By Abraham J. Briloff and Leonore A. Briloff
Filtering out the Noise
In 1997, the U.S. Supreme Court handed down what has become a widely discussed decision on the treatment of certain administrative expenses in Estate of Hubert. It seems that tax laws and regulations allow an estate two choices on how to treat certain administrative expenses incurred after the date of death of the decedent. They can be taken as a deduction against the income of the estate, thereby reducing income taxes payable, or they can be deducted in the calculation of the net estate subject to the estate tax. There is a bit of a wrinkle, however, under Regulations section 20.2056(b)-4, which says that in determining the value of an interest passing to a spouse, any material limitations on the right to income on the interest must be taken into account. The IRS has interpreted this to mean that, in situations where administrative expenses are taken as a deduction for income tax purposes, there must be an evaluation whether there is a material limitation on the surviving spouse's right to income on property going to that spouse. If so, in the IRS's mind, the marital deduction should be reduced to reflect that limitation. The overall effect is to reduce the amount of the marital deduction and increase the estate tax.
In Hubert, the Supreme Court found in favor of the estate and overturned the IRS's attempt to so reduce the marital deduction. Esteemed professor of accounting Abraham Briloff and his daughter Leonore analyze and question the Hubert decision. It is not that they don't like the end result of Hubert: They don't like the fact that the Court did not discredit the IRS's interpretation of the regulations. As a mirabile dictu, the Briloffs bring the readers up to date on recent proposed regulations to resolve what the Supreme Court left unresolved. The Briloffs became interested in the issue when the IRS raised the issue with a client of their firm. They are pleased to note that the case has recently been settled to their satisfaction.
On March 18, 1997, the U.S. Supreme Court handed down its "decision," euphemistically speaking, in Comm'r of Internal Revenue v. Estate of O. Hubert (117 S. CT. 1124). The case resulted in four separate opinions, to wit:
* The plurality by Justice Anthony M. Kennedy, in which Chief Justice William H. Rehnquist and Justices John Paul Stevens and Ruth Bader Ginsburg joined;
* A concurring opinion by Justice Sandra Day O'Connor, joined by Justices David H. Souter and Clarence Thomas;
* A dissent by Justice Antonin Scalia, joined by Justice Stephen Breyer; and
* A further dissent by Justice Breyer.
By combining the votes of the plurality and concurrence we have the decision on behalf of a majority of seven in favor of the estate of O. Hubert, the respondent. Those opinions, in turn, led to a spate of articles by legal scholars--all involving an exegetic analysis of the justices' opinions and attempting to provide guidance for the perplexed. Regrettably, it would appear neither the justices, their clerks, nor the scholars were constrained to evaluate the areas of fiduciary accounting and mathematics of finance; had they done so the opinions and commentaries would have been far more informative and definitive.
Before proceeding, herewith a "crash course" in the estate tax mystique. According to the Federal estate tax return (Form 706) the starting point is the gross estate, comprised of the assets listed on schedules A through I. The gross estate is followed by deductions, which are displayed on the following schedules:
* Schedule J--Funeral expenses and expenses incurred in administering property subject to claims
* Schedule K--Debts, mortgages, and liens
* Schedule L--Net losses during administration
* Schedule M--The marital deduction (especially relevant to Hubert and this analysis), and
* Schedule O--Charitable gifts and bequests.
The aggregate of schedules J through O represents the total allowable deductions.
On the first page of Form 706, the deductions are subtracted from the gross estate to produce the taxable estate. There then follow adjustments, e.g., inter vivos gifts, to provide the basis for determining the gross estate tax, from which credits for the unified credit and state death taxes are deducted to produce a net tax payable.
The administration expenses entered on Schedule J are those described by IRC section 212. That section allows a deduction for individuals and estates of the ordinary and necessary expenses paid or incurred during the taxable year 1) for the production or collection of income, 2) for the management, conservation, or maintenance of property held for the production of income, or 3) in connection with the determination, collection, or refund of any tax.
But IRC section 642(g), which relates to "special rules for credits and deductions" in determining the income tax of estates and trusts, prohibits "double deductions." It says that deductions under section 2053 (administration expenses) or 2054 (losses) in computing the taxable estate of a decedent shall not be allowed as a deduction on the Form 1041 unless a statement is filed saying that the amounts have not been allowed as deductions for estate tax purposes and that the right to have such amounts allowed at any time as deductions for such purposes is waived. Thus, the expenses of administration referred to by Schedule J are something of a "wild card" in that they may be claimed by the fiduciary as either income tax deductions on the estate's Form 1041 or as part of Schedule J on the 706, but not on both.
