WHAT EVERY CPA SHOULD KNOW ABOUT ESTATE OF HUBERT
By Frank G. Colella, JD, LLM, CPA
In Commissioner v. Estate of Otis C. Hubert, the U.S. Supreme Court significantly increased the tax savings available to estates when it held that some level of administrative expenses can be allocated to, and deducted from, an estate's post-mortem income without a corresponding reduction in the estate's marital deduction. Once the administrative expenses reach the level of a "material limitation," however, a reduction in the marital deduction would be required. How to calculate the reduction in the marital deduction is unclear because material limitation was not defined by the Supreme Court, nor was the method for reducing the marital deduction agreed upon by the justices. The question is how to use the Hubert decision to achieve tax savings.
Despite the lack of a working definition of material limitation, or a method for computing the reduction, estate plans should be developed with the wherewithal to allocate administrative expenses to post-mortem income. One of the first provisions that should be examined in a will or trust should be the flexibility granted to the fiduciary to do this.
Background
Otis C. Hubert died in 1986 leaving a gross estate valued in excess of $30 million. In addition to a standard will contest that alleged fraud and undue influence, a number of civil suits also commenced, including claims of slander and abuse of process. The executors of Mr. Hubert's estate filed the Federal estate tax return (Form 706) in 1987, and, in 1990, the IRS, following a lengthy examination, issued a notice of deficiency in the amount of $14 million.
The principal assertion in the notice of deficiency was that the marital bequest did not meet the requirements for the estate tax marital deduction. The estate timely filed a petition in the Tax Court for a redetermination of the deficiency. Shortly after the petition was filed, most of the litigation and claims against the estate were settled. The settlement agreement divided the residuary estate into two parts: marital and charitable. Each share was worth approximately $13 million. The settlement agreement, incorporating the discretion contained in the decedent's will, specifically provided that the estate fiduciaries could pay the expenses of administration from either the estate's principal or income.
That fiduciary discretion to apportion administrative expenses, was appropriate under the laws of Georgia, where the decedent had lived. The estate incurred approximately $2 million in administrative expenses, of which the fiduciaries elected to allocate $500,000 to principal and the remainder, $1,500,000, to post-mortem income. The marital and charitable deductions were reduced by the amount of expenses allocated to principal, but not the amount allocated to income.
The issue of qualification for the marital and charitable deductions was ultimately resolved in the estate's favor and, accordingly, both deductions were permitted. But the IRS continued to maintain that the administrative expenses allocated to post-mortem income should reduce the marital and charitable deductions dollar-for-dollar. That position was rejected by the tax court. The Court of Appeals for the Eleventh Circuit, adopting the tax court's opinion as its own, affirmed the decision. The Supreme Court agreed to review the decision and, as a consequence, resolve the split among the circuit courts.
Applicable Authority
The Estate Tax Marital Deduction. IRC section 2056(a) provides a deduction from the gross estate for the value of any interest passing to the surviving spouse. Almost any conceivable bequest to a surviving spouse can qualify for the marital deduction, including joint tenancies, statutory elective shares, settlements from a will contest, and certain interests in trust (most typical is the QTIP). It is important, in this regard, to distinguish between qualifying the interest for the marital deduction and valuing that interest for purposes of claiming the deduction on the estate tax return.
For example, Estate of Hubert ultimately held that whether the administrative expenses allocated to post-mortem income should reduce the marital deduction was a valuation issue. A qualification issue could resurface, however, if the allocation goes beyond a material limitation and becomes, instead, a substantial limitation on the surviving spouse's beneficial enjoyment of the interest. Although the consequence of a material limitation is a reduction in the value of the deduction, the consequence of a substantial limitation is a disallowance of the deduction in its entirety.
Deduction of Administrative Expenses. IRC section 2053 provides a deduction from the gross estate for administrative expenses incurred during the estate administration. IRC section 642(g) provides that administrative expenses otherwise deductible from the gross estate pursuant to IRC section 2053 may, if an irrevocable election to do so is made by the executor, be deducted on the Fiduciary Income Tax Return (Form 1041). The executor must file a statement with Form 1041 that expenses deducted pursuant to IRC section 642(g) have not been deducted on the estate tax return and waives the right to claim such deduction on the estate tax return pursuant to IRC section 2053.
