A recent Tax Court case provides a blueprint for making sure
that the IRS and lawyers will prosper at the expense of your
intended beneficiaries. In Upchurch v. Commissioner, T.C. Memo.
2010-169; Nos. 14827-07, 14959-07 (1 Aug 2010), the court held that two estate
beneficiaries were liable for taxes and interest on their bequests. The
net result was that the IRS and the lawyers involved in the case made out like
bandits, and the intended beneficiaries were left holding an almost empty bag.
This sad tale involves a second marriage, where each spouse brought along children
from a prior marriage. Husband brought two sons, and Wife brought two
sons and a daughter. Husband died in 1994. Wife signed a Will in June of 1999 and then
died in August of 2000.
Under Wife's Will, her personal
effects were to be divided among the five children. Her cash and
securities were to be transferred to her natural-born children and
grandchildren, and her home was to be divided equally among the five children.
However, after executing her Will,
Wife divided the lot into two parcels and gifted one of them (the lot without a
house on it) to one of her sons and his wife. The son then built a home
on the gifted lot. Wife then gave her residence to her daughter.
After Wife died, Husband's sons sued
the estate, claiming that Wife was obligated to include them in the
distribution of the real estate that she had gifted to two of her children.
A settlement was reached, and each of Husband's sons received $53,500
cash. Here is where the fun begins.
Wife's estate
deducted the payments to Husband's sons as debts on Wife's federal estate tax
return. The IRS disallowed the
deductions because the debts were to family members, and it declared a
deficiency of $46,758.12 in taxes, plus interest of $7,162.53. Subsequently,
the IRS added insult to injury by assessing a "failure to pay
penalty" of $11,727.32 against the estate.
Husband's two sons claimed that they were exempt from the IRS claim because
they received the property from Wife's children rather than from the estate. The Tax Court noted that the payments were
made directly from the estate and that the estate was a party to the lawsuit.
Thus, the sons were on the hook. Husband's
sons also argued that their obligation should be limited to two-thirds of the
payouts because they had paid their lawyers one-third of their payouts in contingency
fees. Unfortunately for them, the court noted that they were the legal
recipients of the full $53,500; therefore, their liability extended to that
amount. Finally, the court determined
that interest was properly calculated under federal law.
The bottom line was that instead of receiving their $107,000.00 in
settlement proceeds, the two sons received $41,352.03. This does not count the cost of dealing with
the IRS assessments and the time and aggravation that the sons experienced
during this nightmare.
The
morals of the story: Blended families are fertile grounds for disagreements
that can enrich the IRS and the legal profession. In the case of a blended family, it is
critical for the parents to have a clear agreement during their joint lifetime regarding
which children will receive what from their respective estates. It is also not a bad idea to give careful
consideration to who will serve as trustee after the parents are gone. Blended families can benefit greatly from
having independent trustees in place. Finally,
the judicial system can be unpredictable, and the IRS can be unforgiving. It is best to avoid judges, litigators, and tax collectors altogether, if at all possible.