Continuing with the lesson, the marital deduction on Schedule M, which is provided for by IRC section 2056, is a deduction for "the value of any interest in property which passes or has passed from the decedent to his [or her] surviving spouse." This deduction is not limited to outright bequests to the surviving spouse but includes an entitlement to life estates under QTIP trusts, i.e., those described in subsection 2056(b)(7) as qualified terminable interest property trusts.
By way of example, Exhibit 1 presents information about an estate--we'll call it the Estate of K--that our office had been working on that involved the principles in Hubert. It is here to be noted that the bequest to K's surviving spouse was outright and not limited in any way. But probably more significant to this analysis is that no administration expenses were claimed for the purposes of the 706. This is because had they been claimed on Schedule J, they would have reduced the resultant bequest to the surviving spouse, thereby rendering the expense deduction nugatory.
Now for the Hubert Donnybrook
The gross estate in the Hubert case amounted to about $30 million. The surviving spouse's interest qualifying for the marital deduction was solely as the income beneficiary of two trusts created under the will--the corpus was divided between a QTIP trust and a general power of appointment trust with the power vested in the spouse. The fiduciaries elected to deduct about $1.5 million of administration expenses for purposes of the income tax.
The commissioner of internal revenue asserted that because the $1.5 million materially impacted the spouse's beneficial interest, the marital deduction otherwise allowable had to be abated dollar for dollar. The U.S. Supreme Court majority determined that the $1.5 million was not such a material limitation on the widow's entitlement in view of the $30 million gross estate.
The Alpha and Omega
Regulations section 20.2056(b)-4(a) provides the essential frame of reference for resolving the issues in Hubert and the Estate of K. That section reads as follows:
In general the value for the purpose of the marital deduction, of any deductible interest which passed from the decedent to his surviving spouse, is to be determined as of the date of the decedent's death.... The marital deduction may be taken only with respect to the net value of any deductible interest which passed from the decedent to his surviving spouse.... In determining the value of the interest in property passing to the spouse account must be taken of the effect of any material limitations on her right to income from the property.
The "Alpha": The Date of Death, Point in Time, Aspect. The opinion of Justice Kennedy makes clear that the starting point for determining the marital deduction is the property passing to the marital deduction pool determined as of the date of death unless the alternative valuation date is selected (which was not involved in Hubert, nor in the Estate of K). According to Justice Kennedy, a marital deduction should not be reduced by obligations and expenses that occur subsequent to the date of death. The conclusion that follows is that expenses taken as a deduction for income tax purposes that arose subsequent to the date of death should not then be used to reduce the marital deduction.
The Commissioner Is "Hoist on Her Own Petard." As an incident to her consideration of the date of death aspect, Justice O'Connor's opinion took issue with the commissioner's application of Rev. Rul. 93-48, 1993-2 CB 270. That ruling, inter alia, clarified Rev. Rul. 80-159 so as to hold that "the value of the marital bequest for purposes of section 2056(b)(4) is not reduced by post-death interest expenses accruing on taxes even if state law requires payment from the marital bequest of estate tax and interest on the tax."
The commissioner insisted that the ruling should be restricted to the interest on the estate tax and nothing more, so as not to extend to the administration expenses. Justice O'Connor reasoned in her opinion that interest accruing on estate taxes is no different than the administrative expenses at issue in Hubert:
By definition, neither of these expenses can exist prior to the decedent's death; before that time, there is no estate to administer and no estate tax liability to defer. Yet both types of expenses are inevitable once the estate is open because it is virtually impossible to close an estate in a day so as to avoid the deferral of estate tax payments or the incursion of some administration expenses.... Both types of expenses are, moreover, of uncertain amount on the date of death. Because these two types of expenses are so similar in relevant ways, in my view they should be treated the same under section 20.2056(b)-4(a) and Ruling 93-48, despite the commissioner's limitation on the applicability of Revenue Ruling 93-48 to interest on deferred estate taxes.
As noted, the commissioner sought to restrict that ruling to interest on the estate taxes; nonetheless, as expanded by Justice O'Connor's opinion, the critical provision in the revenue ruling would read as follows: The value of the marital bequest for purposes of section 2056(b)(4) is not reduced by post-death interest expenses accruing on taxes nor by administration expenses even if state law requires that they be charged against principal.
We accountants can readily comprehend Justice O'Connor's assertions in this regard. Thus, if we were preparing a balance sheet as of Hubert's date of death, neither the subsequent charges for the interest nor the administration expenses would be booked as a liability, per se. They might be reflected as contingencies under SFAS No. 5, Contingencies, but not as a liability.
