The United States Tax Court recently decided a case where the issue was the role that a tax return due to the decedent played in overall estate tax liability. The Estate of Russell Badgett, Jr. et al v. Commissioner, T.C. Memo 2015-226 (Nov. 24, 2015) dealt with a very large overpayment of taxes by the decedent during his last full calendar year of his life. The estate failed to include the value for the tax returns that Mr. Badgett, Jr. (or his estate as it were) received, which ultimately undervalued the estate a rather significant amount.
The Internal Revenue Service indeed caught this accounting error and sent out a notice of deficiency approximately a year and a half after the filing of the last tax return. The Tax Court ruled in favor of the Internal Revenue Service because estate tax returns must list all the property that an estate owns. The Tax Court cited an United States Supreme Court case that held that state law defines what property rights, while federal law defines what property is taxed. Morgan v. Commissioner, 309 U.S. 78, 80 (1940).
THE CASE OF MR. BADGETT, JR.
Mr. Badgett, Jr. was a very successful Kentucky mine owner and mining engineer, where he was one of the pioneers in strip mining. He also previously owned his own bank. When he passed away in March, 2012 he still did not file his tax return for 2011. When it was filed it was discovered that he paid $429,315 too much. The same return requested that $25,000 of the overpayment be credited towards his tax liability for 2012. In December, 2012 the estate filed an estate tax return which did not include the value of the 2011 or 2012 tax returns. The estate for Mr. Badgett, Jr. then filed a personal tax return in April, 2013.
The personal tax return of April, 2013 noted that Mr. Badgett, Jr. incurred $10,874 in tax liability. With the $25,000 pre-payment from the 2011 tax return, Mr. Badgett was due $14,126 as a tax return. It was the collective amounts of these two tax returns that were not included in the value of the estate. Consequently, the Internal Revenue Service sent a notice of deficiency to Mr. Badgett, Jr.’s estate for $146,454 for not including these amounts as part of the value of the estate.
THE STATE LAW
The Russell estate did not pay the deficiency and disagreed with the Internal Revenue Service that the tax return amounts were taxable. More specifically, Kentucky law requires that the property be in existence at the time that tax liability was imposed. A mere expectancy is insufficient to create tax liability. Since Mr. Badgett passed prior receiving the tax return money, no tax liability attached. The Tax Court disagreed. While Mr. Badgett, Jr. did not have the tax return money in his account at the time of passing, his estate had the right to compel the Internal Revenue Service to pay him the monies due and owing from previous years. As such, the estate had those monies, or more accurately, had the right to those monies. The legal right to something is more than a mere expectancy. The Tax Court cited specific Tax Court caselaw that holds that previous tax return monies must be specifically included as property of the estate in tax returns.
As this case demonstrates, it is critical to have the aid of an experienced estate planning attorney who understands the tax implications of your actions and the unique state law issues that may affect your situation.