Life insurance proceeds not includible in estate

By James A. Beavers, CPA, CGMA, J.D., LL.M.

Rejecting the IRS’s assertion that the step-transaction doctrine applied to a series of transactions with respect to life insurance policies, the Tax Court held that the proceeds of the policies were not includible in a decedent taxpayer’s estate.

Decedent’s trust

Larry Becker, a physician who resided in Maryland, died in a car accident in January 2016. Prior to his death, in July 2014, Becker created an irrevocable life insurance trust, the Larry Becker Irrevocable Family Trust. The trust was set up in Maryland and was subject to the laws of that state. The trustees of the trust were Becker’s son and one of his daughters.

The beneficiaries of the trust were Becker’s wife, his children, and his grandchildren. The trust was created to hold assets for the benefit of the trust’s beneficiaries, including specifically life insurance policies on Becker’s life. Pursuant to the trust agreement, the trustees could borrow on any insurance policy held under the trust to pay any premiums due on such an insurance policy.

Becker, as the trust’s grantor, had relinquished all power to alter, amend, revoke, or terminate the trust agreement in any way. He did not retain or have any vested or contingent beneficial interest in the trust and did not have any reversionary interests or possibilities of reverter under the trust. Also, Becker had no control over the administration or disposition of any assets held in the trust under the trust agreement.

Life insurance policies

In 2014, Becker and the trust obtained two life insurance policies from Zurich American Life Insurance Co. (issued in Maryland) on Becker’s life. Barry Steinfelder, an insurance broker, assisted Becker and the trust in connection with the procurement of the policies.

The trust was the sole beneficiary of both Zurich policies. The first policy had a total death benefit of $11.47 million and a required initial premium of $999,693. The second policy had a total death benefit of $8 million and a required initial premium of $697,257.

Becker was not the owner of the policies at any time. The terms of the policies did not provide Becker or his estate any claim to the policies or their proceeds; power to change the beneficial ownership in the policies or the time or manner of enjoyment of the policies or their proceeds; power to change the beneficiary, surrender or cancel the policies, assign them, revoke an assignment, pledge the policies for a loan, or obtain from the insurer a loan against the surrender value of the policies; or a right to the economic benefits of the policies. Under the policies, neither the trust nor its trustees were required or under any obligation to pay taxes, debts, or other charges enforceable against Becker’s estate.

The trust agreement’s terms provided that the trustees “possess[ed] and own[ed] all the incidents of ownerships, rights, powers, interests, privileges, and benefits of every kind that may accrue on account of any insurance policies” that were part of the trust property, including the Zurich policies.

Funding of the policies

The trust funded payment of the initial premiums for the Zurich policies with borrowed funds from Becker, who in turn borrowed the funds from Steinfelder. Steinfelder borrowed the amounts he loaned to Becker from an acquaintance, Julia Wen. Steinfelder gave Wen promissory notes dated August 2014 (with Steinfelder listed as borrower) and September 2014 (with JJM LLC, a single-member limited liability company (LLC) owned by Steinfelder as borrower) in return for the two loans.

Transfer of the trust’s initial loans to JTR

ALD LLC was a North Carolina LLC controlled by Steinfelder. In August and September 2014, Steinfelder had ALD transfer funds to Wen to repay Wen’s loans to him.

The right to receive repayment from the trust of the loans that funded the initial premiums was assigned and transferred to ALD as the payee of the loans, pursuant to amended and restated promissory notes (ALD notes). Under the ALD notes, the trust was obligated to repay to ALD the funds that it borrowed to fund the initial premiums of the Zurich policies. Becker had no right to receive any funds from the trust as a result of the ALD notes. The ALD notes granted ALD first-priority security interests in the Zurich policies. In December 2014, the ALD notes were assigned to JTR LLC.

LT Funding’s loan to the trust to fund future premiums

On Dec. 15, 2014, the trustees of the trust entered into a loan and security agreement with LT Funding LLC and executed two promissory notes pursuant to this loan agreement. The agreement and associated promissory notes were secured with a security interest in the Zurich policies (LTF agreement).

Under the terms of the LTF agreement, LT Funding was obligated to pay future premiums due on the Zurich policies, and the trust was obligated to pay LT Funding (1) 75% of the total death benefits of the Zurich policies, (2) all premiums advanced by LT Funding, and (3) interest on all premiums advanced by LT Funding at the rate of 6% per year.

