Section 2053 Final Regulations: Continued Uncertainty?
On October 20, 2009, the Treasury Department issued final regulations under Code §2053, effective for decedents dying on or after that date.1 S ection 2053 allows deductions for funeral expenses, administration expenses, claims against the estate, and most indebtedness in arriving at the taxable estate. Very often there is an inherent difficulty in determining the value of a taxable estate due to post-mortem events extending beyond the filing period for the estate tax return. The proposed regulations under §2053 provided that post-death events are to be considered in determining deductible amounts. With recurring expenses and lengthy litigation that can continue long after the filing of the estate tax return, and in response to fears of protracted administration and tax motivated litigation strategies, the Treasury issued the final regulations to clarify its position and provide guidance on the most complicated and controversial of deduction issues:administration expenses and claims against an estate.2
Actual Payment Requirement
Consistent with the proposed regulations, the most significant of the changes under the final regulations requires practitioners to deduct administration expenses and enforceable claims only as they are paid and to the extent they are actually paid. This rule requires personal representatives to pay claims and expenses prior to the estate tax return being filed, or file supplemental returns for additional deductions and seek refunds for tax overpayments. In an effort to ease the burden placed on estate administration by the new “must be paid” rule, three exceptions were created for personal representatives under the final regulations: 1) reasonably ascertainable amounts, 2) claims in the aggregate totaling $500,000 or less, and 3) claims and counterclaims related to assets of the estate.
• Reasonably Ascertainable Amounts — Thefirst exception allows deductions for claims or expenses when the amount is ascertainable with reasonable certainty and will be paid.3 With few exceptions, contested or contingent claims generally fail to meet the reasonable certainty exception. This exception was originally packaged as “estimated amounts,” but the Treasury modified its title, intending no substantial changes.4 The regulation cites a personal representative’s estimated compensation amount based on a local statute as an example of an ascertainable amount. The deduction of personal representative’s fees and attorneys’ fees in this manner has been long-standing with the IRS, and its inclusion in the regulations serves only to further solidify its status in practice. While expenses are usually ascertainable with reasonable certainty, the question remains as to what types of claims can be determined with “reasonable certainty.”
The final regulations specifically exclude vague and uncertain estimates and contested or contingent claims and expenses from using the reasonable certainty exception. Extending well beyond the filing period for an estate tax return, recurring payments for noncontingent obligations will be allowed a deduction as an amount ascertainable with reasonable certainty if all of the requirements are met.5 Recurring payments that are contingent upon death or remarriage are treated as noncontingent under the regulations and, thus, are ascertainable for purposes of this exception. To determine the value of such payments, life expectancy tables must be used, and the IRS has indicated that it will supply a remarriage factor.
Under the proposed language and as noted in the preamble, the regulations sought to allow deductions only for the date of death present value of recurring noncontingent obligations. The Treasury Department and the IRS later dropped this requirement to promote consistent treatment relative to contingent claims that could be deducted in full. Nonetheless, the present value is regarded as the more appropriate figure, and §20.2053-1(d)(6) is reserved for future guidance on this issue. As an alternative for the satisfaction of recurring obligations, personal representatives can purchase a commercial annuity from an unrelated dealer and deduct the sum of 1) the amount paid for the commercial annuity, 2) amounts paid prior to the purchase of the annuity in satisfaction of the obligation, and 3) any additional amount in excess of the commercial annuity amount necessary to satisfy the obligation.6
• Claims Totaling $500,000 or Less — Thelast two exceptions to the “must be paid” rule are found within §20.2053-4 of the final regulations following the review of general deductibility requirements for claims against an estate representing personal obligations of the decedent at the time of the decedent’s death. The first of these relates to claims totaling not more than $500,000.7 It should be noted that this exception applies only to claims and not to administration expenses.
Even though no payment has been made, personal representatives may deduct the current value of a claim or claims not totaling more than $500,000. Each claim must be deducted for its full value such that personal representatives cannot squeeze in a deduction for a portion of a claim and file an amended return to recoup the excess taxes paid later. At first glance, this exception appears to be straightforward and an administrative blessing, but that is hardly the case.
Annexing §170(f)(11)(E) from the income tax code, a “qualified appraiser” must determine the value of any such claim in a “qualified appraisal.”8 Whereas estate tax regulations omit any reference to qualified appraisals, the inclusion of an income tax rule for purposes of §2053 is a severe mismatch. The income tax “qualified appraiser” has successfully completed coursework from a professional or college level institution, or has earned a recognized appraisal designation and values assets based upon well-established guidelines and years of specialized knowledge.9 In terms of the estate tax regime and deductions under §2053, a personal representative must seek out an attorney or retired judge specializing in the practice area of the claim with an appraisal designation from an association that has yet to exist in the field. Without further guidance, it may be difficult to value claims for purposes of this exception.
