Monday, September 19, 2022
Lesson From The Tax Court: Checks ... Still Matter
Who uses paper checks anymore? Not my kids. My daughter even prefers to incur a surcharge for using her debit card to pay her rent rather than walking a paper check to the rental office. The practical reason, she says, is that when she uses her debit card she can immediately see the impact on her checking account balance by looking at her “available balance” number in her banking app. If she wrote a check, she’d have to wait until the check cleared and she fears over-drawing her account.
That delay—between the time a person writes and check and the time it gets reflected in their checking account—is what gives us our lesson in Estate of William E. Demuth Jr. et al. v. Commissioner, T.C. Memo. 2022-72 (July 12, 2022 )(Judge Jones). In that case the issue was the value of an investment account on the date of the decedent’s death. On that date there were 10 checks totaling $436,000 that had been written on the account but had not cleared. The Executor did not include that amount on the Form 706 because the recipients of the checks had deposited them before the decedent died. Their accounts had been credited. They had been paid. Or so thought the Executor. The IRS, however, thought that the checks had not been paid because they had not cleared the decedent’s bank. So the money still belonged to the taxpayer and should have been included in the valuation of his Estate.
In (mostly) agreeing with the IRS, Judge Jones gives us a useful lesson on basic commercial law principles. Maybe my kids won't care, but enough folks still use checks that it's a lesson worth remembering. Details below the fold.
Dr. William Demuth, Jr. died on September 11, 2015 at age 94. His son Donald was the Executor and filed a Form 706 Estate Tax return. Computing an applicable Estate Tax requires determining the value of the decedent’s gross estate.
One of Dr. Demuth’s assets at the time of his death was an investment account at a brokerage firm called Mighty Oak Strong America Investment Co. (MOSAIC). The account had a check-writing feature. Under state applicable law, MOSAIC was to be treated as a bank . Op. at 6.
For years Dr. Demuth had written checks on that account to give annual gifts to various family members. Starting in 2007, he had give his Power of Attorney (POA) to Donald to write the yearly gifts.
On September 6, 2015, five days before Dr. Demuth died, Donald signed and sent out 11 checks, totaling $464,000. Apparently all of the folks who received the checks deposited them before Dr. Demuth died. However, only one check, for $28,000, cleared MOSAIC before that date. MOSAIC did not pay the other 10 checks until September 14th or later.
On the Estate Tax Return, Donald did not include the amount of these checks as part of the reported value of the Estate. On audit, the IRS said that $436,000 worth of uncleared checks needed to be included.
Law and Lesson: When and How State Law Matters
When a taxpayer dies, their Estate is potentially subject to two types of taxes. First, if the Estate has more than $600 of gross income, it must file an income tax return on Form 1041. Second, if the Estate is worth more than the applicable lifetime exemption amount, for the year of the decedent's death, the Estate must file an Estate Tax return on Form 706.
As I understand the Estate Tax (and I welcome corrections) an Estate uses Form 706 to: (1) report the gross value of the Estate; (2) take allowed deductions (funeral expenses, gifts to charity, etc.); (3) apply the rate structure in §2001 to the resulting taxable estate; (4) and only then apply the lifetime exemption amount as a credit against taxes. Since the highest marginal rate of 40% kicks in at valuation of over $1m, and the lifetime exemption amount has been well over that for decades, that effectively that means any amounts over the lifetime exemption amount get taxed at 40%.
Thus, if all of the amount of the uncleared checks was includable in Dr. Demuth’s gross estate, then at the 40% tax rate, we have a fight here over about $175,000 in Estate tax. At least that’s true if my limited understanding of how the Estate tax works is correct. Again, I welcome corrections.
The important part for today’s lesson, however, is the interplay of federal tax law and state law. The basic balance is this: the shape and content of legal interests is generally controlled by state law but federal tax law controls the federal tax consequences of those state-defined legal interests. You see that in both the determination and collection of federal taxes.
