Navigating the Minefield of Settlements: A Primer on Tax Issues for the Probate and Trust Litigator
In these economic times, probate and trust litigators have a growing practice. Litigation results not only from clients who are more knowledgeable in pursuing their rights, but also from the proliferation and increasing complexity of trust documents, together with the demographics of baby boomers and their parents reaching middle and old age. This author has worked with many excellent litigators and has had the opportunity to advise them on various tax issues in resolving disputes and documenting the resolutions in settlement agreements. This article is intended to help litigators spot various tax issues and assist in properly documenting the resolution in an agreement.
Florida law permits settlements in disputed will matters1 and trust matters.2 Agreements avoid the unnecessary expense of a trial and may resolve issues between family members that have been brewing for many years. Agreements can be as creative as the litigators who draft them. Unfortunately, while an agreement may resolve family issues and address the equitable distribution of the assets, tax consequences to the beneficiaries may not be considered until well after the agreement is finalized by the court. These tax issues can expose litigators to unforeseen liability because the parties assume (perhaps incorrectly so) that the litigators have addressed all the tax issues in an agreement.
One beneficial way to analyze tax issues in the negotiation of an agreement is to realize that every transaction, change, or addition affecting a disputed will or trust can have a tax consequence. The tax consequence may be favorable, unfavorable, or neutral to any one or more of the parties to the agreement. Obvious tax areas that must be addressed are income tax, gift tax, estate tax, and generation skipping transfer tax (GSTT) matters, and the 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. While a discussion of all these taxes is beyond the scope of this article, the author believes that litigators should be aware of the “ticking time bomb” of undisclosed and unknown tax effects to the parties to the agreement.
Some litigators may assume that the certified public accountant (CPA) or tax attorney (collectively the “tax professionals”) will cover the litigator’s exposure. However, if the facts, details, and the background of an agreement are not adequately communicated to the tax professionals, then tax advice will not be comprehensive. Tax advice is extremely detail-driven, and it is this author’s experience that in the rush to sign an agreement, details may be overlooked. Litigators should involve tax professionals as early as possible. In many cases, “the tax tail cannot wag the dog,” but adverse tax consequences found after entering into an agreement will surprise the parties who will look to the attorneys who negotiated the agreement for satisfaction.
The purpose of this article is to focus on identifying issues, not resolving them. The author wants to help litigators spot issues so that they will know when it is appropriate to contact the tax professionals to clarify the outcome of the desired transaction. Litigators often provide their expertise and creativity to alternatives not considered by the tax professional because the litigators generally understand the controversy and the family dynamics much better than the outside tax professionals. Working with the litigator and the tax professional in unison is a win-win situation.
The following fact pattern will be analyzed throughout this article. Assume Duke, age 87, a Florida resident, dies in 2009 with a $10 million estate, $1 million passing through probate to his trust, $7 million already funded in his revocable trust, and $2 million in joint names with his surviving spouse, Daisy. Duke and Daisy, age 98, have each been married several times, and each has adult children from prior marriages. Duke’s children are Jim, Fred, and Charles and his grandchildren are Fred’s children, Mindy and Mark. Daisy’s only child is a daughter, Samantha. Duke leaves via a pecuniary formula his maximum exemption amount (the exemption assets) outright in equal shares to his children and his grandchildren. The balance is left to a qualified terminal interest property (QTIP) trust for Daisy’s benefit and at her death, the QTIP assets will be distributed in equal shares to Duke’s children, Duke’s grandchildren, and Samantha.
Prior to Duke’s death, Duke’s son, Jim, under a Florida durable power of attorney, made substantial gifts in equal shares to Duke’s children for estate planning purposes. The durable power of attorney does not authorize any gifts. Samantha has retained counsel to sue Duke’s granddaughter, Mindy, the named personal representative and trustee, because Samantha was omitted as a beneficiary from the exemption assets. Samantha claims that one month before Duke died, Mindy took Duke to Mindy’s favorite attorney to change his documents to remove Samantha as a beneficiary of the exemption assets. Samantha argues that the Carpenter3 factors are present to make a claim for undue influence. Language in prior wills and/or trusts indicates that all assets were to be distributed to Duke’s children, Duke’s grandchildren, and Samantha equally as is evidenced by the residuary disposition of the QTIP trust.
Further, Duke’s children are suing Daisy, arguing that Daisy coerced Duke to leave the $2 million in assets jointly. Duke’s children believe Duke’s intent was that Daisy should not receive any money outright.