• Claims and Counterclaims in a Related Matter — The final exception is for claims and counterclaims in a related matter. When a decedent’s gross estate possesses one or more causes of action and there are one or more claims against the estate in the same or a substantially related matter, or when there is particular asset in the gross estate that is generating claims against the estate, personal representatives may deduct the current value of the claim without actual payment if 1) it is a bona fide claim that represents a personal obligation of the decedent; 2) the claim is enforceable against the estate; 3) a qualified appraisal is obtained; and 4) the aggregate value of the related claims included in the decedent’s gross estate exceeds 10 percent of the value of the estate.10 As a result of this last requirement, small claims will not fall within this exception, essentially limiting its use to fairly substantial claims. Also, deductible amounts under this exception are limited to the value of the related asset or claim included in the gross estate.11
As with the exception under §20.2053-4(c) above, the IRS may effectively foreclose the use of this exception by challenging personal representatives to find “qualified appraisers” to value their claims. Even if a claim meets all the requirements for the deduction mentioned above and a qualified appraiser can be found, personal representatives may be reluctant to obtain an appraisal because of unintended consequences in litigation and/or settlement negotiations.
Protective Claims for Refund
When the value of a personal obligation of the decedent representing a bona fide claim or expense cannot be ascertained with reasonable certainty or is incapable of valuation, a protective filing is the only course of action outside of the narrowly drawn exceptions. A protective claim for refund may be filed at any time within the later of three years after the filing date or two years after payment.12 The protective filing need not state a dollar amount or the value of the claim, but it must identify each such claim or expense and explain the reasons or contingencies delaying its payment. The IRS indicated in the preamble to the final regulations that it will revise its Form 706 to include a refund schedule, but until such change is made, refunds must be filed on the standard Form 843.13
After a personal representative has notified the IRS “within a reasonable period of time that the contingency has been resolved,” the IRS will begin to consider the protective claim for refund. Providing a safe harbor for only those personal representatives with claims or refunds ripening after the three-year period of assessment, the IRS will review the entire return when considering a protective claim for refund so as to offset the refund.14
Family Members and Bona Fide Requirement
Generally, deductibility depends upon whether the claim or expense is “bona fide.” Except for enforceable charitable pledges under §2055, Regulation §20.2053-1(b)(2) does not allow deductions founded on transfers that are “essentially donative in character.” The proposed regulations automatically denied many claims and expenses by incorporating a rebuttable presumption identifying transactions involving family members, beneficiaries, and related entities as mere cloaks for gifts and bequests. Finding this rebuttable presumption to be unwarranted, the Treasury ultimately removed it from the final regulations and replaced it with factors indicative of the bona fide nature of a claim.
Under §20.2053-1(b)(2)(ii), factors indicative of a bona fide claim include 1) when the transaction occurs in the ordinary course of business, is negotiated at arm’s length, and is free from donative intent; 2) when the claim or expense is not related to an expectation or claim of inheritance; 3) when there is an agreement between the decedent and the related party; 4) when the performance thereof by the parties can be established with contemporaneous evidence; and 5) when all the parties report the payment in a manner consistent with federal income and employment tax laws. Complying with any single factor listed is not determinative of the nature of the claim, and Example 3 of the regulations highlights this point by integrating every factor listed.15
The regulations supplement the bona fide requirement with a definitional provision identifying family members, beneficiaries, and related entities under the section. Family members include the spouse of the decedent, the grandparents, parents, siblings, lineal descendents of the decedent or the decedent’s spouse, and the spouse and lineal descendents of any such grandparent, parent, or sibling, as well as any adopted individuals.16 It should be noted that the use of “include” fails to limit the breadth of individuals included in one’s family, so practitioners should be wary of transactions involving child in-laws and more remote ancestors. A “related entity” under the regulations is a private entity in which the decedent held a combined beneficial interest of 30 percent or more at the time the claim is asserted, or an entity in which the decedent directly or indirectly held a managing interest.17
Court Decrees, Settlements, and Unenforceable Claims
The final regulations also establish rules of deductibility for court decrees and settlements involving bona fide claims and expenses. A court of competent jurisdiction rendering its approval of funeral expenses, administration costs, unpaid mortgages, or claims against the estate must pass upon the merits of the claim and the facts upon which deductibility depends in order for its decree to be relied upon.18 Although a review of the facts is presumed in an active and genuine contest, if the result appears unreasonable, evidence should be kept to rebut the lack of such a contest.19 A local court’s issuance of a consent decree permitting the payment of a claim or expense may be used to establish deductibility since an adverse party’s consent presupposes an active and genuine contest.20 Even when court approval is unnecessary under local law, a deduction may still be allowed.21
A settlement reached by adverse parties in arms’ length negotiations will be allowed as a deduction provided that there was a bona fide issue in a genuine contest. The Treasury originally promulgated an additional requirement that the settlement reached must be within a reasonable range of outcomes under state law, but later removed it in recognition of the redundancy posed by requiring adverse interests to negotiate at arms’ length.22 Accordingly, the IRS will not deny a deduction for a settlement reached in an amount greater than the merits of the claim when the estate can establish the costs associated with defending or contesting the claim and prolonging the administration of the estate would impose a greater burden upon the estate than the payment of the settlement amount.23 Nonetheless, a settlement agreement for an unenforceable claim cannot be deducted.
