRUST DISPUTES

By Steven P. Flowers

December 8, 2016 Steven P. Flowers

ELLER & DETRICH, P.C. 2727 East 21st Street, Suite 200 Tulsa, Oklahoma 74114-3533 Telephone (918) 747-8900 E-Facsimile (918) 392-9457 E-Mail [email protected]

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INCOME TAX CONSIDERATIONS IN THE SETTLEMENT OF ESTATE AND TRUST DISPUTES

I. INTRODUCTION

This presentation is intended to provide an overview of some of the more common income tax problems encountered in the settlement of trust disputes, breach of fiduciary duty lawsuits and to a lesser extent will contests. This presentation in not intended to be an exhaustive study of potential income tax issues in these areas.

Tax considerations are of paramount importance in probate and trust litigation. It is a rare dispute that does not have income tax implications. The failure to take these implications into consideration can have a dramatic impact on the net result obtained for your client.

The structure of a settlement can affect its tax consequences. For example, assume that a

trustee pays money to the trust to settle a claim against the trustee for breach of trust. If the trustee paid the money to remedy damage to trust principal, the payment will result in a reduction of the trust's basis in its assets. If the trustee paid the same amount for damage to trust income, the trust will recognize income from the payment.

Professionals involved in the settlement of estate and trust disputes must recognize and

address basic income tax concepts such as distributable net income and income in respect of a decedent, as well as more sophisticated tax concepts such as the effect of IRC §643(f) on the partition of a single trust into multiple trusts.

While beyond the scope of this presentation issues relating to estate, gift and generation skipping transfer tax, should be considered. In addition other not-so-obvious taxes should be considered, as appropriate, in settlement agreements. These “not-so-obvious” taxes include (but are not limited to) foreign tax, employment tax, excise tax, return filing, collection, penalties, criminal tax misconduct, corporate tax, deferred compensation, UBTI, partnership tax, capital gains tax, and special valuation rules.

II. BASIC TAX CONSIDERATIONS

Everything is taxable; nothing is deductible; everything else is an exception.

- Unknown

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The forgoing quote contains one of the most basic principles of tax law, everything is taxable. The phrase “everything is taxable” is based upon the provisions of IRC §61. Code §61 provides that “Except as otherwise provided . . . gross income means all income from whatever source derived . . .”

The origin of the phrase “noting is deductible” can be traced to of the U.S. Supreme Court

in New Colonial Ice Co. where the court held “Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.” New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 78 L. Ed. 1348, 54 S. Ct. 788 (U.S. 1934).

The holding that deductions are a “matter of legislative grace” has been universally

adopted by the courts. The phrase was used by the US Supreme Court in both Deputy v. Du Pont, 308 U.S. 488, 493, 84 L. Ed. 416, 60 S. Ct. 363 (1940) and in Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593, 87 L. Ed. 1607, 63 S. Ct. 1279 (1943). However, the earliest use of the phrase appears to be by the Alabama Court of Appeals in the case of Tarrant v. Bessemer National Bank, 61 So. 47 (1912).

III. GENERAL PRINCIPALS APPLICABLE TO SETTLEMENTS To be effective for tax purposes, a settlement of a trust or estate dispute must be (a) the settlement of an actual bona fide dispute; (b) of valid and enforceable rights of the parties under state law; (c) made in good faith; (c) as the result of arm's-length negotiations; (d) that meets all state law requirement for settlement; and (f) is enforceable under state law. Bona Fide Dispute Requirement

The settlement must be a bona fide compromise of an actual dispute in order to be given effect for tax purposes. Although the compromise need not be based on a dispute which is the subject of actual litigation, it must be based on “something more than a naked threat.” Bailey v. Ratterre, 144 F. Supp. 449, 453 (N.D. N.Y. 1956), aff’d, 243 F.2d 454 (2d Cir. 1957); See also Howard v. Commissioner, 54 T.C. 855 (1970).

The Service takes the position that even if there is a bona fide dispute between persons claiming interests in estates, the resolution of those disputes, even an adjudication in a will contest, will not be recognized for federal tax purposes unless the Service believes the claims are valid. In other words, the Service will substitute its judgment on the outcome of the litigation or dispute

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over that of the parties or even of the court. Commissioner v. Estate of Bosch, 387 US 456, 87 S.Ct. 1776, 18 L.Ed. 886 (1967), rev’g 363 F. 2d 1009 (1966).

The Internal Revenue Service will not consider a settlement agreement to be a bona fide

compromise agreement unless the parties' claims are (i) bona fide and (ii) satisfied on an economically fair basis. See Priv. Ltr. Rul. 8902045 (Oct. 21, 1988).

If an assignment or surrender of property was pursuant to a decree rendered by consent, or pursuant to an agreement not to contest the will or not to probate the will, it will not necessarily be accepted as a bona fide evaluation of the rights of the parties. See Estate of Hubert v. Commissioner, 101 T.C. 314, 318 (1993)

In deciding whether a settlement agreement is a "bona fide recognition of enforceable rights of the surviving spouse in decedent's estate", the Court has looks to whether the agreement was made in good faith as the result of arm's-length negotiations. Estate of Barrett v. Commissioner, 22 T.C. 606, 611 (1954). In some cases emphasis is placed upon the fact that the settlement agreement is made a part of the probate proceeding. However, such fact is not determinative and each case should be decided on its own facts. See Vease v. Commissioner, 35 T.C. 1184. Enforceable Right under State Law

State law determines what property rights and interests a taxpayer has, but federal law determines the consequences of such rights and interests for tax purposes. The meaning of "gift, bequest, devise, or inheritance" in federal revenue laws is a matter of federal law. Cotnam v. Commissioner, 263 F.2d 119, 120, (5th Cir. 1959).

If the decision of a state trial court on a matter of state law is not binding for tax purposes, it follows that a good faith settlement of such an issue cannot be binding either. In deciding whether a party to the settlement agreement has enforceable rights in a decedent's estate, the court must look behind any settlement agreement to ensure that the claim on which it is based is valid. Estate of Hubert v. Commissioner, 101 T.C. 314. A case often cited by the Service regarding the effects of settlement agreements is Ahmanson Foundation v. United States. 674 F.2d 761 (9th Cir. 1981). Ahmanson Foundation stands for the proposition that attention must be focused on the legitimacy of claims in determining whether an intra-family settlement of litigation will be treated as a bona fide compromise settlement.