On the determination side, for example, §102 excludes from gross income any amounts “acquired by gift, bequest, devise, or inheritance.” Well, it's state law that determines who has the legal relationship of heir to the deceased, but once that legal relationship is established, it’s federal law that controls whether what is received is an inheritance within the meaning of §102. Lyeth v. Hoey, 305 U.S. 188 (1938)(taxpayer who was an heir under state law could exclude under §102 a settlement of a will contest, notwithstanding contrary state law rule that settlements were contractual, and not testamentary, receipts).
On the collection side, the federal tax lien attaches to "all property and rights to property" belonging to the taxpayer. §6321. Here, again, it’s state law that determines the shape and scope of a taxpayer’s interests but federal law tells you whether those interests amount to "property" for §6321 purposes. See Drye v. United States, 528 U. S. 49, 58 (1999)(Court will “look initially to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer's state-delineated rights qualify as 'property' or 'rights to property' within the compass of the federal tax lien legislation.")
In today’s case the applicable Treasury Regulation says that value of a decedent’s gross estate includes “The amount of cash belonging to the decedent at the date of his death, whether in his possession or in the possession of another, or deposited with a bank.” Treas. Reg. 20.2031-5.
But it’s state law that determines the scope and shape of a decedent’s rights to their cash in a bank account when they have written checks but the checks have not yet been paid as of the date of death. That is because checks are negotiable instruments and that subject is covered by state law.
The basic law of negotiable instruments is found in §3 of the Uniform Commercial Code (UCC), as more or less adopted by all the States. In today’s case, everyone agrees Pennsylvania law governs. The PA version of the UCC is found in the Pennsylvania Commercial Code (PCC), which is Title 13 of the Pennsylvania Consolidated Statutes. Division 3 governs negotiable instruments.
PA law says that a check is a negotiable instrument, written to the check-writer’s bank and ordering the bank to pay a sum to the order of a named person. The check-writer is also called the drawer or payor. PCC §3103. The bank ordered to make payment is called the drawee or payor bank. Id. Also PCC §4105. The person to whom the check is payable is called the payee. PCC §3310. And the bank where the payee first deposits the check for payment is called the depository bank. PCC §4105.
Judge Jones gives a great explanation of PA law, the gist of which is this: the amounts on a check still belong to the drawer until such time as the drawer can no longer stop payment of the check. Under PA law, the earliest that can happen is “when the drawee bank accepts, certifies, or makes final payment of the check.” Op. at 6.
Here, since the decedent could have issued a stop-payment order as of the date of death, the funds in the MOSAIC investment account still belonged to him on that date (per state law) and, accordingly, must be included in the value of the Estate (per federal law).
Judge Jones believes this case turns on the state law definition of gift. She states that “the funds from...a check no longer belong to a decedent at their death if they executed a completed gift of the check during their life. As such we must determine whether the checks at issue represent completed gifts.” Op. at 4. I’m not sure I follow that reasoning. Seems to me the purpose of the checks was not relevant to the question of when the funds ceased belonging to the decedent.
To me the question is simply at what point did the funds in the MOSAIC account cease to belong to Dr. Demuth. If they belonged to him on the day he died, they should be included in the gross Estate. I think that’s supported by the same federal regulations defining a decedent’s gross estate cited above. In part of the regulation that comes right after the part Judge Jones quotes, it also provides that “If bank checks outstanding at the time of the decedent's death and given in discharge of bona fide legal obligations of the decedent incurred for an adequate and full consideration in money or money's worth are subsequently honored by the bank and charged to the decedent's account, the balance remaining in the account may be returned, but only if the obligations are not claimed as deductions from the gross estate.” Treas. Reg. 20.2031-5. To me, that rule implies that checks outstanding at the time of the decedent’s death must generally be counted as part of the gross Estate. The regulation then gives the exception. But one must still consult state law to validate that implication, because it is state law that determines the scope and shape of the decedent’s interest in their bank accounts. So that takes us right into Judge Jone's commercial law analysis.
