• Court Could Consider Post-Death Settlement Of California Tax Liability When Valuing Claims For Federal Estate Taxes
  • March 2, 2012 | Author: Linda M. Monje
  • Law Firm: Kronick Moskovitz Tiedemann & Girard A Law Corporation - Bakersfield Office
  • The United States Court of Appeals for the Ninth Circuit recently held that a district court could consider a $26 million post-death settlement of California tax liability as dispositive of the value of a California income tax claim which was estimated to be $62 million on an estate’s federal estate tax return. (Marshall Naify Revocable Trust v. United States of America, (--- F.3d ----, C.A.9 (Cal.), February 15, 2012).

    Marshall Naify (“Naify”) was a long time resident of California until his death in 2000.  Naify devised a plan to avoid paying California income tax on gains he expected to realize from converting notes he owned in Telecommunications, Inc. (“TCI”) into AT&T stock after a merger.  Naify formed Mimosa, Inc. (“Mimosa”) as a Delaware Corporation, of which he was the sole shareholder, and tried to make sure Mimosa did not operate in California.  Naify then transferred his TCI notes to Mimosa and after the merger converted the notes into AT&T stock, which resulted in a gain of $660 million.

    When the estate of Marshall Naify (“Estate”) filed Naify’s personal California income tax return after his death, it did not report the $660 million gain as taxable income.  Approximately one year later, the Estate filed its federal estate tax return in which it deducted, as a claim against the Estate, $62 million for the estimated amount that the Estate might owe California for income taxes if Naify’s tax avoidance plan failed.  However, at the time the Estate filed the federal return, the California Franchise Tax Board (“FTB”) had not yet asserted a claim against the Estate for income tax owed on the $660 million gain.

    Three months after the Estate filed its federal return, the FTB initiated an audit of Naify’s California personal income tax return.  Although initially the FTB asserted the Estate owed $58 million plus interest and penalties for California income tax, the Estate ultimately settled the California income tax claim for $26 million.

    The IRS initiated an audit of the estate tax return and decided to disallow the $62 million deduction.  The IRS did allow a $26 million deduction for the amount the Estate paid to settle the income tax claim.  As a result of this adjustment, the Estate paid the IRS a deficiency of $11 million.  However, the Marshall Naify Revocable Trust (“Trust”), the successor in interest to the Estate, filed a claim for a refund of $11 million.  The Trust claimed that the allowed income tax deduction should have been $47 million.  It reached this figure by reducing the $62 million estimate by 67%, which was the Trust expert’s estimate of the probability that Naify’s tax plan would fail.  The IRS rejected the Trust’s claim for a refund finding that “the California income tax claim was contingent and disputed and, thus, the amount of the deduction for the claim was limited to the $26 million the Estate paid post-death to settle the claim.”

    The Trust brought a lawsuit against the United States (“Government”) in which it asserted that the FTB’s claim against the Estate at the time of Naify’s death was for $47 million.  The Government claimed the deduction for California income taxes was limited to the $26 million the Estate paid to settle that claim.  The district court found in favor of the Government.

    The federal estate tax, a tax on the privilege of transferring property upon a decedent’s death, is imposed on a decedent’s taxable estate.  A decedent’s taxable estate is determined by reducing the gross amount of the estate by the deductions allowed by the Internal Revenue Code.  One type of deduction is a claim against the estate, which is defined as a personal obligation of the decedent which existed at the time of death, regardless of whether the obligation had matured, and the interest that had accrued at the time of death.  Tax obligations may be deductible as claims against an estate.  The Trust asserted the district court erred when it rejected its estimated claim of $62 million and instead limited the income tax claim to the $26 million it paid.  The court of appeals disagreed and upheld the decision of the district court.

    Treasury Regulations provide that before an estate can deduct the estimated amount of a claim, it must show that the claim is “ascertainable with a reasonable certainty.”  A claim that is based on an estimate that is vague or uncertain cannot be deducted by an estate.  Here, the court of appeals determined that the estimated amount of the California income tax claim was not ascertainable with reasonable certainty at the time of Naify’s death.  The FTB had not yet asserted a claim much less assigned a value to the California income tax claim at the time of Naify’s death.  Information from the Trust and its expert revealed that the income tax claim was contingent and had a possible value between $0 and $62 million.

    The court of appeals has “never concluded that there is a complete bar to considering post-death events when valuing a disputed or contingent claim.”  In fact, a United States Supreme Court decision, as well as federal statutes and Treasury Regulations, allow a court to consider post-death events when determining the value of a disputed or contingent claim.  The court rejected the Trust’s claim that the district court could not consider as dispositive the $26 million post-death settlement of the California income tax claim.

    The district court did not err when it limited the Trust’s deduction to $26 million.  Treasury Regulations provide that an estate can deduct a claim that initially had an uncertain value once the value becomes certain.  Here, the value of the California income tax claim became certain once the Trust settled that claim.