Equitable Apportionment of Estate Tax Deficiency

L died in 1990, survived by his wife and six minor children. During his life, L’s mother created various family trusts; L exercised a power of appointment over these and other trusts to create various new trusts (N). However, the value of the N trusts was not included in L’s gross estate on the Federal estate tax return. On audit, the IRS found that the N trusts should have been included in L’s gross estate; the increase in the taxable estate led to an estate tax deficiency, which left the residual probate estate insufficient to pay the estate’s outstanding expenses.

Tax Court

In Tax Court, the parties stipulated that the N trusts would be included in L’s gross estate, but left it to the Tax Court to decide whether the resulting estate taxes were payable from N (the trusts that generated the tax) or a revocable trust (R) created by L three days before he executed his will. R provided that on L’s death, the R assets would be allocated between a marital trust (M) and a nonmarital residuary trust.

The Tax Court found that the R trust instrument provided for payment of estate taxes and legal costs if the residuary probate estate was insufficient, and that the estate taxes and legal costs should be paid out of R assets that otherwise would go to M. The estate appealed to the Seventh Circuit.

Analysis

Under Sec. 2056(b)(4), an estate is only required to pay estate tax on transfers not qualifying for the marital deduction, such as transfers to beneficiaries other than the surviving spouse. Typically, the resulting estate tax is paid from property that otherwise would pass to the surviving spouse, thereby reducing the marital deduction by that amount of Federal estate tax. State law controls, however, how the estate tax burden is allocated among the estate assets; see Riggs, 317 US 95, 101 (1942). Here, the decedent was domiciled in Illinois when he died, so that state’s law governs how his estate tax is to be allocated; see Caroline C. Doetsch, 312 F2d 323, 328 (7th Cir. 1963).

State law: Illinois has no statute specifying which assets of a taxable estate bear the burden of any estate tax, but the state’s default rule is equitable apportionment; thus, the estate tax burden is allocated pro rata to the portions of the taxable estate that generated the tax. “[L]ogic, reason, and simple justice dictate that, unless there is a contrary intention expressed by the decedent, as in a will in testate estates, the doctrine of equitable contribution should be invoked as to nonprobate assets to fairly distribute the federal estate tax burden” (Roe v. Farrell, 372 NE2d 662 (IL 1978)).

Intent: This leads to the ultimate question: whether L expressly intended not to have the rule of apportionment apply. L’s will specifically references R and directs that it governs the administration and distribution of the residue estate. Administration of L’s residue estate includes the payment of estate taxes and legal fees ordinarily payable therefrom. R states that it will, “to the extent that the assets of the Grantor’s estate...are insufficient, pay the...reasonable expenses of administration of his estate.” Thus, in his will, L gave specific instructions as to how the residual estate was to be administered and how the expenses of his estate were to be handled if the residue estate was insufficient, and sufficiently intended to negate the default rule of apportionment.

Scope: The estate also argues that the Tax Court erred in reviewing both the valid will and the N trust agreement to conclude that L intended to negate apportionment. However, no Illinois case limits the search for the decedent’s intent to negate equitable apportionment to the decedent’s will. The decedent’s intent, as expressed in the language of a will or a trust instrument, can control both the source of assets used to pay estate taxes and whether equitable apportionment applies; see, e.g., Harris Trust & Sav. Bank v. Donovan, 582 NE2d 120 (IL 1991) (construing both a trust instrument and a will to determine that the decedent’s “illegitimate” children, as defined by both the will and trust agreement, were disinherited by necessary implication); Frederick v. Lewis, 517 NE2d 742 (IL App. Ct. 1988) (construing the terms of a trust agreement to determine that it did not negate apportionment); Harris Trust & Sav. Bank v. Taylor, 364 NE2d 349, 354 (IL App. Ct. 1977) (construing the language of a trust instrument to determine an intent to preclude apportionment). Thus, the Tax Court properly considered both the trust instrument and the will to discern the decedent’s intent to negate the rule of apportionment.

Finally, the Tax Court correctly determined that legal costs associated with the audit and this litigation should be paid from the R assets. R directs that if the residuary probate estate assets are insufficient, then the estate’s remaining administration costs are to be paid from R assets. For all the foregoing reasons, the Tax Court’s decision is affirmed.

Est. of Robert H. Lurie, 7th Cir., 9/30/05