Wealth

Tax Court Rules Debts Weren’t Deductible from Decedent’s Estate

In Estate of Bernard J. Macelhenny, Jr. v. Commissioner, the Tax Court ruled on two separate but related issues: (1) whether the estate may properly deduct the value of two consent judgments entered against the decedent; and (2) whether decedent’s children received taxable gifts by purchasing property at a discount. 

Son Purchases Judgment

In 2011, pursuant to a settlement agreement signed by New Healdsburg Venture, LP (of which decedent held a limited partnership interest, referred to here as the LP), the decedent, the general partner (GP) (who had acted as guarantor to the original debt) of the LP (all as debtors) and Union Bank (as creditor), the parties stipulated to Union Bank obtaining a judgment against the borrowers for a $6.5 million debt. In early 2012, the decedent suffered a series of embolic strokes that severely incapacitated him – the decedent’s son (Son) thereafter managed the decedent’s financial affairs under a conservatorship. The judgment against the decedent demanded that the decedent pay Union Bank a second installment payment by Aug. 31, 2011. Son, acting on behalf of the decedent, was unable to make the payment, and Son (individually) purchased Union Bank’s judgment against decedent (that is, Son “stepped into the shoes” of Union Bank as a creditor of the decedent). Son’s attorney advised him that this debt could be used to offset the purchase price of any assets of the decedent’s estate that Son might wish to purchase. Son’s business partner paid $2.65 million to Union Bank in purchase of the judgment (a presumed loan, although based on the case text, there doesn’t appear to have been a formal loan agreement between Son and his business partner). Pursuant to a separate agreement between Son and the decedent’s daughter (Daughter), Daughter obtained a 50% interest in the judgment acquired by Son. Ultimately, in September 2012, Son and Daughter had a judgment of $6 million at 10% annual interest against the decedent, the LP and the GP of the LP (the Union Bank judgment).

In a similar (but separate) fact pattern, Son acquired a judgment against the decedent for $865,517 at 10% annual interest (the Westamerica judgment).  

Both the Union Bank judgment and the Westamerica judgment were filed with the Sonoma County Superior Court.  

Purchase of Property

In October of 2012, the trustees of the decedent’s revocable trust (Son and Daughter were two of the three acting trustees) transferred 50% interests in the “El Mercado property” to each of Son and Daughter for a stated price of $4.75 million. The purchase agreement provided that Son and Daughter assumed an existing mortgage of $1,614,391 and received a credit for the remainder comprised of: (1) the amount paid to acquire the Union Bank judgment; and (2) a further offset against the Union Bank judgment. Simultaneously with the sale, Son and Daughter contributed the El Mercado property to a Delaware limited liability company (LLC) and then borrowed $4.75 million from UBS Real Estate Securities, Inc. in exchange for a security interest in the El Mercado property. The LLC used the borrowed funds to: (1) pay off the $1,614,391 mortgage encumbering the El Mercado property; and (2) repay Son’s business partner the $2.65 million loaned to Son for the purchase of the Union Bank judgment. Note that the decedent’s revocable trust would have left the El Mercado property equally to Son and Daughter on the decedent’s death.  

The decedent didn’t file a gift tax return for 2012. In July of 2016, executors of the decedent’s estate filed the decedent’s estate tax return, which claimed a $3,638,083 deduction attributable to the remaining value of the Union Bank judgment and a $1,007,320 deduction attributable to the Westamerica judgment (now assigned to Son and Daughter). The Internal Revenue Service disallowed both deductions.  

Debts Not Bona Fide

The IRS asserted that the debts owed by the decedent to Son and Daughter (the Union Bank judgment with respect to Son and Daughter, and the Westamerica judgment with respect to Son) aren’t “bona fide debts” and therefore aren’t deductible from the decedent’s gross estate. The court noted that no deduction is permitted “to the extent [the claim] is founded on a transfer that is essentially donative in character (a mere cloak for a gift or bequest).” Some of th factors to consider when determining whether claims are bona fide include whether the claim: (1) occurs in the ordinary course of business (the court held it didn’t); (2) is related to an expectation or claim of inheritance (it was); and (3) originates pursuant to an agreement between the estate and a family member (it did).  Another factor is whether the performance by the claimant is done pursuant to terms of an agreement (there was no real attempt by Son and Daughter to collect on the debt).

Son and Daughter argued that because the state court entered the assigned judgments, they were bona fide. However, the Tax Court notes that such a judicial decision is binding as to the estate’s deductibility only to the extent the state court actually passes on the facts on which the estate’s deductibility depends (which they didn’t in this case – the Sonoma Superior Court didn’t consider whether the claims continued to be decedent’s personal obligation after the assignments were made). The Tax Court further notes that Son was on both sides of the transaction, representing the decedent under conservatorship and as the assignee to creditor’s rights. There was no evidence that the attorneys on either side of Son’s multiple roles actually negotiated, and so the assignment wasn’t negotiated at “arms length.”  

The court further noted that Son and Daughter haven’t taken any action to collect on their purported debts owed from the estate so far, and there was no reasonable certainty of payment, which in itself renders the debts as not being deductible.  

Gifts Received

Further, because the Union Bank claim wasn’t a bona fide liability once assigned to Son and Daughter, that reduction in debt isn’t consideration as to the decedent’s “sale” of the El Mercado property to Son and Daughter.  Therefore, the court held that Son and Daughter each received gifts of $967,805 pursuant to the transfer of the El Mercado property to them in 2012. 

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