On April 23, 2007, the Internal Revenue Service published proposed regulations under section 2053 regarding the determination of the amount of a claim against the decedent’s estate that is deductible for estate tax purposes. Pursuant to the 2008-09 Treasury-IRS Priority Guidance Plan (see Capital Letter Number 12), Treasury released those regulations in final form on October 16, just in time to be discussed at the ACTEC meeting in Williamsburg.
The focus of this regulation project, which first appeared in the 2003-04 Priority Guidance Plan, is the extent to which post-death events may be considered in determining the deductible amount of a claim. It addresses a conflict among the federal courts of appeals, with the Fifth, Tenth, and Eleventh Circuits unwilling to consider post-death events and the Eighth Circuit apparently more willing to do so. See Estate of Smith v. Commissioner, 198 F.3d 515 (5th Cir. 1999); Estate of McMorris v. Commissioner, 243 F.3d 1254 (10th Cir. 2001); O’Neal v. United States, 258 F.3d 1265 (11th Cir. 2001); Estate of Sachs v. Commissioner, 856 F.2d 1158 (8th Cir. 1988).
The Approach of the Regulations
In general, the proposed regulations would have allowed a deduction of otherwise deductible claims (that is, claims existing at the date of death and legally enforceable) only if and when they are paid or ascertainable with reasonable certainty. If that does not occur before the estate tax statute of limitations runs, the executor’s recourse is to file a protective claim for refund. As for claims that are paid, a court decree would be respected if the court reviewed the relevant facts and its decision was consistent with applicable law. A consent decree would be respected if the consent was a bona fide recognition of the validity of the claim and was accepted by the court as satisfactory evidence upon the merits. A settlement would be respected if it resolved an active and genuine contest, was the product of arm’s-length negotiations by parties with adverse interests, and was within the range of reasonable outcomes under applicable law. Claims by family members would be presumed to be nondeductible, but this presumption could be rebutted by evidence of circumstances that would reasonably support a similar claim by unrelated persons.
Whenever a rule affecting the calculation of the estate tax strays from the “snapshot at the moment of death,” it wanders into uncharted territory. Like the notice of proposed rulemaking, the preamble to the final regulations seeks to rationalize this wandering by noting that “[s]ection 2053 specifically contemplates expenses such as funeral and administration expenses, which are only determinable after the decedent's death.” While it is certainly true that funeral and administration expenses generally cannot be incurred until after death so that a “snapshot” approach would be impossible, the opposite is true of claims, which typically are claims against the decedent existing before death. Moreover, the rationalization might be criticized for placing too much weight on the formality of the division of the Code into sections, while in fact the deductibility of funeral expenses, administration expenses, and claims against the estate are provided for in three discrete paragraphs of section 2053(a).
Nevertheless, it is understandable that Treasury would see the need to deal with this troublesome area, particularly when the federal courts of appeals cannot agree. If someone has a gross estate of 100 against which there is a claim of 80, a deduction of 80 would produce a taxable estate of 20 and a tax (assuming a flat 45 percent rate) of 9. But then if the executor is successful in defending against the claim, the estate has in effect paid a tax of 9 percent. It is easy to see why Treasury, and other executors, would find that unfair.
On the other hand, if the executor is not allowed a deduction while contesting the claim, the tax will be 45. Then if the defense is unsuccessful and the claim of 80 must also be paid – a total of 125 even though the gross estate was only 100 – it is easy to see why that is unfair too.
While many practitioners, including many Fellows, disapproved of the approach taken by the proposed regulations – and still do – this observer believes that in a world where precise justice is elusive the proposed regulations were a reasonable attempt to achieve rough justice. Furthermore, the changes in the final regulations in the main are thoughtful improvements that make the regulations fairer and more workable.
Changes Made in the Final Regulations
In the regulations, effective for the estates of decedents dying on or after October 20, 2009, the basic criteria for evaluating a claim that is paid is not changed greatly from the previous regulations drafted in the 1950s. For example, the discussion of the weight to be given to court decrees (former Reg. § 20.2053-1(b)(2) and new Reg. § 20.2053-1(b)(3)) continues to require that the court decree “passes upon the facts” and “actually passed upon the merits of the claim.”