Estate Tax Marital Deduction
Upon initial review, no estate tax will be payable at Duke’s death as the exemption assets fully utilize Duke’s exemption amount, and the other assets pass to a QTIP trust or via joint ownership, both of which qualify (subject to the making of a timely election in the case of the QTIP trust) for the unlimited marital deduction.4 However, if the assets did not pass to the spouse in a disposition qualifying for the marital deduction, then the agreement could be structured to save estate taxes. If property passes to a spouse as a result of a will contest, the marital deduction will be preserved if it passes as a result of a “bona fide recognition of enforceable rights of the surviving spouse in a decedent’s estate.”5 The agreement must be entered because of a valid, enforceable claim.6 If the parties agree for an amount to be distributed to a spouse and no claim is established, the Internal Revenue Service will argue that the agreement is not bona fide and the marital deduction will be disallowed.7 One method determining the “bona fides” of a transaction is whether the proceeding is adversarial. If the matter is tied to a construction or reformation, the Tax Court has found the state court decree was not a bona fide controversy and there was no “genuine and active contest.”8
Under this fact pattern, the QTIP deduction is not at issue. Samantha is not requesting that the QTIP trust be terminated. Suppose, however, the litigators propose to resolve the matter by distributing trust assets to Samantha. Of course, before the beneficiaries of the exemption assets agree to relinquish a portion of their share of the exemption assets to satisfy Samantha’s claim, the parties may agree that the QTIP trust assets of $4.5 million plus the joint assets of $2 million may not be necessary for Daisy’s care, as she is now 98 years old. Thus, if a portion of the QTIP trust is terminated under the agreement and distributed to Samantha to resolve the dispute, then the Internal Revenue Code must be reviewed. An early termination of the QTIP trust will trigger gift taxes,9 a discussion of which is provided later in this article. The cost of a private letter ruling from the IRS and the complications of how to determine how much of the QTIP should be terminated may cause litigators to look to the exemption assets as the source of Samantha’s payment. Nevertheless, litigators should consider that any termination of a QTIP trust will result in gift taxes which are tax exclusive (no tax upon a tax) and will not be includable in Daisy’s estate at her death. As the QTIP assets are includable in Daisy’s estate at Daisy’s death, then the estate tax is tax inclusive (a tax that is calculated on the tax that is paid). Thus, the early termination of a portion of the QTIP may be a viable option considering the age of Daisy.
If Duke’s children are successful in arguing that the jointly held assets should be distributed to Duke’s children instead of Daisy, then the transfer will not qualify for the marital deduction because the assets will not pass from Duke to Daisy, as required by the Internal Revenue Code. Because, however, the exemption assets are funded via a pecuniary formula (the maximum amount that could be funded incurring no estate tax), the QTIP trust would actually be funded with more money, and Duke’s children, grandchildren, and Samantha will be beneficiaries at Daisy’s death.
Assume the fees and costs for negotiating and implementing the agreement total $200,000. From which assets do the fees and costs get paid? Assume the parties agree that the exemption assets should be distributed equally to all of Duke’s children, Duke’s grandchildren, and Samantha, but they do not want their shares reduced by any administration expenses, i.e., the beneficiaries want as much money as they can have now, and they agree to give Samantha a portion of the exemption assets so the litigation matter will be resolved. Can those fees and costs be deducted from the principal and/or income of the QTIP trust or must expenses be apportioned between the exemption assets and the QTIP trust? Administration expenses can generally be taken either on the estate tax return or the estate’s income return, but not both.10 If deducted from the estate income, then the marital deduction is not reduced. However, if deducted from the estate principal on the estate tax return, then the marital deduction may be reduced. An analysis must further be made as to whether expenses are management expenses or transmission expenses.11 If the expenses are management expenses, then such expenses generally cannot reduce the amount of the principal for purposes of the marital deduction,12 unless the expenses are attributable to and paid from the marital share and are actually claimed on the estate tax return.13 If the expenses are transmission expenses, then such expenses can reduce the principal.14 The agreement should reflect from what source attorneys’ fees and other administrative expenses are to be paid, and from which trust the expenses will be distributed. These discussions should be coordinated with the tax professionals preparing the estate tax return and the estate and trust income tax return.
