Postmortem Events and Claims Against an Estate

By Ted D. Englebrecht and Joseph J. Suhoski

In Brief

Judicial Rulings Expose Discordant Views

Estate executors have relied on the 1929 Supreme Court decision in Ithaca Trust in establishing the deductibility and valuation of certain claims against an estate. During the past several years, a series of cases that interpreted Ithaca more narrowly found their way to conflicting results in different federal circuit courts. The authors suggest that the Supreme Court should resolve the conflicts between the districts; they argue that the original decision in Ithaca not only makes sense but has also stood the test of time.

Generally, deductions from a gross estate for federal estate tax purposes are valued as of the date of death of the decedent or at the alternative valuation date six months later. Beginning with the 1929 Supreme Court case Ithaca Trust [Ithaca Trust Co. v. United States, 7 AFTR 8856 (49 S. Ct. 291)], however, there has been a series of judicial decisions addressing whether postmortem events have an effect on deductions from the gross estate. The two issues that have arisen in these cases focus on the valuation of deductions and the enforceability of claims against the estate, either jointly or separately.

Until Smith (Estate of Smith v. Comm’r, 84 AFTR 2d 99-7393) in 1999, the courts had ruled uniformly on the two issues. The decisions in Smith and, more recently, in McMorris (Estate of McMorris v. Comm’r, 87 AFTR 2d 2001-1310) and O’Neal [Estate of O’Neal v. U.S., No. 00-11663 (11th Cir. 7/26/01)], however, illustrate that the courts have begun to readdress their interpretations. These three cases discredit the notion that the effects of postmortem events in specific cases should be divided according to the valuation and enforceability dichotomy. The history of prior decisions underscores the impact of the three most recent cases in this area and identifies potential problems yet to be resolved judicially.

Deductions from the Gross Estate

IRC sections 2053–2057 define deductions for calculating the net estate taxable base. The following may reduce the gross estate to the extent that they are allowable under local law: funeral expenses, administrative expenses, claims against the estate, and indebtedness (e.g., unpaid mortgages). Any sudden losses due to casualties or theft are also deductible from the gross estate. There is an unlimited deduction for property gifted to charities, as well as for property passed to a surviving spouse. Lastly, the value of any qualified family-owned business interest may be deducted from the gross estate (currently limited to $675,000; the 2001 tax act will eliminate this deduction in 2004).

Although the IRC is silent on the effects of postmortem events on deductions from the gross estate, Treasury Regulations address them in a manner that the courts have followed. Treasury Regulations section 20.2053-4 specifies that an estate is allowed a deduction for claims against the estate in existence at the time of death. Additionally, Treasury Regulations section 20.2053-1(b)(3) provides that an estate may deduct a decedent’s tax liabilities as a claim against the estate if the exact amount is not known, as long as the tax claim can be reasonably valued and payment is certain.

Judicial History

The impact of Smith, McMorris, and O’Neal becomes more apparent in the light of prior judicial decisions since Ithaca Trust, specifically those cases involving both the deductibility and the enforceability of claims. See Exhibit 1 for cases that figure in the judicial history.

Postmortem Events and Valuation of Deductions

The benchmark for successive decisions regarding the postmortem valuation of deductions is Ithaca Trust. Edwin C. Stewart, the decedent, died on June 15, 1921. In his will, he appointed the Ithaca Trust Company as trustee of several testamentary trusts. He left the residual of his estate to his wife for her lifetime, along with the authority to use the principal to maintain a comfortable life. Upon his wife’s death, the remainder was to go to specific charities. In order to derive the amount of the charitable deduction, the wife’s residual was calculated with a mortality table and then subtracted from the principal of the estate.

The situation became complicated when the widow died within six months of her husband. The Ithaca Trust Company sought to use the widow’s life expectancy at the husband’s date of death to establish the value of the estate’s deduction. The Court of Claims denied Ithaca’s motion, forcing the estate to use the amounts contributed at the widow’s actual date of death for the estate’s deduction.

