Estate Did Not Permanently Set Aside Funds for Charitable Purpose When It Knew of Possibility of Prolonged Litigation

The Tax Court had to decide when a part of the gross income of an estate is considered “permanently set aside” for a charitable purpose as defined in IRC §642(c)(2) in the case of Estate of Belmont v. Commissioner, 144 TC No. 6.  In such a situation an estate would be allowed a charitable contribution deduction for the year in which this occurred.

Charitable contribution deductions for estates and trusts are governed by IRC §642(c).

IRC §642(c)(1) provides the general rule, which states:

In the case of an estate or trust (other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a), relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

Under a special rule, estates may qualify for the deduction if they “set aside” such funds from income.  This is governed by IRC §642(c)(2) which provides, in part:

In the case of an estate...there shall also be allowed as a deduction in computing its taxable income any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a purpose specified in section 170(c), or is to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, or for the establishment, acquisition, maintenance, or operation of a public cemetery not operated for profit.

The decedent’s estate consisted of her residence, an interest in a condominium in California and the remaining balance due from a retirement account.  For the estate year ended March 2008 the estate received a distribution of just over $240,000 from the retirement plan which was taxable as income in respect of a decedent.  The estate also received proceeds of $217,900 from the sale of the decedent’s estate.

Under the terms of the estate, $50,000 was left to the decedent’s brother with the remainder to a charity.  As of March 31, 2008 the estate had just over $285,000 remaining in its checking account.

On the March 31, 2008 Form 1041 the estate claimed a deduction of $219,580 for a charitable contribution, stating the funds had been permanent set aside for a charitable purpose.  This represented the retirement fund distribution reduced by the federal income tax withheld on that distribution.  The return was prepared by a CPA.

However there was a fact the CPA was not made aware of when preparing the return.  The decedent’s brother was living in the condominium in California at the time and claimed he had an arrangement with his sister that he could live in that property until he died. 

The brother approached the estate initially with an offer to exchange his specific bequest of $50,000 for recognition of the validity of his life estate. 

The charity to receive did not want to hold real estate, so the estate in February 2008 sent the brother a letter indicating that because the charity did not want to hold real estate he could not purchase a life estate and offered instead that he vacate the condominium in exchange for a $10,000 stipend from the foundation.

On April 2, 2008 the brother filed a creditor’s claim against the estate in the ancillary probate in California.  The estate decided to contest this action, resulting in significant legal fees as well as additional costs for the continued administration of the estate.  The brother was awarded the life estate by a California probate court, at which point the estate filed an appeal.  The estate lost the appeal, with appellate court sustaining the original court ruling.

At the time of the Tax Court trial there was only $185,000 remaining in the estate’s checking—clearly less than the amount the estate had claimed was “permanently set aside” for charitable purposes.

Under Reg. §1.642(c)-2(d) an amount is “permanently set aside” if “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.”  The estate argued that it met this requirement.

The estate pointed out that the entire residuary of the estate was to be transferred to the charity, and that at the time the estate tax return was filed the trust had more than enough assets that were not derived from estate income to pay remaining liabilities existing at that date.

The IRS argued that the estate was aware at March 31, 2008 that there was a significant chance that the decedent’s brother would contest the estate’s attempt to boot him out of the condominium, and that such litigation could be expensive and prolonged, resulting in the estate using these “set aside” funds to continue the contest and pay administrative expenses.  Thus no deduction should be allowed on the March 31, 2008 income tax return.

However the estate protested that there no reasonably foreseeable possibility that it would incur the substantial costs that it incurred due to the dispute with the brother. 

The Tax Court ultimately sided with the IRS.  The court noted it had not previously dealt with this sort of situation as provided for under IRC §642(c), but the court had looked at similar language under IRC §170 (the general charitable contribution standard for other taxpayers).

The Court summarized that view of “so remote as to be negligible” as follows:

In 885 Inv. Co. v. Commissioner, 95 T.C. 156, 161 (1990) (quoting United States v. Dean, 224 F.2d26, 29 (1st Cir. 1955)), we defined “so remote as to be negligible” as “‘a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction’”.  In Briggs v. Commissioner, 72 T.C. 646, 657 (1979), aff’d without published opinion, 665 F.2d 1051 (9th Cir. 1981), we construed the standard as being “a chance which every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance.”  With these interpretations in mind, we will consider the facts and circumstances of the matter sub judice to determine whether the possibility that the estate would invade the money set aside for the foundation was “so remote as to be negligible”.  See Graev v. Commissioner, 140 T.C. at 394; sec. 1.642(c)-2(d), Income Tax Regs.

The Court then looked at the brother’s (David) claims:

The information that was known or reasonably knowable to the estate when it filed its Form 1041 on July 17, 2008, indicates that David’s claim to a life tenancy interest in the Santa Monica condo was a serious claim based on alleged events that predated the end of the taxable year ending March 31, 2008.

The responsibility of the estate in claiming a charitable contribution deduction pursuant to section 642(c)(2) was to marshal information pertaining to the taxable period in order to prepare its return.  Using such information the estate was required to make a judgment regarding the possibility that the funds ostensibly set aside for the foundation might be depleted for another purpose (i.e., litigation over the Santa Monica condo).

The Court pointed out that, if nothing else, the mere passage of time would cause the estate to incur significant expenses if the estate could not be closed due to the dispute. 

The Court pointed out:

As of March 31, 2008,after subtracting the funds that had been ostensibly set aside for the foundation, there was “approximately $65,000” remaining in the estate’s residue to cover the remaining expenses associated with the estate administration.  When the estate filed its Form 1041 on July 17, 2008, there were no income-producing assets remaining in the estate.  From the amount remaining in its residue, the estate was responsible for various expenses.  First, the estate was responsible for paying homeowners association fees and property taxes associated with the Santa Monica condo.  Second, because the estate administration in Ohio could not be closed until the ancillary proceeding in California was concluded, the estate was responsible for attorney’s fees to Mr. Flaherty.  The attorney’s fees paid to Mr. Flaherty for his work on the Ohio estate administration were not insignificant.  For example, from April 1, 2008, to March 23, 2009, the estate paid Mr. Flaherty$29,548.15.  Finally, the estate was responsible for attorney’s fees to Hoffman, Sabban & Watenmaker for the administration of the ancillary estate in California. These fees included an upfront fee of $13,000 and approximately $350 to $450 per hour for any extra legal services related to potential litigation or an appeal.

Thus, the estate knew the possibility was not “so remote as to be negligible” that the funds it claimed to have set aside permanently for the charity would end up being used for legal fees and/or continued administration of the estate.