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Promissory Note Between Spouses Did Not Reduce Taxable Estate
Estate Planning Journal April 2013
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.
Facts
Marion and Willard Derksen each had separate investment accounts, as well as a joint investment account. In May 1994, the couple moved the assets in their joint account into Mr. Derksen's individual account. At trial, the couple's only child, Lynn Bailey, testified that her parents called her in 1994 after meeting with an attorney for the purpose of estate planning and mentioned to her that they intended to keep their estates equal. There was no written evidence of an agreement between Mr. and Mrs. Derksen to maintain equal estates.
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.
Analysis
Section 2053 authorizes a deduction for claims against or debts of an estate. If the claim is based on a promise to pay, the estate must show that there was a bona fide contract, promise, or agreement made in exchange for adequate financial consideration, and demonstrate that the claim was an enforceable obligation that existed on the date of the decedent's death.2 Generally, deductible claims must actually be paid by the estate. If an estate does not meet this burden of establishing that it is entitled to a deduction under Section 2053, the claim is not deductible.
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 first factor regarding the bona fides of the loan, the court found no evidence of any agreement between Mr. and Mrs. Derksen to maintain equal estates that arose in the ordinary course of business or was negotiated or bargained for at arm's length. With respect to the second factor regarding whether the transaction is testamentary in nature, the court found that Mr. and Mrs. Derksen entered into a cooperative plan to pass on their assets to their heir in a manner that minimized estate tax liability. Thus, the agreement maximized the assets that passed on to their heir, and therefore the agreement served a donative intent related to an expectation of an inheritance. With respect to the third factor regarding the evidentiary support for the transaction, the court found that there was no evidence that Mr. and Mrs. Derksen entered into a written agreement, and the only evidence that an oral agreement existed is their daughter's recollection of a telephone call in which her father noted the Derksens' intent to keep their estates equal.
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.
Comments
While the technique used by the Derksens was certainly creative, one of the reasons it failed is because the Derksens failed to transfer funds between themselves during their lifetimes in a manner that would have much better documented the transaction. The lesson to be learned from this case is that the actions of the taxpayer should be in accordance with the reporting position that they are claiming on a return or will claim on a future return. While the loan technique employed by the Derksens was not guaranteed of success, the estate's position would certainly have been stronger if assets had actually been transferred from the account of Mrs. Derksen to the account of Mr. Derksen and if repayment of the loan had actually occurred by transferring funds from the account of Mrs. Derksen to Mr. Derksen rather than Mrs. Derksen merely writing a check that was never deposited.
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 fsbaldino@lerchearly.com.
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.
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