This post was originally published on Forbes Feb 24, 2015
The Tax Court decision in the Estate of Eileen S. Belmont is probably one of good intentions gone awry. Ms. Belmont wanted to provide something for her brother, who had issues, and have the bulk of her estate go to the Columbus Jewish Foundation. Unfortunately, a lack of clarity caused a good chunk of her estate to be spent on litigation and a substantial income tax hit that might have been avoided. The tax court decision is of course about the income taxes. The litigation that created the income tax problem was in California state courts.
Charitable Set Aside
What the Tax Court was dealing with was the concept of charitable "set aside". A trust or estate can take an income tax deduction for money that it has not yet paid to charity, provided it is "set aside". Ms. Belmont's estate consisted of her primary residence in Ohio, a condo in California where her brother was living and a retirement account just shy of a quarter million. The residue of the estate went $50,000 to her brother and the balance to Columbus Jewish Foundation. On its 1041 for the year ended May 31, 2008 the estate reported a distribution of $243,463 from the retirement account. It claimed a $219,580 charitable set aside deduction for the portion of the residue projected to go to the CJF. The funds were not segregated, which in and of itself is not fatal to the deduction.
Thus, for an estate to properly claim a charitable contribution deduction pursuant to 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 pursuant to the terms of a governing instrument; and (3) the charitable contribution must be permanently set aside for purposes specified in section 642(c)(2). Respondent does not dispute that the $219,580 distribution was to be from the estate's gross income (i.e., income in respect of a decedent) or that the money was designated for the foundation pursuant to the terms of a governing instrument (i.e., decedent's will). The parties agree that in order for an amount to be “permanently set aside” for a charitable purpose, the estate must be able to establish that “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.” Sec. 1.642(c)-2(d), Income Tax Regs. The parties are in disagreement over whether this standard was met.
What complicated matters was that Ms. Belmont's brother did not want to move out of the condo. He made an offer to CJF to give up his cash bequest in exchange for a life estate in the condo. He was told that the Foundation was not interested in having a real estate investment and he was offered $10,000 to move out quickly. In retrospect, it would have been a lot a better for the Foundation to have taken the offer.
On April 2, 2008, David filed a creditor's claim with the Los Angeles County Probate Court claiming an alleged breach of contract on the basis that an oral agreement (agreement) existed between him, decedent, and their mother, giving him a life tenancy interest in the Santa Monica condo despite the agreement not being reflected in decedent's will. Peter Gelblum, a prominent California attorney, represented David pro bono. David was a client of a local mental health organization in California where Mr. Gelblum is a member of the board of directors.6 On April 24, 2008, David filed a Lis Pendens, Notice of Pendency of Action (lis pendens) with the California Recorder's Office and the Los Angeles County Probate Court to alert third parties of potential action against the Santa Monica condo.
Ultimately he would get his life estate in the condo, presumably the $50,000 and the estate, and indirectly the CJF would be out a lot of attorney's fees. The estate appealed and lost.
Nobody Told The Accountant
Meanwhile back in Ohio, it appears that nobody thought that the accountant preparing the 1041 needed to know about this drama.
The estate faced the possibility that David would engage in prolonged and expensive litigation over his interest in the Santa Monica condo. David's actions leading up to the estate filing its Form 1041 on July 17, 2008, provided information indicating that he would put up a litigious fight. First, David did not vacate the Santa Monica condo and did not agree to the request made in Ms. Sater's letter dated February 14, 2008, to vacate the Santa Monica condo in exchange for a "$10,000 stipend”. Second, on April 2, 2008, David filed a creditor's claim with the Los Angeles County Probate Court asserting information supporting his claim to a life tenancy interest in the Santa Monica condo. Third, on April 24, 2008, David filed a lis pendens action with the California Recorder's Office and the Los Angeles County Probate Court. Fourth, David filed an 850 petition with the Los Angeles County Probate Court on May 30, 2008, asserting the basis for his claims. The estate was aware of these claims and filed its objections. Finally, David retained a prominent California attorney, pro bono, to represent his interests in the Santa Monica condo. All of these events occurred and were known to the estate before July 17, 2008, when the estate claimed a $219,580 charitable contribution deduction on its Form 1041.
These facts and circumstances provided an indication to the estate that the possibility of David litigating his alleged interest in the Santa Monica condo was more than negligible. Nevertheless, the estate failed to inform Ms. Becker—the C.P.A. who prepared the return in question—of David's claims against the Santa Monica condo.
Not A Great Outcome
So now there will be a $75,662 income tax deficiency reducing the portion of Ms. Belmont's estate that will go towards ensuring the continuity of Jewish life and meeting changing needs locally, in Israel and in the worldwide community.
I can't help but Monday morning quarterback a mess like this. The first strategy that comes to mind would be for the executor to have turned over all the money to CJF and quitclaimed the condo to them and let them carry on the fight or make a deal with the brother. That would have avoided the income tax problem. Of course there might be probate law reasons why that would not work. Regardless of which way it went CJF would have ended up with an additional $75,622. They also might have been more inclined to settle with the money in their own till rather than being an expectancy.
The cautionary tale here is probably more about taking into account family issues and contingencies in estate planning for even relatively modest estates. Reading the state court decision, it appears that planning was done on the assumption that Ms. Belmont was going to outlive her brother and the implication of his being potentially made homeless in the event of her earlier death was not thought through.
What is really annoying about the outcome in this case is that the final return of the estate will pass through a useless deduction for administration expense to the charity. There is something odd about this mess ending up being a windfall for the treasury, but as Reilly's First Law of Tax Planning goes - "It is what it is. Deal with it."
Lew Taishoff focused on the failure to clue in the tax preparer on the contingency.
The UCLA planned giving website remarked
This is a textbook case why IRD should not be transferred to the estate, but through selecting the charity as a designated beneficiary. While some IRD transfers through the estate are qualified, the tax disaster in this case highlights the evident risk. The charitable recipient waited eight years and lost approximately one-half of the value due to litigation costs and income tax.