The Supreme Court unanimously overturned the Court of Claims’ decision. Citing numerous judicial precedents, the Court held that the values calculated statistically as of the testator’s death remained valid because the validity of those values at that time would not be changed by subsequent events. Through its ruling, the Court established the precedent that the valuation of an estate’s deductions should not consider postmortem events. This precedent has been the guiding factor in every lower-court case that has dealt with postmortem valuation of deductions.

Another case that dealt with the effects of postmortem events on valuing deductions from the gross estate is Estate of Van Horne vs. Comm’r (53 AFTR 84-1549). Ada E. Van Horne died September 4, 1976. At the time of her death, she was under judicial obligation to pay $5,000 per month for spousal support to her surviving ex-husband for the remainder of his life. Upon her death, the judgment provided that her estate should make the remaining payments.

Van Horne’s ex-husband died in April 1977 after receiving only $35,000 in payments from her estate, much less than the actuarially calculated amount. Van Horne’s estate claimed a deduction of nearly $600,000, the expected value of future spousal support. The government sought to reduce the deduction to the $35,000 actually paid by the estate. The IRS won its case in Tax Court in 1978 and the estate appealed to the Ninth Circuit Court of Appeals.

The Ninth Circuit Court rendered its decision on the Van Horne case in 1983, a year after it had held in Propstra (Propstra v. U.S., 50 AFTR 2d 82-6153) that postmortem events should not be considered in determining deductions from past due penalties. In Van Horne, the court noted that Congress intended to disregard postmortem events when valuing legally recognized and enforceable claims against an estate. The Ninth Circuit Court reversed the Tax Court’s decision, allowing the estate to use the actuarial value of the spousal support payments for the deduction, holding that “legally enforceable claims valued by reference to an actuarial table meet the test of certainty for estate tax purposes.”

Postmortem Events and Claims Against the Estate

In Cafaro (Estate of Charles P. Cafaro, TC Memo 1989-348), settlements of certain debts against the estate became relevant because the claims were neither for a sum certain, nor were they legally enforceable at the date of death.

Charles P. Cafaro died September 26, 1978, as a resident of Illinois. His wife was the executrix of the estate, which owed a total of more than $660,000 to five separate entities. In August 1984, the IRS disallowed a portion of the $660,000 claimed as deductions and sent the estate a notice of deficiency. The IRS reasoned that the amounts of the claims were uncertain and not legally enforceable. After minor concessions by both parties, the case was brought before the Tax Court.

Cafaro was one of the first decisions to explicitly make the distinction between issues involving valuation and enforceability. The Tax Court acknowledged that postmortem events should not be considered for valuation cases, agreeing that Ithaca created an appropriate precedent for such cases. Yet, citing Propstra, the court ruled that “post-death evidence is excluded only where the claims are for ‘sums certain’ and where the claims are ‘legally enforceable as of the date of death.’” Treasury Regulations section 20.2053-4 allows a deduction for claims against the estate only when the amount is reasonably estimable and the claim is certain to be paid.

Using the dual criteria for excluding postmortem events, the Tax Court determined that the facts in Cafaro did not meet the criteria of Propstra: The claims were neither legally enforceable nor reasonably estimable. The subsequent consideration of the postmortem events led to the claims’ disallowance, increasing the net estate and leading to a higher estate tax liability.

The decedent in Estate of Sachs v. Comm’r (62 AFTR 2d 88-6000), Samuel C. Sachs, died on June 27, 1980, less than three years after making joint gifts of stock with his wife to three irrevocable trusts for the benefit of their grandchildren. The trusts paid gift taxes of $612,000 on the stock, which had received a valuation of nearly $2.4 million. At the date of death, however, the stock had fallen in value to just under $2.2 million. The executors followed common practice and subtracted the tax paid by the trusts from the value of the gift reported by the estate.

The executors filed an estate tax return in March 1981. In 1982, however, the Supreme Court affirmed a decision by the Eighth Circuit Court that any gift tax paid by a donee is taxable income to the donor (Deidrich vs. Commissioner, 457 U.S. 191). Accordingly, Sachs’ executors agreed to pay the amount of the adjusted gift tax paid by the donee.