Coda: Words Matter
While the IRS won on the law, it had a partial loss because of some confusion about words. Both the IRS and the taxpayer referred to the payee’s banks as the “drawee banks.” Nope, those were “depository banks.” MOSAIC was the drawee bank (it would also have been the depository bank if one of the payees had presented the check to it for payment, but the reasonable inference from the opinion is that the payees all presented their checks to their own banks). What bit the IRS on the hindquarters here was its concession that three of the checks had been “credited by drawee banks” before Dr. Demulth died. The IRS meant to say that these checks had been credited by the depository banks. Under PA law that did not mean that the funds ceased to belong to Dr. Demulth. When the IRS realized its error, it attempted to backpedal, but Judge Jones held the IRS to its concession. So the Estate was able to exclude those three checks from the gross Estate, some $70,000. That still left the Estate required to include about $366,000 that it had omitted.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to "check in" to TaxProf Blog each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.
FWIW, the decedent died on a Friday (9/11/2015) and the checks were paid on Monday (9/14/2015). Also FWIW, and I certainly can't prove it, I think taxpayer would have gotten different result in district court.
Posted by: Tu Phat | Sep 19, 2022 1:03:09 PM
@John: I'd have to research it! [grin] Offhand, I would say that seems more like the charitable donation situation than it does the Estate valuation situation. But I would never rely on my intuition! I'm sure there's a reader out there who actually knows the answer to that...
Posted by: bryan | Sep 19, 2022 11:06:01 AM
With regards to the annual gift tax exclusion ($16,000 in 2022), would it be like charitable gifts or noncharitable gifts? (John gifted Joe $10,000 in the form of a check on December 31, 2021 and gifted another $10,000 in the form of a check January 15, 2022. Both checks cleared January 20, 2022. Would John have to pay gift tax on $4,000 in 2022?
Posted by: John Green | Sep 19, 2022 10:40:55 AM
I think that the lesson in Demuth is also not to use brokerage account checks if there are gift deadlines coming up. The result might have been different if he had used a national bank chartered by the federal office of the comptroller of the currency, or bothered to get the checks certified by Mosaic’s bank before sending them out.
Posted by: Roy B Stromme | Sep 19, 2022 8:50:03 AM
Hi John, excellent point! For charitable donations, the Tax Court has long treated the date of mailing a check as the date of donation under a relation-back doctrine for purposes of the section 170 deduction for contributions to charities. See Estate of Spiegal, 12 T.C. 524 (1949). https://www.leagle.com/decision/194953612bstc5241466.
But the Court has a different rule for Estate Tax purposes. Here's how the Court explains it:
"Charitable gifts differ from noncharitable gifts in that charitable gifts are deductible for income tax purposes. We have not extended the relation-back doctrine for estate tax purposes to noncharitable gifts made by check which were unpaid when the donor died. This result avoids the possibility that payments deducted for income tax purposes by the donor would be includable in the donor's gross estate. See Estate of Newman v. Commissioner, supra at 88; Estate of Gagliardi v. Commissioner, 89 T.C. 1207, 1212 (1987)."
That is from DiSanto v. Commissioner, T.C. Memo 1999-421. Found at https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/court-values-decedent%27s-stock%2c-limits-marital-deduction-to-reflect-surviving/1p3yt?h=DiSanto
I don't make up the rules, just report them!
Posted by: bryan | Sep 19, 2022 7:06:25 AM
Based on this, a charity check written December 25 20x1 that was not cleared by the 31st, can be used as a deduction only in year 20x2. Correct?
Posted by: John Green | Sep 19, 2022 4:45:31 AM
Why isn't there an offsetting increase in the liabilities of the estate?
Posted by: Charles David Anderson | Sep 19, 2022 11:20:36 PM