Post-Death Settlement Limits Deduction for Contested Taxes
Marshall Naify Revocable Trust, 106 AFTR 2d 2010-6236 , 2010-2 USTC 60603 (DC Calif., 2010)
In Marshall Naify Revocable Trust, 1 the U.S. District Court for the Northern District of California limited the estate tax deduction for a claim arising from the decedent's state income tax liability to the amount at which the claim was ultimately settled. The district court denied the estate's claim for a refund that was based on a much larger estimate of the claim as of the decedent's date of death.
On 12/18/1998, Marshall Naify—a Hollywood tycoon—formed Mimosa, a wholly owned Delaware investment corporation with offices initially in Delaware. In early 1999, the principal office of Mimosa was moved to Reno, Nevada. In late December 1998, Naify contributed to Mimosa notes convertible into stock of Telecommunications, Inc. (TCI). In early 1999, Mimosa converted the notes into TCI stock in a transaction that was taxable for federal income tax purposes. Naify's intention in forming Mimosa was to avoid California income tax on the gain resulting from the TCI stock conversion. Before his death, Naify made estimated California income tax payments that assumed the success of the tax shelter.
After Mr. Naify's death in 2000, his estate filed his 1999 income tax returns. Gain from the TCI stock conversion was included on Naify's 1999 federal income tax return but was omitted from his 1999 California income tax return. The estate posited that Mimosa was a Subchapter S corporation for federal income tax purposes but a Subchapter C corporation for California income tax purposes, and therefore Naify owed no California income tax on the gain resulting from the TCI stock conversion. The California Franchise Tax Board (CFTB) issued notice on 7/6/2001 that Mimosa's 1999 income tax return had been selected for examination.
On 7/18/2001, the estate filed a federal estate tax return, which listed as a deduction Naify's 1999 California income tax liability of $62 million as a claim against the estate. The $62 million figure was the estate's estimate of Naify's California income tax liability resulting from the TCI stock conversion. On 10/2/2001, the CFTB issued notice that Naify's 1998 and 1999 individual income tax returns had also been selected for examination.
In February 2004, the estate and the CFTB reached a settlement of Naify's 1999 California income tax liability for $26 million, which the estate paid. In March 2004, the IRS allowed the $26 million California income tax liability as a deduction on the federal estate tax return. Shortly thereafter, the estate filed with the IRS an $11 million estate tax refund claim based on an upward adjustment of Naify's 1999 California income tax liability to $47 million—an amount the estate's expert determined was the total potential liability for tax and penalties given the likelihood of success of Naify's Mimosa scheme on the date of Naify's death. The IRS denied the refund claim, and the estate brought an action for refund of overpaid estate tax.
The U.S. District Court for the Northern District of California dismissed the estate's refund claim on the following grounds:
- The value of the estate's estimated claim (i.e., the $47 million deduction) was not “ascertainable with reasonable certainty” on the date of Naify's death, as required by then Reg. 20.2053-1(b)(3) .
- The estate was unable to satisfy the corollary requirement under Reg. 20.2053-1(b)(3) that as of Naify's death, it was clear that the claim would be paid.
Under Ninth Circuit precedent, post-death events are relevant in the consideration of disputed claims.
The estate was judicially estopped from taking the position that Naify was subject to California income tax on the TCI stock conversion because the estate used the contrary position in settling the California income tax matter with the CFTB.
Reg. 20.2053-1(b)(3) requires that an estimated claim be “ascertainable with reasonable certainty” to be deductible on the estate tax return. The facts in the case show that Naify went to great lengths to establish a non-California principal place of business for Mimosa to avoid California income tax on the TCI stock conversion. When the estate filed Naify's 1999 income tax returns, none of the gain related to conversion was reported on his California return. Yet in its estate tax refund claim and the ensuing litigation, the estate essentially took the position that the failure of Naify's tax planning strategy was apparent at the time of his death so as to render the estimated claim “ascertainable with reasonable certainty.”
Based on Naify's extensive actions in setting up the tax shelter and his estate's reporting position on Naify's 1999 income tax returns, the district court held that the $47 million claim reported on the refund claim was not at the time of Naify's death “ascertainable with reasonable certainty” within the meaning of Reg. 20.2053-1(b)(3) .
The district court concluded that the estate was unable to prove the additional requirement under Reg. 20.2053-1(b)(3) that, as of Naify's death, it was apparent that the claim would be paid. Based on the estate's calculations, a total failure of Naify's tax shelter would have resulted in a California income tax liability of $62 million on the TCI stock conversion. If the plan succeeded, however, Naify would have owed no California income tax. Therefore, at the time of Naify's death, it was uncertain whether the uncertain claim “would be paid” within the meaning of the regulation. The district court further stated that the $47 million claim, which is essentially the $62 million figure discounted by the possibility that the shelter would succeed, was almost certain at the time of Naify's death not to be the amount that would be paid.
Under Ninth Circuit precedent, consideration of post-death events in valuing a disputed claim is permissible. In Propstra, 2 the Court of Appeals stated that “[t]he law is clear that post-death events are relevant when computing the deduction taken for disputed or contingent claims.” In this case, Naify's estate reached a $26 million settlement with the CFTB several years after his death and subsequently reported that amount as a deduction with respect to the claim. The estate then filed a claim for a refund claiming a $47 million deduction, and this rendered the claim uncertain. The district court followed Ninth Circuit precedent under Propstra and found the $26 million settlement amount to be dispositive.
Finally, the district court held that the estate was judicially estopped from seeking the $11 million refund. The estate took the position that Mimosa was a legitimate Nevada corporation on Naify's 1999 income tax returns in order to avoid California income tax on the TCI stock conversion. In its subsequent negotiations with the CFTB, the estate continued to take this position and ultimately a $26 million settlement was reached. In claiming the $47 million deduction, the estate was attempting to claim that at the time of Naify's death, the shelter was at least partially ineffective to the tune of $47 million notwithstanding the $26 million settlement. As the district court pointed out, the estate had “succeeded in largely avoiding the state income tax, but now seeks a benefit as if it had failed to do so.”
Under the 2009 amendments to the Regulations under Section 2053 , which apply to estates of decedent's who died after 10/19/2009, a claim that is contested or otherwise unascertainable cannot be deducted on the Form 706 until the claim is paid, and post-death events are determinative. Even without these regulations applying here, the district court was clearly put off by the estate's inconsistent position with respect to the California taxes and attempting to deduct far more than it actually paid.
1 106 AFTR 2d 2010-6236, 2010-2 USTC 60603 (DC Calif., 2010).
2 50 AFTR 2d 82-6153, 680 F2d 1248 , 82-2 USTC 13475 (CA-9, 1982).
Frank Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or email@example.com.