Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

Would You Believe?

It is a specialized issue, but I am going to write about it anyway.

Why?

Because I believe this may be the only time I have had this issue, and I have been in practice for over thirty years. There isn’t a lot in the tax literature either.

As often happens, I am minding my own business when someone – someone who knows I am a tax geek – asks:

          “Steve, do you know the tax answer to ….”

For future reference: “Whatever it is - I don’t. By the way, I am leaving the office today on time and I won’t have time this weekend to research as I am playing golf and sleeping late.”

You know who you are, Mr. to-remain-unnamed-and-anonymous-of-course-Brian-the-name-will-never-pass-my-lips.

Here it is:

Can a trust make a charitable donation?

Doesn’t sound like much, so let’s set-up the issue.

A trust is generally a three-party arrangement:

·      Party of the first part sets up and funds the trust.

·      Party of the second part receives money from the trust, either now or later.

·      Party of the third part administrates the trust, including writing checks.

The party of the third part is called the “trustee” or “fiduciary.” This is a unique relationship, as the trustee is trying to administer according to the wishes of the party of the first part, who may or may not be deceased. The very concept of “fiduciary” means that you are putting someone’s interest ahead of yours: in this case, you are prioritizing the party of the second part, also called the beneficiary.

There can be more than one beneficiary, by the way.

There can also be beneficiaries at different points in time.

For example, I can set-up a trust with all income to my wife for her lifetime, with whatever is left over (called the “corpus” or “principal”) going to my daughter.

This sets up an interesting tension: the interests of the first beneficiary may not coincide with the interests of the second beneficiary. Consider my example. Whatever my wife draws upon during her lifetime will leave less for my daughter when her mom dies. Now, this tension does not exist in the Hamilton family, but you can see how it could for other families. Take for example a second marriage, especially one later in life. The “steps” my not have that “we are all one family” perspective when the dollars start raining.

Back to our fiduciary: how would you like to be the one who decides where the dollars rain? That sounds like a headache to me.

How can the trustmaker make this better?

A tried-and-true way is to have the party of the first part leave instructions, standards and explanations of his/her wishes. For example, I can say “my wife can draw all the income and corpus she wants without having to explain anything to anybody. If there is anything left over, our daughter can have it. If not, too bad.”

Pretty clear, eh?

That is the heart of the problem with charitable donations by a trust.

Chances are, some party-of-the-second-part is getting less money at the end of the day because of that donation. Has to, as the money is not going to a beneficiary.

Which means the party of the first part had better leave clear instructions as to the who/what/when of the donation.

Our case this week is a trust created when Harvey Hubbell died. He died in 1957, so this trust has been around a while. The trust was to distribute fixed amounts to certain individuals for life. Harvey felt strongly about it, because - if there was insufficient income to make the payment – the trustee was authorized to reach into trust principal to make up the shortfall.

Upon the last beneficiary to die, the trust had 10 years to wrap up its affairs.

Then there was this sentence:

All unused income and the remainder of the principal shall be used and distributed, in such proportion as the Trustees deem best, for such purpose or purposes, to be selected by them as the time of such distribution, as will make such uses and distributions exempt from Ohio inheritance and Federal estate taxes and for no other purpose.”  

This trust had been making regular donations for a while. The IRS picked one year – 2009 – and disallowed a $64,279 donation.

Here is IRC Sec 642(c):

(c)Deduction for amounts paid or permanently set aside for a charitable purpose

(1)General rule

In the case of an estate or trust (other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a), relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A)). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

The key here is the italicized part:        

“which pursuant to the terms of the governing instrument…”

The Code wants to know what the party of the first part intended, phrased in tax-speak as “pursuant to the terms of the governing instrument.”

The trustees argued that they could make donations via the following verbiage:

in such proportion as the Trustees deem best, for such purposes or purposes, to be selected by them as the time of such distribution….”

Problem, said the IRS. That verbiage refers to a point in time: the time when the trust enters its ten-year wrap-up and not before then. The trustees had to abide by the governing instrument, and said instrument did not say they could distribute monies to charity before that time.

The trustees had to think of something fast.

Here is something: there is a “latent ambiguity” in the will. That ambiguity allows for the trustees’ discretion on the charitable donations issue.

Nice argument, trustees. We at CTG are impressed.

They are referring to a judicial doctrine that cuts trustees some slack when the following happens:

(1) The terms of the trust are crystal-clear when read in the light of normal day: when it snows in Cincinnati during this winter, the trust will ….

(2) However, the terms of the trust can also be read differently in the light of abnormal day: it did not snow in Cincinnati during this winter, so the trust will ….

The point is that both readings are plausible (would you believe “possible?”).

It is just that no one seriously considered scenario (2) when drafting the document. This is the “latent ambiguity” in the trust instrument.

Don’t think so, said the Court. That expanded authority was given the trustees during that ten-year period and not before.

In fact, prior to the ten years the trustees were to invade principal to meet the annual payouts, if necessary. The trustmaker was clearly interested that the beneficiaries receive their money every year. It is very doubtful he intended that any money not go their way.

