Law Office of John S. Palmer Attorney at Law

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Life Insurance, Estate Taxes, and Divorce

Posted Friday, May 25, 2012 by John S. Palmer

Pursuant to section 2042 of the Internal Revenue Code, life insurance is included in the gross estate of a decedent for estate tax purposes, even though the proceeds are payable to third parties, so long as the decedent had any “incidents of ownership” in the insurance policy. Treasury Regulation 20.2042-1(c)(2) states:

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, etc.

In a divorce proceeding, it is common for one spouse to be required to pledge or assign the proceeds of a life insurance policy to the other spouse to secure his or her obligation to pay maintenance and/or child support. In such cases, the amount so pledged or assigned may generally be deducted from the value of the gross estate pursuant to the holding of Estate of Robinson v. Commissioner, 63 T.C. 717 (1975), in which the United States Tax Court held that where (1) a property settlement agreement entered into in a divorce proceeding obligates one party to name the other party as a beneficiary to life insurance proceeds; (2) the obligee receives the life insurance proceeds upon the death of the obligor; and (3) the obligor’s estate includes the life insurance proceeds in the value of the gross estate, the obligor’s estate may deduct the life insurance proceeds the obligor was required to provide under the divorce decree.

The U.S. Tax Court recently ruled that an estate was entitled to deduct the entire proceeds of a $2.5 million life insurance policy paid to the deceased husband’s ex-wife, even though she was only entitled to one-fifth of the proceeds under the original divorce decree. In Estate of Kahanic v. Commissioner, TC Memo 2012-81, decided March 21, 2012, the husband and wife entered into a settlement agreement obligating the husband to irrevocably name the wife as beneficiary to $500,000 in life insurance proceeds from a $2.5 million policy. The decree approving the settlement gave the husband 10 days to comply with this provision. Four months after the decree was entered, the wife asked the court to hold the husband in contempt for failing to do so. Before the court ruled on the contempt motion, the parties entered an agreed order obligating the husband to keep the wife as beneficiary of the entire policy until he complied with the original decree’s life insurance provisions.

The husband died before complying, the entire $2.5 million was paid to the ex-wife, and the IRS took the position that the estate could only deduct $500,000 per the terms of the original decree. The estate argued that it was entitled to deduct the entire $2.5 million per the agreed order entered four months later.

The tax court noted that a debt based on a promise or agreement is deductible under code section 2053(c)(1)(A) only if the debt is “contracted bona fide and for an adequate and full consideration in money or money’s worth.” In the divorce context, section 2516 provides that property transferred pursuant to a property settlement is generally presumed to be a transfer made for “adequate and full consideration in money or money’s worth” provided certain conditions are met, primarily that the settlement agreement and divorce decree are both entered within a specified time period.

The tax court held that the agreed order entered four months after the divorce decree modified the parties’ original settlement agreement, and was entered within the time frame set by section 2516; therefore it was entitled to section 2053’s presumption that the transfer was made for adequate consideration, and the estate was entitled to deduct the entire $2.5 million in insurance proceeds.

Estate of Kahanic v. Commissioner, TC Memo 2012-81, decided March 21, 2012

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