Sunday, June 19, 2011

Pending Legal Malpractice Claim Against A Decedent is Disallowed as a Deduction under the Federal Estate Tax If Claim Amount is Uncertain

The United States Tax Court has held that a decedent's federal taxable estate for Federal Estate Tax ("FET") purposes may not include, as a deduction, a $30 million potential legal malpractice litigation claim pending against it as of the date of death.  Rather, the amount actually paid during the administration of the Estate is deductible for the FET.  The test is whether the amount due is "reasonably certain" as of the date of death.  See (Former) Treas. Reg. 20.2053-1(b)(3) and (Current) Treas. Reg. 20.2053-1(d)(4).  In Estate of Saunders, 136 T.C. No. 18 (2011), the conflicting expert reports on the value of the claim as of the date of death, led the Tax Court to conclude that the value of the claim was too uncertain to be deducted based on estimates as of the date of death.  Therefore, the court concluded that the deduction was required to be based on the ultimate outcome.
Facts.  The taxpayer was an attorney who had a significant claim pending against him which alleged that he was a secret IRS informer against the interest of his client.  The complaint requested over $90 million in compensatory damages plus additional punitive damages. After death, a jury returned a verdict in favor of the taxpayer and on appeal, the Estate paid only $250,000.  Prior to the jury verdict, the estate tax return was filed and a $30 million deduction was claimed for the malpractice claim.  The IRS allowed a $1 deduction for the malpractice claim and assessed a $14.4 million deficiency.
Analysis: Code Section 2053(a) permits certain deductions in calculating the taxable estate, including litigation claims against the estate.  However, to be deductible, the amount of the claim must be ascertainable with reasonable certainty. The Tax Court stated that it did not consider the subsequent settlement in its discussion of the question of whether the value of the claim was ascertainable with reasonable certainty as of the date of death.  Instead, the Tax Court ruled based upon the various reports of the value of the claim.  The Tax Court concluded that the claim was not deductible as of the date of death, and only the amount actually paid during the administration of the estate could be deducted in accordance with Prior Reg § 20.2053-1(b)(3).  Current Treas. Reg. 20.2053-1(d)(4) would apply to new cases and the current regulation also requires: "A deduction under this paragraph (d)(4) will be allowed to the extent the Commissioner is reasonably satisfied that the amount to be paid is ascertainable with reasonable certainty and will be paid. In making this determination, the Commissioner will take into account events occurring after the date of a decedent's death."
Conclusion:  It is important to understand the rules concerning claim deductibility when assessing the effect of potential lawsuits pending against a Decedent in preparing the estate tax return and when addressing the concerns that the IRS will pose on audit of such claims. 

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