Estates, Trusts & Gifts
The Ninth Circuit held that an estate could deduct as a claim against it only the amount of state income tax and interest with respect to the income on a transaction that the estate ultimately paid, not the amount that it estimated at the time of the decedent’s death it would have to pay on the income.
Marshall Naify was a longtime California resident until his death in April 2000. In December 1998, Naify began implementing a plan to avoid paying California income tax on gains he expected to realize from converting his Telecommunications Inc. (TCI) notes into AT&T stock after TCI merged into AT&T. As part of the plan, Naify formed and became the sole shareholder of Mimosa, Inc., a Delaware corporation that did not operate in California. Naify then transferred his TCI notes to Mimosa. After TCI merged into AT&T, Mimosa converted the TCI notes into AT&T stock, which led to a gain of $660 million for Naify. After Naify’s death, his estate filed his California personal income tax return for the 1999 tax year. The return did not report any income from the transaction.
In July 2001, Naify’s estate filed its federal estate tax return. At the time the estate filed its return, the California Franchise Tax Board had not asserted a claim against the estate for California income tax on the $660 million gain. On the estate tax return, however, the estate deducted, as a claim against the estate, $62 million for the estimated amount of California income tax that Naify might owe if his California tax avoidance plan failed. The plan did fail, but after negotiating with the state of California, Naify’s estate ended up paying the state only $19 million in tax and $7 million in interest in settlement of the claim.
In early 2003, the IRS audited Naify’s estate tax return and disallowed the $62 million claim against the estate as a deduction. After the estate settled with California, however, the IRS allowed it to deduct the $26 million it paid to settle the income tax claim. As a result of the adjusted deduction, Naify’s estate paid a federal estate tax deficiency of $11 million.
In March 2006, the estate filed a refund claim for the $11 million tax deficiency it had paid. In its claim, the estate sought to adjust the deduction from $26 million to $47 million. The estate arrived at this amount by discounting the $62 million that it believed that Naify owed in California income tax by 67%, which was the probability, according to an expert, that Naify’s tax plan would fail. The IRS rejected the estate’s claim: It concluded 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 postdeath to settle the claim.
In April 2009, the Marshall Naify Revocable Trust (Naify trust), as successor in interest to Naify’s estate, filed a refund suit in district court. The IRS moved to have the case dismissed. The district court granted the IRS’s motion because, among other things, the Naify trust had not shown in its petition to the court that the estimated amount of the deduction for the California income tax claim was ascertainable with reasonable certainty as of the date of Naify’s death and, as a result, the deduction for the claim was limited to the $26 million the estate paid to settle it.
The Ninth Circuit’s Decision
The Ninth Circuit held that the trust could deduct only the $26 million for the claim on Naify’s estate tax return. The court found that, under Regs. Sec. 20.2053-1(b)(3), to deduct an estimated amount of a claim against an estate on an estate tax return, the estate must show that the amount of the claim is ascertainable with reasonable certainty. The court held that the Naify trust had failed to prove that the estimated amount of the claim against the estate for California income tax was ascertainable with reasonable certainty.
As part of its petition to the district court in the case, the Naify trust submitted a lengthy expert’s report that the Naify trust argued proved that the claim met the certainty requirement. The Ninth Circuit concluded that the report showed the opposite. According to the court, the report did not identify any specific facts that showed that the estimated amount of the California income tax claim was ascertainable with reasonable certainty as of the date of Naify’s death and that, in fact, the report showed that Naify had gone to considerable efforts to avoid having to pay any tax on the $660 million gain. The court also noted that the report showed that the amount of tax the estate would have to pay on the transaction was contingent and had a range of possible values between $0 and $62 million. Finally, the court rejected the expert’s use of the probability of the success of Naify’s tax avoidance plan to determine the proper estimate of the amount of the claim.
The Naify trust had also argued that Ninth Circuit precedent did not allow the courts to consider any postdeath events in determining the value of the claim. Based on its opinion in Propstra , 680 F.2d 1248 (9th Cir. 1982), the Ninth Circuit held that, under its precedent, courts could consider postdeath events “when valuing disputed or contingent claims.” The Naify trust asserted that this statement of the law in Propstra was dicta (i.e., an expression of the judge’s opinion that went beyond the facts of the case and therefore not binding precedent). The Ninth Circuit rejected this assertion, identifying the statement not as dicta but as “reasoning central to a [court’s] decision” and stating that the idea that contingent or disputed claims could be valued by considering postdeath events was central to the court’s holding in Propstra .
Since the claim for California income tax was contingent, the Ninth Circuit held that it could consider the postdeath settlement of the claim. Because the Naify trust had not pointed to any other event that rendered the amount of the claim certain, the Ninth Circuit affirmed the district court’s holding that the settlement amount was the proper value of the claim.
While courts often use a probability analysis to determine the discount factor to use in calculating the value of a claim or asset, the probability that they should consider is the probability of what the claim or asset actually is worth based on the relevant facts in the case. Here, the Naify trust tried to use the probability that the California Franchise Tax Board would allow its tax avoidance plan as a discount factor. As the Ninth Circuit found, the probability of the plan’s being successful did not prove anything with respect to the actual value of the claim against the estate at the time of Naify’s death. To hold otherwise would have allowed the estate to deduct millions of dollars in state taxes that it never actually paid.
As the Ninth Circuit pointed out, the regulations support the idea that a postdeath settlement determines a claim’s value (Regs. Sec. 20.2053-1(b)(3)). Here the actual amount of tax due became determinable when the estate settled the claim with California. To argue that the court was precluded from using the actual value and instead required to use the possible value as determined at the time of death seems like overreaching.
Marshall Naify Revocable Trust, No. 10-17358 (9th Cir. 2/15/12)