Estate was entitled to deductions for reimbursed gift taxes that heirs paid.

• Author: Fiore, Nicholas J.

In November 1987, T and her husband H gave voting and nonvoting stock in the T Steel Company to their children and grandchildren. T and H timely filed gift tax returns for these gifts, valuing the stock pursuant to a 1951 buy-sell agreement. The value of the stock was based on the option price at which T and H could sell the stock; the prices had been set in 1976.

In 1988, H died. In 1990, the IRS audited H's estate tax return, examining the 1987 gift tax returns and the buy-sell agreement.

The limitation period for assessing gift taxes against T and H for their 1987 gifts ended on April 15, 1991. At no point before this date did the Service assess any gift taxes.

In September 1991, the IRS appraised the T Steel stock and determined that it was worth approximately seven times as much as stated on T's and H's 1987 gift tax returns. In April 1992, the Service asserted transferee liability against the donees of the 1987 gifts and issued liability notices totaling over $9 million in taxes and penalties. In May 1992, the donees made partial payments to the IRS and filed claims against H's estate in probate court, seeking reimbursement for any taxes, additions or interest arising from the 1987 gifts.

In July 1992, the donees brought suit in Tax Court, seeking a redetermination of their transferee tax liabilities. In 1998, the Tax Court ruled for the Service, holding that the IRS could revalue the 1987 gifts and that the donees could be personally liable for the transferee tax liability.

In 1994, T died. In August 1994, the donees filed claims in probate court against T's estate, seeking reimbursement for any gift taxes, additions and interest they might be required to pay for the 1987 gifts.

In April 1995, the Service and the donees settled the valuation issue, increasing the stock's value and thereby increasing the gift tax due from T and H.

In 1996, the probate court held that the donees' claims against T's and H's estates were valid, and that they were entitled to recover the taxes and interest paid as a result of the 1987 gifts. T's estate paid these amounts to the donees and, in 1996, filed an amended estate tax return, reducing the deduction for the donees' claims (based on the IRS settlement) and claiming a refund for estate taxes overpaid. The Service did not respond to the refund claim; T's estate filed suit in August 1997.

After 1995, T's estate tax return was audited; the IRS challenged the estate's deduction for the donees' claims. In...