Opinion ID: 7103
Heading Depth: 1
Heading Rank: 3

Heading: Life Insurance Proceeds

Text: 17 The conflict between the Commissioner and the Estate over the proper taxation of term life insurance proceeds paid to Herbert's estate raises a much closer question. Internal Revenue Code Sec. 2042(1) dictates that the value of the gross estate shall include    the amount receivable by the executor as insurance under policies on the life of the decedent. Section 20.2042-1(b)(2) of the Regulations, however, excludes life insurance proceeds payable to the estate to the extent that they belong to the decedent's spouse under state community property law. Herbert's estate labors to avail itself of this exception by insisting that one-half of the $650,000 proceeds still belonged to Mary Jane's residuary trust. 5 Although the Commissioner ridicules this argument as pure metaphysics, the truth of the matter is decided under state law. Broday v. United States, 455 F.2d 1097, 1099 (5th Cir.1972). Therein lies the rub. 18 In Texas, the status of property is fixed at the time of acquisition or inception of title. Colden v. Alexander, 141 Tex. 134, 171 S.W.2d 328, 334 (1943). Since Herbert's term life insurance policy was purchased initially with community property in 1980, ordinarily Mary Jane would retain a one-half community interest in the policy and its proceeds: [I]f life insurance is purchased during a marriage and paid for with community funds, the 'policy rights' or incidents of ownership and the 'proceeds rights' or the rights to receive the proceeds in the future constitute community property. Freedman v. United States, 382 F.2d 742, 745 (5th Cir.1967), (citing Brown v. Lee, 371 S.W.2d 694 (Tex.1963)). Two factual wrinkles obscure this simplicity: (1) Mary Jane died in 1983; (2) Herbert personally had to renew the policy in 1984, 1985 and 1986. 19 Prompted by these complications, the IRS fires three broadside assaults on the suggestion that Mary Jane 6 continued to sustain an unmatured interest in the proceeds. First, the IRS posits that because the marital community dissolved at her death any community interest in the policy or unmatured right to the proceeds terminated upon expiration of the last one-year term of the policy paid with community funds. Alternatively, the Commissioner argues that Texas caps Mary Jane's community interest at one-half the cash surrender or interpolated terminal reserve value of the policy at her death. 7 As the term policy here had no cash surrender value nor any value computed by the interpolated terminal reserve method, the Commissioner reasons the remaining $650,000 of value must be ascribed to Herbert's estate. The final challenge recasts the lack of monetary value at the moment of her death into an extirpating force. The Commissioner explains that the absence of monetary value removed the need for partition of Mary Jane's community interest in the policy, thereby transforming Mary Jane's communal right into an extinguished interest. 20 Under circumstances where the uninsured spouse predeceases the insured spouse, settlement of the decedent's community interest in the unmatured chose has ordinarily been resolved by allocating one-half of the cash surrender value to the deceased's estate and the other one-half ... to the surviving spouse. Brown v. Lee, 371 S.W.2d 694, 696 (1963) (emphasis added). Significantly, however, Mary Jane's property was not settled or partitioned prior to Herbert's death. Accordingly, the normal rule of Brown is inverted: [W]here settlement of the deceased wife's community interest in the policies was not made prior to the death of the insured ... the wife's community interest was never extinguished and the policies retained their community status up to the time of maturity. Consequently, the proceeds are community. Id. 21 Elaborating on the consequences of treating life insurance purchased by the community as community property, Amason v. Franklin Life Insurance Co., 428 F.2d 1144 (5th Cir.1970), provides a mandatory lesson on the treatment of insurance proceeds received after the dissolution of the marital community where no partition has yet occurred. The case holds explicitly that divorce does not automatically divest either spouse of his or her interest in the policy, that this interest is preserved in both benefits of ownership of the policy and the eventual proceeds from the policy, and that the need to pay premiums subsequent to the divorce from separate funds cannot terminate either spouse's right to the proceeds. Id. at 1146-1148. Furthermore, Amason prescribes the tenancy-in-common as the proper prism to assess the legal relationship. Id. at 1147 (After divorce each spouse owns an undivided one-half interest in that property as a tenant in common in the same fashion as if they had never been married.) 22 Hence Amason instructs that the death of Mary Jane without a partition created a tenancy-in-common between Mr. Cavenaugh and her estate's designated heirs vis a vis the policy. 8 Moreover, this tenant in common relationship continues until the proceeds are paid. Nonetheless, persuasively distinguishing death from divorce or adopting a limiting principle in cases where the policy has no cash value at the moment of the uninsured spouse's death would still permit the Commissioner to prevail. Yet previous resort to these exact maneuvers failed to capture any bounty for the Internal Revenue Service. See Scott v. Commissioner, 374 F.2d 154, 159-160 (9th Cir.1967). 23 In Scott, a remarkably similar case 9 , the precise question tackled by the court was how much of the insurance proceeds the husband must include in his estate. Critically, the cash surrender value of the policy at the date of the wife's death was zero. Interestingly, the Commissioner advanced a familiar logic: 24 [The wife's] only interest at her death, and therefore the only interest that passed ... under her will was the right to receive one-half of the cash surrender value of the policies. The theory ... is that while the insured husband is alive the only value that can be realized is the cash surrender value, and that the right to receive the face amount of the policies upon the husband's death ... is kept alive only by payment of further premiums by the husband after the wife's death. Consequently to the extent that the proceeds receivable at the husband's death exceed the cash surrender value at the wife's death, this is attributable to those premiums, which were not paid from community property the marital community having been dissolved by the death of the wife. Accordingly, the entire proceeds, less one-half the cash surrender value at the time of the wife's death, are part of the husband's estate. 