U.S. SUPREME COURT STRUGGLES WITH ESTATE TAX ACCOUNTING ISSUE

In a plurality decision, the U.S. Supreme Court held that an estate tax marital or charitable deduction need not be reduced when part of the administration expenses are paid out of the income from assets destined for the marital or charitable trust. Four justices voted for the court's decision, three more voted for the decision's result but for very different reasons, and two justices dissented against both the result and the reasoning. Because the decision is a plurality decision, tax advisors are advised to appropriately caution clients who rely on this case.

Otis Huber died in 1987 possessed of a taxable estate approximating $26 million. While there were several recipients of Mr. Huber's largesse, the residue of the estate--the bulk of the estate--was divided between one trust for his wife and another for charity. The will permitted the executor discretion to pay administration expenses either from the principle or the income of the assets that would make up the trusts. Of the estate's $2 million in administrative expenses, $500,000 came from principle and the remainder from the income of those assets.

In computing its estate taxes, the estate reduced the residue--and therefore the marital and charitable deductions--for the amount of the administration expenses taken from principle, but not the $1.5 million taken from income. The IRS took issue with this approach, arguing that amounts taken from income for these purposes--income, which after all would end up in the marital and charitable trusts--must reduce the marital and charitable deductions. The Tax Court held for the estate and was upheld by the Eleventh Circuit Court of Appeals. This set up a conflict between the circuits, the Sixth Circuit Court of Appeals having previously overruled the Tax Court on this issue in Estate of Street v. Comm'r., 974 F.2d 723 (6th. Cir. 1992). Also, the Court of Appeals for the Federal Circuit had also held for the IRS on the issue in Burke v. U.S., 994 F.2d 1576, cert. denied, 510 U.S. 990 (1993).

The commissioner had argued that the following text from the regulations governed:

In determining the value of the interest in property passing to the spouse, account must be taken of the effect of any material limitations upon her right to income from the property. An example of a case in which this rule may be applied is a bequest of property in trust for the benefit of the decedent's spouse but the income from the property from the date of the decedent's death until distribution of the property to the trustee is to be used to pay expenses incurred in the administration of the estate. 26 CFR section 20.2056(b)-4(a) (1996).

The court noted that this regulation did not help the commissioner's argument because the example of payment of administrative expenses applied only if it had a material effect. And there was nothing in the record supporting a finding of material effect.

The concurring decision focused on this weakness in the commissioner's case. The commissioner had argued that there must be a dollar-for-dollar reduction in the marital and charitable deductions for the amount of administrative expenses paid out of the income of assets destined for the marital and charitable trusts. She argued that any reduction in the benefit to be received by the spouse or charitable beneficiary was, by definition, material. However, because there was no quantitative evidence of materiality, the concurring justices were left no choice but to support the result of the case. Their decision would have been different had the commissioner chosen a different litigation strategy which enabled the court to reach a decision on the "net value" of the reduction of the two bequests caused by their inability to enjoy the benefit of $1.5 million of income from the assets in their trusts.

This may well not be the final word on this issue. If it is raised again in the Supreme Court and the commissioner adjusts her litigation strategy as indicated in the concurring decision, the concurring and dissenting justices could form a new majority endorsing the idea that the marital and charitable deductions should be reduced by some amount when administrative expenses are paid from income allocable to marital or charitable trust assets. *

Source: Comm'r v. Huber Estate, __ U.S. __, No. 95-1402 (Mar. 18, 1997).