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In Ahmanson Foundation, the court considered whether a marital deduction would be

allowed for property passing pursuant to a settlement agreement. The court concluded that a good faith settlement must be based upon an enforceable right under state law properly interpreted in order to qualify the property distribution as “passing” from the decedent for purposes of the federal estate tax marital deduction. Further, the spouse’s interest must be enforceable and not simply sufficiently plausible to support a good faith arm’s-length settlement.

In 1967, the United States Supreme Court considered the issue of whether the Internal Revenue Service in a tax controversy is conclusively bound by a state court adjudication of property rights when the United States was not a party. See Commissioner v. Estate of Bosch, 387 U.S. 456, 87 S. Ct. 1776, 18 L.Ed. 886 (1967).

In reaching its decision, the Supreme Court reiterated its longstanding holding that property rights are determined by state law. See Bosch at 467 ("it is incumbent upon federal courts to take state law from state court decisions when federal tax consequences turn on state law"). The Court held, however, that when federal estate tax liability as it related to a settlement was contingent on the character of a property interest held and transferred by a decedent under state law, the Internal Revenue Service is not "conclusively bound" by a state court ruling as to a property interest. Rather, the Court formulated a new test which essential provided that:

(i) When a state law property right has been decided by the highest court of the state, the decision should be followed and respected as the best authority for that state's law; (ii) When a state law property right has not been decided by the highest court of the state, federal authorities (be it the Internal Revenue Service, the tax court or a federal district court deciding the issue) "must apply what they find to be the state law after giving 'proper regard' to relevant rulings of other courts of the State." Bosch at 465.

The Bosch Court recognized that its ruling will require the deciding authority to sit "as a

state court." Thus, a fundamental requirement of any settlement agreement is that it meets all state law requirements and is based on valid and enforceable rights of the parties under state law.

The Supreme Court held in Bosch that the "test of 'passing' for estate tax purposes should be whether the interest reaches the spouse pursuant to state law, correctly interpreted [by the federal court]--not whether it reached the spouse as a result of a good faith adversary confrontation." Estate of Brandon v. Commissioner, 828 F.2d 493, 497 (8th Cir. 1987) (citing Bosch at 774).

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The Service has added its own gloss to the Bosch rule. Revenue Ruling 69-285 interpreted Bosch as requiring a two-part test: (1) that the opinion be issued by the highest court of the state; and (2) that the decree must have determined state property rights. Character of Settlement Proceeds

The taxation of property received in settlement of an estate or trust dispute is often dependent upon on the character of a property interest held and transferred by a decedent under state law. Proceeds received in the compromise of a dispute are characterized for tax purposes in accordance with the nature of the claims which were compromised. Lyeth v. Hoey, 305 U.S. 188, 59 S. Ct. 155, 83 L. Ed. 119 (1938). The form of the action filed by the petitioner is not controlling. See Getty v. Commissioner, 91 T.C. 160, rev’d, 913 F.2d 1486 (9th Cir. 1990). The Internal Revenue Code provides that, in general, the value of property acquired by gift, bequest, devise, or inheritance is not subject to income tax. See IRC §102(a) (“Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.”)

The predecessor to IRC §102(a) was specifically applied by the United States Supreme Court to property received in settlement of a will contest in Lyeth v. Hoey, 305 U.S. 188, 59 S. Ct. 155, 83 L. Ed. 119 (1938) (settlement amount not subject to income tax under §22(b)(3) of the Revenue Act of 1932 (“there is exempted from the income tax -- "The value of property acquired by gift, bequest, devise, or inheritance.).

In Lyeth, the Supreme Court addressed for the first time the issue of whether property received by a person from the estate of a decedent in compromise of his claim as an heir was subject to income tax. Because the property was received via a settlement instead of pursuant to a will or heirship statute, the Internal Revenue Service took the position that the property was subject to income tax.

The Supreme Court found that “[i]n exempting from the income tax the value of property

acquired by 'bequest, devise, or inheritance', Congress used comprehensive terms embracing all acquisitions in the devolution of a decedent's estate.'” Id. At 194. The Supreme Court went on to hold that the property was properly excluded from income because:

There is no question that petitioner obtained that portion, upon the value of which he is sought to be taxed, because of his standing as an heir and of his claim in that capacity. It does not seem to be questioned that if the contest had been fought to a finish and petitioner had succeeded, the property that he would have received would have been exempt under the federal act. Nor

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is it questioned that if in any appropriate proceeding, instituted by him as heir, he had recovered judgment for a part of the estate, that part would have been acquired by inheritance within the meaning of the act. We think that the distinction sought to be made between acquisition through such a judgment and acquisition by a compromise agreement in lieu of such a judgment is too formal to be sound, as it disregards the substance of the statutory exemption.

Id. at 196; see also Quigly v. Commissioner, 143 F.2d 27 (7th Cir. 1944). Application of IRC §102(a) to Estate and Trust Disputes. For property and proceeds received or paid in settlement of an estate or trust dispute to qualify for non-taxable treatment pursuant to IRC §102(a) the property must pass by devise or inheritance. In other words, the property must pass by will or statutes of distribution or descent. See United States v. Merriam, 263 U.S. 179, 182, 44 S. Ct. 69, 70, 68 L. Ed. 240, 242 (U.S. 1923) (Congress manifestly used the words "bequest, devise, or descent" to mean property given by will or descending by statutes of distribution or descent).

The amount received is taxable or nontaxable according to what it represents. If the settlement was for an amount due under a contract for personal services, a reference in the settlement or judgment supporting a claim that the sum recovered 'in the nature of a bequest' will not change the compensation from taxable income to an exempt bequest. Thus, in order to acquire property by inheritance, a party must bring suit against the estate as an heir. He must participate in the proceeds as an heir.

