When Settlement Agreements Create Unexpected Income Tax Consequences

This article addresses the unexpected income tax consequences that can arise when estate or trust disputes
are resolved by settlement agreement.

There are many reasons why beneficia­ries enter into settlement agreements to resolve disputes arising in the course of administering an estate or trust includ­ing the following:

1. The beneficiaries may voluntarily want to change the terms of distri­bution set forth in a will or trust.
2. A child who was estranged from his
   parents may challenge the terms of a will or trust after his parents are deceased when he is either omit­ted entirely as a beneficiary or is granted a lesser bequest than his siblings.
3. The decedent’s children may chal­lenge the larger bequest one child receives which they claim was the result of undue influence when their parents were drafting their estate plan.
4. The children may be satisfied with the terms of the will or trust but object to how one sibling who is named as the fiduciary is adminis­tering the estate.

In re Raymond T. Conley Trust¹ involves litigation brought by two of the dece-dent’s children challenging the admin­istration of a trust created by their parents in which the parent’s third child, Maureen, was named as trustee. The suit alleged that Maureen breached her fiduciary duties. An agreement was ultimately reached to resolve how the trust administration should be settled. Pursuant to the terms of the settlement agreement, the two children who chal­lenged their sister’s administration of the trust received cash distributions, and Maureen received, as her share, a residence owned by the trust.

The children who received cash distributions thought that the settle­ment agreement resolved all remaining issues. They did not anticipate that they would be receiving a Schedule K-1 (Beneficiary’s Share of Income, Deductions, Credits, etc.) from the trust showing their respective share of the trust’s distributable net income. The income realized by the trust was due to the fact that the fair market value of the residence at the time of distribution to Maureen was greater than the trust’s adjusted basis in the property. The two children who received monetary distri­butions from the trust took the position that any responsibility resulting from Maureen’s in-kind distribution of the house should be borne entirely by her. The court reasoned that the issuance of the Schedule K-1 was an obligation of the trust that was a natural result of implementing the settlement agree­ment. Each beneficiary was responsible for his respective obligations associated with the settlement including a pro rata share of the resulting tax liabilities.

Conley serves as a wakeup call that income tax consequences need to be considered whenever there is a settle­ment of estate and trust litigation.

DISTRIBUTION THROUGH ESTATE ADMINISTRATION V. SETTLEMENT OF LITIGATION

When does it make a difference for income tax purposes whether beneficia­ries receive distribution in the course of normal estate administration versus as a result of a settlement of litigation?

Gift, bequest, devise, or inheritance.

The Code is very clear that the value of property acquired by gift, bequest, devise, or inheritance is not income to the beneficiary.² Nonrecognition on death is among the strongest tenets inherent in the income tax law.³ For federal income tax purposes, the characterization of a payment received upon settlement of a lawsuit depends on the nature and ori­gin of the claim upon which the lawsuit was based.⁴

A payment in settlement of a will contest can be considered acquired by bequest, devise, or inheritance and, thereby, excluded from gross income under Code Section 102(a). In Lyeth v. Hoey,⁵ the taxpayer received a small legacy from his grandmother, who left the majority of her estate to a trust established to preserve “the records of the earthly life of Mary Baker Eddy,” the founder of the Christian Science religion. The taxpayer joined other heirs in oppo­sition to probate of his grandmother’s will. Eventually, the parties involved entered into a settlement in which the decedent’s individual heirs and the trust effectively split the estate’s assets between them. The Commissioner determined that the cash and stock received by the taxpayer as a result of the settlement must be included in his income. The Supreme Court disagreed. The Court observed that “EImn exempt­ing from the income tax the value of property acquired by ‘bequest, devise, or inheritance,’ Congress used compre­hensive terms embracing all acquisi­tions in the devolution of a decedent’s estate.”⁶ The Court then disregarded the form of the taxpayer’s challenge to his grandmother’s will to focus on his status as an heir. The Court concluded that:

The portion of the decedent’s prop­erty which petitioner obtained under the compromise did not come to him through the testator’s will. That portion he obtained because of his heirship and to that extent he took in spite of the will and as in case of intestacy. * * *7

There may be more than one rea­son why parties enter into a settle­ment agreement. The Fifth Circuit has held that "where the rationale of Lyeth is implicated but where, in addition, the transaction resembles a sale or exchange of property, we think that Lyeth governs unless it may be said that the circumstances surrounding the transaction fairly exclude the possibility that the exchange is in reality a compro­mise of an underlying and controverted claim such as one of gift, bequest or inheritance."⁸

The Conley court did not address the terms of the trust or how it provided for distribution of the assets among the decedents’ children had there not been litigation and a subsequent settle­ment agreement. However, there is a good chance that distribution pursuant to the trust agreement would not have caused the beneficiaries to recognize any income. If the trust agreement pro­vided that the home was to be specifi­cally bequeathed to Maureen, then there would not have been gain to either the trust or to the beneficiaries.⁹ A similar result would have occurred if the trust agreement provided that each ben­eficiary was to receive a pro-rata (1/3) share of the estate. This is because the estate does not recognize income when the estate makes distributions of prop­erty to satisfy a fractional interest of the residuary estate as opposed to a pecu­niary bequest.¹⁰

PECUNIARY BEQUESTS.