To be deductible on the estate tax return, the administrative expenses must be “actually and necessarily incurred in the administration of the decedent’s estate; that is, in the collection of assets, payments of debts, and distribution of property to the persons entitled to it.”15 Attorneys’ fees incurred by or for the benefit of beneficiaries who are parties to litigation are not deductible “if the litigation is not essential to the proper settlement of the estate.”16 Thus, litigators should carefully negotiate the terms of the agreement to confirm that such fees and costs are deductible.
Generation Skipping Transfer Tax Issues
Duke’s grandchildren will receive a portion of the exemption assets and may receive a portion of the QTIP trust if any portion of the QTIP trust passes to them at Duke’s death. If a transfer is made to a grandchild from either the exemption assets or QTIP trust, then the GSTT17 may apply. Duke’s personal representative can allocate Duke’s unused GST exemption18 to such transfers. If the personal representative properly allocates the GST exemption to the exemption assets on the estate tax return prior to finalization of the agreement, and assuming Duke has his full GST exemption of $3.5 million available, then the GST exemption allocated will be two-fifths of the $3.5 million, or $1.4 million. The balance of the GST exemption will be allocated to the QTIP trust if the personal representative makes a reverse QTIP election and the QTIP trust can be severed,19 Thereby creating an exempt QTIP trust and a nonexempt QTIP trust.
Suppose, however, as a result of the agreement, Duke’s grandchildren only receive two-sixths of the exemption assets, or $1,166,667, instead of $1.4 million to which the personal representative allocated GST exemption on the estate tax return. Can the wasted GST exemption allocated on the estate tax return ( i.e., $1.4 million of exemption was allocated instead of $1,166,667) be fixed? Once the GST exemption is allocated on a timely filed estate tax return, the allocation may not be reversed.20 Thus, if an agreement is being hammered out, an extension of the estate tax return should be filed, and the GST allocation should be made by a formula.
When an agreement adjusts grandchildren’s interest or those in lower generations from the decedent, defined as “skip persons,”21 GSTT issues must be considered because the GSTT is at the highest estate tax rate. The attorney must consider not only biological grandchildren, or individuals inherently skip persons, but also beneficiaries who are otherwise skip persons because of ages.22 Remember that if a partner is more than 37 and a half years younger and is a beneficiary of an individual’s trust, a GSTT can result.
Further, if litigators are dealing with an exempt GSTT trust in existence prior to September 25, 1985, care must be made as to contributions or dispositions to or from such a trust. If improperly handled, a fully exempt grandfathered GSTT-exempt trust23 could lose its exemption if assets are contributed to or distributed from such a trust.
Income Tax Issues
Suppose, as part of the agreement, Duke’s son, Fred, wants his share comprised of a specific painting which has appreciated from the date of death. Is this in-kind distribution taxed? If so, then who pays the taxes? From what trust do the funds get paid? Generally, a distribution of an in-kind distribution which has appreciated and is distributed pursuant to a pecuniary (a fixed dollar amount) formula will trigger capital gains tax.24 Thus, if the date of death value of the painting is $100,000, and the date of distribution value is $150,000, then the agreement should provide who will be responsible for those taxes, if any. If the agreement ultimately changes the amounts received by each beneficiary, amounts received that would otherwise be exempt from income taxes25 because the amount received is a gift or bequest,26 Then the amount received under the agreement should also be exempt from income taxes. If, however, distributions made pursuant to the agreement would otherwise be taxable income ( i.e., income in respect of a decedent27 ), then the beneficiary will be taxed on such income.
Suppose, after the estate tax return has been filed, an agreement is negotiated that provides a portion of the QTIP trust is to be terminated and such assets are to be distributed equally to Duke’s children, Duke’s grandchildren, and Samantha. Generally, one can sever a QTIP by making partial elections,28 and Florida law29 permits such elections. Most trust documents are drafted to provide for such elections. If the trustee of a QTIP trust terminates a QTIP trust, then the spouse is deemed to make a gift of all of the interests in that trust except for the qualifying income interests.30 Thus, the spouse will incur gift taxes on that distribution.
A recent article by Charles D. Rubin, “Tax Results of Settling Trust Litigation Involving QTIP Trusts,”31 discusses such tax consequences in detail. Mr. Rubin’s article contains an excellent chart that outlines the various issues. To confirm the estate tax, gift tax, and GSTT consequences of a QTIP termination pursuant to agreement, it is the author’s opinion that a private letter ruling should be obtained as the tax exposure can be high if the consequences are not, in fact, those expected by the parties. However, a private letter ruling can only be relied upon by the taxpayer requesting the ruling. Therefore, it is best to carefully review the successful rulings32 and pattern the agreement accordingly.
