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By Kathleen Ford Bay, Esq.
Lippincott Phelan Veidt PLLC, Austin, TX
Section 642(c)(2) and the applicable Treasury regulations allow an estate to take a charitable contributions deduction on its fiduciary income tax return for "income in respect of a decedent" (IRD) before the IRD is actually distributed to the charity, if, "under the terms of the governing instrument and the circumstances of the particular case the possibility that the amount set aside, or to be used, will not be devoted to such purpose or use is so remote as to be negligible."1 [Emphasis added.] In Estate of Belmont v. Commissioner,2 the Tax Court concluded that IRD was not permanently set aside for the charity where the executor of an estate knew that the possibility was not "so remote as to be negligible" that the funds it claimed to have set aside for charity would end up being used for legal fees in connection with estate litigation.
The decedent's Will provided for a $50,000 pre-residuary bequest to her brother and then left the residuary estate to a public charity. The decedent's estate consisted of her primary residence located in Ohio, an interest in a condominium in California that was used as a residence by the decedent's mentally and physically disabled brother and approximately $243,000 from a state teacher's retirement system, which was IRD. (The opinion does not specifically disclose whether the decedent had her estate named as beneficiary or if she had no beneficiary and so, by default under the plan, the monies went to her estate.) On the estate's first fiduciary income tax return (IRS Form 1041), the executor took a charitable contributions deduction pursuant to §642(c)(2), its position being that the IRD had been permanently set aside for the charity. Neither the attorney for the estate nor the executor told the return preparer that a dispute had arisen over the refusal by decedent's brother to move out of a condominium which was part of the residuary estate that was to pass to charity.
The brother asserted that his sister intended for him to have a life estate in the property and initially approached the estate with an offer to exchange his specific bequest of $50,000 for recognition of the validity of his life estate. The charity instead offered the brother a $10,000 stipend to move out of the condominium. On April 2, 2008, the brother filed a creditor's claim against the estate in the ancillary probate proceeding in California. The estate contested this action and in connection therewith hired a law firm recommended by the charity, resulting in significant legal fees as well as additional costs for the continued administration of the estate. After a 2011 trial, the Los Angeles County Probate Court entered a judgment in favor of the brother on January 26, 2012, granting a life tenancy to the brother, followed by distribution at his death to the charity. This would have resulted in the estate remaining open until the brother's death, but, upon appeal, the appellate court revised the probate court's judgment on February 28, 2013, to allow the executor to execute a deed granting the brother a life tenancy, with the remainder to the charity.
The executor did not segregate the IRD from other estate assets, so there was no way to determine how much of the IRD had been used in the administration. However, a charitable contributions deduction of approximately $220,000 was taken; at the time of the Tax Court hearing only approximately $185,000 remained in the estate, which was less than the amount permanently set aside for charity.
Everyone agreed that the first two prongs of the standard under §642(c)(2) had been met. However, the estate and the IRS disagreed on whether the third prong requiring the charitable contribution to be permanently set aside for purposes specified in §642(c)(2) had been satisfied. The Commissioner stated that "there was a substantial possibility of a prolonged and expensive legal fight which would have required the estate to dip into the funds it allegedly `set aside' for charity in order to not only pay for the litigation, but to also pay additional administrative costs for the estate as the probate proceedings dragged on for years and years." The facts certainly could be viewed (and were viewed by the Tax Court) as follows: the executor knew that it was more than just a remote possibility, more than a "negligible chance" that protracted litigation was in the offing and, given the financial situation of the estate, the executor would have to use IRD to pay for that litigation.
The estate relied upon Commissioner v. Upjohn's Estate,3 in arguing that "remote possibilities that may deplete funds should not be considered when determining whether funds are permanently set aside for purposes of I.R.C. §642." The Tax Court remained unconvinced. First, the statute in Upjohn's Estate was the predecessor to §642.4 Second, there were no facts or circumstances in Upjohn's Estate that indicated any possibility that the estate might be depleted by litigation.
The estate also argued, basically, that there had to be a lawsuit actually pending at the time the income tax return was filed in order for the charitable contributions deduction to be disallowed, citing Estate of Wright v. United States.5 In Estate of Wright, litigation was pending at the time the executor filed the fiduciary income tax return; later, charity received only 50% of what it had anticipated it would receive when the return was filed and the decedent's sister (and other "will challengers") received the other 50%; the IRS disallowed the charitable contributions deduction and the Ninth Circuit upheld this decision.
The Tax Court stated it had not previously dealt with what constituted "negligible" for purposes of §642(c), and so looked to cases and rulings under §170 addressing the "negligible" requirement under that provision. In 885 Inv. Co. v. Commissioner,6 the Tax Court had concluded that "so remote as to be negligible" was defined as "a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction." Additionally, in Briggs v. Commissioner,7 the Tax Court had defined it as "a chance which every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance." Additionally, the Tax Court cited Rev. Rul. 70-452,8 wherein the IRS concluded with respect to an irrevocable charitable remainder trust that there must be at least a 95% probability that a bequest will pass to a qualifying charity before an estate tax charitable deduction is permitted. With these cases and rulings as the framework, the Tax Court, citing Graev v. Commissioner,9 then considered the facts and circumstances in order to determine whether the possibility that the estate would use the monies set aside for the charity was "so remote as to be negligible."
The Tax Court concluded that the facts and circumstances of the Belmont matter indicated that the parties' positions were so opposed that there was more than a "negligible chance" that the charity would not receive the entire IRD; there was no requirement that litigation actually be pending.
What could have been done to avoid or ameliorate the situation?
If the decedent had made the charity the direct beneficiary of her teacher's retirement system, then the charity would have received the assets in the retirement plan directly and would not have had to pay income taxes on that receipt due to its tax-exempt status.
Alternatively, upon receipt, the executor could have segregated the IRD on the books so that the amount used in litigation or administration could have been clearly established.
The executor, perhaps with probate court permission and agreement of the brother, could have also considered conveying the condominium to the charity subject to the claims of the brother and let the charity decide whether to proceed with the litigation or not. This, at least, would have reduced the estate's legal fees.10 Obviously, the ability to take this step rests on the probate laws in California.
For more information, in the Tax Management Portfolios, see Acker, 852 T.M., , Income Taxation of Trusts and Estates, Acker, 862 T.M., Income in Respect of a Decedent, and Kirschten and Freitag, 863 T.M., Charitable Contributions: Income Tax Aspects, and in Tax Practice Series, see ¶6120, Estate and Trust Income Taxation — General Rules, and ¶6150, Income in Respect of a Decedent.
Copyright©2015 by The Bureau of National Affairs, Inc.
10 This approach was also considered in the Forbes blog of Peter J. Reilly (a CPA), Contributor, dated February 24, 2015: "I can't help but Monday morning quarterback a mess like this. The first strategy that comes to mind would be for the executor to have turned over all the money to CJF [Columbus Jewish Foundation] and quitclaimed the condo to them and let them carry on the fight or make a deal with the brother. That would have avoided the income tax problem. Of course there might be probate law reasons why that would not work. Regardless of which way it went CJF would have ended up with an additional $75,622. They also might have been more inclined to settle with the money in their own till rather than being an expectancy."
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