It was only upon the death of the last beneficiary that the trustees had some free play.

The Court decided there was no latent ambiguity. They were pretty comfortable they understood what the trustmaker wanted. He wanted the beneficiaries to get paid every year.

And the trust lost its charitable deduction.

For the home gamers, our case this time was Harvey C. Hubbell Trust v Commissioner.

How An Estate Can Lose A Charitable Deduction

It happened again this week. I was speaking with another accountant when he raised a tax question concerning an “estate” return. My stock question to him was whether it was an “estate fiduciary” or an “estate estate.” Both have the word “estate” in it, so one needs further clarification.

What is the difference?

If one dies with too many assets, then the government requires one to pay taxes on the transfer of assets to the next person. This is sometimes referred to as the “death” tax, and I sometimes refer to it as the “estate estate” tax.

It has gotten a little more difficult to trigger the federal estate tax, as the taxable threshold has been raised to over $5 million. That pretty much clears out most folk.

Then you can have the issue of the estate earning income. How can this happen? An easy way is to own stock, or a business – or perhaps a part of a business through a partnership or S corporation. That income will belong to the estate until the business is transferred to the beneficiary. That may require a trip to probate court, getting on the docket, waiting on the judge…. In the interim the estate has income.

And what do you have when an estate has income? You have an income tax return, of course. There is no way the government is not going to grab its share. I sometimes refer to that tax return as the “estate fiduciary.” A trust is a fiduciary, for example. The estate is behaving as a fiduciary because it is handling money that belongs to other people – the same as a trust.

Say that an estate receives a disbursement from someone’s 401(k). That represents income. This is usually a significant amount, and Hamilton’s Third Theorem states that a percentage of a significant number is likely to also be a significant number. This seems to always come as a surprise when the attorney fires over an estate’s paperwork – usually very near the filing due date – with the expectation that I “take care of it.”

Then we are looking for deductions.

A fiduciary has a deduction called an “income distribution,” which I rely upon heavily in situations like this. We will not dwell on it, other than to say that the fiduciary may be allowed a deduction when he/she writes a check to a beneficiary.

No, the deduction I want to talk about today is about a contribution to charity.  Does our “estate fiduciary” get a deduction for a charity? You bet.

Let’s take this a step further. What if the estate intends to write a check to charity but it cannot just yet? Can it still get a deduction?

Yep.

This is a different rule than for you and me, folks. The estate has a more lenient rule because it may have to wait on a court hearing and receive a judge’s approval before writing that check. The IRS – acknowledging that this could wreak havoc on claiming deductions – grants a little leeway.

But only a little. This rule is known as the “set aside,” and one must meet three requirements:

(1)   The contribution is coming from estate income (that is, not from estate corpus)

(2)   The contribution must be allowed by estate organizing documents (like a will), and

(3)    The money must be permanently set aside, meaning that the likelihood that it would not be used as intended is negligible.

So, if we can clear the above three requirements – and the estate intends to make a contribution – then the estate has a possible deduction against that 401(k) distribution that I learned about only two or three days before the return is due.

What can go wrong?

One can flub the “negligible” requirement.

I cannot remember the last time I read about a case where someone flubbed this test, but I have recently finished reading one.

The decedent (Ms Belmont) passed way with a quarter million in her 401(k) and a condo in California. She lived in Ohio.

Alright, there is more than one state involved. It is a pain but it happens all the time.

Her brother lived in the condo. He was to receive approximately $50,000, with the bulk of the estate going to charity. He was under mental care, so there may have been a disability involved.

How can this blow up? Her brother did not want to move out of the house. He offered to exchange his $50,000 for a life estate. He really wanted to stay in that house.

The charity on the other hand did not want to be a landlord.

Her brother brought action and litigation. He argued that he had a life estate, and he was being deprived of his contractual rights.  He filed with the Los Angeles County Probate Court and the California Recorder’s Office.  

Meanwhile the estate fiduciary return was due. There was a big old number in there for the 401(k) distribution. The accountant – who somehow was not fully informed of developing events in California – claimed a charitable contribution deduction using the “set aside” doctrine.

The California court decided in the brother’s favor and orders a life estate to him and a remainder deed to the charity.

The estate thinks to itself, “what are the odds?” It keeps that set aside deduction on the estate fiduciary return though.

The IRS thinks otherwise. It points out that the brother was hip deep by the time the accountant prepared the return, and the argument that risks to the set aside were “negligible” were unreasonable when he was opening up all the guns to obtain that life estate.

The estate lost and the IRS  won. Under Hamilton’s Third Theorem, there was a big check due.

What do I see here? There was a tax flub, but I suspect that the underlying issue was non-tax related. Likely Ms Belmont expected to outlive her brother, especially if he was disabled. It did not occur to her to plan for the contingency that she might pass away first, or that he might contest a life estate in the house where he took care of their mom up to her death while his sister was in Ohio.

Can A Trust Carryback A Loss for A Tax Refund?

