In Estate of Heller,1 the Tax Court addressed a question of first impression: whether an estate may take a theft loss that befell property it didn’t hold directly. In this case, the estate owned an interest in a limited liability company (LLC), whose only assets were investments held by Bernie Madoff. Although the value of the LLC was undisputedly reduced by Madoff’s Ponzi scheme, the Internal Revenue Service argued that a deduction under Internal Revenue Section 2054 wasn’t appropriate, as the theft occurred to the assets of the LLC and not to the estate itself. The court read the statute in a way that permitted the estate to take the loss for the theft of LLC assets based on a purportedly plain reading of the statute’s text and the policy reasons behind it. In light of this decision, it’s interesting to apply the Tax Court's reasoning to a question not presented in this case—whether a deduction under IRC Section 2054 would be appropriate if a loss occurred to property includible in the decedent’s gross estate but that didn't pass through probate.
Section 2054 permits the deduction of certain losses that occur during the estate administration period, specifically for “losses incurred during the settlement of estates arising from fires, storms, shipwrecks, or other casualties, or from theft, when such losses aren't compensated for by insurance or otherwise.”2 As with the deduction available under Section 2053, an estate may deduct a loss for estate tax purposes or income tax purposes, but not for both.3
Compared with IRC Section 2053 (deductions for expenses, indebtedness and taxes), which is surrounded by detailed regulations, substantial guidance from the IRS and a large body of jurisprudence, there’s very little guidance available for Section 2054. This alone makes the Heller case interesting. Most of the case law and guidance that’s available is related to what type of events cause a loss that will qualify for a deduction. For example, a loss to an estate’s property caused by an earthquake qualifies as a loss arising from “other casualties,” but a loss to an investment as result of the United Kingdom leaving the gold standard doesn’t qualify as a loss arising from “other casualties” under Section 2054.4 To determine the events that will qualify for a casualty loss deduction, the IRS and taxpayers may look the principles related to the parallel income tax provision under IRC Section 165.5
While the type of losses that will qualify for the deduction is fairly clear, one issue that’s been and remains uncertain is the required proximity of a loss to an estate. An asset an estate holds directly and which suffers a casualty loss clearly qualifies. For example, if a house was titled in the name of the decedent and burned down uninsured prior to distribution, the estate could deduct the loss under Section 2054. On the other hand, a loss suffered to an asset previously held by an estate but after it was distributed out to a beneficiary wouldn't qualify.6
Between these black and white answers has lingered a substantial gray area. How might the result change if the house were titled in the name of a business entity that was directly held by the probate estate?7 What if the house were instead titled in the name of a revocable trust or a qualified personal residence trust that, under state law, never touches the estate despite the inclusion of the property in the decedent’s gross estate for tax purposes? Because the estate never distributes the house, which in both scenarios is a non-probate asset, it was unclear whether the estate may deduct losses that occur to such assets during the estate administration period. Heller answers the first question only.
The Heller Case: A Case About Proximity and Not Type
James Heller died on Jan. 31, 2008. His estate held a 99 percent interest in James Heller Family, LLC, whose only asset was an account with Bernard L. Madoff Investment Securities.8 On its estate tax return, the estate reported the value of the decedent’s 99 percent interest at $16,560,990. In the 9-month period after James’ death, the estate received $11,385,000 in distributions to pay taxes and estate administration expenses. Following the decedent’s death and these distributions, Madoff was arrested, and the investment account became worthless. The estate claimed a theft loss deduction under Section 2054 for $5,175,990. The IRS disputed the deduction on the ground that under local law, the LLC, not the estate, was the victim of the theft.
The IRS argument presented an interesting issue to the Tax Court. There was no issue here with the type of loss that occurred. It’s widely known that Madoff’s actions constituted theft, and Section 2054 explicitly allows a deduction for a loss created by a theft. In Heller, the case focused on the proximity of the theft to assets actually held by the probate estate. Had the probate estate held the investment account directly, the case would be a clear cut yes and qualify for the deduction. But what if the LLC, which was 99 percent owned by the probate estate and includible in the decedent's gross estate, owned the investment account: Would the result change?
