9th Circuit Holds Actuarial “Bet” Voided by Step-Transaction Doctrine

The 9th Circuit, in Brown v. U.S., 91 AFTR 2d 2003-2085 (5/1/03) upheld the IRS interposition of the step-transaction doctrine to derail an estate plan involving the creation of a life insurance trust to fund a future estate tax liability. The eternal bane of the taxpayer, the doctrine is asserted when the formalities of a transaction are consistent with the tax treatment sought by the taxpayer, but the end result, in the Service’s view, could have been achieved in manner resulting in a tax liability.

Brown intended that his entire estate of $180 million pass into a marital deduction trust, thus avoiding payment of any estate tax at his death. A life insurance policy was also purchased on the life of his spouse; policy proceeds were intended to fund estate taxes due at her death.

Since the spouse was without the means to herself purchase the policy, Brown gave her $3.1 million to accomplish this. All agreed that this gift qualified for the unlimited gift tax marital deduction. However, Brown also gave his wife $1.4 million to pay the gift tax associated with the purchase of the insurance policy by the trust. At issue was whether Brown or his spouse paid this gift tax.

Brown died within 3 years after payment of the gift tax. The IRS asserted that in substance if not in form, Brown paid the gift tax liability of $1.4 million. Under § 2035, gift taxes paid on transfers made within 3 years of death are included in a decedent’s estate. The IRS therefore asserted that Brown’s gross estate should be increased by $1.4 million. To make matters worse, the IRS further argued that the $1.4 million included in Brown’s estate failed to qualify for the estate tax marital deduction.

Taking a “realistic view of the entire transaction,” while acknowledging that “anyone may so arrange his affairs that his taxes should be as low as possible,” the 9th Circuit nevertheless found the spouse to be a “mere conduit” of funds. Despite the lack of a legally enforceable obligation to purchase the policy, the step-transaction doctrine was apposite since “family members colluded to accomplish a prearranged plan.”

Brown had made an actuarial “bet” seeking to hedge against the possibility that he, but not his spouse, would die within 3 years after the gift tax payment. The hedge seemed to work: Brown in fact died within 3 years. However, the § 2035 inclusion risk did not track the “economics” of the tax payment. The “bet” would have been respected had the spouse paid the gift taxes with her own funds. However, her “transient ownership” for one day “had no independent purpose or effect beyond the attempt to alter tax liabilities.”

Interestingly, IRS Counsel allowed during oral argument that had the spouse died first, the Service would not have acquiesced in favor of relieving her of estate tax liability, even though she would have been forced to include the $1.4 million in her own estate under § 2035. This “asymmetry” in the application of the step-transaction doctrine, while giving the court “pause,” did not affect its holding, since it did not “reach” this issue.

After finding that the $1.4 million should be included in Brown’s gross estate, the court determined that since trust beneficiaries, rather than the surviving spouse, would benefit from the life insurance proceeds, the estate could not take a corresponding $1.4 million estate tax marital deduction. While the case does not, as counsel argued, “vitiate the entire estate planning profession,” it does illustrate its limits. Had the risk been foreseen, Brown, if insurable, could have purchased a 3-year term policy on his own life for the appropriate amount.

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