25 Id. at 159. Dismissing this argument, the Ninth Circuit recognized that under California community property law, the right to have the contract of insurance continued in force by virtue of payment of premiums from its issuance is itself a valuable right even when the policy at dissolution has no cash surrender value. Id. at 159-160. The question in California law was not whether the community interest in the life insurance policy lapsed after the death of the uninsured spouse but was instead the proportion of ownership attributable to the uninsured spouse's estate. 26 Although the community property laws of California and Texas differ in many respects, neither the IRS nor the Tax Court has produced authority confirming a meaningful variation between California and Texas law on this issue. Specifically, Scott's treatment of a marital community dissolved via death--construction of a tenant in common relationship--accords with the solution to dissolution adopted by Amason in the context of divorce. This parallelism is not only logical, but appears compelled by the synergy of Amason and Brown v. Lee. 10 27 Furthermore, Scott 's holding that the community interest is not commuted by a zero cash surrender value harmonizes with Texas law. Even though the policy provides only for term insurance and has no cash value, it is still a property right. Seaman v. Seaman, 756 S.W.2d 56, 58 (Tex.App.1988) (citation omitted). The contrary position of the IRS conflates value with a property interest. Within and without Texas, property is distinct from value; surely one can own property that is worthless by any market measure, but still is not subject to confiscation by the state or invasion by other members of the public. 11 28 Mitchell v. Mitchell, 448 S.W.2d 807, 811 (Tex.App.1969), does not hold otherwise. That case resolved a dispute between the original wife and the second wife of the deceased over an interest in the proceeds of his federal group life insurance policy. Applying federal law, the court concluded that the first wife could have no interest in the policy because the federal statute strictly assigned all interests to the widow. Id. Preservation of a community interest in the coverage afforded by the federal policy would violate the conditions of the federal statute. Citing this court, Mitchell observed: The words 'payable' and 'widow'    in the    statute do not refer to the status of the beneficiary at the time the policy    is issued and the beneficiary is designated, but are clearly applicable to the status of the beneficiary when the policy matures and becomes due and payable. Id. (alterations in original). To effectuate this design, the Mitchell court held that the term 'widow' clearly means [only] the woman surviving on the death of the man to whom she was legally married at the time of his death. Thus, the original wife's interest was truncated by operation of the statute and not because of its lack of cash value. 29 Now confronted by the Commissioner's final bolt, this court must divine whether each yearly renewal of a one-year term life insurance policy by means of increasing premiums creates a (new) separate policy or continues to relate to the initial (communal) investment. Because Texas follows the inception of title doctrine, the choice is binary: If the community received all of what it bargained for in the original policy while Mary Jane lived, the post-communal renewals are separate property, but if elements of the contract remained unexpired at Mary Jane's death then the community interest survives. Examining the terms of the policy discloses several guarantees of more than de minimis import to the community's transaction. 30 A. The Cavenaughs purchased the unrestricted right to renew the policy for a period of up to 21 years at a fixed (albeit increasing) rate. The security of this protection is compounded by two provisions that expressly permit exercise of this right without proof of insurability and entitle the owner of the policy to automatic conversion to any whole life insurance policy issued by the insurer. In economic terms, the Cavenaughs negotiated a one-year term life insurance policy plus an option with a defined--and lengthy--exercise period. This option alone might suffice to track the coverage afforded by the later renewals back to the community. See Demler v. Demler, 836 S.W.2d 696 (Tex.App.1992) (options earned during marriage were community property). 31 B. The policy also became uncontestable after two years and no longer excluded payment upon suicide of the insured. 32 C. The annual dividends (of at least 3.5%) payable to the Cavenaughs increase in a non-linear progression as the policy is renewed for extended terms. For example, in year 1 of the policy the Cavenaughs were scheduled to receive $2,730, for the second year $2,379, and the fourth year $2,944.50. But by renewing the policy through year 10, they could expect to receive $5,726.50 annually and by year 15 the return would jump to $8,970. Hence the financial terms of subsequent renewals for one-year increments were not completely independent. By continuing coverage after Mary Jane's death, Mr. Cavenaugh apparently reaped some benefit from the four years of prior insurance. 33 Taking these factors together, we believe it unlikely that a Texas court would dismiss these benefits produced by the community as trivial. Employing the time of acquisition rule, Mr. Cavenaugh's later actions could not therefore convert the character of the property. 34 In the absence of any argument or evidence by the IRS that might justify assigning less than one-half of the proceeds to Mary Jane's unpartitioned community interest, we see no basis to deviate from applying the conventional principles of Texas community property law to the proceeds. Accordingly, the Tax Court erred in determining that Herbert's estate should include for tax purposes 100% of the proceeds of the term life insurance purchased initially by the community. The tax liability must be recalculated, attributing one-half of the proceeds to his estate. 12 35 For the foregoing reasons, the judgment of the United States Tax Court is AFFIRMED in part, and REVERSED in part. 36