The "Omega": The Material Limitation Factor. We turn to the substantive aspect of the controversy. Thus, as noted, Hubert's fiduciaries elected to deduct the $1.5 million for the purpose of the income tax, i.e., on the Form 1041, and thereby elected not to deduct those "presumed expenses" of administration on the Form 706 as deductions for the estate tax which might otherwise be allowable under IRC section 2053.
Simple enough! Except that the commissioner, as previously noted, determined that the administration expense election by the fiduciaries triggered a dollar-for-dollar reduction in the marital deduction. The basis on which she made that assertion is not especially discernible from the Supreme Court opinion. Apparently, the commissioner presumed that the widow's deprivation of the $1.5 million deducted from her income entitlement was such a "material limitation" on her entitlement so as to reduce the amount claimed for the marital deduction on the 706.
But here, as Justice Scalia noted in his dissent, is where the issue was never satisfactorily addressed. Neither the commissioner nor the respondents, in his view, addressed what a material limitation on her right to income from property means. He also felt that the justices whose decisions comprised the plurality opinion did not define the term, merely relying upon examples which state that material means relatively substantial.
Dragging a Red Herring
In the course of his opinion, Justice Kennedy might be said to be "dragging a red herring" when he alluded to the fact that the allocation of administration expenses between corpus and income was determined by Hubert's fiduciaries in accordance with the fiduciaries' enjoyment of the powers conferred on them by provisions of Hubert's will and Georgia statutes.
It is that red herring which has been picked up by the authors of articles relating to Hubert that recommend the drafting of wills to ensure the benefits of the decision. For example, in "What Every CPA Should Know About Estate of Hubert" (The CPA Journal, September 1998), Frank Colella suggests a sample provision for wills in which Hubert may become an issue that would give fiduciaries the power to allocate the expenses of administration to either the principal or income of an estate in such a manner as to reduce the overall tax liability payable by an estate. The provision would go on to say, however, that the fiduciaries shall not exercise this discretion in any manner that may impose a material limitation on the spouse's beneficial enjoyment of the income generated from the assets allocated to the marital share.
Why the Red Herring Epithet? It is essential that we here observe that the Internal Revenue Code, whether it relates to the income tax or the estate tax, is neutral insofar as the principal vs. income issue is concerned. Accordingly, IRC section 642(g), which governs the deductions available to a fiduciary for expenses on filing the fiduciary income tax return Form 1041, goes no further than a denial of the dual deduction for both the income tax and estate tax under section 2053 on Form 706. Administration expenses that are properly chargeable against principal are available as deductions on Form 1041 and, accordingly, may be used to reduce the income taxable to the income beneficiary. On the other hand, an administration expense that under fiduciary accounting is chargeable against the income of a trust may nonetheless be availed of as a deduction for the estate tax hence on Form 706.
There may be a crossing over of tax determinants with fiduciary accounting determinants, and these determinants can be taken in whatever combinations or permutations the fiduciary may determine consistent with his or her prudent administration of the estate.
Logic vs. Taxation
Justice O'Connor introduced her opinion by observing that "logic and taxation are not always the best of friends." That might well be; but taxation should not presume the absurd. In its holding against the commissioner, the Court determined that the $1.5 million charge against income was not such a "material limitation" as to run afoul of Regulations section 20.2056(b)-4(a).
Logic would dictate that had the $1.5 million been charged against the corpus, the economic impact on the surviving spouse, the sole object of the marital deduction, would have been even less material. Thus, assume that the $30 million would have a present value for the income interest of 40% or $12 million; as a consequence, the $1.5 million charge against the income share would represent a 12.5% reduction in the widow's share. On the other hand, had the $1.5 million been charged against the corpus, so that the estate was reduced to $28.5 million, the spouse's share would be reduced to $11.4 million (40% of $28.5 million), a reduction of just $600,000 from the $12 million. This follows logically from the fact that the present value of the income interest is reduced only by the 40% factor assigned to the income share.
Justice Kennedy's opinion for the plurality touched on this simple arithmetic truism:
[W]hether a limitation is material will also depend in part on the nature of the spouse's interest in the assets generating income. This analysis finds strong support in the text of Regulations section 20.2056(b)-4(a). The regulation gives an example of where a limitation on the right to income "may" be material--bequests "in trust" for the benefit of a decedent's spouse. The example suggests a significant difference between a bequest of income and an outright gift of the fee interest in the income-producing property. A fee in the same interest will almost always be worth much more. Where the value of the trust to the beneficiaries is derived solely from income, an obligation to pay administration expenses from that income is more likely to be "material."