The focus of the court’s inquiry should be on what the settlement payment was in lieu of rather than on the form in which the payment was received. Getty v. Commissioner, 91 T.C. 160, 177, rev’d Getty v. Commissioner, 913 F.2d 1486 (9th Cir. 1990); See also Parker v. United States, 573 F.2d 42 (Ct. Cl. 1978); United States v. Gavin, 159 F.2d 613, (9th Cir. 1947).

In Irwin v Gavit the Supreme Court determined that the predecessor to IRC §102 exempting bequests assumes that bequest is of corpus of estate as contrasted with income arising from it. Irwin v Gavit, 268 US 161, 69 L Ed 897, 45 S Ct 475 (1925).

Property received by natural daughter and pretermitted heiress of decedent in compromise of claim against estate of her alleged father is exempt from income taxation as "property acquired by gift, bequest, devise, or inheritance", although compromise agreement stated that she was not heir. United States v Gavin, 159 F.2d 613, 615 (9th Cir. 1947) (Probate courts may distribute a

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decedent's estate in accordance with his will, or the local laws of descent and distribution if there is no will, or in accordance with a court approved agreement if there is a threatened contest. In either event, it is the decedent's estate which is being distributed and property acquired by virtue of such a decree is property acquired by 'inheritance' in the comprehensive sense intended by Congress when it used the term.).

Money received in compromise settlement of claim as heir to estate is not taxable as income, and courts will not go behind the compromise and try issue of heirship, or determine who won or lost by compromise. Gavin v United States, 63 F Supp. 425, (1945, SD Cal).

Taxpayers, who sued trustees, estate administrators, and accountants, alleging numerous claims, including breach of duty of care and loyalty, negligence, self-dealing, and other matters with respect to trust, were not entitled to exclude from gross income funds they received in settlement of lawsuit because they did not receive settlement funds as bequest, devise, or inheritance under 26 USCS § 102(a). Clayton v United States, 2006 U.S. Dist. LEXIS 52974, 2006-2 USTC (CCH) P 50,533, 98 AFTR 2d (RIA) 2006-5839 (N.D. W. Va. 2006).

In Harrison v. Commissioner, a surviving spouse was unhappy with the provisions of her husband's will because it did not comply with a prenuptial agreement in which he agreed to establish a trust that would pay all of its income to her for life. She was entitled, under Illinois law, to renounce the will and take one-half of the estate. She gave up that right in an agreement with the charitable beneficiaries of the estate, in which they agreed to pay certain income to her. The Court held that the amount received was taxable under the predecessor of section 102(b), after concluding that the interest that was the subject of the taxpayer's claim was an interest in income. Harrison v. Commissioner, 119 F.2d 963 (7th Cir. 1941), aff‘g. 41 B.T.A. 1217 (1940),

Whether a claim is resolved through litigation or settlement, the nature of the underlying

action determines the tax consequences of the resolution of the claim. In Getty v Commissioner a lump-sum payment received in settlement of claim by dissatisfied heir against residuary beneficiary was a nontaxable bequest despite IRS claim that amount compensated beneficiary for lost income since. The court held that it was sufficient for the beneficiaries to show that the settlor probably would have remedial inequality of bequest. Getty v Commissioner, 913 F.2d 1486 (9th Cir. 1990), rev’g 91 T.C. 160 (1988).

Private Letter Ruling 9716011 involved a settlement among various beneficiaries focusing primarily on whether the term “lineal descendants” was limited to grandchildren. This ended up with a proposed settlement under which over eighty beneficiaries would receive distributions under a formula contingent on getting a favorable ruling on the tax consequences. The Service found no income tax consequences, basically on the theory these were what amounted to specific bequests, with no gift tax consequences because there was a bona fide dispute, and for the same

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reason, no estate tax consequences. Finally, there were no GST tax consequences, since the Service found the payments were in accord with their respective claims or interests in the estate. Settlement Representing Rights to Income

IRC § 102 does not apply to amounts required to be paid from income pursuant to a settlement agreement. If the bequest or inheritance is the right to receive income, the amounts are taxable to the beneficiary. See IRC § 102(b). Specifically, IRC §102(b) provides that IRC §102(a) shall not exclude from gross income (1) the income from any property referred to in IRC §102(a); or (2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income.

In settlements, an issue whether the settlement will be characterized as a bequest of income when the original bequest was of income. When the settlement is in lieu of an income interest, the courts have generally held the settlement amount is includable in gross income under IRC §102(b). See Getty v. Commissioner, 91 T.C. 160, 176 (1988), rev'd. 913 F.2d 1486 (9th Cir. 1990). In Getty, the court noted that:

[W]hether a claim is resolved through litigation or settlement, the nature of the underlying action determines the tax consequences of the resolution of the claim." Tribune Publishing Co. v. United States, 836 F.2d 1176, 1177 (9th Cir. 1988). In characterizing the settlement payment for tax purposes, we ask, "'In lieu of what were the damages awarded?'"

If amounts received in settlement relate to the recipient’s right to income, such settlement

proceeds will generally be taxable as ordinary income. Getty v Commissioner, 913 F.2d 1486 (9th Cir. 1990), rev’g 91 T.C. 160 (1988).

In Lang v. Commissioner the court focused upon the structure of the settlement documents

in determining that payments to a recipient were taxable as ordinary. Lang v. Commissioner 913 F.2d 1486 (9th Cir. 1990). Treatment of Receipts as Compensation for Services.

A number of cases have held that amounts received in settlement of a will contest will be treated as taxable income where the amounts are based upon claims that the decedent promised to make a bequest to the individual in exchange for services rendered or to be rendered.

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Payment for services, even though entirely voluntary, is nevertheless compensation constituting taxable income to employee. Old Colony Trust Co. v Commissioner 279 US 716, 730, 49 S Ct 499, 73 L Ed 918 (1929).

