TAX TREATMENT OF WILL CONTEST RECOVERIES

by Robert W. Wood

I’ve long been preaching that taxes should be considered by litigants. One particular niche which has garnered surprisingly little attention is the tax treatment of will contest recoveries. An estate’s distribution of property to its beneficiaries generally does not result in taxable income to the beneficiaries. The same is true for most settlement amounts paid to contesting beneficiaries of an estate. See Chait v. Commissioner, T.C. Memo. 1983-272, T.C.M. (P-H) ¶83272, 46 T.C.M. (CCH) 169 (1983).

Compensation vs. Inheritance?
The primary line that is litigated concerning the tax aspects of will contests is between inheritance and the amorphous concept of gross income. It is axiomatic that gross income includes income derived from all sources. Yet, where a litigant in a will contest receives money or property in compromise of a claim as an heir, the receipt is held to be exempt from tax, even though under state law the money or property might not be regarded as received by inheritance for other purposes. See Lyeth v. Hoey, 305 U.S. 188, 38-2 U.S.T.C. ¶9602, 21 A.F.T.R. 986 (1938). See also Rhodes v. Commissioner, T.C.M. (P-H) ¶44301, 3 T.C.M. (CCH) 963 (1944).

Apparently it does not matter whether the plaintiff’s asserted claim as an heir of the estate is well-supported. If a settlement is reached, notwithstanding relatively shaky grounds of heirship, the recoveries are typically held nontaxable. See U.S. v. Gavin, 159 F.2d 613, 47-1 U.S.T.C. ¶9157, 35 A.F.T.R. 829 (9th Cir. 1947). But see several earlier decisions to the contrary, including Sterling v. Commissioner, 93 F.2d 304, 37-2 U.S.T.C. ¶9589, 20 A.F.T.R. 549 (2d Cir. 1937), cert. denied, 303 U.S. 663 (1938); and Kearney v. Commissioner, 31 B.T.A. 935 (1934).

Suppose a lawsuit makes claims for compensatory damages, as well as for amounts to recompense the plaintiff for having been overlooked as an heir? Here, the compensatory damages will have to be analyzed. In one case, a settlement amount was allocated between the claimants’ interest as overlooked heirs of an estate and their interest in compensatory damages for lost income from a partnership. See Parker v. U.S., 573 F.2d 42, 78-1 U.S.T.C. ¶9248, 41 A.F.T.R. 2d 78-888 (Ct. Cl. 1978), cert. denied, 439 U.S. 1046 (1978).

The most widely-known case in this area involved the eldest son of J. Paul Getty. In Getty v. Commissioner, 913 F.2d 1486, 90-2 U.S. Tax Cas. (CCH) ¶50502, 66 A.F.T.R.2d (P-H) ¶90-5517 (9th Cir. 1990), J. Ronald Getty’s $10 million lump-sum settlement of a lawsuit against competing beneficiaries of J. Paul Getty’s will was held not to be taxable. The Ninth Circuit Court of Appeals found that the money was excludable from Getty’s income under Section 102(a) of the Internal Revenue Code as property acquired by gift, bequest, devise or inheritance.

J. Ronald Getty had been the beneficiary of an irrevocable trust established in 1934 by J. Paul Getty and J. Paul Getty’s mother to provide income to J. Paul for life, and then to his children or their descendants. Nevertheless, J. Ronald  was cut out of these benefits. He filed suit against the Getty Museum, seeking an amount equal to the amount he and his children should have received from the trust. The trustees of the Museum entered into a settlement agreement under which Ronald would receive $10 million in exchange for dropping the suit.  Ronald did not report the $10 million on his tax return.

Ronald argued that the money was excludable as property acquired by gift, bequest, devise or inheritance. The IRS contended that Ronald’s claim was for income from property and was consequently not excludable. See I.R.C. §102(b)(2). Ronald had alleged that J. Paul promised to provide income to Ronald in his will equal to the income of the other children received from the trust. The Tax Court agreed with this approach, upholding the IRS’ assessment of a deficiency.

