Divorce, Death and Deductions

Divorce, Death and Deductions

When a divorce settlement requires an ex-spouse to make a testamentary bequest to children what are the implications for estate taxes and the spousal right of election? Divorce attorneys often do not consider these questions when negotiating divorce settle­ments.
 
Is the bequest estate tax neutral because the value of assets bequeathed is offset by a deductible claim against the estate? For an obligation to make a bequest to qualify as a deductible claim the following must be met:
·              the claim must be an allowable and enforceable personal obligation of the decedent under the laws of the jurisdiction where the estate is adminis­tered; and
·               the claim must represent a bona fide obligation contracted for full and adequate consideration in money or money’s worth.
 
                It isn’t easy to satisfy these requirements since the decedent’s death may occur long after the divorce when information regarding the circumstances may be hard to obtain. It is the taxpayer who bears the burden to prove the estate’s entitlement for the deduction and to demonstrate that all the statutory conditions to the deduction are met.
 
               The courts have had a tendency to rule that where a spouse’s sup­port rights are exchanged for transfers to adult children the transfers are not deductible. One critical question seems to be whether the ex-spouse used the occasion of entering into such an agreement as a way to avoid estate taxes on what would otherwise have been a gift to the chil­dren. If one of the divorcing spouses does not give up something in order to obtain such a bequest to the children then the bequest will probably not be an estate deduction.   
 
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But, in Kosow v. Commissioner of Internal Revenue, 75 AFTR 2d 95-1272, 45 F 3d 1524, 95-1 USTC 60190, the decedent’s promise in a separation agreement to make bequests to his two sons was supported by full and ade­quate consideration in the form of reduced support and fore­gone marital rights by his former spouse. The spouse testified that she had accepted lower support in order that the decedent agree to make a substantial bequest in his Will to the children. Subsequently, the decedent died and the children obtained a settlement against the estate for the bequest in the amount of $4 million. It is important to note that in this case the IRS stipulated that the settlement agreement in the divorce was bona fide resulting from arms-length bargaining by separate counsel and was not an attempted subterfuge to avoid the payment of taxes.
 
In Private Letter Ruling 200011008 the IRS distinguished the Kosow v. Commissioner of Internal Revenue case and found that the bequest to children under a divorce decree was not for full consideration. In that letter ruling the controversy was over life insurance proceeds payable to a spouse or designated children beneficiaries. The IRS pointed out that the children were adults at the time of the settlement agreement and that there was no evidence that the spouse accepted a lower than normal support award in order to obtain the ability to restrict the decedent’s desig­nation of the life insurance beneficiaries. 
 
A separate problem arises with respect to the rights of any surviving spouse with respect to property bequeathed to children pursuant to the obligation arising in a prior divorce. Are such bequests subject to diminution by reason of the exercise of the right of election?  
 
The New York spousal right of election entitles the electing surviving spouse to a pecuniary amount equal to 1/3rd of the “net estate.” The estate includes:
·        all property “passing” under decedent’s Will,
·        all property qualifying as a “testamentary substitute,” and
·        all property passing to distributees under the laws of intestacy should de­cedent not have a Will.
 
To arrive at the “net estate” the decedent’s debts, funeral expenses and estate ad­ministration expenses are deducted.
 
Once the pecuniary value of the elective share is determined and any testamentary dispositions, distributive share or testamentary substitutes passing to the surviving spouse are deducted, then the remaining amount due as an elective share must be satisfied on a pro rata basis from the other estate beneficiaries. 
 
A previously divorced testator often is required to make specified testamentary dispositions in connection with a separation agreement. As a general rule, these testa­mentary provisions are subject to the right of election.
 
For example, in In re Dunham, 36 A.D. 2d 467, 320 N.Y.S.2d 951, 1971 LEXIS 3988, appeal denied, 29 N.Y. 2d 485, 274 N.E. 2d 753, LEXIS 2194, 325 N.Y.S.2d 1025 (1971), the testator, in a separation agreement with his first wife, agreed to bequeath her his stock in a closely-held corporation, which he did. His second wife elected against the Will and the court held that the second spouse’s right of election was superior to the agree­ment to make a testamentary disposition. Thus, the first wife was required to make a pro rata contribution to the elective share.
 
A more recent case In re Calligaro, 19 Misc. 3d 895, 855 N.Y.S.2d 873, 2008 N.Y. Misc. LEXIS 1913, the Surrogate reached a different result with respect to a separation agreement obligating the decedent to designate his daughter as a beneficiary of his pen­sion until the daughter reached majority. Because the daughter had a claim against the estate that was established prior to the surviving spouse having an interest in the pension payments those benefits were not subject to the right of election. The surviving spouse could, however, elect against pension payments payable to the daughter after she reached her majority since those payments were made at the voluntary option of the decedent.
 
The best response to these cases is to obtain from the second spouse a limited waiver of the right of election with respect to the specific assets. If that is not possible the divorced spouse could make a lifetime gift of the asset required to be bequeathed by the term of the separation agreement. If the gift is not in contemplation of death then it will not be a “testamentary substitute” and will not be includable in determining the elec­tive share. The divorcing spouse and such spouse’s counsel should realize that neither of these alternatives are likely or within their control and it would be much better to require a transfer at the time of the divorce. Alternatively, the separation agreement could require the ex-spouse to carry life insurance payable to the divorced spouse or children as life insurance is not subject to the right of election.  Such alternate planning would avoid an otherwise messy and expensive result at the ex-spouse’s death. 
 
Resources
·        IRC §2043, §2516, §2053
·        N.Y. EPTL §5-1.1-A
·        Warren’s Heaton on Surrogate’s Court Practice §73.02[7][e]