New York Provisions Governing Principal and Income Allocations. New York State Estates Powers and Trusts Law (EPTL) section 112.1(d)(1) provides that, "unless the will provides otherwise ... all expenses incurred in connection with the settlement of a decedent's estate ... shall be charged against the principal of the estate." This default provision is applicable when the will is silent on this issue. To take advantage of Estate of Hubert's holding, a New York will must contain specific language granting the fiduciaries the authority to make the allocation. The same requirement applies to trust documents. Unless the decedent's will or trust contains that specific grant of authority, all administrative expenses must be charged to principal and cannot be allocated to post-mortem income.
The Supreme Court's Decision
Estate of Hubert did not gather enough affirmative votes from the justices to constitute a full opinion of the Supreme Court. It is, instead, a plurality decision. Nevertheless, seven of the nine justices held that, under the particular facts presented in Estate of Hubert, the level of administrative expenses charged by the fiduciaries to post-mortem income did constitute a "material limitation" requiring that the marital deduction be reduced.
The Plurality Opinion. Writing for the plurality, Justice Anthony Kennedy held:
Where the will requires or allows the estate to pay administration expenses from income that would otherwise go to the surviving spouse, our analysis requires that the marital deduction reflect the date-of-death value of the expected future administration expenses chargeable to income if they are material as compared to the date-of-death value of the expected future income. Using this approach to valuation, the estate will arrive at the net economic interest received by the surviving spouse.
The plurality did not find, however, that the material limitation resulted in an outright denial of the marital deduction, in and of itself, because it rose to the level of a substantial limitation on the surviving spouse's right to all the income. Instead, the plurality assumed that the interest qualified for deductibility but, for valuation purposes, a reduction in the marital deduction was appropriate.
Accordingly, if the limitation is material, the plurality's decision requires balancing the anticipated administration expenses of the estate against the surviving spouse's interest in the estate. Left unclear is how, in practice, this balancing should be computed. The plurality's approach incorporates present value concepts and requires that the estate, at a minimum, approximate its expected administration expenses and balance that figure against the initially computed value of the marital deduction.
The Concurring Opinion. While Justice Sandra Day O'Connor agreed with the result reached by the plurality and agreed that some level of administrative expenses charged to post-mortem income would not reduce the estate's marital deduction she did not agree that employing a present value analysis of anticipated expenses and income was the correct method to adopt. Instead, Justice O'Connor focused on the IRS's own revenue rulings to conclude that some level of administrative expenses could be charged to post-mortem income without reducing the date of death value of the marital deduction.
Justice O'Connor relied, in particular, on Revenue Ruling 93-48 which permitted the allocation of post-mortem interest on estate taxes against post-mortem income. Revenue Ruling 93-48 specifically held that interest charges would not ordinarily result in a diminution of the deduction. Justice O'Connor found that the administrative expenses were "functionally indistinguishable" from interest on estate taxes and therefore, held that both expenses should receive similar treatment. She observed that "the commissioner's treatment of interest on deferred estate taxes ... indicates ... rejection of the notion that every financial burden on a marital bequest's postmortem income is a material limitation warranting a reduction in the marital deduction."
The Dissent. Justice Antonin Scalia, however, agreed with the IRS and held that any allocation of administrative expenses to post-mortem income requires a reduction in the estate tax marital deduction: "In my view ... the marital (and charitable) deductions must be reduced whenever income from property comprising the residuary bequest to the spouse (or charity) is used to satisfy administrative expenses." However, Justice Scalia declined to adopt the dollar-for-dollar reduction advanced by the IRS. Instead, Justice Scalia would have remanded that question, whether to use present value concepts or a dollar-for-dollar reduction, to the lower courts. Justice Stephen Breyer concurred with Justice Scalia's dissent.
Planning Opportunities
The planning opportunities associated with the decision can be divided into three basic categories:
* The client is alive and the planning documents can be newly created or amended to take advantage of Hubert;
* There is a current estate administration underway in which a Hubert allocation may be appropriate; and,
* The estate has been closed, but the statute of limitations has not yet expired, and the estate may be reopened for purposes of making the allocation.
Planning for Current Clients. For large estates, given the significant tax savings generated by an appropriate allocation of administrative expenses to an estate's post-mortem income and the corresponding deduction on the fiduciary income tax return, it makes sense to have this discretion included in wills and trust documents. Existing wills and trusts, should be reviewed to determine whether the appropriate discretion is contained among the enumerated fiduciary powers. In New York, the discretion to allocate expenses to income must be specifically stated. If not, administration expenses reduce principal, not income.
