Update: On February 23, 2018, the Iowa Supreme Court vacated this Court of Appeals decision and reinstated the district court's judgment.
Can a family settlement agreement (FSA) govern the imposition of inheritance tax liability? Under the right set of circumstances, yes. After a recent case, the answer to that question in Iowa appears to turn on whether the FSA seeks to avoid tax or to reach a compromise as to an alleged wrong that created the tax liability in the first place. In this case, the court found that the facts supported a finding of the latter. Thus, the FSA was allowed to effect a reduction in Iowa inheritance tax liability.
In 2003, a married couple executed a transfer on death (TOD) agreement for their brokerage accounts. They named their son as the beneficiary and his wife as the contingent beneficiary. The couple had three grandchildren, all of them step-children of their son’s wife. The mother died first, but the son predeceased his father. Consequently, the son's wife was the lone survivor when the father died. The wife was entitled to the brokerage account pursuant to the terms of the TOD agreement. Although such property transfers outside of probate, Iowa inheritance tax was due upon the transfer because the wife was not a descendent of her husband’s parents.
The estate of the father, which was administered by his three grandchildren, filed an action seeking to invalidate the TOD agreement. They alleged that the father was not competent at the time of the agreement’s execution. During the pendency of the action, the estate paid $18,988 in inheritance tax to the Iowa Department of Revenue based upon the TOD transfer to the wife.
The estate and the wife eventually executed an FSA under which the wife agreed to forfeit half of the TOD account to the estate in exchange for a dismissal of the lawsuit. After executing the agreement, the estate sought a refund of $10,034 of inheritance tax, the amount attributable to the grandchildren’s share pursuant to the FSA. IDOR denied the request, finding that FSAs cannot change the calculation of inheritance tax. The district court agreed with IDOR.
The Iowa Court of Appeals, however, sided with the wife, finding that the facts were similar to In re Estate of Van Duzer, 369 N.W.2d 407 (Iowa 1985). In Van Duzer, a surviving spouse sought to recover her distributive share against her husband’s estate. An FSA provided that the trustee who had received the estate’s money would return the amount of the surviving spouse’s distributive share to the estate and the estate would pay that sum to the surviving spouse. The Iowa Supreme Court ruled that the decedent’s surviving spouse did not receive the funds at issue from parties to the settlement agreement, but rather from the decedent by claiming against his will. As such, inheritance tax was not due on the amount distributed to the surviving spouse under the FSA.
Here, the court found a similar distribution scheme. The FSA provided that the TOD funds were to be liquidated and that half of the money was to be paid to the estate for distribution to the grandchildren, who were not subject to Iowa inheritance tax. This settlement was in compromise of a claim alleging that the contract which granted the wife the right to receive any of the TOD funds was invalid. Had there been no contract, there would be no inheritance tax liability. As such, the court ruled that the amount recovered by the estate in settlement of this claim should not be subject to inheritance tax liability. The grandchildren were receiving the funds from the estate, not the wife. The principle that the property in a TOD account becomes the property of the designated beneficiary immediately upon death presumes a valid contract. Here, the settlement agreement negated that presumption, as to the amount paid to the grandchildren.
The court was careful to clarify that not all FSAs could dictate inheritance tax liability. IDOR has an obligation to collect taxes on schemes designed to avoid inheritance tax. But this FSA, the court ruled, was not one of those.
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