In Uncategorized on 03/22/2012 at 16:02

Sorry, guys, March Madness is upon us, so I place a basketball metaphor on an estate tax case, once again featuring inclusion-exclusion. This time it’s an insurance policy, taken out by Decedent Dave for the benefit of his loved-once, Sweet Sue, and their minor offspring. The case is Estate of David A. Kahanic, Deceased, Edward M. Fiala, Executor, 2012 T.C. Mem. 81, filed 3/21/12, Judge Vasquez holding court.

Decedent Dave ran an outfit called Aesthetic Eye Plastic Surgery, that apparently did well enough for Decedent Dave to buy a $2.495 million life insurance policy from Reliastar Insurance (wasn’t it great when insurance companies had real names, like “Security”, or “Home”? Now they sound like rock groups).

Of course, when Sweet Sue bailed on Decedent Dave and entered into a marriage settlement agreement, she made sure Decedent Dave had to keep the policy current.

Decedent Dave shuffles off this mortal coil, the 706 (filed by Ed Fiala, executor and brother of Sweet Sue), includes the policy as an asset of the estate, but claims an offsetting deduction based on Sweet Sue’s security interest therein. IRS allows a $500K deduction, because the original settlement agreement gave her a $500K security interest.

But Sweet Sue had to drag Decedent Dave through the courts to get him to live up to their agreement. Finally, with contempt hanging over his head, Decedent Dave agreed not to change the policy or the beneficiary designation, encumber it or transfer it, and that was embodied in a “so ordered” stipulation. He did stop paying premiums, but the no-lapse clause and his previous premium payments kept the policy alive, even when Decedent Dave wasn’t. So Sweet Sue gets the whole $2.495.

But Decedent Dave’s estate has a lot less in it than first thought. There was a lot less cash available, and there was less to Aesthetic Eye than first met the eye. Moreover, there was no contribution clause in Decedent Dave’s will, so Sweet Sue was looking at transferee liability.

IRS wanted to limit Sweet Sue to the $500K of the original agreement, but Sweet Sue claimed the result of the contempt proceeding worked a modification of said agreement, and gave her enough of the incidents of ownership of the $2.495 policy to take it out of Decedent Dave’s estate.

No, says Judge Vasquez, Section 2042 says if Decedent Dave had any incidents of ownership, the whole policy (less IRS’ conceded $500K) is in. The magic language in Section 2042 is subsection (2): “To the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person. For purposes of the preceding sentence, the term ‘incident of ownership’ includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent. As used in this paragraph, the term ‘reversionary interest’ includes a possibility that the policy, or the proceeds of the policy, may return to the decedent or his estate, or may be subject to a power of disposition by him.”

The estate offers no evidence on the worth of Decedent Dave’s reversionary interest, and concedes that if the policy had any value at Decedent Dave’s date of death it was greater than 5%. I am at a loss to understand why Ed Fiala gave away the ranch in that wise, but he did.

IRS claims that since the policy was paid up beyond Decedent Dave’s death, the reversionary interest was the unapplied premium, and, per Ed’s concession, was more than 5% so the policy stays in. Ed says, “no cash surrender value”. Judge Vasquez: “…decedent’s final premium payment provided him with coverage until September 1, 2005. Thus, as of the date of decedent’s death, the Reliastar policy could have provided 20 days’ more coverage. …the Reliastar policy’s fair market value as of August 11, 2005, would at least be the cost of insuring decedent for 20 days, or $390.79.” 2012 T.C. Mem. 81, at p. 33 [Footnote omitted.].  Moreover, cash surrender value is not the only criterion for measuring a policy’s FMV.

Now, given Ed’s concession, $390.79 lets IRS claim the 5% reversionary interest and subject the whole policy to estate tax (less the conceded $500K).

But the ball bounces out. Ed argues Section 2516 provides full and fair consideration for Sweet Sue’s security interest in the policy, via the contempt proceeding modification of the original settlement agreement. And property encumbered in exchange for fair and reasonable compensation is not included in the taxable estate to the extent of the indebtedness per Section 2053(a)(4).

So the policy is in the estate, then out of the estate, and Sweet Sue comes down with a $2.495 million rebound.

Sweet Sue lent the estate money to pay the taxes, and there’s plenty in the decision about that, so read it.

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