The will or trust documents should also include a savings provision that prohibits the fiduciary from exercising the discretion in such a way as to create a material limitation that would require a reduction in the marital deduction. This proscription against creating a material limitation serves the dual purpose of permitting a deduction for some level of administrative expenses without reducing the marital deduction and, more importantly, preventing the allocation from affecting the qualification for the marital deduction.
A sample provision reads as follows:
I hereby give my fiduciaries the power to allocate the expenses of administration to either the principal of my estate or the income generated therefrom. This discretion may be exercised to reduce the overall tax liability payable by my estate, or any trust created by me, incurred as a result of my death. Provided however, my fiduciaries shall not exercise this discretion in any manner that may impose a material limitation on my spouse's beneficial enjoyment of the income generated from the assets allocated to the marital share and for which an estate tax marital deduction is claimed.
The actual drafting of the language is the province of a qualified attorney.
Planning for Current Estates. For existing estates currently under administration which have the discretion to make a Hubert allocation contained in their governing documents, practitioners should consider doing so, despite the lack of practical guidance on what level of expense can be allocated before it becomes a material limitation. While there is no clear line delineating a level of material limitation, some dollar amount can be deducted without reducing the marital deduction. If the proposed regulations subsequently articulate guidelines that have been exceeded, the appropriate remedial steps can be taken (such as amending the returns and paying whatever additional tax and interest that may be due).
For fiduciaries not authorized to make such an allocation, it may be appropriate to undertake, before the Surrogate's Court, a reformation proceeding to judicially approve the amendment of the governing documents to permit the allocation. Whether a given surrogate would permit a reformation depends upon the particular facts and circumstances of each estate. However, should the IRS promulgate regulations to implement Hubert which include guidance on making the allocation, a surrogate may be more favorably inclined to entertain such a proceeding and grant the reformation.
Planning for Closed Estates. While it would seem unlikely that planning opportunities exist for closed estates, if the statute of limitations has not yet expired, an analysis may still be taken to determine whether amending the estate tax return and the corresponding fiduciary income tax returns is a viable option. This particular option should be chosen carefully, because a host of unknown issues, unrelated to the allocation itself, could be reopened and examined by the IRS. Unless the potential tax savings are substantial, this option should rarely be exercised.
If it is decided to reopen the estate, the fiduciary should nevertheless only proceed with the written consent of all of the estate beneficiaries. In addition, the actual consequence of making the allocation should be carefully computed on a pro-forma basis. The consequence of retroactively allocating expenses to income may require the income beneficiaries to return a portion of the income they have already received to the estate, which would, in turn, use those proceeds to increase the marital share.
It is appropriate to note that the result in Hubert could be negated by Congressional legislation. While such a drastic action may not seem likely, it is possible. More realistically, however, the IRS may seek to curtail the benefits of Hubert by issuing proposed regulations that severely limit its practical application (see discussion in sidebar). For example, if the IRS establishes safe harbors based on artificially low thresholds (either based on projected income or size of the gross estate) and provides that allocations in excess of those amounts would trigger examinations or dollar-for-dollar reductions in the marital deduction, the use of Hubert allocations may no longer make sense. *
An article by the author on this case from a legal perspective appeared in the New York State Bar Journal, published by the New York State Bar Association, vol. 70, no. 3.
THE IRS SEEKS INPUT
The IRS issued Notice 9763 (199747 IRB 6) on November 24, 1997, which requested guidance on implementing the Estate of Hubert decision. Specifically, the IRS requested public comments on three principle alternatives: distinguishing between expenses properly chargeable to income and those chargeable to principal; creating a de minimis safe harbor; and treating any allocation of expenses as a material limitation. The IRS requested comments on the following additional issues in connection with the Estate of Hubert: 1) using a quantitative method to determine materiality; 2) date of death valuations; 3) present value concepts; and 4) whether the distinction between post-mortem interest and administrative expenses in Revenue Ruling 9348 is still valid. The IRS anticipates issuing proposed regulations during 1998. *
Editors:
Alan D. Kahn, CPA
Contributing Editors:
Frank G. Colella, JD, LLM, CPA
Jerome Landau, JD, CPA
James B. McEvoy, CPA
Nathan H. Szerlip, CPA
Lenore J. Jones, CPA
September 1998 Issue
Eric M. Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.
The AJK Financial Group
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP
Own Account
The Chase Manhattan Bank
Edward Isaacs & Company LLP
Jacobs Evall & Blumenfeld LLP
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.