The proposed amendments added standards for settlements. The final regulations (§ 20.2053-1(b)(3)(iv)) still require that a settlement resolve a bona fide issue in a genuine contest and be the product of arm’s-length negotiations by parties with adverse interests. But the final regulations drop the requirement in the proposed regulations that the settlement be “within the range of reasonable outcomes.” The preamble explains that this was done in response to public comments that the IRS should not be put in the position of evaluating the legal merits of unresolved claims and that the requirement is superfluous anyway in light of the other requirements. Consistent with the removal of the reference to the range of reasonable outcomes, the final regulations acknowledge that the cost and delay of seeking a possibly better outcome may also be taken into account in justifying a settlement.
The preamble to the final regulations notes that many commentators objected to the rebuttable presumption that claims by family members are not deductible. The preamble defends the presumption, but then relents and points out that it is removed from the final regulations. Instead, amended Reg. § 20.2053-1(b)(2)(i) provides that deductible expenses and claims must be “bona fide in nature” and that “[n]o deduction is permissible to the extent it is founded on a transfer that is essentially donative in character (a mere cloak for a gift or bequest) except to the extent the deduction is for a claim that would be allowable as a deduction under section 2055 as a charitable bequest.” (Similar “bona fide” and “mere cloak” language was previously found in Reg. § 20.2053-1(b)(2) in the context of consent decrees and now applies more universally, including to all claims by family members.) Reg. § 20.2053-1(b)(2)(ii) goes on to list the following five factors that will indicate a bona fide nature:
“(A) The transaction underlying the claim or expense occurs in the ordinary course of business, is negotiated at arm’s length, and is free from donative intent.
“(B) The nature of the claim or expense is not related to an expectation or claim of inheritance.
“(C) The claim or expense originates pursuant to an agreement between the decedent and the family member, related entity, or beneficiary, and the agreement is substantiated with contemporaneous evidence.
“(D) Performance by the claimant is pursuant to the terms of an agreement between the decedent and the family member, related entity, or beneficiary and the performance and the agreement can be substantiated.
“(E) All amounts paid in satisfaction or settlement of a claim or expense are reported by each party for Federal income and employment tax purposes, to the extent appropriate, in a manner that is consistent with the reported nature of the claim or expense.”
The old regulations (§ 20.2053-1(b)(3)), the proposed regulations, and the final regulations (§ 20.2053-1(d)(4)(i)) all permit the deduction of eligible claims and expenses, even though they are not paid, if they are “ascertainable with reasonable certainty and will be paid.” Treasury expressly rejected the suggestion that it add a reasonableness component directly to the seemingly absolute standard that the amount “will be paid,” but noted that Reg. § 20.2053-1(d)(4)(ii) clarifies that the deduction will be allowed “to the extent the Commissioner is reasonably satisfied that the amount to be paid is ascertainable with reasonable certainty and will be paid” (emphasis added).
The proposed regulations provided that a deduction would not be allowed to the extent that a claim or expense is or could be compensated for by insurance or otherwise reimbursed. The final regulations (§ 20.2053-1(d)(3)) add that “[a]n executor may certify that the executor neither knows nor reasonably should have known of any available reimbursement for a claim or expense described in section 2053(a) or (b) on the estate’s United States Estate (and Generation-Skipping Transfer) Tax Return (Form 706), in accordance with the instructions for that form.” This certification is evidently intended to be a helpful alternative to the difficult task of proving a negative, although it is awkward to contemplate the executor’s own certification to what the executor “reasonably should have known”; presumably the instructions to the Form 706 will relieve this awkwardness. For the case where reimbursement might be available but difficult to obtain, Reg. § 20.2053-1(d)(3) adds, again helpfully, that the executor may simply provide “a reasonable explanation for his or her reasonable determination that the burden of necessary collection efforts in pursuit of a right of reimbursement would outweigh the anticipated benefit from those efforts.”
The Matter of Protective Claims for Refund
It is with respect to claims not adjudicated, settled, or “ascertainable” before the estate tax statute of limitations runs that the regulations have the greatest impact – and have produced the greatest controversy. In the final regulations, Treasury stands its ground and generally permits no deductions for such claims, relegating executors in such cases to protective claims for refund.
