Final Section 2053 Regulations (T.D. 9468): Save Ferris!

by Carter Ruml on March 3, 2010

KYEstate$ readers are well aware that administration expenses and claims against the estate are deductible from the decedent’s taxable estate under section 2053.  This is economically significant, of course, because when an estate is taxable, the government effectively picks up 45% of the attorneys’ fees or claim. (Ah, yes, the faraway days of December 2009 when there still was such a thing as a “taxable estate”, before estate tax repeal actually happened….)

KYEstate$ readers, remember the scene in “Ferris Bueller’s Day Off” when Ferris parks Gordon’s father’s Ferrari, tips the parking lot attendant, and then turns to confide to the camera: “It’s amazing what a Five-ski can do to a guy’s attitude.”?

Likewise, in the T&E world, it’s amazing what a 45% discount on after-tax legal fees can do to a guy’s attitude. Today’s post is about the Great Big Five-ski that is section 2053, and how our friends at Treasury have modified that Five-ski with their final regulations under section 2053.

The final regulations relating to the amount deductible from a decedent’s gross estate for claims against the estate under section 2053(a)(3) were issued on October 20, 2009 in T.D. 9468 (2009-44 I.R.B. 570), and became effective on the date of issuance.

The basics of section 2053 are well known:

Pursuant to section 2053(a) “the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts: (1) For funeral expenses, (2) for administration expenses, (3) for claims against the estate, and (4) for unpaid mortgages on, or any indebtedness in respect of, property where the value of the decedent’s interest therein, undiminished by such mortgage or indebtedness, is included in the value of the gross estate, as are allowable by the laws of the jurisdiction, whether within or without the United States, under which the estate is being administered.”

Yet with section 2053(a)(3), as in so many other areas of life, the devil’s in the details.  Or, as Treasury put it: “The amount an estate may deduct for claims against the estate has been a highly litigious issue.”  You have to hand it to Treasury: they do understatement well.  (Except when they’re seeking $700 billion in emergency TARP funding.)

Treasury explained the scope of the proposed regulations:

The proposed regulations proposed amendments to the regulations under section 2053 to clarify that events occurring after a decedent’s death are to be considered when determining the amount deductible under all provisions of section 2053 that deductions under section 2053 generally are limited to amounts actually paid by the estate in satisfaction of deductible expenses and claims. The proposed regulations also proposed amendments to address more specifically issues involving final court decisions, settlements, protective claims, reimbursed amounts, claims that are potential, unmatured, or contested, claims involving multiple defendants, claims by a family member or beneficiary of a decedent’s estate, unenforceable claims, recurring payments, and the changes made to section 2053(d) in 2001.

Understanding that practitioners viewed the deduct-when-paid approach in the proposed regulations as impractical, Treasury squarely identified the core controversy:

The proposed regulations generally provide that only claims actually paid by the estate may be deducted under section 2053(a)(3). Many commentators disagreed with this approach and suggested that claims against a decedent’s estate be valued on the basis of what was reasonably known on the date of the decedent’s death….Commentators were concerned that the approach of the proposed regulations could lengthen the process of estate administration (on account of the anticipated increase in the need for protective claims), cause tax motivations to factor into litigation strategy, and produce liquidity shortfalls in estates with both claims by and claims against a decedent.

The Treasury is willing to listen, but not so willing to change its mind (at least on the core issue):

… the Treasury Department and the IRS continue to believe that a deduction for claims under section 2053(a)(3) only for amounts actually paid by the estate most closely aligns with the legislative intent behind section 2053 and its predecessors and best furthers the goal of effective and fair administration of the tax laws. Accordingly, the final regulations generally maintain the approach of the proposed regulations.

While it remained true to the deduct-when-paid approach of the proposed regulations in the final regulations, the Treasury did yield to practical concerns in a few respects:

…the Treasury Department and the IRS acknowledge that … there are practical difficulties associated with each of the alternatives, including the approach taken in the proposed regulations. In order to make the practical application of the approach more administrable, the final regulations include several exceptions to the approach of the proposed regulations.

Treasury yielded to practicality in two ways. First, the “final regulations include an exception for claims against the estate with respect to which there is an asset or claim includible in the gross estate that is substantially related to the claim against the estate.”  Second, the “final regulations also include an exception for claims against the estate that, collectively, do not exceed $500,000 (not including those deductible as ascertainable amounts).”

Yet, even for these two exceptions, Treasury reserves the right to take a second look: “Although both exceptions provide an opportunity to claim a deduction at the time of filing the United States Estate (and Generation-Skipping Transfer) Tax Return (Form 706), in each case, the amount of the deduction is subject to adjustment to reflect post-death events, consistent with the general approach of the regulations.”

The proposed regulations had required the amount paid to settle a claim be “within the range of reasonable outcomes under applicable state law” in order to be deductible.”  Practitioners viewed this requirement skeptically, “because the requirement places the Commissioner or a court in the position of having to evaluate the legal merits of a claim adjudicated in another court proceeding.”  Treasury retreated in the face of these concerns: “the final regulations eliminate the separate requirement that the settlement be within the range of reasonable outcomes under applicable state law.”