Although specific bequests received by a beneficiary do not cause the ben­eficiary to realize taxable income, an estate or trust recognizes income when it distributes property to beneficiaries which has appreciated in value to sat­isfy a pecuniary bequest. In Kenan,¹¹ a decedent’s will provided that a benefi­ciary was to receive $5 million when she attained 40 years of age. The will pro­vided that the trustees were authorized to satisfy the bequest either in money or in securities equal in value to the sum to be paid. The trustees satisfied the bequest partly in cash and partly in securities. The court held that satis­faction of the bequest with securities caused the trust to recognize income to the extent that the fair market value of the securities exceeded their tax basis. The court reached its finding based on what is now Section 1001(a) which provides that "the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis."

The Kenan court distinguished the situation where a trust satisfies a pecu­niary bequest with appreciated property from where an estate distributes a spe­cific legacy to the beneficiary. In Kenan, the beneficiary was never in the position occupied by the recipient of specific securities under a will. She had a claim against the estate for $5 million, payable either in cash or securities of that value, but had no title or right to the securi­ties until they were delivered to her by the trustees after the exercise of their option. She took none of the chances of a legatee of specific securities that the securities might appreciate or decline in value between the time of the death of the testator and the transfer to her by the trustees.

Pecuniary bequest v. residual bequest.

What if an estate does not have suffi­cient assets to make final distribution of a pecuniary bequest, but instead makes distribution of appreciated property in an amount which is insufficient to com­pletely satisfy the bequest? In Rev. Rul. 66-207, the IRS described the income tax consequences where the decedent’s will made a bequest of a specific sum of money in the amount of 250x dollars, but after payment of all debts, costs of administration, claims, and specific bequests, other than the 250x dollars specific bequest, the assets remaining in the estate had a fair market value of only 200x dollars and an aggregate basis to the estate of 150x dollars. All of these assets were transferred to the benefi­ciary in satisfaction of the amount it was to receive under decedent’s will. The Service ruled that although the assets remaining in the estate were insuffi­cient to completely satisfy the specific amount of the legacy, the bequest did not, for federal income tax purposes, become a bequest of the residue of the estate (a residuary bequest).

If the transfer were treated as a bequest of the residue, then it would not have been taxable to the estate. However, because it was treated instead as in satisfaction of a pecuniary bequest, the Service ruled that, based on the holding in Kenan, the estate realized gain or loss measured by the difference between the fair market value of the property distributed and the property’s tax basis. Treas. Reg. 1.663(a)-1(b)(1) pro­vides that in order to qualify as a gift or bequest of a specific sum of money or of specific property under Section 663(a), the amount of money or the identity of the specific property must be ascertain­able under the terms of a testator’s will as of the date of death. The bequest of unspecified property with a specified value at the date of distribution cre­ates a right to receive a ‘specific dollar amount’ under section 1.661(a)-2(f)(1) of the regulations. Therefore, gain or loss is realized by the estate upon a distribu­tion in kind to satisfy the specific dollar amount.¹²

The Service further ruled that no amount of the income realized upon transfer of the property to satisfy the bequest was deductible by the estate under Section 661 since the distribu­tion was in satisfaction of a bequest of a specific sum of money, as defined by section 1.663(a)-1(b) of the regulations.

Similarly, the beneficiary who received distribution of the property was not required to report the income under Section 662 when it received the distri­bution. Section 662 provides that there shall be included in the gross income of a beneficiary to whom an amount speci­fied in Section 661(a) is paid, credited, or required to be distributed. In other words, since the estate was not entitled to a deduction under Section 661, the beneficiary was not required to report the income under Section 662.

How does the estate pay the tax liability after it makes distribution of its remaining sole asset?

Capacity of beneficiaries entering into settlement agreement.

