Crossed Circuits on Estate Tax Deductibility of Disputed or Contingent Claims

• Publication year: 2006
• Author: By Jeffrey M. Loeb

CROSSED CIRCUITS ON ESTATE TAX DEDUCTIBILITY OF DISPUTED OR CONTINGENT CLAIMS

By Jeffrey M. Loeb^*

I. INTRODUCTION

Although federal tax laws are supposed to be applied uniformly throughout the nation, there is at least one law which is applied differently depending on where an estate is administered following death. Internal Revenue Code § 2053(a)(3)¹ allows a deduction for "claims against the estate" which are "allowable by the laws of the jurisdiction . . . under which the estate is being administered." But even if the laws regarding estate claims were exactly the same in every jurisdiction, the deductibility of claims that are disputed or subject to contingencies at death depends on the federal circuit in which the decedent's estate is administered.² This article explains how this unusual situation developed inside the federal judicial system and offers an opinion as to how the U.S. Supreme Court should resolve the conflicting judicial views.

II. CROSSED CIRCUITS

As discussed below, the Ninth and Fifth Circuit Courts of Appeals have diametrically opposing views as to the deductibility under I.R.C. § 2053(a)(3) of disputed or contingent "claims against the estate" as of the decedent's date of death. In the Ninth Circuit,³ a decedent's estate is not entitled to deduct for federal estate tax purposes the date of death value of a disputed or contingent claim but rather must await resolution of such claim before seeking a refund of any estate tax paid.⁴ On the other hand, in the Fifth Circuit,⁵ a decedent's estate may deduct the date of death value of a disputed or contingent claim against the estate and it is left to the IRS to challenge this value.⁶

To appreciate these conflicting judicial views, consider the hypothetical scenarios which follow.

In the first scenario, Polly Plaintiff is suing Danny Defendant for breach of contract and seeks to recover $10 million in compensatory damages. Upon leaving a witness deposition at the same time, both Polly and Danny are hit by a bus and killed. Based on an expert appraisal, Polly's executor includes in Polly's gross estate a $6 million date of death value for Polly's claim against Danny. Danny's executor, using the same appraisal obtained by Polly's executor, claims a $6 million estate tax deduction under I.R.C. § 2053(a)(3) for the amount of Danny's disputed liability in the case brought by Polly. After several years of litigation, Danny's estate finally agrees to settle the dispute by paying $2 million to Polly's estate. Here's the rub: If Danny's estate were administered somewhere in the Ninth Circuit, no deduction under I.R.C. § 2053(a)(3) could be claimed on the estate tax return for Danny's estate (as initially filed) for the amount of the disputed liability.⁷ Conversely, if Danny's estate were administered somewhere in the Fifth Circuit, then a $6 million deduction under I.R.C. § 2053(a)(3) properly could be claimed on the estate tax return as initially filed.⁸ The rationale for this disparate treatment is not easily understood.

In theory, the same economic outcome should result in both circumstances, i.e., since the interest rate paid by the IRS on overpayments and that paid by the taxpayer on underpayments is the same, the taxpayer who pays the estate tax and is later allowed (or sues for) a refund of the tax paid (plus interest) should be in the same economic position as the one who pays the estate tax (plus interest) in response to a notice of deficiency.⁹ However, in reality, the date of death value of the I.R.C. § 2053(a)(3) deduction allowed to the Fifth Circuit taxpayer for the disputed or contingent claim may end up being greater than the amount actually paid to resolve or otherwise liquidate the claim. So long as the original appraised value of the disputed or contingent claim (based on the facts known at the date of death) withstands challenge by the IRS, the fact that a smaller amount was actually paid post-death to resolve or otherwise liquidate the claim is irrelevant. On the other hand, the amount of the Ninth Circuit taxpayer's I.R.C. § 2053(a)(3) deduction is based entirely on the amount ultimately paid post-death to resolve or otherwise liquidate the disputed or contingent claim, i.e., the date of death value of the claim is irrelevant.

In the second scenario, Larry Loser and Wendy Winner die on the same day and both of their estates are administered somewhere in the Ninth Circuit. If an identical disputed claim was pending against Larry's estate at his death as was pending against a closely-held corporation in which Wendy owned a significant interest, Larry's estate would not be able to take an I.R.C. § 2053(a)(3) deduction for the value of the disputed claim, yet the appraised value of Wendy's corporate stock would necessarily reflect the contingent liability—it would have been taken into consideration in valuing the corporation. Had Larry's and Wendy's estates been administered in the Fifth Circuit, both estates, rather than Wendy's alone, would have been able to report a taxable estate reduced, directly or indirectly, by the date of death value of the disputed claim.