Helpfully, the final regulations “clarify that a deduction will not be denied for a settlement amount otherwise deductible under section 2053 if an estate can establish that the cost of defending the claim or contesting the expense, the delay associated with litigating such claim or expense, or another significant factor will impose a higher burden on the estate relative to the amount paid to settle the claim or the contested expense.”

Practitioners had also been concerned about timing issues with the statute of limitations posed by the proposed regulations, concerned that the proposed regulations might “impose a duty on the executor to report amounts that were claimed as deductions on the estate tax return, but were subsequently not paid or not paid in full.”  Practitioners also wondered “whether such a duty could be enforced after the period of limitations on assessment has expired.”

Treasury responded to these concerns positively: “Treasury Department and the IRS did not intend for the proposed regulations to impose a duty on the executor that could be enforced after the expiration of the period of limitations on assessment. As a result, the final regulations eliminate this provision. The final regulations also include a provision clarifying the period during which post-death events will be considered.”

There had also been concerns “that the protective claim procedures in the proposed regulations would result in increased administrative costs and a delay in the administration of the estate because filing a protective claim effectively would keep the period of limitations open to the extent of the amount of the claim for refund.”

Again, the Treasury responded positively: “In an effort to make the regulation more administrable for both taxpayers and the Commissioner, the final regulations in § 20.2053-4(c) include an exception for claims against the estate that do not exceed, in the aggregate, $500,000.”  The preamble clarifies, however, that “a claim is not eligible for this provision unless the entire amount of the claim may be covered within this cap.”

To address concerns about the effect of a protective claim for refund on the applicable period of limitations, Treasury issued a Notice concurrently with the issuance of the final regulations announcing the IRS’s decision “to limit the review of a return, in certain circumstances, when a timely-filed claim for refund of estate taxes that is based on a deduction under section 2053 ripens after the expiration of the limitations period on assessment.”

The IRS received requests for more detailed guidance on the procedures for filing a protective claim for refund. Accordingly, the final regulations include a provision under § 20.2053-1(d)(5) to explain the protective claim for refund process, and disclosed the IRS’s intent “to provide, by publication in the Internal Revenue Bulletin, further procedural guidance on protective claims for refund due to section 2053 claims or expenses.” The IRS is also contemplating amending Form 706 to incorporate a protective claim for refund so that separate Form 843 does not need to be filed.

The IRS explained that some:

…commentators requested clarification of the impact of the approach taken in the proposed regulations on the marital and charitable deductions in estates where a claim or expense is payable in whole or in part from a bequest that qualifies for the marital or charitable deduction. Commentators requested that the final regulations include a rule confirming that, if a claim or expense is the subject of a protective claim for refund under section 2053 is payable out of a fund that meets the requirements for a charitable or marital deduction under section 2055 or 2056, respectively, the charitable or marital deduction will not be reduced by the amount of the claim or expense until the amount is actually paid.

The IRS responded positively to this request for symmetry in reducing marital or charitable deductions when the claim is actually paid (rather than disallowing some deductions immediately, but only allowing other deductions in the future), and included such a rule in the final regulations.

On the issue of reimbursements, the “proposed regulations provide that a deduction is not allowed to the extent that the expense or claim is or could be compensated for by insurance or is or could be otherwise reimbursed.”  The IRS noted that:

A commentator recommended that the final regulations explain the method by which an executor may establish that there is no available reimbursement either from another party or insurance. In response to this comment, the final regulations provide that an executor may certify on Form 706 that no reimbursement is available for a claim or expense if the executor neither knows nor reasonably should have known of the availability of any such reimbursement…. the final regulations provide that an executor need not reduce the amount of a claim or expense deductible under section 2053 by the amount of a potential reimbursement if the executor provides a reasonable explanation on Form 706 for his or her reasonable determination that the burden of necessary collection efforts would outweigh the anticipated benefits from those efforts.

In the proposed regulations, the IRS had appeared not to understand that as long as the estate tax rate is not 100%, clients won’t have any reason to incur attorneys’ fees or other administration expenses merely to obtain an estate tax deduction.  After practitioners reminded the IRS that clients do not always enjoy paying the 55% of administration expenses not absorbed by the government on a net basis, the IRS reversed its position:

Some commentators recommended omitting the sentence in Prop. Reg. § 20.2053- 3(d)(3) that prohibits a deduction for expenses incurred merely for the purpose of unreasonably extending the time for payment, or incurred other than in good faith. The commentators stated that a situation where litigation has been intentionally prolonged other than in good faith is rare and unlikely to occur. Furthermore, the commentators expressed concern that the rule may subject the estate’s legal strategy to IRS inquiry. The Treasury Department and the IRS find these comments persuasive.  The proposed regulations provide that deductible claims against a decedent’s estate are limited to legitimate and bona fide claims. A commentator stated that the terms “legitimate” and “bona fide” in Prop. Reg. § 20.2053-4(a)(1) are redundant. The final regulations remove the term “legitimate” and provide that deductible claims against a decedent’s estate are limited to bona fide claims.

