Filing a Tax Court petition regarding a tax assessment carries risks, some of which an adviser may not normally consider. In the case of Estate of Billhartz v. Commissioner, No. 14-1216, 2015 TNT 143-12 the issue that arose came after the estate had entered into a settlement with the IRS.

Under IRC §6512 a taxpayer who files a petition with the Tax Court regarding a proposed tax deficiency may not later file a claim for refund—rather, all issues need to resolved in the Tax Court case. That’s true even for issues that may come to the taxpayer’s attention following the conclusion of the case.

In the case in question the IRS had examined the estate regarding a claimed deduction for a payment to various children of the decedent. The estate had paid the children $20 million and had a claimed a deduction for $14 million of that amount. The IRS initially denied the entire $14 million deduction and the estate filed a petition in Tax Court. Before the case went to trial the IRS and the estate entered into a settlement agreement where IRS agreed to allow 52.5% of the original $14 million deduction which they informed the Tax Court of.

Following that notice to the Court, but before the deadline the Court gave the parties for submitting documents that detailed the formal terms of the settlement the estate discovered that some of the children were suing the estate over the amount of the payments. While the children had entered into a waiver of a right to dispute the payment due to them as part of the agreement under which they received the $20 million in payments, these children alleged that the estate had obtained that waiver had been procured by fraud.

As the Seventh Circuit panel summarized the issue:

The children argued that Marcia had intentionally and fraudulently concealed documents from them and had threatened to withhold any of the trust money from the children unless they signed the waiver. And, even though the 2007 Waiver Agreement mentioned the terms of the Marital Settlement Agreement, the children asserted that they did not became aware of their right to 50% of the estate, and of the value of the estate, until the Estate brought the Tax Court case in 2012.

The estate eventually settled the issue by agreeing to pay each of the complaining children an additional $1,450,000.

The estate asked the Tax Court to set aside the settlement agreement, arguing that either a) it was based on a mutual mistake of fact between the taxpayer and the IRS since the parties had believed the issue of the payment to the children was settlement or b) the IRS had been aware that information that one of the children was planning to file suite before the settlement was given to the Tax Court and failed to inform the estate of this fact.

The Tax Court had rejected these arguments and refused to set aside the original settlement agreement. The estate filed an appeal with the Seventh Circuit arguing the Tax Court had abused its discretion in refusing to set aside the settlement.

The panel notes that generally settlements will not be overturned, noting:

When parties to a civil suit reach a settlement, they are usually barred from later tearing up that agreement or filing a new lawsuit when they learn new information—not because of statute, but because of the terms of the settlement. And, of course, for cases that make it to trial, the doctrine of res judicata blocks future legal action based on the same claims. Settlements are meant to substitute certainty for risk, but that does not make them risk free. By settling, parties close the door to new information; that's risky, because they do not know whether new information will be helpful or harmful. A party may later come to believe that it received a bad (or good) deal, but only rarely will that provide grounds for setting aside the settlement.

However, as noted, there are those rare grounds where the court will set aside a settlement agreement. The panel notes:

The Tax Court has its own test, laid out in Dorchester Industries Inc. v. Commissioner, for determining when to set aside a settlement. 108 T.C. 320, 335 (1997), aff’d, 208 F.3d 205 (3d Cir. 2000). When, as here, a “settlement agreement ha[s] led to the vacation of the trial date and would have led to entry of [a] decision[ ] had the parties complied with their agreement,” a motion to vacate a settlement agreement will be denied “[a]bsent a showing a lack of formal consent, fraud, mistake, or some similar ground.” Id.

The estate argues first that it should be granted relief under the mistake provision, noting:

it relies on the doctrine of mutual mistake of fact, arguing that “the parties' belief that the Estate's debt to the Children had been finally determined” by the 2007 Waiver Agreement “was a basic factual assumption underlying the April 2012 Settlement.” It was a basic factual assumption, the Estate argues, because “the parties negotiated the April 2012 Settlement as a percentage of the Original Deduction that arose directly out of the” 2007 Waiver Agreement. As it turns out, the Estate argues, the amount actually paid by the Estate to the children was not finalized by the 2007 Waiver Agreement, and so the settlement was reached while the parties were mistaken about a key “fact.”

