Promissory Note Between Spouses Did Not Reduce Taxable Estate
Estate of Derksen, 110 AFTR 2d 2012-6620, 2012-2 USTC ¶50668 (DC Pa., 2012).
In Estate of Derksen,1 the U.S. District Court for the Eastern District of Pennsylvania held that a promissory note between a wife and her husband was not deductible for estate tax purposes in the wife's estate because the note was not bona fide.
In late 1996 or early 1997, Ms. Bailey noticed that the balance in her mother's account was larger than the balance in her father's account. Because the accounts were not equal, Ms. Bailey drafted a $200,000 promissory note for Mrs. Derksen to sign in favor of Mr. Derksen. Because Mr. Derksen was dying at the time, Ms. Bailey did not discuss with him the loan from him to Mrs. Derksen. Mrs. Derksen signed the promissory note in April 1997. Mr. Derksen died, in June 1997. About nine months later, Mrs. Derksen signed a $200,000 check payable to her husband's estate. The $200,000 promissory note was listed as a receivable on Mr. Derksen's state estate tax return. However, the $200,000 check was never deposited, and the funds were never transferred into Mr. Derksen's estate. Mrs. Derksen was the heir to Mr. Derksen's estate, and would have received the $200,000 back, free of federal estate taxation, once Mr. Derksen's estate was settled.
While not stated in the opinion, presumably the purpose of the loan was to address the inconsistency between Mr. and Mrs. Derksen's agreement to maintain equal estates and the fact that the balance in Mrs. Derksen's account was larger than that of Mr. Derksen. The loan served the purpose of returning $200,000 of assets to Mrs. Derksen's account following the constructive or deemed transfer of $200,000 of assets from Mrs. Derksen to Mr. Derksen in order to equalize their estates. Essentially the loan returned the accounts of Mr. and Mrs. Derksen to their balances prior to their alleged agreement to equalize their estates.
Mrs. Derksen died in 2001, and her entire estate, which included the assets she inherited from Mr. Derksen's estate, passed to their daughter. The estate filed a federal estate tax return, which included a deduction for a $200,000 debt Mrs. Derksen allegedly owed to the estate of her late husband. The IRS audited the return and disallowed the deduction for the $200,000 debt, citing lack of consideration for the agreement that created the debt. The estate challenged the disallowance and argued that there was adequate consideration for the claimed debt.
The government argued that the estate did not demonstrate that there was a bona fide agreement supported by consideration between Mr. and Mrs. Derksen to maintain equal estates. Because Mrs. Derksen had more wealth than her husband, any agreement to equalize their estate would have required her to transfer her own money to her husband. However, the court found that the estate presented no evidence that Mrs. Derksen received any value, rights, or privileges in return for her transfer of assets to Mr. Derksen. The court therefore concluded that the evidence did not support the estate's argument that an agreement, supported by financial consideration, existed between Mr. and Mrs. Derksen to maintain equal estates.
The court noted that agreements between family members are viewed with particular scrutiny. In determining whether family members entered into a bona fide agreement, the court listed five factors that are indicative of a genuine contractual arrangement:
- The transaction underlying the claim or expense occurs in the ordinary course of business, is negotiated at arm's length, and is free from donative intent.
- The nature of the claim or expense is not related to an expectation or claim of inheritance.
- The claim or expense originates pursuant to an agreement between the decedent and the family member, related entity, or beneficiary, and the agreement is substantiated with contemporaneous evidence.
- Performance by the claimant is pursuant to the terms of an agreement between the decedent and the family member, related entity, or beneficiary and the performance and the agreement can be substantiated.
- All amounts paid in satisfaction or settlement of a claim or expense are reported by each party for federal income and employment tax purposes, to the extent appropriate, in a manner that is consistent with the reported nature of the claim or expense.
With respect to the fourth factor regarding whether the parties acted in accordance with the purported agreement, the estate's claim that Mrs. Derksen owed Mr. Derksen $200,000 pursuant to an agreement to keep their estates equal in size was not enforced by either decedent during their lifetimes or by Mr. Derksen's estate following his death. With respect to the last factor regarding consistent reporting, the court recognized that Ms. Bailey, as executrix of her father's estate, did claim the $200,000 note as an asset of his estate, and when Mrs. Derksen died four years later, Ms. Bailey, as executrix of her mother's estate listed the $200,000 note as a debt of her estate. However, the court found that this consistent reporting evidences only Ms. Bailey's belief that it was the intent of her parents to equalize their estates. The court stated that such consistent reporting was insufficient to outweigh the evidence that Mr. and Mrs. Derksen did not enter into a bona fide contract, promise, or agreement made in exchange for adequate financial consideration.
Having satisfied only one of the five factors, the court concluded that the estate was not entitled to a $200,000 estate tax deduction.
1110 AFTR 2d 2012-6620, 2012-2 USTC ¶50668 (DC Pa., 2012).
2Section 2053(c)(1); Reg. 20.2053-4(a).
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more about promissory notes, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the April 2013 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.