In order to continue each of the Zurich policies, the trust was required to pay a minimum premium during a minimum premium period and the amount of premium required to maintain a positive policy value under each policy. As a condition of the loan and security agreement, JTR, LT Funding, and the attorney signing for the trustees of the trust entered into two subordination and intercreditor agreements in December 2014. Under these agreements, each of the security interests in the Zurich policies created by the ALD notes was subordinated to a first-priority security interest in favor of LT Funding.

No additional premiums were actually paid on the Zurich policies by LT Funding before Becker’s death in January 2016.

Payment of the benefits from the Zurich policies

In March 2016, following Becker’s death, Zurich paid death benefits under the Zurich policies to the trust totaling more than $19.5 million. A dispute arose as to who was entitled to the proceeds of the Zurich policies, which resulted in a settlement under which the trust paid $9 million to LT Funding in exchange for the release of its claims.

Tax return and notice of deficiency

In April 2017, Becker’s son, Gary Becker, executor of his father’s estate, filed an estate tax return for the estate. The return did not include the death benefits paid on the Zurich polices in the value of the gross estate.

In February 2020, the IRS issued a notice of deficiency for the estate tax return to Gary Becker. In it, the IRS determined a deficiency in estate tax liability for tax year 2016 of $4.19 million. The deficiency was based primarily on an adjustment that included nearly $19.5 million of the death benefit proceeds of the Zurich policies in the value of the gross estate and an adjustment allowing an additional deduction to the estate in the amount of $9 million, based on the amount paid by the estate to LT Funding under the settlement agreement with it.

The estate timely filed a petition with the Tax Court challenging the IRS’s determinations.

The Tax Court’s decision

The Tax Court held that the death benefits paid by the Zurich policies were not includible in Becker’s gross estate. Because they were not, the court further held that because there was no increase in the gross estate, Becker’s estate was not entitled to a deduction for the amounts paid to LT Funding under the settlement agreement as a claim against the estate.

The Tax Court found, based on its own and Ninth Circuit precedent, that federal choice-of-law principles apply in deficiency cases, and these rules embrace the Restatement (Second) of Conflict of Laws (Am. L. Inst. 1971). Under the Restatement, “rights and duties of the parties with respect to an issue in contract are determined by the local law of the state which, with respect to that issue, has the most significant relationship to the transaction and the parties.” In the estate’s case, the court determined that Maryland had the most significant relationship to the transaction and parties, and therefore Maryland law governed the Zurich policies.

Under Maryland Code, Insurance, Section 12-201, an insurance contract on the life of a person for the benefit of any person will be valid if the benefits are payable to the individual insured, his or her personal representative, or a person with an insurable interest in the individual insured at the time the insurance contract was made. Also, under this section, a trustee of a trust has an insurable interest in the life of an individual insured under a life insurance policy owned by the trust or the trustee of a trust if, on the date on which the policy is issued, the insured is the grantor of the trust and the life insurance proceeds are primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured. Under Maryland case law, if an insurance policy is valid at its inception, the assignment of this policy is legal, even if it is to a person who does not have an insurable interest in the life of the insured.

The Zurich policies, the Tax Court observed, were owned and payable to the trust; Becker was the trust’s grantor; and on the date of each policy’s issuance, the proceeds were primarily for the trust’s beneficiaries. Therefore, the court found that the policies were valid at inception and freely transferable.

The IRS, however, argued that the proceeds of the policies were not primarily for the benefit of the beneficiaries. It contended that the step-transaction doctrine applied to the overall transaction involving the insurance policies, and when the steps involving the insurance policies were collapsed, the proceeds were primarily for the benefit for LT Funding under the terms of the LTF agreement. Consequently, the trust lacked an insurable interest in the Zurich policies on the date of issuance.

As a result, under the IRS’s theory, the insurance contracts violated Maryland’s insurable-interest statute and gave rise to a cause of action by the executor of Becker’s estate to recover the benefits from the payee. This cause of action would, according to the IRS, under Sec. 2031 and/or Sec. 2042(2), require the proceeds of the policies to be included in Becker’s estate, triggering the estate tax liability in the notice of deficiency.

Step-transaction doctrine

Courts have articulated three threshold tests for determining when it is appropriate to apply the step-transaction doctrine: the “binding commitment” test, the “end result” test, and the “interdependence” test. The Tax Court found that the binding-commitment test would not be appropriate because the parties had not made any binding commitments and the steps were completed in a short period of time. Thus, the court analyzed the series of transactions only under the end-result and interdependence tests.