The Tax Court’s reading of Section 2054 resulted in a negative answer to that question and a positive result to the taxpayer. The court found that the IRS view was overly narrow. Section 2054 states that the estate is entitled to a deduction for losses “arising from fires, storms, shipwrecks, or other casualties, or from theft.…” The court gave a plain English reading of the term “arise,” citing Merriam-Webster’s Collegiate Dictionary, in which the word is “generally defined as ‘to originate from a source’.” This lead the Tax Court to set the standard for proximity as follows: “Pursuant to the phrase ‘arising from’ in [S]ection 2054, the estate is entitled to a deduction if there is a sufficient nexus between the theft and the estate’s loss.” Applying this standard to the facts presented, the court found that because there was a “direct and indisputable” nexus between the theft and the loss, the estate was entitled to the deduction. Effectively, Estate of Heller avoided the question of whether an estate must actually hold the asset suffering the loss by tracing the theft to an asset the estate did hold – the LLC interest.9
Does this Nexus Extend to Non-Probate Property?
Section 2054 has been on the books for decades, yet there’s still no definitive guidance as to its applicability to non-probate assets. And while the recent Heller decision didn’t provide a clear resolution of this particular issue, given how rare Section 2054 decisions are, it’s worth trying to read the tea leaves as the Tax Court provided useful insight as to how it may approach the provision in the future.
The potential argument against allowing a deduction for a casualty loss to non-probate property is that under the Treasury Regulation accompanying Section 2054, losses must be incurred prior to an asset’s distribution to a distributee.10 The executor of the probate estate will never “distribute” the asset to a beneficiary. Rather, any transfer of rights will occur independently on the decedent’s death, and therefore no loss should be allowed.
However, this narrow reading of Section 2054 could produce unjust results that don’t achieve the overall policy objectives of the estate tax regime. If all the assets in the gross estate, including non-probate assets, are subject to estate taxation, then presumably they should be treated alike, and should be able to qualify for loss deductions alike, during the administration period. As the non-probate assets are never actually distributed out by the estate, instead passing by independent means, the regulations never effectively cut off the estate’s ability to deduct a loss until the close of the estate administration period. Such a position isn’t necessarily contrary to the position that distribution of an asset would preclude an estate from taking a deduction. Both the IRC and the accompanying Treasury Regulation state that losses are only allowed for those incurred “during the settlement of the estate…”11 The term “during” literally read is a temporal restriction, not one requiring that the loss be incurred as part of the probate estate. Further, the term estate is never limited to the probate estate under the IRC or accompanying Treasury Regulation.
The Heller decision avoids this question of whether the estate must hold the asset that’s the victim of theft, by tracing that theft to an asset the estate actually held. The court states that a loss is a “reduction of the value of property held by an estate” (emphasis added). From this, it appears as if the Tax Court might deny a loss deduction, depending on whether the term “estate” is meant to refer only to the probate estate and not the gross estate. The court’s decision, however, provided some policy reasons in the course of its decision related to the facts presented in Heller that would suggest that a loss should be available for non-probate property. Specifically, the Tax Court held that “[w]hile the estate tax is imposed on the value of property transferred to beneficiaries, estate tax deductions are designed to ensure ‘that the tax is imposed on the net estate, which is really what of value passes from the dead to the living.’ See Jacobs v. Commissioner, 34 B.T.A. 594, 597 (1936). The theft extinguished the value of the estate’s JHF interest, thereby diminishing the value of property available to James Heller’s heirs. Thus, the estate’s entitlement to a [S]ection 2054 deduction is consistent with the overall statutory scheme of the estate tax.”12
Tax Court Approach to Policy Objective
Say there’s a parcel of real property that’s not fully insured, worth $8 million, which is titled in the name of a revocable trust. Within a month of the decedent’s death, the improvements on the parcel are severely damaged by fire so that the value of the property becomes be negligible. Meanwhile, the probate property is only worth $4 million.