If the beneficiaries change their relative interests in the will or trust as between themselves, then, provided that the interests are being adjusted in a bona fide controversy, no gift tax issues should result.33 For example, if each child and grandchild is to receive $700,000 of the exemption assets, and instead each child and grandchild receives $585,333, the amount given to Samantha of $116,667 from Duke’s children and grandchildren is not deemed a gift if a valid agreement is entered into by the parties.
What if Samantha contests the gifts made by Jim under the durable power of attorney? Do those gifts reflect a “receivable” that should be included on the estate tax return? If so, how is the receivable valued? A decedent’s gross estate is the value of all property owned by a decedent.34 The value is its fair market value35 at the time of the decedents’ death.36 How much would someone pay for this receivable? Any value of that receivable will affect the value of the QTIP trust. Further, if the estate tax return has already been filed, should an amended estate tax return be filed? In “Filing a Supplemental Estate Tax Return After Probate Litigation,”37 David Pratt and George D. Karibjanian provide an excellent discussion on this issue.
Tax issues can vary substantially depending on the facts of each situation and how litigators negotiate and resolve the dispute. While the fact pattern discussed in the article may not arise in your practice, the discussion should sensitize you to the different tax areas that can affect the negotiations, and how these issues can best be resolved in a tax-favored way that will be beneficial (or at least not harmful) to all parties to the agreement.
1 Fla. Stat. §733.815 (2009).
2 Fla. Stat. §§736.0412 and 736.0416 (2009).
3 Carpenter v. Carpenter, 253 So. 2d 697 (Fla. 1971).
4 I. R.C. §2056(b)(7).
5 Treas. Reg. §20.2056(c)-2(d)(2).
6 Ahmanson Foundation v. United States, 674 F.2d 761 (1981).
7 TAM 9610004.
8 Estate of Aronson v. C.I.R., T.C. Memo. 2003-189.
9 I. R.C. §2519.
10 I. R.C. §642(g).
11 Treas. Reg. §20.2056(b)-(4)(d).
12 Treas. Reg. §20.2056(b)-(4)(d)(3).
13 Treas. Reg. §20.2056(b)-(4)(d)(5)Ex3.
14 Treas. Reg. §20.2056(b)-(4)(d)(2).
15 Treas. Reg. §20.2053-3(a).
16 Treas. Reg. §20.2053-3(c)(3).
17 See I.R.C. Ch. 13.
18 I. R.C. §2631(a).
19 I. R.C. §§2652(a)(3) and 2642(3).
20 I. R.C. §2631(b), but see I.R.C. §2642(g)(1) for relief for late elections.
21 I. R.C.§2613.
22 I. R.C. §2651(d).
23 Treas. Reg. §26.2601-1.
24 Kenan v. Commissioner of Internal Revenue, 114 F.2d 217 (1940).
25 Lyeth v. Hoey, 305 U.S. 188 (1938).
26 I. R.C. §102.
27 I. R.C. §61(14).
28 Treas. Reg. §20.2056(b)-7(b)(2)(ii).
29 Fla. Stat. §736.0417 (2009).
30 I. R.C. §2519(a).
31 Charles D. Rubin, Tax Results of Settling Trust Litigation Involving QTIP Trusts, 36
Fla. Bar J. 23 (Jan. 2009).
32 See PLRs 200801009, 200717016, 200628007.
33 Treas. Reg. §25.2512-8.
34 I. R.C. §2031.
35 Treas. Reg. §20.2031-1(b).
37 David Pratt & George D. Karibjanian, Filing a Supplemental Estate Tax Return After Probate Litigation, 36
Estate Planning 17 (Sept. 2009).
Linda S. Griffin is a sole practitioner in Clearwater. She is a fellow of the American College of Trust and Estate Counsel and is board certified in wills, trusts, and estates and tax law. She graduated from the University of Florida, received her LL.M. in taxation from the University of Florida, and is a Florida certified public accountant. The author thanks Board of Governors member from the Sixth Circuit Andrew B. Sasso of Clearwater and Simi Bhatia, a graduate of the paralegal program at St. Petersburg College, for their help in preparing this article.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, Brian J. Felcoski, chair, and William P. Sklar and Kristen Lynch, editors.