IRC section 1026(a), as enacted by the Tax Reform Act of 1984, allowed gift taxes paid by a donee to be excluded from a donor’s gross estate (for gifts made before March 4, 1981). Because of this statute, Sachs’ estate received a refund of those taxes it had paid for the gift taxes on the stock. The IRS then sought to disallow the estate’s deduction for the tax liability created by the donee’s gift tax, arguing that because the tax liability ceased to exist, no IRC section 2053(a)(3) deduction should be granted. The Tax Court ruled in the estate’s favor; the IRS appealed to the Eighth Circuit Court.

The Eighth Circuit Court overturned the Tax Court’s decision, citing Jacobs v. Comm’r (7 AFTR 9308) in support of its decision. In Jacobs, the Eighth Circuit noted that the Supreme Court’s ruling in Ithaca applied only to valuations of charitable bequests. By differentiating between a claim against an estate and a charitable bequest, the Eighth Circuit held that no deduction was allowed if the claim ceased to exist.

The Eighth Circuit also stressed the substantial difference between a claim held by a private party and a tax liability to the federal government. In Sachs, a statute changed a federal law that initially created the tax obligation. Furthermore, it noted that “in a legal sense, Section 1026(a) of The Tax Reform Act retrospectively declared that the claim never existed to begin with.” The court also reasoned that there was no clear congressional intent to allow taxpayers to receive a refund and a deduction from a forgiven gift tax liability.

Three Recent Landmark Cases

The decedent in Estate of Smith v. Comm’r, Algerine Allen Smith, died on November 16, 1990. In 1970, she had leased tracts of land in Wood County, Texas, to a company that was eventually acquired by the Exxon Corporation. The lease agreement awarded the decedent royalty payments for any oil and gas extracted from the leased land. In 1978, the Department of Energy filed a lawsuit against Exxon for violations of federal pricing regulations. In 1981, Exxon was found guilty and fined about $2.1 billion. Under numerous legal theories, Exxon sued the decedent and other lessors or royalty owners in 1988 in an attempt to recover some of the judgment. Summary judgment was granted in favor of Exxon in February 1991, four months after Smith’s death.

Exxon claimed that Smith’s estate owed the company $2.48 million; the estate was ordered to pay only $681,840. On the estate’s Form 706, a deduction was taken based on the $2.48 million claim in Exxon’s suit. The IRS issued a notice of deficiency to the estate, based on the actual judgment. The IRS argued that the deduction for the Exxon claim should have been based on the actual amount paid. The estate filed a petition to the Tax Court. Citing Cafaro, the Tax Court ruled in favor of the IRS to permit the examination of postmortem events. The estate appealed to the Fifth Circuit Court.

The dispute over the amount of the deduction hinged on whether the postmortem enforceability of the summary judgment should be considered in the valuation. After concluding that neither the IRC nor Treasury Regulations definitively addresses the issue of postmortem events, the court examined case law, citing Ithaca, Propstra, and Van Horne in deciding to exclude postmortem events from considerations.

In its ruling, the Fifth Circuit Court held that Congress had shown no intent to modify the IRC to consider postmortem events when valuing deductions. In none of the three reenactments and numerous modifications to the IRC had Congress legislatively overruled Ithaca. Therefore, the court interpreted Congress’ failure to act in this matter as tacit approval of the Ithaca precedent.

The Fifth Circuit Court’s ruling is noteworthy because it argues against considering postmortem events when dealing with claims enforceability. Before Smith, postmortem events were routinely considered in such cases. The court stated that “although this dichotomy, which distinguishes between enforceability on the one hand and valuation on the other, has superficial appeal, closer examination reveals that it is not a sound basis for distinguishing claims in this context.”

Unlike other appellate-level cases, the Fifth Circuit chose not to calculate the deduction itself. Instead, it reversed the Tax Court’s decision and remanded the case to the Tax Court with instructions to disregard postmortem events when calculating the deductions. It noted that although the Commissioner’s valuation was incorrect, the estate was not automatically allowed to deduct the full amount of the claim.