The rationale of Lyeth does not apply where the agreement among the estate beneficiaries is made in a capacity other than as heirs or as beneficiaries of the decedent’s estate. In Estate of Vease,¹³ the beneficiaries of decedent’s estate mutually agreed to modify the terms set forth in the decedent’s signed will, which was submitted to probate by the terms set forth in an unsigned will made subsequent to the signed will. The probated will provided that one of the decedent’s daughters (Elizabeth) was entitled to receive a portion of her mother’s estate outright upon attaining a prescribed age. Pursuant to the terms of the agreement made by the benefi­ciaries, the property Elizabeth received was transferred to a new trust in which she was granted a life estate, with other family members being named as con­tingent beneficiaries. The question was whether the assets remaining in this trust on Elizabeth’s death should be includible in her estate for federal estate tax purposes. The Tax Court referenced Lyeth where the Supreme Court decided in an income tax setting that a receipt of property assumes the nature of the underlying claim upon which it is based. The Tax Court held that Elizabeth received her life estate by inheritance, and therefore it was not includible in her estate for estate tax purposes.

The Ninth Circuit in Vease reversed the Tax Court and held that Lyeth was distinguishable. All of the parties to the settlement agreement were named in the executed will, and none of them challenged the probated will or any pro­vision thereof.

The basis of the family agreement was therefore not the standing of an heir or heirs to contest the will as a whole, or of a beneficiary under a previous will to question a provi­sion of a later will. Rather, it was the standing of each, as a beneficiary under the executed will, to agree upon a disposition of the property bequeathed and devised to all of them thereunder in a manner differ­ent from that provided in the will.¹⁴

The settlement agreement was noth­ing more than a voluntary rearrangement of property interests acquired under an admittedly valid will, concluded with­out duress of unsatisfied claims. The transfer to the trust was made from property Elizabeth received from the estate. She was treated as the grantor of the trust and the property was included in her estate pursuant to Section 2036. Although Vease was made in an estate tax setting, the rationale as to why Lyeth may not apply to a settlement agree­ment should equally apply to whether an agreement among beneficiaries gives rise to income tax.

It is not always clear in what capac­ity estate beneficiaries are entering into a settlement agreement. For example, in Ltr. Rul. 200112038 the Service found that an agreement among beneficiaries to resolve an ambiguous disposition under decedent’s estate plan was treated as a compromise of their claims against the estate, which was exempted from tax by Section 102, consistent with the provisions of Lyeth.

Ltr. Rul. 200315015 involved a genera­tion skipping trust created by grandfa­ther for the benefit of father and father’s lineal descendants. Father was granted a limited testamentary power to appoint the property among his lineal descen­dants. If he did not exercise the power of appointment, then the property passed by representation to father’s lineal descendants. Father exercised the power of appointment to create trusts for the benefit of father’s children. After father’s death, a dispute arose among father’s children and grandchildren con­cerning whether the power was exercis­able to appoint property only outright or whether the property could be appointed in further trust. In an attempt to avoid protracted litigation, the parties, which included the Trustee and father’s children and grandchildren, entered into a settlement agreement concerning how the power of appointment should be applied. The letter ruling provides that the parties to the settlement agree­ment would not recognize taxable income pursuant to Section 1001(a). The settlement agreement constituted a compromise between the children, grandchildren, and unborn issue of their claims against the Trust created pur­suant to the exercise of the power of appointment. The parties to the agree­ment will receive distributions from the settlement agreement because of their status as heirs based on Lyeth. Also, there was no modification of any benefi­cial interests in the Trust father created. Therefore, the terms of the settlement agreement, including the material ele­ments, did not result in the realization of taxable income by any party to the settlement agreement.

Kenan involved a situation in which an estate was required to recognize income where property which had appreciated in value was distributed in satisfaction of a pecuniary bequest. In some instances, courts have found that the beneficia­ries, and not the estate, must personally realize income when they receive cash distributions attributable to appreciated assets owned by the estate.

In Parker,¹⁵ the decedent died in 1944 owning a farm containing about 2,000 acres. There was no formal administration of the decedent’s estate. In 1964, 20 years after decedent’s death, two children of the decedent’s deceased daughter (i.e., decedent’s grandchildren) became aware of their entitlement to share in the estate. The estate brought an action to quiet title naming the two grandchildren as defendants. They in turn cross-claimed seeking their share of the estate, lost income, and puni­tive damages. The court dismissed the punitive damages claim. The parties subsequently entered into a settlement agreement whereby the two grandchil­dren received cash in satisfaction of their remaining claims. The portion of the settlement allocated to lost income was taxable to the grandchildren as ordinary income. The bulk of the settle­ment was attributable to the grandchildren's interest in the decedent’s estate. The value of the farm property had increased by a factor of 500 percent in the 20 years since the decedent died. As to the proceeds received in lieu of the fractional ownership claims to realty, Section 102, as interpreted in Lyeth, allows that portion received by reason of heirship and thus akin to “inheritance” to be excluded from taxable income. The court held that the value of the grand-children’s fractional interest computed as of decedent’s death was excludable from gross income under Section 102. However, where the taxpayer receives more in settlement than he would have received under a will or through intes­tacy, he must prove that the excess was something other than income from the property which is the subject of the inheritance claim. The court held that the portion of the settlement attribut­able to the appreciation in the value of the property constituted a taxable event taxed as long-term capital gains.

