Tax Issues When Settling a Trust or Estate Dispute: a Guide for the Litigator

• Jurisdiction: United States,Federal,California
• Author: By Brian G. Fredkin, Esq.,* and Ryan J. Szczepanik, Esq.
• Publication year: 2019
• Citation: Vol. 25 No. 3

TAX ISSUES WHEN SETTLING A TRUST OR ESTATE DISPUTE: A GUIDE FOR THE LITIGATOR

By Brian G. Fredkin, Esq.,* and Ryan J. Szczepanik, Esq.^**

The merits of the claims typically drive the negotiations to resolve a trust or estate dispute. Tax issues often are a secondary focus. It is not uncommon for the litigator to wake up the morning after reaching a settlement wondering if she or he neglected to appreciate a significant tax issue. The purpose of this article is to help trust and estate litigators identify the tax issues most likely present in a trust or estate dispute, so they can be sensitive to these issues when guiding their clients through settlement.

The trust and estate litigator advising on a settlement strategy should always consider the impact that taxes may have on the value of a claim. If a property right or interest is transferred, modified, or terminated in a settlement, the client may be subject to unanticipated tax exposure. For example, the client may receive an IRS Form K-1 or 1099 in the year following a settlement requiring the client to report as taxable income all or part of the settlement payment. The IRS may notify the client who is the surviving spouse that a lump-sum payment he or she received in a settlement terminating the surviving spouse's interest in the deceased spouse's estate has triggered an estate or gift tax. The IRS may notify the client that the partition through settlement of a trust that was exempt from the generation-skipping transfer tax has caused the trust to lose its exempt status. The local county assessor may notify the client that real property received in the settlement will be reassessed for property tax purposes.

This article focuses on the relevant tax laws and techniques an attorney may employ to: (1) avoid an unexpected tax surprise when guiding the client through settlement of a trust or estate dispute; and (2) reach a settlement agreement that the IRS and federal courts are more likely to respect for federal tax purposes.

Part I of this article summarizes the tax laws that the authors anticipate may be involved in a typical trust or estate dispute.

Part II discusses the factors the IRS and federal courts will apply to determine whether to respect a settlement agreement and the principles that have emerged from the relevant case law.

Part III presents a hypothetical to illustrate the tax laws and factors discussed in Parts I and II.

Part IV evaluates the scrutiny the IRS will give to the pleadings, discovery, and settlement documents in deciding whether to respect the tax-related provisions of a settlement agreement. Part IV concludes with strategies an attorney may employ to obtain a favorable decision on those tax provisions.

I. RELEVANT TAX LAWS

A. Federal Income Tax 1. Gross Income

Gross income means "all income from whatever source derived" unless specifically excluded by law.¹ Property received by "gift, bequest, devise, or inheritance" is excluded from gross income and is therefore not subject to income tax,² although the income generated by such property after receipt is included in gross income and subject to income tax to the recipient.³ A gift, bequest, devise, or inheritance of income from property, as opposed to the property itself, is also included in gross income and therefore, subject to income tax.⁴

2. Income Tax Basis

"Basis" is the amount of a taxpayer's investment in property for tax purposes.⁵ Basis of property is used to figure depreciation, amortization, depletion, casualty losses, and gain or loss on the sale or other disposition of property.⁶

The donee's basis of property received by gift during a donor's lifetime equals the donor's basis at the time of the gift, plus any gift tax paid by the donor.⁷ The basis of the property in the hands of the donor immediately prior to the gift "carries over" to the donee and is commonly referred to as a "carryover basis." However, if the basis of the property exceeds its fair market value⁸ at the time of the gift, the donee's basis in the property will be its fair market value at the time of the gift if the donee later sells or disposes of the property for a loss.⁹

The basis of property received by reason of a decedent's death is generally equal to the property's fair market value on the date the decedent died, or the alternate valuation date.¹⁰ In general, the basis of all community property held by the decedent and the surviving spouse, as well as the decedent's separate property, is adjusted to the fair market value of the property on the applicable valuation date.¹¹ The date of death basis adjustment is typically referred to as a "step-up" in basis since the basis of the property in the hands of the decedent is usually lower than the fair market value at the date of death, resulting in an increase in basis. However, if the fair market value of the property on the decedent's date of death is lower than its basis in the hands of the decedent, the basis will be reduced or "stepped down."¹²