III. THE EARLY DECISIONS

At the core of each of these cases is the issue of whether Congress, in imposing an estate tax on the act of transferring wealth at death, intended the value of the wealth transferred to be determined based solely upon the facts known at death or instead, to be determined after considering post-mortem events and occurrences. Clearly, there is a fundamental difference of opinion among the Circuit Courts of Appeals on this question and it is that difference which dictates whether a disputed or contingent claim is deductible under I.R.C. § 2053(a)(3) even before the actual amount needed to resolve or otherwise liquidate that claim is known.

The seminal case on the subject of the deductibility of claims is Ithaca Trust Co. v. United States,¹⁰ in which the U.S. Supreme Court

[Page 6]

addressed the effect of post-mortem events and occurrences on the amount of an allowable federal estate tax charitable deduction. In Ithaca Trust, the decedent made a gift to his wife of a life estate in the residue with the remainder passing on her death to charity. The wife was entitled to as much income and principal as was necessary "to suitably maintain her in as much comfort as she now enjoys."¹¹ Thus, the first issue presented was whether the terms of the wife's life estate rendered the gift to the charity "so uncertain"¹² as not to allow a charitable deduction to be taken. Writing for the Court, Justice Holmes quickly answered this question "in the negative"¹³ based on the fact that the distributions which could be made to the wife were subject to an ascertainable standard and the fact that the income "was more than sufficient to maintain the widow as required"¹⁴, thus obviating the need for principal invasions. In describing the level of uncertainty attached to the charitable gift, Justice Holmes wrote "There was no uncertainty appreciably greater than the general uncertainty that attends human affairs."¹⁵ Had the great Justice been able to fashion a less comprehensible measure of uncertainty, there can be little doubt he would have done so.

The second issue presented in Ithaca Trust was whether the amount of the charitable deduction should be determined based upon the value of the gift to the charity on the decedent's date of death reduced by the "amount of the diminution [resulting from the value of the wife's life estate] . . . to be determined by the event as it turned out [i.e. the wife's death within six months of the decedent's] . . . or by mortality tables showing the probabilities as they stood on the day when the testator died."¹⁶ The government argued that the post-mortem event, i.e., the wife's death six months after the decedent's, should be used to calculate the value of the charitable deduction.¹⁷ In response to this argument, Justice Holmes wrote:

"The first impression is that it is absurd to resort to statistical probabilities when you know the fact. But this is due to inaccurate thinking. The estate so far as may be is settled as of the date of the testator's death. [Citations.] The tax is on the act of the testator not on the receipt of property by the legatees. [Citations.] Therefore the value of the thing to be taxed must be estimated as of the time when the act is done."¹⁸

On this basis, the high Court concluded in Ithaca Trust that "[t]empting as it is to correct uncertain probabilities by the now certain fact, we are of the opinion that it cannot be done, but that the value of the wife's life interest must be estimated by the mortality tables."¹⁹ According to Holmes, "that value, [l]ike all values . . . depends largely on more or less certain prophecies of the future, and the value is no less real at that time [i.e., the decedent's date of death] if later the prophecy turns out false than when it comes out true. [Citations.]" In other words, in fixing the value of the charitable deduction, it does not matter whether the wife lived longer or shorter than her life expectancy; the value was based on the date of death estimate of her life expectancy notwithstanding the uncertainty inherent therein.

Several months following the Supreme Court decision in Ithaca Trust, the Eighth Circuit Court of Appeals decided Jacobs v. Commissioner.²⁰ In Jacobs, the husband's estate deducted $75,000 from the husband's gross estate,²¹ the amount to which the wife, who survived, was entitled under a prenuptial contract in the place of her dower and other marital rights.²² Pursuant to an election given to the wife under the husband's will, in lieu of collecting the $75,000 due her under the prenuptial agreement, the wife elected to receive the net income for her life from $250,000 of the husband's estate. The Eighth Circuit, in reviewing the contentions of the parties, wrote:

"[T]he contention in behalf of the estate is built upon the antenuptial contract, and the moment of

...