In Marcus,¹⁶ the Tax Court held that a beneficiary may be required to recognize income on a portion of the proceeds received pursuant to the terms of a set­tlement agreement where there was a valid compromise of the taxpayer’s claim to an inheritance under the decedent’s will. In Marcus, the taxpayer and her two sisters shared a remainder interest in their mother’s home which took effect upon the death of their stepfather. The taxpayer did not want to be a co-owner of the property with her sisters. An agreement was reached whereby the parties agreed to sell the property after their stepfather died and to distribute one-third of the net proceeds to the taxpayer. Judge Vasquez held that the portion of the proceeds received under the settlement agreement which repre­sented the corpus of the estate valued as of decedent’s date of death was excludable from an individual’s gross income under Lyeth. The court found that Lyeth controlled because there was a compromise of a disputed claim by the estate or its heirs, as opposed to a voluntary rearrangement of property interests amongst heirs. However, the court further held that the portion of the proceeds received which represented the increase in the value of the home as of decedent’s death represented a settlement of a claim for lost income that was includible in the beneficiary’s income. The character of the income is a capital gain.¹⁷

CONCLUSION

In Conley, the decedents’ children were not challenging the terms of their par­ents’ trust, in which they were all named as beneficiaries. The settlement agree­ment did not pertain to their status as heirs. Based on Lyeth, Section 102 should not apply so as to make the distributions non-taxable.

The fact that the beneficiaries in Conley made a settlement agreement whereby one beneficiary received real property and the other beneficiaries received cash does not necessarily mean that the distribution of the home was made in satisfaction of a pecuniary bequest. There was no mention in the case as to the value of the residence. The agreement merely provided that the two beneficiaries each agreed to receive the sum of $220,000 and that their sister would receive the home. The court did not make a finding that the cash dis­tributions were equal to the fair market value of the home at the time when it was distributed. Therefore, the Kenan rule, which stands for the proposition that an estate recognizes income based on the fair market value of the property distributed, was never fully addressed.

The question remains that in those instances where Lyeth does not apply, are there any situations where income need not be recognized when the settlement agreement provides that one beneficiary is to receive assets which have appreci­ated in value? The facts in Marcus are distinguishable in that the settlement agreement provided for the proceeds from sale of the estate’s sole asset to be used to pay the beneficiary’s pro-rata share of the net sale proceeds. There was an actual sale of the asset to a third party. In Marcus, the income realized on the sale needs to be realized either by the estate or by the beneficiary. But what if the asset is distributed to one of the beneficiaries in-kind without there being an actual sale?

Should it be relevant when the set­tlement agreement is made or by how much the estate property increased in value? In the case of Parker, the settlement agreement was made over 20 years after the decedent died, by which time the value of the estate property had increased five-fold. What if the settlement agreement is made during the normal course of administration and the property has not increased so dramatically in value? Are the beneficiaries required to obtain an appraisal to determine the property’s fair market value as of date of death and also as of the date of distribution?

Lyeth stands for the proposition that the income tax consequences should be the same regardless of whether an heir receives his share of an estate as a result of estate litigation or by means of a settlement agreement. However, should the income tax consequences depend on whether a fiduciary exer­cises discretion in the normal course of administering an estate by distrib­uting different assets including cash and property among the beneficiaries, which would not be taxable where the distribution is being made of the resid­uary estate, as compared to the situa­tion where the beneficiaries enter into a settlement agreement to determine among themselves what each is to receive?

End Notes 1                 N.W.3d , 2024 WL 3906499 (MI Ct. App. 8/22/24). 2      Section 102(a).

3    Estate of Bakemeyer, 147 TC 526 (2016).

4    Raytheon Product Corp., 144 F.2d 110

(1st Cir. 1944).

5    305 U.S. 188 (1938).

6    Id. at 194

7    Id. at 196

8    Early, 488 F.2d 166 (5th Cir. 1971). 9    See IRC Section 102(a) and Treas. Reg. 1.663(a)-1(a). 10    See Rev. Rul. 1982-4. 11    114 F.2d 217 (2d Cir. 1940) 12    See also Rev. Rul. 86-105.
314 F.2d 79 (9th Cir. 1963).
Id. at 87
573 F.2d 42 (Ct. Cl. 1978).
T.C. Memo 1996-190 (4/22/96).
See Note 15, supra.

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*Published in Estate Planning, a Thomson Reuters Journal*