The Fifth Circuit Court’s decision in Smith paved the way for another landmark decision in the Estate of McMorris v Comm’r. Because the decisions in Smith and McMorris overlap in time (see the timeline in Exhibit 2 for more detail), the Tax Court did not have the benefit of the Fifth Circuit Court’s remanded decision in Smith. If it had considered the Smith ruling before deciding McMorris, then the Tax Court could well have ruled differently.

Estate of McMorris

McMorris deals with the effects of postmortem events on the deduction of federal and state income taxes. Donn McMorris, a resident of Colorado, passed away in 1990. As part of his will, his widow, Evelyn McMorris, received stock in NW Transport Service, Inc. The stock was valued at $1,726,562.50 per share; Evelyn redeemed the stock for a total of $29,500,000 (about $2,200,000 per share). When she died in 1991, a significant portion of the income reported on her income tax return was due to the gain on the redemption of the NW Transport stock.

In January 1994, the IRS served a notice of deficiency to Donn McMorris’ estate. Among the disputed items was the value of NW Transport stock. The IRS determined that the stock’s value was significantly higher than originally reported by the estate. In January 1996, the two sides reached an agreement to value the stock at $2,500,000 per share, which became the stock’s new basis for Evelyn’s estate. This higher basis in the stock turned the taxable gain into a realized loss. Her estate filed an amended 1991 return that sought a refund of over $3,000,000. Her estate simultaneously challenged in Tax Court a deficiency notice regarding a charitable deduction on the estate tax return.

In March 1996, the IRS increased the deficiency associated with the charitable deduction because the estate tax liabilities were now subject to refund and no longer entitled to the federal and state income tax deductions. The estate took the position that postmortem events could not be considered for valuing the deductions for income taxes, because they were valid and enforceable claims at the time of her death. The Tax Court issued a memorandum decision in 1999 against the estate. The estate appealed this decision to the Tenth Circuit Court of Appeals, which ruled in the estate’s favor in March 2001.

The Tax Court considered the case solely on the issue of the enforceability of the claim. The petitioner’s request for a tax refund led to the change in the stock’s basis, making it appropriate to examine postmortem events for determining the deduction. Once the IRS approved the estate’s refund, the tax claim underlying the deduction was no longer enforceable.

The Tax Court cited its holding in Smith, in which it held that cases involving the enforceability of claims should consider postmortem events. When Smith’s estate appealed this decision, however, the Fifth Circuit Court held that the difference between enforceability and valuation was not a logical basis for treating postmortem events differently. With this ruling as support, the Tenth Circuit Court ruled in McMorris that the Tax Court should not have focused on the enforceability of the estate’s income tax liability.

Tenth Circuit Court Decision. With the issue of enforceability discarded, the Tenth Circuit Court focused solely on the issue of valuation. The Supreme Court had held in Ithaca that postmortem events should not be considered when valuing charitable deductions. The Tenth Circuit Court believed that many courts interpreted Ithaca too broadly, applying the same date-of-death valuation rule for charitable deductions to other deductions.

The Tenth Circuit Court also noted that many other courts had not applied Ithaca to other types of deductions. (See below for a discussion of cases related to the enforceability of claims against the estate and the applicability of postmortem events.) The Court found three common arguments used by other courts against applying Ithaca beyond charitable deductions:

In McMorris, the court dismissed all three of these arguments. Citing Propstra, the Tenth Circuit Court found that the reasons for different deductions should not logically lead to different means of calculating their values. Furthermore, IRC section 2053(a) also contains deductions for unpaid mortgages, which may be valued without reference to postmortem events. Lastly, the Tenth Circuit Court cited Ithaca to emphasize that even though it may seem appropriate to correct date-of-death valuations once subsequent facts can replace estimates, it should not be done.

Finding no grounds to consider postmortem events for the valuation of deductions, along with the precedence of Ithaca, the Tenth Circuit Court overturned the Tax Court ruling. As a result, the estate was both allowed a refund from the realized loss on the increased basis in stock and permitted to maintain the original value of the deductions for the federal and state income tax claims against the estate.