Without exception for any circumstance, unenforceable claims against an estate cannot be deducted under §2053 even if paid. Claims barred by the statute of limitations and fees in excess of statutory limits fall within this ambit. Unlike most unenforceable claims that must be denied in full, only fees or expenses in excess of the statutory limit will be denied as a deduction.24 This rule applies even if a will directs such an amount to be paid to an attorney, accountant, or personal representative. As a result, personal representatives must not pay creditors failing to follow the technical requirements for pursuing their claims or those seeking compensation in excess of statutory guidelines, even if it is the proper thing to do under the will or otherwise. Not to be mistaken with an unenforceable claim, a contested claim where the estate’s liability is at issue can be deducted, but only when the claim has been settled.25
Duty to Report and Other Miscellaneous Issues
Lacking foresight for post-death events, many personal representatives may ultimately find their reported deductions are never paid. Commentators questioning whether the proposed regulations included an affirmative duty to report deductions that were subsequently not paid in full were met with a response from the Treasury Department. After removing language that was believed by many to impose such a duty on personal representatives, the Treasury clarified its position by commenting that it “did not intend for the proposed regulations to impose a duty on the executor that could be enforced after the expiration of the period of limitations on assessment.”26 This statement is ambiguous. If the Treasury did not intend to impose a duty on the personal representative after the expiration of the period of limitations, did it intend to impose such a duty prior to the expiration? The regulations under §2053 make no mention of filing of an amended return, and such references under the regulations are careful to use “may” or “should.” Without a statutory requirement or judicial support for a mandate, voluntary compliance remains a key component to proper tax collection.27
Once it is established that a contested or contingent claim is bona fide and enforceable, amounts actually paid in satisfaction of or in settlement thereof may be deducted after taking post-death events into account.28 The prescribed future outlook period spans the §6501 limitations period and subsequent periods under §6511(a).29 It is within these periods that a personal representative may encounter overpayments and other mishaps that the Treasury and IRS primarily sought to address in the promulgation of the final regulations. The IRS will adjust deductions taken by an estate for payments that are later reimbursed, whether as overpayments or amounts refunded, by the amount returned to the estate.
Payments expected to be reimbursed by insurance carriers and joint tortfeasors may not be deducted unless the personal representative can establish that only a partial reimbursement could be collected. Deductions for unrecoverable amounts are also allowed. The IRS allows a personal representative to certify on Form 706 that he or she did not know and should not have reasonably known about the potential for reimbursement.30 A personal representative may also make a full deduction of a claim with potential reimbursement as long as a statement is filed in accordance with the instructions on Form 706, providing a reasonable determination that the burden of necessary collection efforts outweighs any benefits from such efforts. In such cases, subsequent events will still be taken into consideration, and the deduction may be denied.31
In cases where a protective filing is necessary, the Treasury Department provides guidance for claims or expenses that will ultimately be paid in whole or in part out of a bequest qualifying for a marital or charitable deduction. Marital and charitable deductions under §§2056 and 2055 will not be considered contingent and nondeductible to the extent of the amount of the claim or expense and may be deducted in full. A reduction in the amount of the charitable or marital deduction taken must only be made when the claim or expense is actually paid, becomes an ascertainable amount, or meets the requirements of §§20.2053-4(b) or (c).32
Applying to individuals dying after October 19, 2009, the new regulations under Code §2053 may actually increase the number of estates forced to be kept open if the three exceptions to the general rule — that claims and administration expenses may only be deducted when paid — cannot be utilized. Under the exceptions, deductions may be taken for amounts ascertainable with reasonable certainty, claims totaling not more than $500,000, and claims and counterclaims in a related matter. While the IRS has provided guidelines on filing protective claims for items failing to meet one of the exceptions, further guidance is needed to effectively employ the exceptions. A remarriage factor should be supplied, and a new, more lenient definition of a qualified appraiser must be added to be able to produce the results the Treasury Department intended. In general, the new §2053 regulations provide some guidance and certainty to otherwise ambiguous and uncertain issues encountered by personal representatives and practitioners in the deductibility of administration expenses and claims against an estate related to post-mortem events; however, many issues still remain unclear.
