Don’t Forget About Taxes

Dealing with a loved one’s passing is difficult enough. When an inheritance or will end up in litigation, it only adds to stress and emotion. That there are tax considerations to be made when litigating disputes for either, it can be further disheartening and, worse, downright confusing.

Taxes are a real consideration. How litigation is resolved will have significant consequences to the way taxes are handled for an estate or trust.

Here is how some of that breaks down.

Estate Tax

Under certain conditions, tax deductions on an estate are allowed for administration expenses, transfers to a surviving spouse, and charitable transfers. The estate’s trustees must then identify and resolve the deceased’s assets, figure out liabilities, and dispose of the deceased’s estate. After the taxable estate has been determined, the gross estate tax, before authorized credits, is calculated based on tax rates.

Litigation

What can throw tax calculations entirely off is the prospect or enactment of litigation. What happens when the validity of a will or trust is challenged? New expenses will arise in legal and accounting fees, and the disposition of assets may change. During proceedings, it may come out that certain assets don’t belong to the estate or that particular beneficiaries or charities should not have received benefits. Separate or combined, such determinations made during litigation will affect the estate’s value and, hence, its taxes.

These can affect real changes to the end settlement. The more worrying part, however, is how rarely the tax treatment of the settlement is considered. Failure to take taxes into account earlier in the process can result in a more expensive tax bill than would have been initially necessary.

Litigation Expenses

Administration expenses incurred in the administration of the estate are allowable deductions in most cases. Examples of such costs would include collecting assets, payment of debts, and distribution of property. Expenditures that are not essential to the settlement of the estate are not allowable. These would include any claimed expenses that individually benefit the heirs. For an administrative cost to be permitted, it would have to help the estate as a whole. If there is any difficulty determining the distinction, the trustee should consult with an experienced tax attorney.

Resolving an Estate Tax Return and Payment

Typically, an estate tax return must be filed and paid within nine months of the deceased’s passing. One can apply for an extension for filing, but even then, it will only add six months to the timeline, and being granted an extension for payment is more challenging. The estate would have to demonstrate good reasons for such a delay.

Because litigation can last a long time, it’s possible that a contest will not be resolved by the filing due date. In that case, the amount of estate tax owed may not be yet determined, so the trustees must state the nature of the will or trust dispute on the return.

Just the same, the IRS will still expect a payment. The trustee will have to determine how much estate tax to remit while the outcome of litigation is still pending. In calculating this, the trustee should consider the expected litigation costs and be aware that a refund could be claimed in the case of overpayment. Note, however, that if litigation appears it will extend past the time limit for claiming a refund, the trustee should be prepared to file a timely refund protective claim.

In the meantime, you hope a settlement comes soon.

Settlements and the IRS

Until now, we’ve only considered taxes and estate litigation in terms of federal tax law. However, whether or not the IRS will respect an estate’s taxable value associated with litigation outcomes depends a lot on how federal tax law and state property law meet.

The federal estate tax is based on the property rights of the deceased. This includes all assets owned at the time of death, any liabilities or other creditors owed monies, and the nature of the beneficiaries receiving assets after liabilities are settled. While federal estate tax is based on property rights, the property rights themselves tend to be determined under state law. This includes how state law handles issues under litigation.

In the case of a will or trust contest, the case’s adversarial nature may be a determining factor in any federal tax expectations regarding the settlement. The IRS is free to review applicable state law to see if the settlement is in line with property rights under state law.

In the end, the IRS may not be bound by the results of litigation.

Thinking Ahead On Taxes

There are many reasons to want to avoid litigation when planning your estate. The confusion and hassle surrounding the inevitable taxes are some of those reasons. To avoid all that, it’s best to have a substantial estate plan drawn up, so there are as few surprises as possible for your beneficiaries after you’ve passed.

Thinking ahead is essential. That’s why you should work with a trusted law firm experienced in estate law like HML. We can help you with your estate plans, trusts, and wills, so you don’t have to worry about what happens in the future. And should you find yourself in the position of having to challenge a will or trust, you can contact us for a free case evaluation.

We will work hard on your behalf.