In Cotnam, the taxpayer won a contract action against the decedent's estate based on her

claim that the decedent had promised her one-fifth of his estate in return for her serving him as an attendant. Cotnam was not an heir or beneficiary under a prior will. When Cotnam failed to include the judgment in her gross income, the Internal Revenue Service assessed a deficiently for the amount of the judgment. Cotnam claimed the amount of the judgment was exempt as a bequest under IRC §102. The Fifth Circuit Court of Appeals disagreed finding that the judgment was not exempt as a bequest but, rather, was taxable income for services rendered to the decedent. In finding the payments should be taxed as income, the court noted that “[t]he nature of the transaction underlying the judgment, not the judgment itself, controls the tax effects.” Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959).

Payment to lawyer in the form of bequest was method that parties chose to compensate

lawyer for his legal services. The amount of the bequest was subject to tax as ordinary income. Wolder v. Commissioner, 493 F.2d 608 (2nd Cir. 1974), cert. den. 419 U.S. 828 (1974).

Distribution of property under will in satisfaction of written agreement under which

taxpayers were required to perform services for testator is compensation for services includible in taxpayers’ gross income in the year of receipt. Davies v. Commissioner, 23 TC 524 (1954); See also Estate of Braddock v. U.S., 434 F.2d 631 (9th Cir. 1970); Jones v. Commissioner, T.C. Memo 1958-191; Priv. Ltr. Rul. 67-375 (1967).

Sum of $ 150,000 received by taxpayer in settlement of $ 350,000 claim "for services rendered" against decedent's estate was taxable compensation rather than gift even though taxpayer claimed she had performed 18 years of care and housework on decedent's behalf prior to his death without compensation, and that he had promised her that she would be adequately taken care of in his will. Hansen v Commissioner, TC Memo 1974-12 (1974).

Only when services are not required as a condition of payment of the legacy is the property is acquired by bequest and, therefore, excluded from income. See United States v. Merriam, 263 U.S. 179, 44 S.Ct. 69, 70, 68 L.Ed. 240 (1923).

Green v. Commissioner was an action for breach of contract to make will. Decedent had promised claimant that if she would “stay with him without marriage,” he would leave her “everything” when he died; decedent’s will left his entire estate to his brother and sister; claimant sued estate for the value of services rendered in reliance upon promise to leave her the entire estate;

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because underlying claim was a suit for earned but unpaid compensation, the proceeds awarded to her in litigation were taxable income. Green v. Commissioner, 846 F.2d 870 (2d Cir. 1988). Realization of Capital Gains for Sales or Exchanges under Settlement Agreement In general a “sale or other disposition” of property is subject to income tax under either IRC §§61 or 1001(a). In determining the amount of gain, the transferor’s basis is compared with the value received. Unless the amount received results from a gift, bequest, devise, or inheritance the transferor will generally recognize gain as a result of the exchange. Care must be taken anytime a settlement agreement provides for the receipt of cash in lieu of a like-kind distribution. Unless the settlement is properly documented the IRS will take the position that the settlement constitutes a sale or exchange subject to tax.

In Parker v. United States, the claimant-heirs received a cash settlement in lieu of certain real property and partnership interest they would have received as intestate heirs. The government argued that Lyeth, supra, should not be applied because the heirs did not receive their actual intestate distributions. The Court of Claims disagreed, refusing to hold that the payment of cash in lieu of an in-kind distribution would by itself restrict the application of the Lyeth doctrine. Parker v. United States, 573 F.2d 42 (Ct. Cl. 1978). In White v. Thomas the Fifth Circuit held that if the settlement agreement itself calls for a specific dollar amount payment, and the satisfaction of that specific dollar amount by a transfer of appreciated property resulted in recognition of gain. White v. Thomas, 116 F.2d 147 (5th Cir. 1940), cert. denied, 313 U.S. 581, 61 S. Ct. 1098, 85 L. Ed. 1538 (1941). In White the taxpayers claimed that the decedent gave them his ranch. The executors of the will and the trustees of the charitable trust settled the taxpayers' claim with a cash payment. Thomas, the Collector of Internal Revenue, assessed the settlement as income. The taxpayers brought an action against the collector in which they alleged that the settlement was not taxable under the predecessor to IRC §102(a). The district court held that the settlement was the sale or exchange subject to income tax. The Fifth Circuit affirmed the judgment because the gain from the conversion of the gift to cash was taxable, though the receipt of the gift originally was not. However, the Fifth Circuit appears to have severely limited or perhaps contradicted its decision in White by its decision in Early v. Commissioner. In Early the taxpayers acquired interest in stock from decedent as a gift. Due to a will contest, taxpayers agreed to return the stock to the estate in exchange for a life estate in a portion of the income. Taxpayers sought to amortize the value of the life estate in subsequent tax returns. The Commissioner disallowed the amortization. However, the tax court reversed and allowed the amortization, finding that the life estate was not

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a gift, but an exchange for consideration. On review, the Fifth Circuit disagreed and reversed the tax court's decision, holding that because the original stock exchange from decedent was a gift, the subsequent settlement for the life estate was a gift, as well. Early v. Commissioner, 445 F.2d 166 (5th Cir. 1971).

A related issue arises in reformation proceedings to divide a trust into separate trusts to determine whether a taxable sale or exchange incurs in the division. For example, in Private Letter Ruling 8902045, the Service renewed its position based upon the White case. That ruling involved modifications of various provisions in a trust and the partition of a trust into separate trusts in settlement of trust litigation. The ruling reasoned that the beneficiaries, “unlike the claimants in White v. Thomas, did not receive cash or property in exchange for the release of their claims.” The ruling concluded that no party to the settlement agreement would be treated as realizing gain or loss as a result of the mutual release of claims under the agreement.