Justice Kennedy went on to say that the marital property in this case, trusts involving either a general power of appointment (the GPA trust) or an irrevocable election (the QTIP trust), was considered to be more of a fee interest, and therefore "less likely to be material."
Empathizing with the Commissioner
It is easy to empathize with the pain felt by the IRS commissioner as she confronted the Hubert syndrome: She felt euchred by the estate's getting a "double dipping" from the way in which the administration expenses were treated--by their absence from the 706 and their inclusion on the 1041. For reasons that are not apparent, the commissioner did not pursue this strong logical argument in the lower courts, and first made it orally before the Supreme Court.
Justice Kennedy's opinion, which upheld the estate's entitlement to the deduction for the purpose of the income tax under IRC section 212 without the resultant inimical impact on the marital deduction, refers to this argument. But he goes on to say, as did his colleagues in dissent, that there is nothing in IRC section 642(g) that would require that the marital deduction be reduced to the extent expenses are deducted from the estate's income.
A Somewhat Different View at the State Level
Under New York statutes, at least, it would appear that, regardless of whether these administration expenses are chargeable to principal or income for the purposes of the fiduciary accounting, they would be burdened against the income if the income beneficiary derives the income tax benefit from these expenses and, as a consequence, the estate tax is increased. Section 11-1.2 of the New York Estates Powers and Trusts Law addresses administration expenses chargeable to principal that may be claimed as either estate tax deductions or income tax deductions. It states that if the income taxes of an income beneficiary are reduced because of the deduction of these expenses, and if Federal or New York estate taxes chargeable to principal are increased, then (unless otherwise provided or authorized by the decedent's will) those who have benefited from the use of such income tax deductions shall reimburse the estate the amount of the benefit.
To illustrate, let us assume that an estate incurred administration expenses amounting to $100,000, which the fiduciaries deducted for income tax purposes. Let us also assume those expenses represented a "material limitation" on the spouse's income interest, so that the marital deduction was reduced by $100,000, resulting in an additional estate tax of $100,000. This represents an initial tax of about $55,000 at the assumed maximum rates, which would have to be grossed up to provide for the tax on the tax, so that the resultant tax increase would be at least $100,000. The New York statute would require the income beneficiary to pay over to the principal of the estate $55,000 restoring the corpus, thereby preserving the undiminished marital deduction.
On December 16, 1998, the IRS published proposed regulations intended to resolve the Hubert confusion. The proposals, which would become effective for estates of decedents dying on or after the date when the final regulations are promulgated, would provide that estate administration expenses be categorized as "transmission expenses" and "management expenses." The former would reduce the bequest to the surviving spouse, but the latter would not. In so doing, the IRS is endeavoring to provide rules that would prevail for estates in all jurisdictions.
Transmission expenses would include "expenses incurred in the collection of the decedent's assets [and] the payment of the decedent's debts and death taxes." Examples are executors' fees, attorneys' fees other than those "specifically related to investment, preservation, and maintenance of the assets," probate fees, expenses incurred in construction proceedings and will contests, and appraisal fees.
Management expenses, on the other hand, involve expenses "incurred in connection with the investment of the estate assets and with their preservation and maintenance during the period of administration." Examples are investment advisory fees, stock brokerage commissions, custodial fees, and interest.
Exhibits 2 and 3, adapted from examples provided by the IRS proposal, reflect the application of these rules. Each of the cases involves a gross estate of $9 million, a nonmarital bequest of $3 million, and transmission and management expenses of $400,000 each. The variables result from the discretion exercised by the fiduciary regarding the tax return on which the respective administration expenses are claimed, i.e., on the estate tax return Form 706 or the fiduciary income tax return Form 1041.
We wrote to the IRS commissioner with the recommendation that transmission expenses under any and all circumstances should not come within the ambit of IRC section 212 and, accordingly, should not be deducted for the purposes of the income tax. Such a prohibition would, in effect, be consistent with the denial of the deduction for corresponding costs incident to an inter vivos transfer. Fiduciaries could still avail themselves of the option to deduct management expenses on either the 706 or 1041 returns. *
Abraham J. Briloff, PhD, CPA, is the Emanuel Saxe Distinguished Professor Emeritus at Baruch College (CUNY). Leonore A. Briloff, CPA, is a member of the Estate Planning Committee of the New York State Society of CPAs. The authors constitute the firm of A.J. & L.A. Briloff, CPAs.
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