Potential Litigation Costs Ate Estate's Charitable Deduction
In Estate of Belmont, 1 the Tax Court held that an estate could not deduct income set aside for charity if the chance that the funds might be encroached upon by foreseeable litigation and administration expenses are not so remote as to be negligible.
Eileen Belmont died testate in 2007. Her will provided for a pecuniary bequest of $50,000 to her brother David Belmont and the rest, residue. The remainder of her estate was to be distributed to the Columbus Jewish Foundation. At the time of her death, Eileen owned a condominium in California. Eileen, at the time of her death, also owned a retirement account with the State Teachers Retirement Pension Fund of Ohio. Following Eileen's death the pension fund distributed approximately $245,000 to her estate.
Under Section 691, this distribution constituted income regarding a decedent. The distribution was reported on the estate's income tax return. In addition to other deductions claimed on the estate's income tax return, the estate claimed a charitable contribution deduction of approximately $220,000. When the estate filed the income tax return, the charitable contribution had not been paid to the Jewish Foundation nor had the estate segregated the $220,000 from the other funds of the estate.
After Eileen's death, litigation arose between the estate and Eileen's brother in which he alleged that an oral agreement existed between him and Eileen giving him a life estate in the California condominium. Eileen's brother was successful in the litigation, and an appeals court affirmed the judgment awarding him a life estate in the condominium. The estate incurred various legal expenses during the litigation and the subsequent appeal. To pay these expenses, the estate depleted some of the $220,000 it had ostensibly set aside for the Jewish Foundation.
The issue before the court was whether the estate was entitled to the charitable contribution deduction of $220,000. Under Section 642(c)(2) an estate is allowed a current charitable income tax deduction even if that the amount will not be paid or used for a charitable purpose until sometime in the future. With an estate, Section 642(c)(2) states: "In the case of an estate ... there shall also be allowed as a deduction in computing its taxable income any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a purpose specified in section 170(c), or is to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, or for the establishment, acquisition, maintenance, or operation of a public cemetery not operated for profit."
An amount is not deemed "permanently set aside" for a charitable purpose under Section 642(c)(2) "unless 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." 2 For an estate to properly claim a charitable contribution deduction under Section 642(c)(2), three criteria must be met:
1. The charitable contribution must be an amount from the estate's gross income.
2. The charitable contribution must be made under the terms of a governing instrument.
3. The charitable contribution must be permanently set aside for purposes specified in Section 642(c)(2).
The parties did not dispute that the first two requirements were met. Particularly, that the $220,000 distribution was to be made from the estate's gross income (i.e., income regarding a decedent) or that the money was designated for the Jewish Foundation under the terms of a governing instrument (i.e., Eileen's will). The parties disagreed whether the third requirement was satisfied.
The estate argued there was no "reasonably foreseeable possibility" that it would incur unanticipated costs associated with litigating Eileen's brother's claims regarding the California condominium. The IRS argued the estate was clearly on notice that a prolonged legal fight was more than just a remote possibility when the estate claimed the charitable deduction, and it should have known there was more than a negligible chance it would have to apply some of the funds received from the pension fund to cover the administrative and litigation costs of the estate as the probate proceedings continued.
The Tax Court had not previously had to consider the "so remote as to be negligible" standard under Section 642(c)(2). However, the Tax Court had previously examined identical language in connection with Section 170. In 885 Inv. Co., 3 the Tax Court defined "so remote as to be negligible" 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." In addition, in Briggs, 4 the Tax Court construed the standard as being "a chance that 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." Applying these interpretations, the Tax Court considered the facts and circumstances of the case in order to determine whether the possibility that the estate would invade the money set aside for the Jewish Foundation was "so remote as to be negligible."
The court found the facts and circumstances known to the estate when it filed the income tax return were sufficient to put the estate on notice that the possibility of an extended and expensive legal fight - and consequently the dissipation of the funds set aside for the Jewish Foundation - was more than "so remote as to be negligible." The court pointed to the fact that when the estate filed its income tax return, after subtracting the funds ostensibly set aside for the Jewish Foundation, only $65,000 remained in the estate's bank account to cover the remaining expenses associated with the estate administration. From the amount remaining in its estate bank account, the estate was responsible for various expenses, including homeowner's association fees and property taxes associated with the California condominium, legal fees regarding probate proceeding in Eileen's state of domicile and the ancillary proceeding in California, and attorney's fees related to the litigation of Eileen's brother's claim.
The court also found that when the estate filed its income tax return, it knew or reasonably should have known that it faced the possibility that Eileen's brother would engage in prolonged and expensive litigation over his interest in the California condominium. The court pointed to the fact that Eileen's brother did not vacate the California condominium when requested to do so; he filed a creditors claim in the ancillary probate proceeding in California; he filed a lis pendens action; and he retained a prominent California attorney, pro bono, to represent his interests with respect to the California condominium. The court concluded that these facts and circumstances provided an indication to the estate that the possibility of Eileen's brother litigating his alleged interest in California was more than negligible.
The court found that Eileen's brother's active litigation of his property rights in the California condominium created a real possibility that the funds set aside for the Jewish Foundation would be depleted during the pendency of the lawsuit. Given the estate's known financial situation and the claims brought by Eileen's brother concerning the California condominium, the court believed that a real possibility existed that the funds set aside for the Jewish Foundation would be invaded to continue the estate administration.
For those reasons the court found it was not "so remote as to be negligible" that the funds set aside for the Jewish Foundation would be depleted because of the ongoing and future litigation over the California condominium. The court held that the $220,000 was not "permanently set aside" as required by Section 642(c)(2) and Reg 1.642(c)-2(d).
This case reminds practitioners to be careful in claiming charitable deductions without considering all the facts and circumstances involved in an estate. It appears from a reading of the opinion that the accountant for the estate was not made fully aware of the extent of the litigation involving the California condominium. If the accountant knew all the facts and if he or she understood the requirements for a charitable set aside, the outcome of this case could have been avoided.
1 144 TC No 6 , 2015 WL 690621.
2 Reg. 1.642(c)-2(d).
3 95 TC 156 (1990).
4 72 TC 646 (1979), aff'd without published opinion665 F.2d 1051 (CA-9, 1981).
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more on charitable deductions, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the June 2015 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.