A somewhat similar situation exists if the estate attempts to realize a capital loss as a result of entering into a settlement agreement. In Kirsch v. Commissioner, the sole heir and administrator of his father’s estate transferred real property in settlement of a lawsuit based on the decedent’s signed agreement to make a will leaving farmland to another party. The farmland was transferred to the other party in return for a specified amount of cash (which was less than the estate tax value of the farmland), plus “other consideration.” The administrator claimed a loss for the estate based upon the difference between the amount of cash received and the value of the farmland on the date of death. The Tax Court ruled that the estate realized no loss, reasoning that the administrator knew best the value to be given to “other consideration and would not have given up any more than he thought was fair.” Kirsch v. Commissioner, T.C. Memo 1985-114 (1985). Partition Proceedings

A common action for the reformation of a trust is to divide a trust into separate trusts for separate respective beneficiaries. There may be a variety of reasons for such a division. The family members may not get along with each other, and would prefer not to be involved in the same trust. The beneficiaries may prefer different investment approaches for their respective trusts. The beneficiaries may wish to assure equal treatment among them, rather than allowing the possibility of unequal discretionary distributions. The creation of separate trusts may have tax motives, to allow efficient utilization of the generation-skipping transfer tax exemption, to permit the availability of a marital deduction or charitable deduction, or to allow a specific trust to hold S corporation stock.

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Under IRC §643(f) two or more trust may be treated as one trust if (1) such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of such trusts is the avoidance of the income tax.

If the severance or partition is found merely to alter the method of administering the trust and not to change the economic interests of the beneficiaries, the division will generally not trigger gift, generation-skipping, or income taxes, or create separate trusts under section 643(f), and the separate trusts will continue to be classified as trusts rather than as associations. A variety of private letter rulings have addressed these issues.

Private Letter Ruling 90-52-023 involved the division of a single trust, which provided that one-half of its income would be paid to a mother and the remaining one-half could be accumulated or distributed to the mother’s descendants. The trust would terminate at the mother’s death and the remaining assets would be distributed to the descendants. Under a proposed division, the trust would be divided into two equal trusts. All of the income of one trust was to be distributed to the mother, and all of the income of the other trust would be distributed to the sole surviving child. Both trusts would terminate at the mother’s death and be distributed partly to the child and partly held in trust for the child’s descendants. The Service ruled that the proposed partitions: (1) will not constitute a sale or exchange of property resulting in income, gain, or loss; (2) will result in the new trusts taking a carryover basis and tacked holding periods in trust assets; (3) will be considered separate trusts for federal income tax purposes; and (4) will continue to be treated as grandfathered trusts for generation-skipping transfer tax purposes because the partition does not change the quality, value, or timing of any rights, powers, beneficial interests, or expectations of the beneficiaries.

Private Letter Ruling 90-04-007 involved the court-ordered partition of a trust into three separate successor trusts, each of which would be allocated to a separate beneficiary and that beneficiary’s descendants. The present co-trustees would resign and new trustees would be appointed for each of the successor trusts. The ruling found that the partition: (1) will not create a taxable gift because it does not enhance or diminish the interests of any income beneficiaries or remaindermen (the compensation of trustees will correspond to compensation under the existing trusts and the trustees will acquire fiduciary powers of administration with no discretion over distribution of income or corpus); (2) the partitioned trusts will be treated as grandfathered trusts for purposes of the generation-skipping transfer tax; (3) the trusts will be treated as separate trusts for income tax purposes under section 643(f); (4) the beneficiaries will not be treated as grantors of the successor trusts created by the partition; (5) the partitioned trusts will be treated as trusts rather than associations, under the reasoning that the mere acquiescence of the beneficiaries to the court order is not the type of “volitional activity directed toward the creation of a common enterprise” that is required for association treatment; and (6) the partition will not be treated as a taxable exchange generating gain or loss, under the reasoning that a partition of jointly owned

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property is not a sale or disposition (citing Revenue Ruling 79-44, Revenue Ruling 73-476, and Revenue Ruling 56437). Income in Respect of a Decedent (IRD)

There is no specific definition of "income in respect of a decedent" in the Internal Revenue Code. Income in respect of a decedent, commonly referred to as IRD, essentially is income earned by a decedent before death but not recognized until after death. It is required to be included in the gross income of the decedent's estate or by one or more of the estate beneficiaries at the time the estate or beneficiary, respectively, collects the item of income.

An estate is not entitled to an adjusted tax basis on IRD assets includible in a decedent's estate. A beneficiary (by will or agreement) is generally not entitled to an adjusted tax basis on IRD assets to be received by the beneficiary. Common examples of Income in Respect of a Decedent (IRD):

- Dividends declared on stock owned by a decedent that is payable to shareholders of record on a date before the decedent's death but not actually paid until after death. Estate of Putnam v. Commissioner, 324 U.S. 393 (1945); - Death payments made to beneficiaries under an Individual Retirement Account or an exempt deferred compensation plan. Hess v. Commissioner, 271 F.2d 104 (3d Cir. 1959), rev'g 31 T.C. 165 (1958); - Compensation for the decedent's services, including a bonus paid after death, that the employer had no obligation to pay. Rollert Residuary Trust v. Commissioner, 752 F.2d 1128 (6th Cir. 1985) aff g, 80 T.C. 619; Bausch's Estate v. Commissioner, 186 F.2d 313 (2nd Cir. 1951); Rev. Rul. 68-124, 1968-1 C.B. 124; - Renewal commissions owed a deceased life insurance agent. Findlay v. Commissioner, 332 F.2d 620 (2nd Cir. 1964); Rev. Rul. 59-162, 1959-1 C.B. 224; - Amounts recovered by a decedent's estate as damages for the decedent's lost profits. Estate of Carter v. Commissioner, 35 T.C. 326 (1960), aff'd, 298 F.2d 192 (8th Cir.) cert. denied 370 U.S. 910 (1962);

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- Alimony arrearages owing to a decedent at the time of his or her death and paid after death. Estate of Narischkine v. Commissioner, 14 T.C. 1128 (1950), aff'd, 189 F.2d 257 (2nd Cir. 1951); - Accrued but unreported interest on United States Treasury Series E bonds owned by a decedent at the time of his or her death. Apkin v. Commissioner, 86 T.C. 692 (1986); - Income realized by an estate on nonqualified or non-restricted stock options owned by decedent at the time of his or her death. Rev. Rul. 53-196, 1953-2 CB 178; - Insurance reimbursements of previously deducted medical expenses received after the decedent's death. Rev. Rul. 78-292, 1978-2 CB 233; - Liquidating distributions if the decedent had the right to any liquidation proceeds. Estate of Bickmeyer v. Commissioner, 84 T.C. 170 (1985); - Sales proceeds received after death if (i) the decedent had, before his or her death, entered into a legally binding contract regarding the sale item; (ii) the decedent had performed all of the substantive acts required by the terms of the contract; (iii) on the date of the decedent's death, no economic material contingencies existed that could have disrupted the sale; (iv) the decedent, had he or she lived, received the proceeds of the sale. Estate of Peterson v. Commissioner, 74 T.C. 630 (1980) aff'd, 667 F.2d 675 (8th Cir. 1981).