The property held in the revocable trust is subject to creditor’s claims under local law, the property is includible in the decedent’s gross estate for tax purposes and estate taxes will be in part apportioned to the revocable trust. Let’s say an election was made under Section 645 so the property in the revocable trust is treated as part of the probate estate for income tax purposes. If the objective of the estate tax is to impose a tax on the value passing from the dead to the living—is it a just result that the estate isn’t entitled to a deduction under Section 2054 when it certainly would have been if it were held directly by the estate? Certainly not, given that it’s subject to claim and fully taxable.
If the IRS and, in turn, the Tax Court were to accept such a narrow reading of Section 2054, the form over substance would create an unfair result. Even though there are alternatives to Section 2054 that would mitigate the loss to some extent, these options wouldn’t provide the immediate and full benefit of Section 2054. If the loss occurred early on in the estate administration process, the estate could likely reduce its estate tax burden by making an alternate valuation election under Section 2032.13 However, this election would apply to all property in the gross estate and have the unfortunate side effect of reducing the beneficiary’s basis in the damaged property.14 The beneficiary could also deduct the losses for income tax purposes, but that will likely not prove as effective relief and immediate of an impact as the Section 2054 deduction. The absurdity of such a narrow reading is plain if a casualty loss that occurs to property held in a qualified revocable trust in which a Section 645 election was made would be deductible on the combined income tax return for the estate and qualified revocable trust, but wouldn’t be deductible on the estate tax return.
Practitioners will have to wait for a definitive answer as to whether non-probate property may qualify for a deduction under Section 2054 as well as for what limitations may be imposed on that deduction. Some of the limitations required are plain. For example, to the extent the non-probate holder of the property (such as a revocable trust or joint owner) receives reimbursement, the deduction should be reduced, just as would be the case if the probate estate held the property. What remains difficult to predict is what type of non-probate assets, if any, will be considered to have a sufficient nexus to the estate to permit a loss deduction. For example, would a trust includible in the decedent’s gross estate but not subject to creditor’s claims qualify? Further, how long is “during the settlement of the estate,” especially in estates in which probate isn’t opened? These are interesting questions Heller doesn’t answer, yet the case inspires thought on an IRC section in which there remains little guidance.
1. Estate of Heller, 147 T.C. 11 (2016).
2. Internal Revenue Code Section 2054.
3. IRC Section 642(g).
4. Lyman v Commissioner, 83 F.2d 811 (1936).
5. See Revenue Ruling 69-411.
6. See Treasury Regulations Section 20.2054-1.
7. This is precisely the question that Heller answers.
8. The decedent’s son and daughter each held a 0.5 percent interest in the limited liability company.
9. See Estate of Kessel, T.C. Memo 2014-97 (2014). The Tax Court addressed a question of how to value an estate’s property based on what was considered the estate's “property.” Interestingly the Kessel decision also dealt with a Bernie Madoff casualty. Here, the estate argued that the value of the decedent’s investment account at his death was actually zero, because the securities on which that valuation was based were never actually purchased. In short, the value of the fake securities in the account was zero because there were no securities in the account. The Internal Revenue Service argued that the account rather than the underlying assets should be valued for purposes of the estate tax. In its analysis of what was the property held by the estate, the Tax Court focused on whether the agreement with Madoff Investments constituted a property interest in that account separate from any interest in the underlying assets and concluded there were insufficient facts to say thus denying summary judgment motion by the IRS.
10. Treasury Regs. Section 20.2054-1.
11. IRC Section 2054; Treasury Regulations Section 20.2054-1.
12. Supra note 1.
13. IRC Section 2032 permits an executor to elect to value the estate as of six months after the decedent’s death.
14. IRC Section 1014(a)(2).