The panel, however, finds that it’s not clear that the IRS ever was working in reliance on the question of how much was paid to the children, given that the amount being claimed as a deduction was not, in fact, the total payment amount. As the panel notes:

…[W]e struggle to see how the finality of the Estate’s payments to the children could have been a basic factual assumption underlying the settlement when the amount the Estate wanted to deduct ($14 million) was different from the amount the Estate agreed to pay the children in the 2007 Waiver Agreement ($20 million). (Recall that the Estate attempted to deduct less than the full amount that it paid to Ward.) The Estate has not explained how or why it chose the $14 million amount, so we don't know how or even if it would have changed if the amount originally paid to the children had been different.

As well, the rule generally does apply when the issue is a mistaken assumption about a future development rather than a fact in existence at the time the settlement was entered into:

The Estate failed to foresee the children's lawsuit; there was no fact about which the parties were both mistaken at the time they reached the settlement. The Estate had made a $14 million deduction claim. Both parties knew this at the time, and it was a key background fact when the settlement was reached. It was true at the time, and the fact that the Estate now wants to claim a larger deduction does not render the previous deduction amount false. And that $14 million claim—not the amount actually paid to the children—was the basis for the Commissioner's settlement offer. The Commissioner surely did not care how much was actually paid to the children or whether that amount was final; rather, he cared only about the amount claimed by the Estate as a deduction.

The Court illustrates the nature of this limitation by giving the following analogy:

Consider a lawsuit arising out of a car accident, in which the plaintiff, after consulting with an auto mechanic, initially claims $1000 in damages. The defendant does not think he is actually liable, but fears a large jury verdict and offers to settle for 40% of the plaintiff's claim ($400). The plaintiff accepts the settlement, but a couple of weeks later her car breaks down, and she discovers that the damage from the accident was more extensive than she initially thought—closer to $2000. Under the Estate's theory, the plaintiff could then try to vacate the settlement because the parties were "mistaken" as to a "fact"—i.e., that the amount of damage to the plaintiff's car had been finally determined at the time of the settlement. But, of course, that's not right: by agreeing to a settlement, the plaintiff waived any right to later argue that she actually deserved more than she previously asked for. It makes no difference that the settlement was calculated as a percentage of the amount claimed by the plaintiff—all monetary settlement amounts can be expressed as a percentage of the amount claimed by the plaintiff.

The panel then turns to the estate’s claim that the IRS was aware of a material fact which it knew would change the estate’s view of the settlement. This conduct, as detailed by the Court, was as follows:

The Estate asserts that, at some time between February and April 2012 (before the settlement was reached), the Commissioner's counsel spoke with Billhartz’s daughter Jean, and Jean stated that she was considering consulting with an attorney to see if she could sue the Estate.

The Court first points out that this would allow for a voiding of the settlement only if the IRS was aware that knowledge of this item would correct a mistake of the estate on a basic assumption of the settlement. The Court points out that all the IRS knew was that one child might consult an attorney and, following that consultation, might sue the estate. But the estate arguably should have known that as well—anyone could sue the estate, especially, as the panel notes, “people who have a colorable argument that they were shorted millions of dollars from their father's estate.”

As well, the Court notes, either the estate had committed fraud (in which case it would be aware that it would be held liable to the children for the defrauded funds if the children sued) or, had it not committed fraud, there was no actual liability that would be paid. Being aware child would or would not sue would not change the reality of whether the estate was actually liable—rather it had all the information it needed to anticipate the possibility of having to pay that child or that, in fact, it did not owe the payment.

The fact that the estate did make a settlement payment doesn’t change this. As the court noted:

There was, of course, ultimately a settlement in the children's cases, but that does not change the analysis. Perhaps no fraud occurred, and the Estate chose to settle in order to dispose of the cases. The Estate's choice to voluntarily pay the children extra money should not affect the Commissioner's right to what was agreed upon in the settlement in this case. Or, perhaps there was fraud, and the children gave up the possibility of a larger payday in favor of a settlement. In that case, the Estate should have predicted the suit, meaning that any omission by the Commissioner was harmless.

Finally the Court notes that because the settlement is meant to deal with all issues on the return in question, the estate cannot attempt to use Reg. §20.2053-4(a)(2) to reopen the open. That regulation provides that “[e]vents occurring after the date of a decedent's death shall be considered in determining whether and to what extent a deduction is allowable under section 2053.” The Tax Court was not asked to rule on this issue, rather the parties entered into a final agreement of the amount due.