A protective claim for refund is not a new concept. But the specter of the widespread need for such protective claims attracted vigorous public objection, including public comment on the proposed regulations, on essentially three grounds – administrative hassle and expense, delay in closing the estate, and unfair exposure to unrelated adjustments after the estate tax statute of limitations had run. The guidance released on October 16 acknowledges these difficulties with protective claims and attempts to make the final rules more fair, more workable, and ultimately more palatable. This is addressed in three ways – by beginning to explain the use of protective claims, by providing two exceptions, and by announcing a significant commitment to administrative forbearance.
The preamble to the final regulations states that Treasury and the IRS intend to publish in the Internal Revenue Bulletin further procedural guidance on protective claims for refund and are contemplating a change to the estate tax return (Form 706) to permit a protective claim to be made on the return itself. New Reg. § 20.2053-1(d)(5)(i) confirms that protective claims shall be made in accordance with guidance in the Internal Revenue Bulletin. That regulation itself, however, also states that a protective claim need not state a dollar amount, but must only identify each claim or expense and explain why it has not been paid. This is a welcome provision, because, among other things, it relieves the executor from the obligation to put information on the estate tax return that could be subject to discovery and damaging to the estate’s defense against the claim. Explaining why the claim has not been paid is an ideal opportunity to simply state the executor’s opinion that the claim is not owed. Reg. § 20.2053-1(d)(5)(i) adds that “[a]ction on protective claims will proceed after the executor has notified the Commissioner within a reasonable period that the contingency has been resolved and that the amount deductible under §20.2053-1 has been established” – often referred to as “perfecting” the claim. Reg. § 20.2053-1(d)(5)(ii) helpfully confirms that if a protective claim for refund is filed, a claim payable from a share that otherwise would qualify for a marital or charitable deduction will not reduce the marital or charitable deduction until the claim is paid and the protective claim for refund is perfected.
The final regulations provide two exceptions from the requirement that a deduction is not allowed and a protective claim for refund must be filed instead. Under Reg. § 20.2053-4(b)(1), the executor may deduct the current value of a claim that is “integrally related” to a particular asset or assets the value of which comprises more than 10 percent of the gross estate. Reg. § 20.2053-4(c)(3), Example 3 provides the example of a decedent whose gross estate includes the value of a claim against a third party resulting from an automobile accident. If the third party files a counterclaim against the estate, the executor may deduct the value of that counterclaim, up to the value of the estate’s claim.
The second exception, under Reg. § 20.2053-4(c), allows the deduction of the current value of a claim or claims if the total of such claims is no greater than $500,000. Reg. § 20.2053-4(c)(3), Examples 1, 2, and 3 illustrate the way this math works. If there are three claims with values of $25,000, $35,000, and $1,000,000, respectively (Example 1), the executor may deduct the first two under this exception, but may not deduct any part of the $1,000,000 claim. If the three claims each had a value of $200,000 (Example 2), the executor may deduct any two of them under this exception. Example 3 confirms that this exception is applied after the exception for claims related to assets. In the automobile accident example, if the decedent’s claim is $750,000 and the counterclaim is $1,000,000, the executor may deduct $750,000 as a related claim and the balance of $250,000 as a claim under $500,000. If the counterclaim is $1,500,000, the executor may still deduct $750,000 as a related claim, but may not deduct any part of the balance of $750,000, since it exceeds $500,000.
Under both of these exceptions, the values of the deductible claims may be adjusted during an audit, to the extent justified by post-death developments.
In addition, under each of these two exceptions, the value of the claim must be supported by a “qualified appraisal” done by a “qualified appraiser,” in the same manner that an income tax deduction for certain charitable contributions must be substantiated under section 170(f)(11) and Reg. § 1.170A-13(c). This is a puzzling importation of rules developed in an entirely different context. Applying the qualified appraiser credentials of section 170(f)(11)(E) in a litigation context and generally applying a checklist developed for assets in the context of claims will be a challenge. It is understandable that the regulations would require value to be competently determined. But these exceptions are likely to work only if the specialized requirements grafted in from the income tax rules are essentially ignored and executors simply do the best they can to fulfill the spirit of those rules in this foreign context.