End-result test: Under the end-result test, a series of formally separate steps will be collapsed if they appear to be prearranged parts of a single transaction intended from the outset to reach the ultimate result. The test is objective and focuses on the parties’ intent at the time the transaction is entered into.

In the Tax Court’s view, the facts regarding the transaction (including the reasons for taking out the policies, the trust’s ultimate share of the proceeds of the policy, and Becker’s and the trust’s lack of assets to pay the initial premiums on the policies), taken as a whole, did not show that the subjective intent of the parties at the outset of the transactions was to transfer death benefits to LT Funding, a third party that was not even identified at the time the Zurich policies were issued. Thus, the court found that the step-transaction doctrine did not apply under the end-result test.

Interdependence test: The interdependence test focuses on whether the steps of the transaction are so interdependent that the legal relations created by one transaction would have been fruitless without completion of all the transactions. The test looks at the relationship between the steps to determine what result the participants sought to achieve.

The IRS pointed to the initial flow of funds from Wen to Steinfelder, from Steinfelder to Becker, from Becker to the trust, and from the trust to Zurich in payment for the initial premiums on the Zurich policies as proof of the requisite interdependence between the steps. The IRS also noted that without an outside investor, which gave rise to the LTF agreement, ALD did not have any “real opportunity” of being repaid, even though ALD had a first-priority security interest in the Zurich policies.

The Tax Court disagreed with the IRS and held that the step-transaction doctrine did not apply based on the interdependence of the steps. The court found that even if the trust had needed additional funding, it was entitled to over $10 million (after repayment of the ALD notes). Also, the court found that payments of the initial and subsequent premiums were not necessarily contingent upon the trust’s entering into the LTF agreement. Moreover, the court concluded that the initial acquisition of the Zurich policies was not meaningless without the LTF agreement and that the method of funding the trust chose for possible future premiums was “simply” the option that Becker and the trust found was the most financially beneficial.

Federal estate tax provisions

Having determined that the step-transaction doctrine did not apply, the Tax Court analyzed the application of the federal estate tax provisions to the transaction.

Under Secs. 2033 through 2042, a decedent’s gross estate generally includes the value of property described in those sections. Under Sec. 2033, the gross estate includes the value of all property beneficially owned by the decedent at the time of death. The value of an estate includes, among other things, all choses in action and any rights to income acquired before death or because of the decedent’s death that remain unpaid at the time of death.

Under Sec. 2042(2), the gross estate includes proceeds of life insurance for which the decedent possessed at his or her death any of the incidents of ownership, exercisable either alone or in conjunction with any other person. Regs. Sec. 20.2042-1(c)(2) states that:

the term “incidents of ownership” is not limited in its meaning to ownership of the policy in the technical legal sense. Generally speaking, the term has reference to the right of the insured or his estate to the economic benefits of the policy. Thus, it includes the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy.

The IRS, as described earlier, argued that the step-transaction doctrine applied and that its application would cause a potential state law action that would cause the values of the Zurich policies to be included in the estate. However, the Tax Court, having found that the step-transaction doctrine did not apply, further found that there was no state law cause of action. Consequently, because the claim did not exist, it did not matter whether such a potential claim should be treated as an “incident of ownership” under Sec. 2042(2) or as “property” under Sec. 2033, requiring its value to be included in the value of the decedent’s gross estate under Sec. 2031. Without an increase in the gross estate, the estate was not entitled to an offsetting deduction to the taxable estate for the amounts paid to LT Funding pursuant to the settlement agreement as a claim against the estate.

Reflections

In most instances, the IRS’s determinations set forth in a notice of deficiency are presumed correct, and taxpayers bear the burden of showing the determinations are erroneous under Tax Court Rule of Practice and Procedure 142(a). However, the IRS bears the burden of proof in new matters that it asserts in its answer to a taxpayer’s petition to the Tax Court.

In this case, the IRS only raised its theory that the life insurance proceeds should be included in the gross estate pursuant to Sec. 2031 and, in the alternative, Sec. 2042(2) through the application of Maryland state law in its amended answer during the litigation. Therefore, the burden of proof was shifted to the IRS. While it does not appear to have mattered in the Tax Court’s ultimate decision in this case, the shift in the burden of proof did not make the IRS’s job any easier.

Estate of Becker, T.C. Memo. 2024-89

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.