Distributable Net Income (DNI)

Distributable net income, commonly referred to as DNI, is a fundamental concept of income taxation of trusts, estates and their beneficiaries. It is a concept uniquely applicable to the taxation of trusts and estates and is necessary to implement the conduit principle, that is, a trust or estate is often nothing more than a conduit for property to pass to its beneficiaries.

DNI is basically the amount of trust or estate income available for distribution in a particular tax reporting year, and the amounts which beneficiaries must include in their gross income. It can be described as a trust's gross income, excluding net capital gains allocated to principal, but including net tax exempt income, minus allowable deductions and losses. IRC § 643(a).

Distributable net income serves three functions. First, trust or estate DNI establishes the maximum amount that a trust or estate can deduct under IRC §§ 651 and 661. Likewise, DNI determines the maximum amount that the trust or estate beneficiaries can be required to include in

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their taxable income under IRC §§ 652 and 662. Finally, DNI determines the character of a distribution by a trust or estate. Specifically, it is used to characterize and divide distributions into different "classes" of income. The character of a distribution may also affect the maximum deduction allowed to the fiduciary and the maximum portion of the distribution included in gross income by the beneficiary.

Unless a specific exception applies, all estate distributions, whether in cash or in kind, carry out the estate's DNI. Generally, the amount of DNI carried out by an in-kind distribution to a beneficiary is the lesser of the adjusted basis of the property prior to distribution, or the fair market value of the property at the time of the distribution. IRC § 643(e). The estate does not generally recognize gain or loss as a result of making a distribution to a beneficiary. However, this general rule is subject to some important exceptions.

DNI does not include "[a]ny amount which, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of a specific sum of money or of specific property and which is paid or credited all at once or in not more than 3 installments".

The structure of the payments or distribution may subject the beneficiary to income tax. For example, the payment of an amount from the residuary of an estate could carry out distributable net income, while the payment of a specific sum will not. See IRC § 663(a)(1) Distributions to Satisfying the Estate's Obligations

Distributions that satisfy an obligation of the estate are recognition events for the estate. The fair market value of the property is treated as being received by the estate as a result of the distribution, and the estate will recognize any gain or loss if the estate's basis in the property is different from its fair market value at the time of distribution. Rev. Rul. 74-178, 1974-1 C.B. 196. Thus, for example, if the estate agrees to pay a debt of $ 10,000 pursuant to a settlement agreement, and transfers an asset worth $ 10,000 with a basis of $ 8,000 in satisfaction of the debt, the estate will recognize a $ 2,000 gain. Separate Share Rule

Internal Revenue Code § 663 of the provides that when multiple beneficiaries have substantially separate and independent shares of a trust or estate, each beneficiary's "separate share" may be treated as separate trust or unit for the limited purpose of determining the amount of net income distributed to each beneficiary during the tax reporting period.

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The question of what constitutes "substantially separate and independent shares" is not resolved by the IRC but is instead expressly left to be determined by the Treasury Regulations. IRC § 663(c).

The separate share rule provides a certain measure of relief from the automatic application of the tier system and from the restricted nature of the gift and bequest exclusion. It can prevent one beneficiary being taxed on a corpus distribution as though that beneficiary had received income when the income, in reality, is accumulated for the benefit of another.

Counsel should be particularly careful with settlements of disputes and estate administrations in situations where the separate share rule does not apply. Distributions of substantial settlement amounts to certain beneficiaries in early years may cause those beneficiaries to be charged with income taxes on all of the estate income up to that period of time (if distributions have not been made to other beneficiaries in the same time frame). Sale of Interest in Trust

In a complex family dispute, a taxpayer settled a lawsuit against a trustee by “selling” his interest in a trust created by his mother for cash, forgiveness of a note, and other consideration. The Tax Court in Garrett v. Commissioner held that his “gain” on the settlement, equal to the excess of what he received over the income tax basis of his interest, was taxable income, not a tax-free inheritance. The interest in this case was an income interest for life. Garrett v. Commissioner, TC Memo. 1994-70 (1994).

In Marcus v. Commissioner a taxpayer received cash from her two sisters in the settlement of the taxpayer's claim against their father's estate. The Service asserted that the payment was taxable income to the taxpayer, not an excludable bequest under Section 102(a). The Tax Court disagreed, finding that the property was excludable, but that any amounts received to reflect appreciation in the value of the property after the father's death, which was the basis of the taxpayer's claim, would be taxable as capital gain. In so holding, the court rejected the Service's argument that the taxpayer's claim had a zero basis at the date of death, and thus the entire amount received by her was taxable as capital gain. Marcus v. Commissioner, T.C. Memo 1996-190. Sale of an Expected Inheritance

In Revenue Ruling 70-60, a daughter sold a partial interest in her expected inheritance from her father, who was living at the time of sale and had made no will. The IRS held that "the entire amount received by the [daughter] for the relinquishment of her right to inherit the interest from

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her father" was includible under IRC §61(a) in her gross income in the year of sale. Rev. Rul. 70-60 (1970). Sale of a Remainder Interest in a Trust

One settlement technique used in controversies between the income and remainder beneficiaries of a trust involves a "sale" of the interest of one set of beneficiaries to the other. One effect of the sale is to merger the income and remainder interests in the hands of the "buyer," thereby cause the trust to terminate. For example, if a decedent's Will established a QTIP trust for a second spouse, with the remainder interest passing to children from a first marriage, the surviving spouse might purchase the remainder interest from the children, causing the trust to merge (subject to any spendthrift provisions).