Of course, many executors will be unwilling to test the regulations in that way. Moreover, many executors will be unwilling to disclose sensitive information about their experts’ assessments of the claims in a form that could be subject to discovery in the underlying litigation. Thus, the great irony of the final regulations might be that a protective claim for refund, which was viewed with such suspicion when it was offered as the only remedy in the proposed regulations, might prove to be the option of choice now that a way is provided in some cases to avoid it. Meanwhile, this part of the regulations is a prime candidate for further revision, or for common-sense interpretation in Revenue Procedures or otherwise. Only time will tell. But the exceptions are an important part of the final regulations. They reflect a disposition to be practical and helpful, and they are valuable in providing an executor with options, including a way to obviate a protective claim for refund and maybe simplify the closing of the estate in many cases.
An Exercise in Self-Restraint
This still leaves the concern that a protective claim for refund might expose the executor, de facto, to unrelated adjustments long after the statute of limitations ought to have provided repose. It has long been settled that even after the IRS is prevented by the statute of limitations from assessing additional tax, it still has the right to deny a claim for refund to the extent that it finds offsetting increases in tax that reduce or eliminate the overpayment that is the only acceptable basis for a refund. See Lewis v. Reynolds, 284 U.S. 281, 283 (1932). Thus, the reliance on protective claims for refund in the proposed regulations created concern that there would be no real repose as to any estate tax issues as long as the IRS could raise those issues to deny clearly legitimate perfected claims for refund that had been filed as protective claims in the first place only because of the approach Treasury and the IRS have chosen to take in these regulations.
This concern was addressed, contemporaneously with the final regulations, in Notice 2009-84, 2009-44 I.R.B. 592. The Notice provides “a limited administrative exception” to the Service’s right of offset underLewis v. Reynolds. When a protective claim for refund is perfected pursuant to these regulations, the Service will limit its examination to the claim itself and will refrain from exercising its authority to examine other items on the estate tax return that might generate an offset. This is an extremely important exercise of self-restraint that goes a long way to reassure executors of the fundamental fairness of the regulations.
As stated in the preamble to the regulations, Treasury and the IRS intend to publish further procedural guidance on protective claims for refund, probably as one or more Revenue Procedures. At the ACTEC meeting in Williamsburg, a number of Fellows expressed the hope that this guidance will be published soon – an understandable hope in light of the mystery the requirement of protective claims created when the proposed regulations were published. In fact, because these regulations apply only to the estates of decedents who die on or after October 20, 2009, the first protective claim will not be absolutely due in any estate covered by the regulations before July 2013, although there seems to be no reason why a protective claim cannot be used in any estate. In any event, the IRS is likely to advance this guidance project, which is item 9 under the heading of “Gifts and Estates and Trusts” in the Treasury-IRS 2008-09 Priority Guidance Plan, with some dispatch, although it is to be hoped that enough time will be taken to think through the consequences of the guidance and address troublesome issues. The note of practicality and fairness struck by the regulations and the preamble suggests that, if the IRS is aware of a problem, it will be willing to find a workable solution.
For example, it is entirely foreseeable that in many cases an executor who has filed a protective claim for refund with respect to a claim the estate is contesting will need the tax refund to help pay the adjudicated or agreed amount if the estate’s defense is ultimately unsuccessful. In such a case, the judgment or settlement itself will presumably be enough to satisfy the IRS that the amount is “ascertainable with reasonable certainty and will be paid” (within the meaning of Reg. § 20.2053-1(d)(4)(i)), and all that is needed is to build into the published procedures a guaranteed expedited handling of the perfected claim in those circumstances.
Occasionally, an executor who loses in a trial court may have credible reasons for expecting a reversal on appeal, but is required to pay a substantial sum, perhaps into the court, pending the outcome of an appeal. While such an amount is indeed “paid,” the executor’s view would be that it should eventually be refunded or reimbursed, which would appear to make it nondeductible under Reg. § 20.2053-1(d)(3). In such a case, fairness would suggest the need for a creative solution, such as an arrangement in which the IRS maintains a lien over the refunded tax that is extinguished by its terms if and when the judgment against the estate ever becomes final.
These are difficult issues, and yet there apparently would have been difficult issues no matter what approach these rules might have taken, and this observer continues to believe that the final regulations do a good job of achieving rough justice. That is reason enough to anticipate fairness and moderation in the further refinement, interpretation, and (most importantly) implementation of these rules.