The Ninth Circuit reversed, holding that the settlement money qualified for exclusion. The Ninth Circuit viewed Ronald’s claim broadly, finding the complaint could be viewed as a claim for assets from J. Paul Getty’s estate in an amount equal to the amount received by the other children.

In Nancy C. Roberts v. Commissioner, T.C. Memo. 1995-171, T.C.M. (RIA) ¶95171, 69 T.C.M. (CCH) 2409, 95 T.N.T. 72-10 (1995), a woman caring for an aging man was promised a substantial sum upon his death. She sued for breach of contract, and after her death, her executors settled the suit for $50,000. The IRS determined that the settlement was taxable income to the now-deceased woman. The executor of her estate argued in Tax Court that the $50,000 was received as a bequest or inheritance. The Tax Court agreed, noting that the woman’s primary claim against the estate was for breach of contract with respect to a will.

Finally, in M. Bennett Marcus, et ux. v. Commissioner, T.C. Memo. 1996-190, T.C.M. (RIA) ¶96190, 71 T.C.M. (CCH) 2823 (1996), the Tax Court held that part of the net proceeds from the sale of property received by a woman was received by her in lieu of an inheritance and in settlement of claims against her stepfather’s estate. Accordingly, the Tax Court held this amount to be excludable from her gross income. There were somewhat complicated facts in the case, with the taxpayer entering into an agreement with her sisters in respect of some items. Ultimately, however, the Tax Court was able to point to the IRS since the IRS had actually admitted in its pleadings that the sisters had agreed to pay the taxpayer from the net proceeds as a substitute for a bequest of property. Thus, the language of the agreement between the sisters was given significant weight, even if it was not considered controlling.

When Will Contest Recoveries Are Taxable
Although the general rule is that a compromise of a will contest will result in nontaxable recovery, there have been some circumstances in which this rule has not been applied. In Edwards v. Commissioner, 37 T.C. 1107 (1962), acq., 1963-1 C.B. 4, a widow compromised her claim against her husband’s estate based upon a widow statute in exchange for a promise of monthly payments. The payments were from the income of an irrevocable inter vivos spendthrift trust which had been set up by her husband. The court held that the monthly payments were taxable to the widow because the primary responsibility for payments came from trust income.

In a similar case, Harrison v. Commissioner, 119 F.2d 963, 41-1 U.S.T.C. ¶9449, 27 A.F.T.R. 247 (7th Cir. 1941), a widow settled her claim with a residuary legatee, an educational institution. The educational institution paid her $100,000 plus $21,000 in interest. Although the $100,000 was held nontaxable, the interest was held taxable either as distributions in lieu of income from the trust, or as interest.

Compensation vs. Will Contest Recovery
Occasionally, an amount received by a person in a will contest may be viewed as compensation income. For example, in one case a woman filed suit against the estate of her boyfriend for the value of “wifely” services she rendered to the decedent during his lifetime. The settlement amount she received was held to be in the nature of compensation, and therefore taxable, rather than in the nature of a recovery for a gift, bequest, devise or inheritance. See Green v. Commissioner, 54 T.C.M. 764, 1987 P-H TC Memo 87,503 (1987), aff’d per curiam, 846 F.2d 870, 88-1 U.S.T.C. ¶9349, 61 A.F.T.R. 2d 88-1193 (2d Cir. 1988), cert. den., 109 S. Ct. 131 (1988).
 
In Mertz v. Hickey, 162 F.2d 403, 47-2 U.S.T.C. ¶9304, 35 A.F.T.R. 1482 (2d Cir. 1947), the taxpayer and another legatee jointly contested a will, each receiving a settlement. After the settlement, the taxpayer received an additional amount from the other legatee (his co-plaintiff) representing his part of the legal fees. Although the settlement in the will contest was held nontaxable, the additional amount designed to compensate for attorney’s fees was held to constitute taxable income.

Tax Treatment of Will Contest Recoveries, Tax Notes (November 26, 2001), p. 1198.