The U.S District Court for the Eastern District of Pennsylvania recently decided an interesting matter regarding a debt allegedly owed by a decedent’s estate to the estate of the decedent’s spouse. In Estate of Marion Derksen v. United States, the estate of Marion Derksen, through executrix Lyn Bailey, Marion’s daughter, sought an estate tax refund of $103,326.09, alleging that the Internal Revenue Service disallowed a deduction for a valid debt and reneged on an agreement to abate two months of late fees.
Marion and Willard Derksen maintained three investment accounts with Merrill Lynch: Two individual accounts in their respective names and one joint account. Marion played the stock market as a hobby and found great success, swelling the value of her account to $435,000 in April of 1994. Willard’s account, in comparison, held only $27,000 at that time, while their joint account was worth roughly $260,000.
In May of that year, the couple shifted the balance of the joint account into Willard’s individual account, increasing its value to about $290,00. On April 16, 1997 Marion signed a $200,000 promissory note to Willard. Willard, who was dying at the time, had no knowledge of the note. He died on June 24, 1997. The $200,000 promissory note was listed as receivable on his estate.
About nine months later, Marion signed a $200,000 check to her husband’s estate. However, the check was never deposited and the funds never transferred. Nonetheless, as sole heir to Willard’s estate, Marion would have received the $200,000 back, free of federal estate tax, upon the estate’s settling.
Marion died on Sept. 16, 2001. On Aug. 23, 2002, her estate filed a federal estate tax return, which claimed a deduction of $200,000 for a debt allegedly owed to Willard’s estate. After inquiring into the validity of the debt, the IRS denied the deduction on the grounds of lack of consideration for the agreement that created the debt. The estate then paid the IRS $103,326.09.
Lyn testified that her parents called her in the spring of 1994 and informed her that, going forward, they intended to keep their estates equal. She put forward the transfer made from the joint account to Willard’s account in 1997 as evidence of a formal agreement, supported by consideration. She claims that the $200,000 promissory note that gave rise to the action was also executed pursuant to this alleged agreement. Lyn’s testimony about this phone call was the only evidence of any such agreement.
Internal Revenue Code 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 demonstrate that there was a bona fide contract, promise or agreement made in exchange for financial consideration. The purpose of this section is to prevent estate depletion through “sham” contracts that serve a donative intent.
The court found no evidence supporting the contention that an agreement existed. Because Marion had so much more money than her husband, any agreement to equalize their estates would require her to transfer money to him, but, the court noted,“There is no evidence that she received any value, rights or privileges in return, nor is there evidence that she considered this transfer to be a loan and intended to seek repayment.” The transfer history did show that the Derksens were engaged in joint estate planning, with the intent of creating more equivalent estates, but this doesn’t infer the creation of a formal agreement to maintain equal estates supported by adequate consideration.
Furthermore, agreements between family members are treated with extra scrutiny and require exceptional circumstances to be treated as anything other than an agreement to make a testamentary bequest. The court laid out the following factors as indicative of a genuine contractual arrangement under Section 20.2053-1(b)(2)(ii) of the Code of Federal Regulations:
(A) 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.
(B) The nature of the claim or expense is not related to an expectation or claim of inheritance.
(C) 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.
(D) 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.
(E) 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.
Since the facts demonstrate that the Derksen’s relationship was solely marital and not also a business relationship, the agreement couldn’t have arisen in the ordinary course of business. Moreover, there’s no evidence of bargaining of any kind between the two. Thus, the court deemed that Lyn’s claim failed on this point as well.
Finally, with regard to consistent reporting for tax purposes, the court held that even though Lyn did consistently report the $200,000—first as an asset on her father’s state estate tax return (no federal return was required), then as a debt on her mother’s federal estate tax return—this reporting evidenced only Lyn’s belief that her parent’s agreed to equalize their estates and isn’t sufficient to outweigh the evidence that no such agreement existed, particularly given that the funds in question were never actually transferred.