It should be noted that in the context of a QTIP trust, the purchase of the remainder interest may be treated as a "disposition" of that interest by the spouse pursuant to IRC § 2519, and as a result, the spouse may be treated as having made a taxable gift to the children equal to the value of the purchase price. Rev. Rul. 98-8.

In a Field Service Advisory issued on July 6, 1995, the Internal Revenue Service addressed a request for advice regarding the proper income tax treatment of petitioners' assignment of a remainder interest in a trust in exchange for the canceling of certain indebtedness. Specifically, the taxpayer inquired whether he was required to recognize taxable income under IRC § 61 relating to the assignment of an expectant remainder interest in a trust in exchange for the cancellation of indebtedness. The Service advised that "the transfer of the remainder interest was a taxable event resulting in income to the petitioner." FSA 1632, Vaughn #1632. Life Insurance

Generally speaking, life insurance proceeds are income tax free to the beneficiary of the policy. IRC 101(a)(1). The acquisition of a policy of life insurance by one party to a dispute on the life of another will normally provide that party with tax free income upon the death of the insured.

However, when an existing policy of insurance is among the assets to be divided upon the settlement of an estate dispute, the transfer for value rules of IRC §101(a)(2) must be considered. IRC §101(a)(2) provides, "In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income . . . shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee."

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The transfer for value rules do not apply in the case of a transfer to the insured, to a partner

of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. In a review of a settlement that included the transfer of a life insurance policy to someone other than the insured, the IRS might take the position that insurance transferred is a "transfer for a valuable consideration (i.e., the value of the settlement attributable to the insurance policy--presumably its then cash value), and seek to tax the beneficiary on any excess proceeds received upon the insured's death.

IV DEDUCTIBILITY OF PAYMENTS MADE BY AN ESTATE OR TRUST

As a general rule, the payment of a bequest to a beneficiary is not deductible by the estate unless the bequest qualifies for the estate tax marital or charitable deduction. Therefore, characterizing a claim as taking the form of an inheritance, while preserving favorable income tax treatment for the beneficiary under IRC §102, will yield no tax benefit to the estate. Treatment as Payment of Debts

If the payment takes the form of the payment of a debt owed by the decedent to the claimant/beneficiary, the payment of the claim may be characterized as a debt of the decedent, deductible for federal estate tax purposes. See IRC § 2053. For example, in Bailey v. Commissioner, 741 F.2d 801 (5th Cir. 1984), when a father died, the son inherited property, but the mother never set up a separate account for the son's benefit and did not acknowledge his inheritance rights. In administering the mother's estate, the son first became aware of his inheritance rights in his father's estate, and the son took a IRC §2053 deduction as a claim against the mother's estate. The son contended that the amount of this claim was the current value of the property he should have inherited from his father's estate, and that on these facts the Texas courts would impress a constructive trust in his favor. Although the Tax Court found for the government, the Fifth Circuit Court of Appeals reversed, allowing the IRC §2053 deduction but remanding for a determination of the current value of the son's inheritance from his father. Such a debt is not generally deductible for federal income tax purposes. Generally, the amount of the deduction is the value of the claim as of the decedent's date of death. The IRS may challenge a deduction based on the amount of the ultimate settlement. See Estate of Smith v. Commissioner, 198 F.3d (5th Cir. 1999) (evidence of settlement amount reached after death not admissible to determine date-of-death value of claim).

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Payments to Employees

Section 102(c) of the Code provides that the exclusion from income for bequests does not apply to any amount transferred by or for an employer to or for the benefit of an employee. In the context of settling claims against an estate from an employee or former employee, those claims may be deductible by the estate for income tax purposes under IRC §162 or §212, or for estate tax purposes as a debt of the estate under IRC §2053(a)(3).

If the liability arose prior to the decedent's death, and would have been deductible by the

decedent had it been paid during lifetime, it may constitute a "deduction in respect of a decedent," for which both an income and an estate tax deduction may be permitted. IRC §691(b). Deductions in Respect of a Decedent

The business expenses, nonbusiness expenses, interest, and taxes for which the decedent was liable, that were not properly deductible in the decedent's last tax year or any prior tax year, are deductible by the estate when it pays them. If the estate was not liable to pay those obligations, they are deductible when paid by the person who, by bequest, devise, or inheritance from the decedent or by reason of the death of the decedent, acquires an interest in the property of the decedent subject to the obligation. IRC §691(b).

Deductions (for taxes, interest, deductible expenses, depletion, foreign tax credit) relating

to a decedent's after-death income are not subject to the rule against duplication. IRC §642(g) Thus, if the deceased, at the time of his death, was engaged in a lawsuit against his former employer to enforce a claim for compensation, any attorneys' fees which at that time had accrued but were unpaid may be deducted both as a claim against the estate for estate tax purposes and as a deductible expense in respect of a decedent for income tax purposes. Reg. § 1.642(g)-2

To the extent that these items had not yet accrued when the deceased died, for instance, the

attorneys' fees incurred after his death, the estate must choose whether to take them as administration expenses for estate tax purposes or, with a waiver of any estate tax benefit, solely as deductible expenses for the production of income for income tax purposes

No medical deduction is allowable for an estate or trust because a trust cannot incur such expenses on its own behalf and has no dependents as that term is defined in the law. However, medical expenses for a decedent's care, paid by an estate within one year after the decedent's death, are treated as having been paid by the decedent when incurred and, accordingly, may be deducted on the decedent's return for the year incurred (usually the decedent's last return) if not deducted for estate tax purposes. IRC §213(c)(1); Reg. g 1.213-1(d) (1).

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Litigation Expenses and Expenses of Administration

Litigation expenses are generally deductible on the estate tax return of the decedent as expenses of administration under IRC §2053(a)(2) if they are actually and necessarily incurred in the proper administration and settlement of a decedent's estate and are allowable under applicable state law. Deductions not taken on the estate tax return are generally available as an income tax deduction. IRC §642(g).

Expenses of administration are not generally deductible when incurred for the individual

benefit of heirs, legatees, or devisees. See Estate of Dutcher v. Commissioner, 34 T.C. 918 (1960); Estate of Landers v. Commissioner, 38 T.C. 828 (1962); Estate of Baldwin v. Commissioner, 59 T.C. 654 (1973).

