This case, Estate of Kalikow v. Commissioner of Internal Revenue, CA2, Case No. 23-7957, revolves around a dispute over the estate tax implications of a settlement payment to remedy the trustees’ failure to distribute all of the trust’s net income to Pearl Kalikow during her lifetime. The United States Court of Appeals for the Second Circuit affirmed the Tax Court’s judgment, holding that the settlement liability did not reduce the value of the trust’s assets included in Pearl’s estate.

Facts of the Case

Pearl Kalikow was the beneficiary of a qualified terminable interest property (QTIP) trust (the "SK Trust") established by her deceased husband, Sidney Kalikow. The SK Trust consisted primarily of ten income-earning rental properties. Sidney’s will directed the trustees to pay the trust’s net income to Pearl at least quarterly. Upon Pearl’s death, the remaining property was to be distributed evenly between two trusts for the benefit of Sidney and Pearl’s children (the "Children’s Trusts").

Sidney’s executors elected to treat the ten properties passing to Pearl as a QTIP trust and claimed a marital deduction. Consequently, the properties were not subject to estate tax at Sidney’s death but had to be taxed as part of Pearl’s estate upon her death. The trustees reorganized the property interests by transferring title to Kalikow Family Partnership, LP ("KFLP"), with the SK Trust holding a 98.5% interest. Upon Pearl’s death, the SK Trust consisted of the 98.5% interest in KFLP and $835,000 in cash and marketable securities. The parties stipulated that the 98.5% interest in KFLP was worth $54,492,712 on the date of Pearl’s death.

During Pearl’s probate proceedings, a dispute arose regarding the trustees’ failure to distribute the full amount of income generated from the KFLP partnership to which Pearl was entitled. The parties agreed to a $6,572,310 settlement payment from the SK Trust to Pearl’s estate to resolve the claim. The SK Trust and the Children’s Trusts were to be jointly and severally liable for the settlement payment.

Taxpayer’s Arguments for Relief

The Petitioners, Edward M. Kalikow and Laurie K. Platt, challenged the Commissioner’s valuation of the SK Trust, arguing that the value of the SK Trust assets included in the estate should be reduced by the agreed-upon undistributed income amount. Alternatively, they argued that the amount of the claim was deductible from the gross estate as administration expenses under 26 U.S.C. § 2053.

Court’s Analysis

The court first addressed whether the SK Trust was an asset of Pearl’s estate. The court noted that the taxable estate comprises the decedent’s gross estate minus deductions. The gross estate includes the fair market value of the decedent’s property at the time of death. The court emphasized that the SK Trust is a separate legal entity that is not itself an asset of the estate. The court stated that the trust is an instrument that organized and administered property during Pearl’s lifetime and then transferred that property to her heirs. A liability that belongs to the trust but does not affect the value of the underlying assets would not alter the value of the gross estate.

The court also found that the liability of the SK Trust did not encumber the assets held in the SK Trust. 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. The parties stipulated that the value of the KFLP partnership interest was $54,492,712, and Petitioners knew of the undistributed income claim at the time they stipulated to that value. The settlement agreement acknowledged payment with “readily available funds” of the SK Trust without liquidating the ten properties that comprise the KFLP partnership interest.

The court then addressed whether the Tax Court erred when it denied Petitioners’ request for the estate’s tax return to include an administration expense deduction pursuant to 26 U.S.C. § 2053(b) for the amount of the settlement payment. The court concluded that the Tax Court did not err. The entity responsible for paying the undistributed income claim is the SK Trust. From the estate’s perspective, the claim is owed to the estate to remedy the failure of the trustees to distribute income from the ten properties to Pearl during her lifetime. The claim is “property to be included in the gross estate”—not an expense of the estate.

Finally, the court addressed Petitioners’ argument that the Tax Court’s decision would amount to double taxation because Pearl’s gross estate includes both the settlement for the undistributed income and the underlying assets held in the SK Trust. The court stated that only the underlying assets would be taxed as part of the estate. The settlement payment is part of Pearl’s residuary estate, which she bequeathed to the Sunshine Foundation. Accordingly, the estate will receive a charitable contribution deduction for the amount of the settlement payment rather than it being taxed at all.

Holding

The Second Circuit held that the Tax Court properly determined that the settlement liability did not reduce the value of the SK Trust assets included in Pearl’s estate. The court reasoned that the SK Trust is a separate legal entity, the liability did not encumber the assets, and the settlement payment would be subject to a charitable contribution deduction. The Second Circuit affirmed the Tax Court’s judgment.

Prepared with the assistance of NotebookLM.