I am remembering a tax issue from 2004. The firm I was with had a sizeable business client. The business owner had two daughters and wanted them to participate in the business. One daughter did; the other daughter went on to other pursuits. The father transferred shares to his daughters using special trusts: first a QSST (Qualified Subchapter S Trust), followed by an ESBT (Electing Small Business Trust). Trusts are normally disallowed as eligible S corporation shareholders, but the tax Code makes an exception for a QSST or an ESBT. Dad settled the trusts and acted as their trustee. He was of course also the majority shareholder and CEO of the underlying company.

The company was impressively profitable, but in 2004 it had a loss. It happens.

The company had been profitable. Its shareholders, including the trusts, had previously paid taxes on that profit. Now there was a business loss. Could the shareholders – more specifically, the trusts – use that loss to any tax advantage?

And we walked right into IRS Regulation 1.469-8. As a heads up, there is no Regulation 1.469-8. The IRS reserved that slot to provide its position on material participation by a trust. However the IRS never wrote the Regulation. Practitioners were required to divine whether their client trusts would be “materially participating” in an activity or whether the trust would be “passive” in an activity.

You may remember the “passive activity” rules in the Code. These were passed in 1986 as another effort to limit tax shelters, a task which they accomplished to an admirable degree. It did so by dividing business activities into material participation and passive activities. Generally speaking, losses from passive activities could not offset income from material participation activities.  There were problems, of course, one of which was Congress’ decision to label most real estate activities as “passive.” That may be the case for many, but there are people out there who make their living in real estate. For them real estate is about as passive as my involvement with my CPA firm.

Seven years later Congress corrected this error by enacting Section 469(c)(7), which said that the passive loss rules did not apply to someone who worked at least 750 hours a year in real estate, provided that his/her real estate activities were more than one-half of his/her hours worked for the year.

Now, our client company had nothing to do with real estate but had a lot to do with plastics. Section 469(c)(7) did not apply to them. I was aware that the IRS had informally intimated that a trust could not materially participate because a trust was not a person, and only a person could materially participate. I guess their reasoning made sense if material participation was like breaking a sweat.

The law was relatively new, and no one had yet challenged the IRS. The IRS was in no hurry to publish a Regulation. Why? I thought both then and now that the IRS suspected they had a losing hand, but they were not going to back off until they were forced. The IRS could ride roughshod until someone brought suit.

And I am looking at that someone. The case is Aragona v Commissioner, and it was a Tax Court case decided March 27.

Frank Aragona settled the trust in 1979. He died in 1981, at which time the trust went irrevocable. The trust had several trustees, the majority of which were family members. The trust owned a real estate LLC, which employed several people: family, leasing agents, maintenance workers, clerks, a controller and so on. Three of the trustees worked there and received a paycheck from the LLC. It was clear the LLC was materially participating in a business activity.

During 2005 and 2006 the LLC incurred losses. The trust treated the losses as “material participation” and carried the losses back to the 2003 and 2004 tax years for tax refunds.

The IRS said these were passive losses. No passive losses were allowed, much less operating losses that the trust could carryback for tax refunds. The IRS wanted back almost $600,000 of taxes. In addition, they asserted penalties.

Here was the IRS argument before the Court: a trust is incapable of performing “personal services” because Regulations define “personal services” to mean “any work performed by an individual in connection with a trade or business.” Obviously a trust is not an individual.

The Court immediately spotted the obvious: a trust is a fiduciary vehicle whereby a trustee agrees to act in the best interest of a beneficiary. The trustee may be a “person.” If that “person” in turn performs personal services in his/her role as trustee, then why cannot those personal services be attributed back to the trust?  How else could a trust possibly do anything? The trust would have performed personal services in the only way it can: through its trustees. The same concept applies for example to a corporation. As an artificial entity, a corporation can only act through its officers. It does not have arms and legs and cannot join a softball league. Its officers can, however.

The IRS continued that a trust cannot perform personal services because of words that Congress used in committee reports and selected Code sections. Funny, said the Court. When Congress intended that a Code section disallow trusts, it used the term “natural person.” A trust, not being a natural person, cannot take advantage of that Code section. Congress did not use that term in the Code section addressing material participation. Why-oh-why would that be, asked the Court.

The IRS lost and the Aragona trust won.

Let us say a word about the penalties the IRS wanted. Obviously they became moot when the Aragona trust won, but how could the IRS possibly defend asserting penalties in the first place? It refused to publish Regulations for 28 years, and when someone had the audacity to challenge them it responded by asserting penalties?

Here is an observation from a tax pro: the IRS is all but automatically asserting penalties these days. If there is an adjustment, the IRS clicks through its quiver of available penalties and lobs a few your way. It does not care whether you had authority for your position or whether you were just being zany. The government is going broke and the IRS is chasing money under every seat cushion. However, is this good tax policy? Shouldn’t penalties be reserved for those claiming unsubstantiated deductions, masking transactions or just making up their own tax law?

Here is an idea: if the IRS asserts a penalty and loses the issue, the IRS has to pay you the penalty amount. Force them to risk a losing hand. Maybe that will prompt them to back-off a bit.

Congratulations to the Aragona trust for taking this on.