Court Rejects Use of Step-Transaction Doctrine to Increase Decedent's Gross Estate

(Parker Tax Publishing September 2024)

The Tax Court held that the step-transaction doctrine did not apply to increase a decedent's gross estate by the value of death benefit proceeds from two life insurance policies, because each step of the transactions at issue had independent significance without regard to any of the later transactions. The court thus rejected the IRS's argument that there had been a violation of Maryland's insurable interest statute that would allow a chose in action such that the insurance proceeds would be includible in the decedent's gross estate. Est. of Becker v. Comm'r, T.C. Memo. 2024-89.

Background

Dr. Larry Becker (Dr. Becker) died on January 8, 2016, and his son, Gary Becker (Mr. Becker), is the executor of Dr. Becker's estate. In 2014, Dr. Becker created an irrevocable life insurance trust, the Larry Becker Irrevocable Family Trust (Trust). Dr. Becker's daughter and son were the trustees of the Trust (collectively, Trustees). The Trust agreement named Dr. Becker's wife, children, and grandchildren as beneficiaries of the Trust. The Trust agreement was irrevocable, and Dr. Becker, as the grantor of the Trust, relinquished all power to alter, amend, revoke, or terminate the Trust Agreement in any way.

After creating the Trust, Dr. Becker and the Trust, with the assistance of their counsel, Amy Stampfer, purchased two life insurance policies (Policy No. 1 and Policy No. 2) from Zurich American Life Insurance (Zurich). On the applications for those policies, Dr. Becker said the purpose of the insurance was for estate planning and that no plans had been made to enter into an agreement to borrow current or future premiums or both in connection with the policies. In the net worth section of the application for Policy No. 1, Dr. Becker listed $25 million of investments, $1.6 million in investment property, and zero debt. On the application for Policy No. 2, Dr. Becker reported his salary as $700,000 and the value of his total assets and net worth as $29.5 million. The Trust was the sole owner of both policies.

Barry Steinfelder was the insurance broker who assisted Dr. Becker and the Trust in procuring Policy No. 1. Steinfelder earned a commission on the sale of that policy equal to the first year's premium (i.e., $999,693). Policy No. 1 had the total death benefit of $11,470,000 and required an initial premium of $999,693. Policy No. 1 provided that the "Planned Periodic Premium" was $999,693, which was the target amount that the Trust intended to pay at a fixed interval.

The Trust funded the initial premiums on the policies via borrowed funds from Dr. Becker, who in turn borrowed the same amounts from other individuals. In 2014, Steinfelder borrowed from an acquaintance, Dr. Julia Wen, $999,693 and $697,257. Steinfelder gave Dr. Wen promissory notes that accrued interest at 1 percent. One of the notes issued to Dr. Wen lists the borrower as Steinfelder. The other lists the borrower as JJM, LLC, a single-member limited liability company (LLC) organized by Steinfelder. Steinfelder transferred $999,693 and $697,257 to Dr. Becker, who then deposited each of the amounts into an escrow account maintained by Stampfer on behalf of the Trust. Steinfelder then caused ALD, LLC (ALD), an LLC he controlled, to transfer $999,720 and $697,276 to Dr. Wen to repay Dr. Wen's loans to Steinfelder.

In December 2014, Stampfer and Michael Smith, signing as the trustees of the Trust, entered into a loan agreement with LT Funding, LLC (LT Funding), and executed two promissory notes pursuant to the agreement. The agreement and associated notes were secured by the Zurich life insurance policies (collectively, LTF Agreement). The LTF Agreement provided that LT Funding was obligated to pay future premiums due on the Zurich life insurance policies and that the Trust was obligated to pay LT Funding (1) 75 percent of the total death benefits of the Zurich life insurance policies, (2) all premiums advanced by LT Funding, and (3) interest on all premiums advanced by LT Funding at 6 percent per year. To continue each of the Zurich life insurance policies, the Trust was required to pay certain minimum premium amounts.