Estate of O’Neal

In the relatively straightforward case of the Estate of Elizabeth P. O’Neal, decided July 26, 2001, the Eleventh Circuit ruled that post-death events were not to be considered when determining the value of the estate’s deduction for claims against it. In 1987, the decedent and her husband gifted all of their stock in O’Neal Steel, Inc., to their two children and seven grandchildren. When the gift was made, the nine recipients agreed to pay any gift tax liability arising from this transaction on a pro rata basis.

The O’Neal Steel stock included two classes, A and B. During an IRS audit of the gift tax consequences nine months after the gift, an appraiser assigned values to the stock that were about seven times the reported value. As a result of the change in the appraised stock value, the IRS issued deficiency notices that Elizabeth O’Neal owed just over $9.4 million more in gift taxes. The nine heirs sued in Tax Court because they were liable for the additional gift taxes.

Elizabeth O’Neal died in July 1994, and her estate filed a timely tax return that was selected for audit. During this time, the Tax Court ruled that the gifted stock had a much smaller value; the heirs’ liability was only $488,000, not $9.4 million. Accordingly, the estate filed an amended return with a deduction of $488,000, creating a taxable estate of $4.3 million and an estate tax of $1.9 million. After the estate paid this tax, it filed for a refund of $9.4 million. The case was brought before the Federal District Court in the Northern District of Alabama, which valued the deduction at $563,000. The case was then appealed to the Eleventh Circuit Court of Appeals.

Eleventh Circuit Court Decision. In its ruling, the Eleventh Circuit decided that neither the estate nor the government was correct in its valuation of the deduction for the claim against the estate. Specifically citing Smith and McMorris, the Court ruled that postmortem events were not to be considered when valuing the relevant deduction. The court failed to determine what that amount should be, however, and thus remanded the case to the district court.

Significantly, O’Neal is the third consecutive case in which a Circuit Court of Appeals ruled that postmortem events should be discarded when valuing deductions for claims against an estate. After discussing the two other recent cases on the subject, the court simply ruled that post-death events could not be considered.

Appropriate Handling of Postmortem Events

All the assets includable in a decedent’s gross estate are valued at fair market value at the date of death. (Or at the alternate valuation date, which allows all property to be valued six months after the date of death if it results in a lower gross estate value.) It seems logical that deductions from an amount so calculated should also be based on contemporaneous valuations rather than retrospectively.

To handle the matter of enforceability of claims in the same manner as the valuation of deductions seems correct, logical, and equitable: If postmortem events are not to be considered when valuing deductions from an estate, then they should not be considered when examining events that affect the enforceability of a claim. Not only does this seem logical, but it also eliminates the burden placed on estates to defend, possibly many years later, a position taken on a Form 706.

Consistency. In recent years, there have been judicial decisions allowing postmortem events to be considered in valuing estate property (Englebrecht and Masselli, “Impact of Postmortem Events on Estate Tax Valuation,” The CPA Journal, September 1995). Of course, consistency of application is a valued attribute of taxation. As shown in Exhibit 1, prominent cases involving deductions from the gross estate have disallowed consideration of postmortem events. In making their decisions, each of these courts cited Ithaca as the appropriate judicial precedent. For the sake of consistency, it would be advantageous for the courts to treat the effects of postmortem events on property valuation and deductions from the gross estate in a similar manner.

Unresolved Issues

Smith, McMorris, and O’Neal were appealed and decided in the Fifth, Tenth, and Eleventh Circuit Courts of Appeals, respectively. Their holdings were the exact opposite of that of the Eighth Circuit Court’s ruling in Sachs and of rulings in both the Tax Court and district courts. Other circuit courts have yet to make rulings on the issues of the enforceability of claims as they relate to postmortem events. The only Supreme Court case dealing with postmortem events is Ithaca, which, as discussed, deals only with the valuation of deductions. Unless the Supreme Court rules on the issue, there will likely continue to be different judicial holdings between the circuits on the issue of enforceability of claims. Naturally, this would provide all courts with a precedent on enforceability of claims that carries the same weight that Ithaca has carried on cases regarding the valuation of deductions.

©2002 CPA Journal. Legal Notices