You Cant Have Cake and Eat It, Too

In Estate of William G. Street v. Commissioner (TC Memo 1997-32), the 5th Circuit Court of Appeals affirmed a Tax Court decision to include the proceeds from life insurance policies made payable to the decedents estate in the decedents gross estate for federal estate tax purposes.

William Street and his wife, Amma Elnora, resided together in Texas for several years before his death. He purchased four life insurance policies for himself and named his estate as beneficiary. Street provided for his wife generously in his will, then left the remainder of his estate to his children from a previous marriage.

Upon his death, the proceeds from Streets policies were paid to his estate. His wife filed a claim in a Texas state court opting out of the will and claiming a one-half interest in the community property, including the life insurance proceeds.

Streets daughter (co-administrator of the estate) contested the wifes claim to any portion of the life insurance proceeds on the grounds that the decedent was the sole owner of the policies and had specifically named his estate as beneficiary.

While awaiting the outcome of the litigation, however, the estate filed a federal estate tax return that excluded one-half of the insurance proceeds as representing a one-half community property share not owned by the decedent. The Texas state court eventually held that all insurance proceeds belonged to the decedents estate.

Streets wife appealed, but the Texas Court of Appeals held that the decedent was the sole owner of the policies and could name a beneficiary other than his spouse if the designation was fair and free of fraud. The court held there was no fraud because Street had specifically provided for his wife with more than 50% of his estate under his will.

Subsequently, the IRS issued a notice of deficiency to the estate based upon IRC section 2042(1), which provides that the value of the gross estate includes the value of all the property receivable by the executor as life insurance proceeds of the decedent. The estate contested the deficiency in Tax Court, but the court held (1) that state law determines the ownership of property and (2) that, although the policies were purchased with community funds, the rulings of the Texas courts had removed the proceeds from the regime of community property.

This time it was the estate that filed an appeal, arguing that the Tax Court had misconstrued the Texas rulings and that the proceeds were not removed from the regime of community property for purposes of regulations section 20.2042-l (b)(2). The estate contended that Street had made a gift of his wifes one-half interest to his estate and that one-half of the proceeds should be taxed to the estate and one-half taxed as a gift from the decedents wife, according to regulations section 25.2511-1(h)(9).

Result: Although the Court of Appeals noted the conflict between IRC section 2042(1), regulations section 20.2042-1(b)(2) and Texas community property law, it held that under IRC section 2042(1) the value of the gross estate should include the value of all proceeds of life insurance to the extent receivable by the executor. In the Street case, the proceeds were actually paid to the estate. Thus, the entire amount of the proceeds had to be included for tax purposes.

Tina Steward Quinn, CPA, PhD,
assistant professor of accountancy, and Keith
W. Smith, CPA, PhD, associate professor
of accountancy, Arkansas State University,
Jonesboro.