1 T.D. 9468, 74 FR 53664, Oct. 20, 2009.
3 Treas. Reg. §20.2053-1(d)(4)(i) (2009).
4 T.D. 9468.
5 Treas. Reg. §20.2053-4(d)(6) (2009).
6 Treas. Reg. §20.2053-4(d)(6)(iii) (2009).
7 Treas. Reg. §20.2053-4(c) (2009).
8 Treas. Reg. §20.2053-4(c)(iv) (2009).
9 Prop. Treas. Reg. §1.170A-17(b) (2009).
10 Treas. Reg. §20.2053-4(b) (2009).
11 Treas. Reg. §20.2053-4(b)(2) (2009).
12 I.R.C. §6511(a).
13 T.D. 9468.
14 I.R.S. Notice 2009-84, 2009-44 I.R.B. 592.
15 Example 3 of Treas. Reg. §20.2053-1(b)(4) (2009) provides: “Claim by family member. For a period of three years prior to D’s death, D’s niece (N) provides accounting and bookkeeping services on D’s behalf. N is a CPA and provides similar accounting and bookkeeping services to unrelated clients. At the end of each month, N presents an itemized bill to D for services rendered. The fees charged by N conform to the prevailing market rate for the services rendered and are comparable to the fees N charges other clients for similar services. The amount due is timely paid each month by D and is properly reported for [f]ederal income and employment tax purposes by N. In the six months prior to D’s death, D’s poor health prevents D from making payments to N for the amount due. After D’s death, N asserts a claim against the estate for $25x, an amount representing the amount due for the six-month period prior to D’s death. D’s estate pays $25x to N in satisfaction of the claim before the return is timely filed and N properly reports the $25x received by E for income tax purposes. Barring any other relevant facts or circumstances, E may rely on the following factors to establish that the claim is bona fide: 1) N’s claim for services rendered arose in the ordinary course of business, as N is a CPA performing similar services for other clients; 2) the fees charged were deemed to be negotiated at arm’s length, as the fees were consistent with the fees N charged for similar services to unrelated clients; 3) the billing records and the records of D’s timely payments to N constitute contemporaneous evidence of an agreement between D and N for N’s bookkeeping services; and 4) the amount of the payments to N is properly reported by N for [f]ederal income and employment tax purposes. E may deduct the amount paid to N in satisfaction of the claim.”
16 Treas. Reg. §20.2053-1(b)(2)(iii)(A) (2009).
17 Treas. Reg. §20.2053-1(b)(2)(iii)(B) (2009).
18 Treas. Reg. §20.2053-1(b)(3)(i) (2009).
20 Treas. Reg. §20.2053-1(b)(3)(iii) (2009).
21 Treas. Reg. §20.2053-1(b)(3)(ii) (2009).
22 T.D. 9468.
23 Treas. Reg. §20.2053-1(b)(3)(iv) (2009).
25 Treas. Reg. §20.2053-4(b)(2) (2009).
26 T.D. 9468.
27 See Badaracco v. Commissioner, 464 U.S. 386 (1984); Broadhead v. Commissioner, 14 T.C.M. (CCH) 1284 (1955).
28 Treas. Reg. §20.2053-1(d)(1) (2009).
29 Treas. Reg. §20.2053-1(d)(2) (2009).
30 Treas. Reg. §20.2053-1d)(3) (2009).
32 Treas. Reg. §20.2053-1(d)(5) (2009).
Robert L. Spallina is a partner at Tescher & Spallina, P.A., in Boca Raton where he focuses on wealth transfer planning for high net worth families. He is a former CPA and CFP with a B.S. in accounting from the University of Florida, a J.D. from Loyola Law School in Los Angeles, and an LL.M. in estate planning from the University of Miami School of Law.
Lauren A. Galvani is an associate at Tescher & Spallina, P.A., in Boca Raton. She received her B.A. in English, history, and political science from Boston College and graduated from the University of Miami School of Law with a J.D. and an LL.M. in taxation with a certification in international tax.
This column is submitted on behalf of the Tax Section, Frances D. McCoid Sheehy, chair, and Michael D. Miller and Benjamin Jablow, editors.