Beware the Compromise Tax

One area of estate administration that often gets overlooked on tax returns is the compromise tax. When a decedent transfers assets that are subject to a contingency or are otherwise difficult to value, the taxing jurisdiction and the estate must compromise on the tax due.

There are a variety of reasons an asset may be difficult to value, but the most common reason is because the asset is subject to a lawsuit. For example, if Decedent died owning a 60% interest in a closely held company, it is relatively easy to determine the value (although people may disagree as to the true value). If however, Decedent's surviving business partner claimed that Decedent really only owned 20% and that Decedent "cooked the books", Decedent's estate will be very difficult to determine until the matter of Decedent's true ownership is resolved. The government, however, wants its money now. This is one area in which the estate and the taxing authority can compromise on the tax due. Oftentimes, this type of situation is difficult to avoid even with great planning.

As for transferring assets subject to a contingency, this is something that can be planned for. Let's say there is a man who wants to leave money in trust for his wife, or Civil Union Partner, and then when the wife or Civil Union Partner dies, the money will go to the man's brother. In a states like New Jersey and Pennsylvania, the transfer to the brother would give rise to an inheritance tax of about 15%. So the question then becomes how do we value the likelihood that the brother will receive the money. In essence, we will have to use life expectancy measurements for the surviving wife or Civil Union Partner to determine that person's interest, and then we can determine the remainder interest. This can get very complex depending upon what, if any, rights to principal the survivor has - hence, a compromise tax.

So when does all this knowledge become really important? When filing the tax return, if the proper amount of taxes are not remitted, then large interest and penalties will be due.