Settlement Payment from QTIP Trust Did Not Reduce Estate Value

(Parker Tax Publishing March 2025)

The Second Circuit affirmed the Tax Court and held that in determining the value of a decedent's gross estate, the value of a qualified terminable interest property (QTIP) trust of which the decedent was the beneficiary was not reduced by a settlement payment representing undistributed income from the QTIP trust. The court also agreed with the Tax Court's conclusion that the settlement payment did not qualify as an administration expense deduction and rejected the taxpayers' contention that the Tax Court's decision amounted to double taxation. Est. of Kalikow v. Comm'r, 2025 PTC 76 (2d Cir. 2025).

Background

Pearl Kalikow's husband, Sidney, predeceased her and his will made her the beneficiary of ten income-earning rental properties, known as the SK Trust. Sidney's will also directed the trustees of the SK Trust to pay the trust's net income to Pearl, at least quarterly, during her life. The executors elected to treat the ten properties passing to Pearl as a qualified terminable interest property (QTIP) trust and claimed a marital deduction for it. Because of the SK Trust's designation as a QTIP trust, the transfer of the ten properties was not subject to estate tax at the time of Sidney's death. However, upon Pearl's subsequent death, those ten properties had to be taxed as part of her estate. The trustees subsequently reorganized the property interests in the SK Trust and transferred title in the ten properties to the Kalikow Family Partnership, LP (KFLP).

Upon Pearl's death, the SK Trust ended up with a 98.5 percent interest in KFLP, worth almost $54.5 million, and $835,000 in cash and marketable securities. The SK Trust terminated, and the remaining property was distributed evenly between two trusts for the benefit of Pearl and Sidney's two children, Edward Kalikow and Laurie Platt (the Kalikows). Under Code Sec. 2207A(a) and the terms of Pearl's will, the SK Trust had to pay the estate tax on the KFLP partnership interest and the cash and marketable securities. Pearl's will bequeathed the residue of her estate to the Sunshine Foundation, a tax-exempt entity.

During probate proceedings, a dispute arose regarding the trustees' failure to distribute to Pearl the full amount of income generated from the KFLP partnership. Ultimately, the parties agreed that a settlement payment of $6,572,310 was owed to Pearl's estate from the SK Trust to resolve the undistributed income claim.

After the estate tax return was filed, the IRS asserted a tax deficiency against the estate. The Kalikows and the executor challenged different aspects of the deficiency and, in particular, appealed a decision in which the Tax Court held that the value of the SK Trust assets included in Pearl's estate could not be reduced by the $6,572,310 settlement payment representing the undistributed income claim. The Tax Court also rejected the parties' argument that the amount of the settlement claim was deductible from the gross estate as an administration expense under Code Sec. 2053.

The Kalikows and the estate appealed to the Second Circuit arguing that (1) the Tax Court should have reduced the value of the assets in the SK Trust that were included in Pearl's estate by the Trust's settlement payment to Pearl's estate; (2) the Tax Court erred when it denied a request for the estate's tax return to include an administration expense deduction under Code Sec. 2053(b) for the amount of the settlement payment; and (3) the Tax Court's decision amounted to double taxation since Pearl's gross estate included both the settlement payment for the undistributed income as well as the underlying assets held in the SK Trust.

Analysis

The Second Circuit rejected all of the arguments by the estate and the Kalikows and affirmed the Tax Court's decision. With respect to the first argument, the court said that no evidence was offered to show that the SK Trust liability - a putative claim at the time of Pearl's death - affected the fair market value of the SK Trust's assets on the date of Pearl's death.

First, the court observed, the SK Trust is a separate legal entity that is not itself an asset of the estate. It is, the court noted, an instrument that organized and administered property during Pearl's lifetime and then transferred that property to her heirs. Second, the court found that the terms of the settlement demonstrated that the settlement liability did not affect the fair market value of the assets in the SK Trust and did not encumber the assets held in the SK Trust. According to the court, a hypothetical purchaser of the largest asset in the SK Trust - the KFLP partnership - would not accede to the liability and therefore would not regard the liability as affecting the price of the asset.

With respect to the argument that the estate's tax return should include an administration expense deduction for the settlement payment, the court explained that the entity responsible for paying the undistributed income claim was the SK Trust. By contrast, from the estate's perspective, the claim was owed to the estate to remedy the failure of the trustees to distribute income from the ten properties to Pearl during her lifetime. In other words, the court said, the claim is "property to be included in the gross estate" - not an expense of the estate. That conclusion, the court observed, remains even though the liability is borne by an entity that held assets included within the taxable estate.

Finally, the court said that it did not need to address the estate's last argument about double taxation because it was entirely theoretical. As the court noted, the settlement payment was part of Pearl's residuary estate, which she bequeathed to a tax-exempt organization. Accordingly, the estate will receive a charitable contribution deduction for the amount of the settlement payment rather than it being taxed at all.

For a discussion of qualified terminable trusts, see Parker Tax ¶227,130. For a discussion of deductions against a gross estate for administration expenses, see Parker Tax ¶227,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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