On the interesting issue of counterclaims and the importance of symmetry in the timing of inclusions and deductions on the taxable estate, the IRS noted as follows:

Some commentators, citing fairness and liquidity concerns, suggested allowing a deduction for a claim against the estate on the initial filing of Form 706 if the value of the gross estate includes a claim in the same or a substantially-related matter or includes an asset integrally related or subject to the claim against the estate. The Treasury Department and the IRS find this suggestion persuasive …provided that the related claim or asset of the estate constitutes at least 10 percent of the decedent’s gross estate, the value of each such claim against the estate is determined from a “qualified appraisal” performed by a “qualified appraiser” [as defined under section 170]…and the value of each such claim against the estate is subject to adjustment to reflect post-death events. The deductible amount of each such claim is limited to the value of the related asset or claim included in the gross estate. The amount of the claim against the estate in excess of this limitation may be the subject of a protective claim for refund.

The proposed regulations included a rebuttable presumption that claims by a family member of the decedent, a related entity, or a beneficiary of the decedent’s estate or a revocable trust are not legitimate and bona fide.

The IRS noted:

Many commentators requested that the rebuttable presumption be removed from the regulation. The Treasury Department and the IRS carefully considered these comments and, in response to the enumerated concerns with the creation of a rebuttable presumption, have removed the presumption from the final regulations. Instead, the final regulations…include a paragraph that (as suggested by a commentator) provides a nonexclusive list of factors indicative of the bona fide nature of a claim or expense involving a family member, related entity, or beneficiary of the estate of a decedent.

On issues such as alimony, or other recurring noncontingent obligations of indefinite duration, the IRS noted:

The proposed regulations provide that certain recurring, noncontingent obligations may be deducted as estimated amounts. Some commentators suggested that not allowing an estate to deduct the value of a contingent obligation is inefficient and inequitable because it forces the estate to remain open unless the estate purchases a commercial annuity. The Treasury Department and the IRS acknowledge that a contingent obligation may extend the period of estate administration unless the estate purchases a commercial annuity to satisfy the obligation or makes distributions that are encumbered by the contingent obligation. …Nevertheless, the Treasury Department and the IRS believe that the purchase of a commercial annuity (with a cost determined by the market and based on the particular contingency) to fund a contingent obligation should be deemed to be substantially equivalent to a reasonably ascertainable (and thus deductible) noncontingent obligation for purposes of section 2053 and these regulations.

The final regulations clarify that, for purposes of section 2053, an obligation subject to death or remarriage is treated as a noncontingent obligation.

The IRS also noted that:

some commentators suggested that the disparate treatment afforded noncontingent obligations (deduction for present value of obligations) versus contingent obligations (dollar-for-dollar deduction as paid) is inequitable and produces an inconsistent result without meaningful justification. These commentators requested that the final regulations allow an estate to choose between deducting the present value of a noncontingent recurring payment on the estate tax return, or instead deducting the amounts paid in the same manner as provided for a contingent obligation (after filing an appropriate protective claim for refund). The Treasury Department and the IRS find the arguments against the disparate treatment of noncontingent and contingent obligations to be persuasive. The final regulations eliminate the disparate treatment by removing the present value limitation applicable only to noncontingent recurring payments.

Further, the final regulations clarify that the rules applicable to recurring payments do not apply to payments made in connection with a mortgage or other indebtedness.

On the question of annuities purchased to satisfy claims against the estate, the IRS noted that practitioners had inquired “whether the executor must transfer ownership of the purchased annuity to the creditor or to a third party who will use the annuity to make payments to the creditor, or whether granting the creditor a security interest in the annuity is sufficient in order for the amount paid for the annuity to be deductible under section 2053.”  These concerns arose because for “income tax purposes, the transfer of the annuity is likely to cause immediate gain recognition of the entire amount to the transferee unless the annuity meets several specific requirements.”

Therefore, the Treasury concluded that “in light of the purpose and intent of these regulations, the Treasury Department and the IRS believe that the purchase of a commercial annuity, and the nonrefundable and generally significant costs involved in that purchase, should be sufficient to permit a deduction of the cost of the annuity for purposes of section 2053. For these reasons, the final regulations clarify that the estate may be permitted to own the annuity.”

Readers, T.D. 9468 and the final section 2053 regulations are complicated and present a lot of issues to evaluate.  Let’s close, however, with an important non-tax issue from “Ferris Bueller’s Day Off”: now that the Treasury has taken the 2053 Five-ski for a joyride with its general “deduct-as-paid” approach, will we have better luck than Gordon and Ferris did running the odometer on our clients’ estates in reverse?

The final section 2053 regulations are important and needed to be discussed, but KYEstate$ promises that posts in the next few days will cover material that’s less dense (i.e, no posts on the Smoot-Hawley Tariff).

 

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