Tax Considerations in Will and Trust Litigation Cases
As trust and estate litigation increases, attorneys who represent clients in this area must be aware of the tax issues that occur when the case is settled, mediated or tried in a court. A settlement or court decision that distributes or allocates assets between the litigating parties will always have tax consequences. Attorneys who represent the litigating parties are risking a malpractice claim if they do not secure the advice from a qualified tax attorney as to the potential tax implications of the settlement or court order to their client prior to finalization of the case.
There are many tax issues associated with trust and estate litigation. The purpose of this article is to highlight a few of those issues that I see on a regular basis.
Section 102 of the Internal Revenue Code (hereinafter, “IRC”) sets forth the federal government's income tax laws for gifts and inheritances. According to § 102(a), gross income does not include the value of gifts or inheritances. So when a beneficiary receives an inheritance, the beneficiary receives the inherited assets income tax-free. However, certain amounts received upon the death of a decedent may be classified as income in respect of a decedent (hereinafter, “IRD”) under § 691 of the IRC. IRD is an exception to the general rule stated in § 102 that a beneficiary receives an inherited asset tax-free. IRD generally refers to those amounts to which a decedent was entitled as gross income, but which were not properly includable in the decedent’s taxable income for the tax year ending with the date of his or her death, or for a previous taxable year. The goal of the statute discussing IRD is to reach all income earned by a decedent during his or her lifetime that might otherwise escape income tax. If a beneficiary receives a right to income from a decedent’s estate, that income will be taxable to the recipient, notwithstanding the ordinary rule that distributions from a decedent’s estate are non-taxable to the recipient.
Treasury Regulations relating to IRC § 691 describe what is meant by the term “income in respect of a decedent,” and the situations to which it applies. The character of gross income received as income in respect of a decedent is also generally determined by reference to the character the income would have had in the hands of the decedent had the decedent received the item and been taxed on it prior to his or her death.
Dividing qualified retirement accounts
The most common form of IRD for most estates is qualified retirement accounts such as Individual Retirement Accounts (IRA) and 401(k) accounts. Rev. Rul. 92-47 holds that a distribution to the beneficiary of a decedent's IRA is IRD. The amount of the IRA distribution is included in the gross income of the beneficiary for the tax year when it is received. As discussed earlier, when the beneficiary receives the IRD asset, the beneficiary is taxed on the asset, for income tax purposes, just as the original owner would have been taxed on the asset if he or she had recognized the income.
As a general rule, beneficiary designations may be changed by the owner of an IRA during the IRA owner’s lifetime, but the beneficiary designation becomes irrevocable upon the owner’s death. A change to a beneficiary designation after an owner’s death requires a court order. Without a court order, an attempted change to a beneficiary designation is merely an after-tax distribution of proceeds from a designated beneficiary to another. Recent Private Letter Rulings (hereinafter, “PLRs”) by the IRS have discussed a court’s modification of a trust or beneficiary designation made by the settlor of a trust or an IRA owner. The IRS did not take issue with court orders modifying designations in both PLR 200616041 and PLR 200620026, but both court orders cited in the PLRs specifically state that the beneficiary designations are to be retroactive to a time before the settlor or owner’s death.
If the parties are attempting a division of the decedent’s assets and a portion of those assets consists of an IRA, 401(k) or 403(b) accounts, the parties must exercise extreme caution in the distribution of those qualified retirement account proceeds in a manner that is different from the decedent’s final beneficiary designation. A signed mediation agreement that directs a distribution of an IRA in different percentages than what is stated on the beneficiary designation signed by the decedent will not be recognized by the IRS.
Taxation of a Will Contest
With respect to will contests or other litigation conducted against an estate or between heirs, the taxability of an amount a taxpayer receives in settlement of a lawsuit is determined by reference to the origin and character of the claim which gave rise to the lawsuit and not by reference to state law. In characterizing a settlement payment for federal income tax purposes, the critical question is in lieu of what was the settlement amount paid. In other words, is the settlement being paid as part of a claim for damages or for the settlement of a dispute regarding estate assets.
Consider the following case. The decedent (D) died in 2020. He bequeathed to his spouse (P) minimal assets from a total net estate of $3,361,683. In 2021, P elected against D's will to take the state law elective share of 30% of the net estate or $1,008,504. The estate reported 2021 distributable net income (DNI) of $707,095, including $176,432 of capital gains that D's personal representative treated as estate income and $377,753 of distributions to the estate from D's individual retirement accounts. Pursuant to order of the state Probate Court, D's personal representative paid P the elective share in 2021, but made no distributions to the residuary beneficiaries until 2021. The personal representative claimed a distribution deduction of $707,095 on the ground that all of the estate's DNI had been included in the payments to P in satisfaction of her elective share. P did not include in her gross income any part of the elective share.
In reviewing the tax implications to the parties, the Tax Court stated that P's election resulted in more than two years of acrimonious litigation over the amount of her elective share, the timing of its payments, and, ultimately whether such payment would cause P to suffer the entire federal income tax impact of the estate's DNI.
The Tax Court held that payments to P in satisfaction of her state elective share were not distributions of income or amounts properly paid or credited or required to be distributed to a beneficiary and thus that P's elective share was excluded from her gross income. In so holding, the Tax Court stated that the state elective share should be accorded the same federal income tax treatment as statutory dower because they have common legal and economic characteristics that justify their exclusion from the subchapter J estate. The Tax Court added that the state elective share, unlike statutory dower, does not share in income of the estate, or mesne profits, nor is it entitled to interest from the estate prior to the date distribution is ordered by the Probate Court, under state law.