On March 14, 2016, following the death of Dr. Becker, Zurich paid death benefits from the life insurance policies to the Trust of approximately $11.5 million for Policy No. 1 and $8 million for Policy No. 2. A dispute arose between the Trust and various third parties, including Stampfer, Steinfelder, and LT Funding, as to which parties were entitled to the proceeds of the life insurance policies. Eventually, a settlement agreement was reached pursuant to which the Trust paid $9 million to LT Funding in exchange for release of the claims.

Under Code Sec. 2031(a) and Reg. Sec. 20.2031-1(b), 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. Code Sec. 2042(2) provides that the value of the gross estate includes proceeds of life insurance to the extent of the amount receivable by all other beneficiaries (other than the executor) 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.

Dr. Becker's estate tax return reported a gross estate of approximately $12.6 million. After auditing the return, the IRS determined that the step-transaction doctrine applied to the estate's life insurance transactions. According to the IRS, when the transactions were collapsed, the proceeds were not primarily for the benefit of the Trust beneficiaries but rather for LT Funding and, as a result, the Trust lacked insurable interests in the Zurich life insurance policies on the dates of issuance. The IRS said that the insurance contracts violated Maryland's insurable interest statute and thus gave rise to a cause of action under Maryland law. Based on this potential state law action, the IRS concluded that the face values of the policies should be included in the value of Dr. Becker's gross estate under Code Sec. 2031 and/or Code Sec. 2042(2). Dr. Becker's estate (Estate) filed a Tax Court petition to dispute the IRS's application of the step-transaction doctrine.

Analysis

The Tax Court held that, because each step of the transactions at issue had independent significance without regard to any of the later transactions, the IRS's application of the step-transaction doctrine was inappropriate.

Before determining whether the IRS's position was correct regarding the estate tax provisions, the court considered whether the application of the step-transaction doctrine gave rise to a claim under Maryland law in the first place. Citing the Tenth Circuit's decision in True v. U.S., 190 F.3d 1165 (10th Cir. 1999), the Tax Court observed that there are 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 court said that collapsing the steps under the "binding commitment" test would be inappropriate under the facts of the case and focused instead on analyzing the series of transactions under only the "end result" and "interdependence" tests.

Under the "end result" test, the court observed, transactions will be collapsed if it appears that a series of formally separate steps are really prearranged parts of a single transaction intended from the outset to reach the ultimate result. The court rejected the IRS's contention that it was the intent of the trustees and Dr. Becker to transfer the Zurich life insurance policies to LT Funding and that Dr. Becker's and the Trust's lack of sufficient assets to pay the initial premiums was evidence of the parties' intent to transfer the death benefits to LT Funding. According to the court, these contentions 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 unidentified at the time that the Zurich life insurance policies were issued.

The focus of the "interdependence" test, the court noted, is on whether the steps of a transaction are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. According to the IRS, several events within the transaction were interdependent on later steps, specifically the flow of money used to fund the initial premiums. The court said, however, that even if the Trust would eventually need to seek additional funding, upon the Zurich life insurance policies' issuance the Trust was entitled to nearly $20 million (less repayment of the ALD Notes). Further, the court observed, because Dr. Becker held significant assets at the time of the Zurich life insurance policies' issuance, payment of the initial and subsequent premiums did not appear contingent upon subsequent entry into the LTF Agreement. The court said there was nothing to indicate that payment of the premiums would have been "fruitless" without the LTF Agreement.

The court concluded that, because there was no violation of Maryland's insurable interest statute, there could be no chose in action under Maryland law. Consequently, it did not matter whether a potential claim under that provision should be treated as an "incident of ownership" under Code Sec. 2042(2) or as "property" under Code Sec. 2033, such that its value must be included in the value of decedent's gross estate under Code Sec. 2031, as no such claim existed. Likewise, the court said, without an increase in the gross estate, there could be no offsetting deduction to the taxable estate under Code Sec. 2053 for the amounts paid to LT Funding pursuant to the settlement agreement as a claim against the estate.

For a discussion of the estate tax treatment of life insurance proceeds, see Parker Tax ¶226,700.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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