Litigation expenses incurred by a trust or estate may be deducted as administration

expenses, provided the fiduciary and not the beneficiary paid the expenses. See Erdman v. Commissioner, 37 TC 1119 (1962), aff’d., 315 F.2d 762 (7th Cir. 1963); Moore Trust v. Commissioner, 49 TC 430 (1968). These include the cost of contesting an income tax deficiency and the cost of prosecuting a suit to have a residuary trust declared void with the trust property paid back into the estate. Loyd v. United States, 153 F Supp. 416 (Ct. Cl. 1957).

Expenses incurred in defending or protecting the estate's or trust's title to property, or recovering such properly, are not deductible. Instead, they are treated as capital expenditures. Manufacturers Hanover Trust Co. v. United States, 312 F.2d 785 (Ct. Cl. 1963), cert. denied, 325 US 880. Similarly, expenditures incurred in protecting or asserting the trust's rights to property of a decedent as legatee under a testamentary trust are nondeductible capital expenditures. An item that is nondeductible is not rendered deductible by the fact that the property held by the estate or trust will be sold to satisfy a claim and would otherwise be held for the production of income.

It is immaterial whether the expenses, if deductible, are paid from the corpus or from income of the estate or trust. Commissioner v Estate of Hubert, 520 US 93, 117 S Ct 1124 (1997). They derive their character not from the fund from which they are paid, but from the purposes for which they are incurred.

If the estate is engaged in winding up the decedent's business, it is entitled to deduct ordinary and necessary expenses that occur.

A decedent's estate may have administration expenses and losses for which a deduction is allowable in computing the decedent's taxable estate for federal estate tax purposes and in

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determining the estate's taxable income for income tax purposes. For instance, administration expenses which also qualify as deductible nontrade or nonbusiness expenses would be in this category. However, the law does not allow the estate to take both deductions for the same item. Thus, administration expenses and losses during administration may be taken either (1) as a deduction (or as an offset against the sales price of property in determining gain or loss) in computing the estate's taxable income for income tax purposes or (2) as a deduction in computing the decedent's taxable estate for estate tax purposes. IRC §642(g) As a matter of procedure, this choice is exercised in connection with the claim for the income tax deduction, not for the estate tax deduction. In other words, in claiming the estate tax deduction the fiduciary need give no assurance that he has not or will not also claim the same item as an income tax deduction. IRC §642(g); Reg. §1.642(g)-1 In order for an item to be allowed as an income tax deduction, a statement must be filed that provides that the item has not already been allowed as an estate tax deduction, and that all rights to have it so allowed are waived. IRC §642(g); Reg. §1.642(g)-1 Likewise, there is no need for a waiver of the income tax deduction for the theft or casualty losses sustained by the estate, when such a loss is taken as a deduction in the estate tax return. 40 But if the income tax deduction for the loss is to be allowed, any estate tax deduction for the item must first be relinquished in the same manner as for other deductions allowable under both taxes. IRC §642(g).

A deduction is not allowed for fees incurred by a beneficiary or heir to establish his or her share of the decedent's estate. Nor is a deduction allowed to a trust beneficiary to protect or assert his or her right to property as beneficiary. See IRC § 212. Treasury Regulation 1.212-1(k) provides that:

(k) Expenses paid or incurred in defending or perfecting title to property, in recovering property (other than investment property and amounts of income which, if and when recovered, must be included in gross income), or in developing or improving property, constitute a part of the cost of the property and are not deductible expenses. Attorneys' fees paid in a suit to quiet title to lands are not deductible; but if the suit is also to collect accrued rents thereon, that portion of such fees is deductible which is properly allocable to the services rendered in collecting such rents. Expenses paid or incurred in protecting or asserting one's right to property of a decedent as heir or legatee, or as beneficiary under a testamentary trust, are not deductible.

Treas. Reg. § 1.212-1(k).

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Depending on the facts and circumstances, a portion of the attorney fees and expenses paid by the trust may be deductible. Treasury Regulation § 1.212 provides as follows:

(i) Reasonable amounts paid or incurred by the fiduciary of an estate or trust on account of administration expenses, including fiduciaries' fees and expenses of litigation, which are ordinary and necessary in connection with the performance of the duties of administration are deductible under section 212, notwithstanding that the estate or trust is not engaged in a trade or business, except to the extent that such expenses are allocable to the production or collection of tax-exempt income. But see section 642 (g) and the regulations thereunder for disallowance of such deductions to an estate where such items are allowed as a deduction under section 2053 or 2054 in computing the net estate subject to the estate tax.

Treas. Reg. § 1.212-1(i). Income Tax Basis in Property Received Under Settlement

Stated generally, the estate of a decedent receives a new cost basis in its assets equal to the fair market value of the property at the appropriate valuation date. IRC § 1014. Colloquially referred to as the asset receiving a "step-up" in basis at death. However, it is important to remember that the basis of an asset may step up or down. It is equally important to remember that the basis adjustment rule is subject to some important exceptions.

However, if the alternate valuation date for estate property has been validly elected, that value fixes the adjusted basis of the estate's assets. IRC § 1014(a)(3).

The basis adjustment rule also applies to a decedent's assets held by a revocable trust used

as an estate surrogate, since they are deemed to pass from the decedent pursuant to Sections 2036 and 2038 of the Code.

The adjustment to the basis of a decedent's assets occurs regardless of whether the estate is

large enough to be subject to federal estate tax. Original basis is simply ignored and federal estate tax values are substituted.

Note that the new cost basis applies not only to the decedent's separate property but also to

both halves of the community property owned by a married decedent. IRC § 1014(b)(6).

For most assets, the original cost basis in the hands of the decedent is simply irrelevant.

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No New Basis for Deathbed Transfers to Decedent

IRC §1014(e) provides a special exception for appreciated property given to a decedent within one year of death, which passes from the decedent back to the donor as a result of the decedent's death. This rule is presumably designed to prevent greedy taxpayers from transferring property to dying individuals, only to have the property bequeathed back to them with a new cost basis.