By Larry Maples

Although assets are clearly valued as of the date of death or the alternate valuation date, confusion remains about whether claims against the estate should be similarly treated. Neither the IRC nor the Treasury Regulations give any guidance on whether post-death events are relevant in determining the value of claims which may be deducted on an estate tax return. There is substantial conflict in the courts on this issue. The IRS has fought for the proposition that post-death events may be used to value contingent and contested claims. The Tax Court and the Eighth Circuit have been sympathetic to this view, but the Fifth, Tenth, and Eleventh Circuits have recently held otherwise. The IRS issued a nonacquiescence to one of these decisions, indicating that it will continue to contest this issue.

IRC section 2053(a) allows a deduction in arriving at taxable estate for funeral and administrative expenses, claims, and unpaid mortgages. Some, including the IRS, have reasoned that because funeral and administrative expenses are routinely incurred after death, IRC section 2053(a) must contemplate post-death events. But this conclusion is based more on the desire for symmetry than the statute itself. The Treasury Regulations are not helpful on this point. They provide that deductible claims are those which represent personal obligations of the decedent existing at the time of death, whether or not matured (Treasury Regulations section 20.2053-4). The regulations go on to say that a claim is deductible even though “its exact amount is not then known, provided it is ascertainable with reasonable certainty, and will be paid” [Treasury Regulations section 20.2053-1(b)(3)].

The essence of the current judicial conflict can be traced back to 1929. In Ithaca Trust Co. [29 S.Ct. 291 (1929)], the decedent bequeathed property to charity but reserved a life estate for his spouse. The question was how to calculate the charitable deduction on the estate tax return. Normally the actuarial value of the widow’s life expectancy at the date of the husband’s death would be used to determine the amount the charity could expect to receive. But, in this situation, the wife died before her husband’s estate tax return was filed. Should the charitable deduction be calculated using mortality tables or using her known death date? Justice Holmes, in a unanimous decision, wrote that all values are based on “prophecies of the future, and the value is no less real at the time if later the prophecy turns out false.” He went on to say that although it is tempting to correct uncertain probabilities with now-certain facts, it should not be done. The contrary view was expressed in the same year by the Eighth Circuit in Jacobs [34 F.2d 253 (CA-8, 1929)]. The court, in holding that post-death events should be considered, reasoned that “the claims which Congress intended to be deducted were actual claims, not theoretical ones.”

Why is the issue still in conflict after a Supreme Court decision? Ithaca dealt with a charitable deduction, not a claim. Some courts have interpreted Ithaca as announcing a broad principle that taxable estate should be determined considering only information known as of the date of death. Others, however, believe the precedent does not reach IRC section 2053 claims but is instead limited to IRC section 2055 charitable bequests. For example, the Eighth Circuit, in Estate of Sachs [856 F.2d 1158 (CA-8, 1988)], allowed an income tax event that occurred four years after the decedent’s death to reduce a claim deduction. Retroactive state tax forgiveness legislation had reduced the amount of the decedent’s income taxes that had been claimed as a deduction on the estate return. The court reasoned that there is a public policy reason to provide certainty in the case of charitable bequests: to encourage charitable giving. No such reason exists in valuing claims, according to the Eighth Circuit.

Recent Cases

Three recent circuit court opinions indicate that the basis for the IRS’ insistence on using post-death events may be eroding. In Estate of Evelyn M. McMorris [87 AFTR.2d 668 (CA-10, 2001)], the Tenth Circuit reversed the Tax Court and held that post-death events are not to be considered in valuing a claim against an estate under IRC section 2053. Mrs. McMorris inherited stock in N.W. Transport Service. The stock was redeemed by the corporation and she paid taxes on the difference between the redemption proceeds and the stock value as reflected in her husband’s estate tax return. But the IRS audited the estate return and increased the valuation on the stock. This increase in value was substantial enough to wipe out Mrs. McMorris’ income tax gain. The IRS agreed to offset her income tax refund against the estate tax deficiency. But should the income tax refund reduce the IRC section 2053 deduction for the income tax liability on the estate return? The estate argued that the refund should not affect the tax liability deduction since it was based on a post-death event, the audit. The IRS argued that the tax liability claim was contingent and thus should be adjusted to reflect post-death events. The Tenth Circuit agreed with the estate.

In Estate of Algerine Allen Smith [98 F.3d 515 (CA-5, 1999)], the estate was forced to repay some oil royalty payments to Exxon Corporation. Repayment was necessary because Exxon had been required to refund to the federal government amounts that had violated pricing regulations. Exxon sought reimbursement in part of $2.48 million from Algerine Smith, who died with this claim outstanding. The $2.48 million was deducted on her IRS Form 706, but nine months after filing her estate tax return, the estate settled the claim for $681,840. The Tax Court agreed with the IRS that the deduction of $2.48 million was not certain at date of death, but that even if the estate were allowed the larger deduction, it would still be taxed on discharge of indebtedness income under IRC section 1341(a). The Fifth Circuit disagreed on both points. It refused to value a claim based on post-death events, and held that IRC section 1341 does not require recognition of discharge of indebtedness income for disputed claims.

The Eleventh Circuit, in a case similar to Smith, recently ruled against using post-death events in valuing claims. In Estate of Elizabeth P. O’Neal [88 AFTR2d 5101 (CA-11, 2001)], there was a claim against the estate for reimbursement of gift taxes paid by the transferees of the gifts. The value of the gifts was in dispute at the date of death. Based on the IRS-assigned values, the claim against the estate was in excess of $9 million, but was eventually reduced to less than $600,000. The court held that the date-of-death value should apply in deducting the claim, but was not sure what that value was. Therefore, the case was remanded to the district court for a recalculation of the deduction.

Both O’Neal and Smith were remanded for recalculation of the date-of-death claim values. The Fifth and Eleventh Circuits are clearly sending a message that although claims should be valued without reference to post-death events, these courts will not be bound to Form 706 values as filed. The O’Neal court’s instruction to the district court on remand was very specific: “On remand, the district court is instructed neither to admit nor consider evidence of post-death occurrence when determining the date of death value … It will be incumbent on each party to supply the district court with relevant evidence of pre-death facts and occurrences supporting the date of death values.”

Current IRS Analysis

The IRS issued a nonacquiescence in Estate of Smith, disagreeing with the court’s reasoning in two ways. First, it made the argument that the Supreme Court’s Ithaca Trust decision is not relevant because it involved the IRC section 2055 charitable deduction, rather than an IRC section 2053 claim deduction. Second, the IRS took the position that disputed claims are to be valued with reference to post-death events, seemingly staking out a position which distinguishes between contingent and contested claims. After citing several cases for the proposition that post-death events should be considered in valuing both contested and contingent claims, the IRS only mentions contested claims in the final statement of nonacquiescence.

Planning

Three types of situations could arise relating to the use of post-death events to value claims:

Recent judicial events should encourage consideration of post-death benefits in taking a return position. Perhaps post-death events should be considered only when beneficial to the taxpayer. Furthermore, Estate of Smith makes it even less likely the IRS could recover, via the income tax, some of the estate taxes lost due to an aggressive claim valuation on the estate return. The Fifth Circuit held that no cancellation of debt income results when a claim is settled for less than the deduction allowed on the estate tax return.