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Commonly held property interests that may be eligible for a date of death basis adjustment include real estate, personal property, stock, and entity interests. Deathbed transfers¹³ and payments of income in respect of a decedent, commonly referred to as "IRD"¹⁴ (e.g., qualified retirement plans,¹⁵ IRAs,¹⁶ unpaid wages,¹⁷ accrued interest¹⁸), do not receive a date of death basis adjustment.¹⁹

When property is sold or disposed of, the amount realized in excess of the property's basis results in a capital gain.²⁰ Conversely, if the amount realized is less than the property's basis, a capital loss results.²¹ For federal income tax purposes, capital gain or loss can be either short-term (for property held for one year or less) or long-term (for property held for more than one year).²² Short-term capital gain is taxed at the same rate as ordinary income.²³ Long-term capital gain is taxed at a more favorable rate (0%, 15%, or 20%, depending on the taxpayer's taxable income).²⁴ California taxes capital gain, both short term and long term, at the same rate as it taxes ordinary income.²⁵ The highest tax rate in California is 13.3%.²⁶

When a remainder interest is sold or otherwise disposed of, the basis of the remainder interest is not disregarded.²⁷ However, when a "term interest" (i.e., a life interest in property, an interest in property for a term of years, or an income interest in a trust)²⁸ is sold or disposed of, the basis of the term interest is disregarded; the full sales price is taxable.²⁹ If the entire interest (i.e., the term interest and the remainder interest) in the property is sold or disposed of in a single transaction, the property's basis is not disregarded.³⁰

3. Income Tax Deductions

Expenses paid or incurred to protect or assert one's right to the property of a decedent as an heir or beneficiary are not deductible from gross income.³¹ Ordinary and necessary expenses paid or incurred for the production or collection of income, on the other hand, are deductible.³² Ordinary and necessary business expenses are also deductible.³³Administration expenses include fiduciary fees, accounting expenses, and legal expenses paid by a fiduciary from a decedent's trust or estate to defend a claim against the trust or estate. Those expenses are generally deductible from the trust or estate's gross income if they are ordinary and necessary and paid from the trust or estate in connection with the performance of the duties of administration.³⁴

B. California Real Property Tax 1. Reassessment

In California, property taxes are based on the assessed value of real property. Property taxes are assessed and collected by local county assessors and tax collectors. Property taxes are limited to 1% of the property's assessed value, charged annually.³⁵ Absent a change of ownership, the assessed value may be adjusted annually for inflation at a rate not to exceed 2%.³⁶

In general, California real property is reassessed when a "change in ownership" occurs.³⁷ A "change in ownership" is defined as "a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest."³⁸ A change in ownership occurs on the transfer of property by sale, gift, or inheritance, unless a statutory exclusion applies.

2. Statutory Exclusions

There are a number of exclusions from a change in ownership.³⁹ Two common statutory exclusions from a change in ownership are the interspousal exclusion⁴⁰ and the parent-child exclusion.⁴¹

The interspousal exclusion provides that any interest in real property that is transferred between spouses or registered domestic partners, either during lifetime or at death, is excluded from reassessment.⁴² Qualified interspousal transfers also include transfers of interests in a legal entity (e.g., corporation, partnership, limited liability company) that holds real property.⁴³ The parent-child exclusion is more limited. It excludes from reassessment only the following transfers of real property between a parent and child: (i) the transfer of a principal residence;⁴⁴ and (ii) the transfer of the first $1 million of assessed value of real property other than a principal residence, measured in the aggregate.⁴⁵ For purposes of the parent-child exclusion, "real property" does not include interests in a legal entity that holds real property.⁴⁶ For purposes of the exclusion, "children" include sons and daughters, sons-in-law and daughters-in-law, stepchildren, and children adopted before age eighteen.⁴⁷

When real property is transferred to or from a trust, the assessor will look "through" the trust at who has the present beneficial interest to determine whether a change in ownership has occurred.⁴⁸ A transfer in trust will qualify for a statutory exclusion if the present beneficial interest in the trust passes from a deceased spouse to a surviving spouse, or from a deceased parent to a surviving child.

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3. Transfer of Base-Year Value for Persons...