Commissioner of Internal Revenue v. Keller's Estate

• Decision Date: 28 May 1940
• Docket Number: No. 7242.,7242.
• Citation: 113 F.2d 833
• Parties: COMMISSIONER OF INTERNAL REVENUE v. KELLER'S ESTATE et al.
• Court: U.S. Court of Appeals — Third Circuit

113 F.2d 833 (1940)

COMMISSIONER OF INTERNAL REVENUE v. KELLER'S ESTATE et al.

No. 7242.

Circuit Court of Appeals, Third Circuit.

May 28, 1940.

Samuel O. Clark, Jr., Asst. Atty. Gen., and Sewall Key, Berryman Green, and Carlton Fox, Sp. Assts. to Atty. Gen., for petitioner.

Ferdinand T. Weil and Weil, Christy & Weil, all of Pittsburgh, Pa., for respondents.

Before BIGGS, CLARK, and JONES, Circuit Judges.

CLARK, Circuit Judge.

No one knows better than insurance salesmen that only the "excess over $40,000" of life insurance proceeds receivable by beneficiaries other than the insured's executor are subject to the estate tax, 26 U.S.C.A. Int.Rev.Code, § 811 (g). This $40,000 exemption, a unique characteristic of their general stock in trade, is quite naturally stressed to the customer. Sometimes, however, it is stressed to a paradoxical extreme. The paradox consists in applying a life insurance exemption to the estate of an uninsurable prospect.¹

Mrs. Keller, the prospect (or rather decedent) at bar, had at the age of seventy-five no choice but to follow the course prescribed for uninsurables. She took out a single premium life policy in conjunction with a single premium annuity. Her estate now seeks to complete that course by securing the benefit of the $40,000 exemption. Opinions are divided as to whether it may do so. A majority of the Board of Tax Appeals and a unanimous Second Circuit Court of Appeals accept the paradox and allow the exemption.² On the other hand, a unanimous Eighth Circuit Court of Appeals and several students of the question have taken the opposite view.³ We are constrained to do likewise:

One may ask at the outset: How does an uninsurable life become insured? The explanation lies in the mathematical correspondence between annual interest and annuity payments. $100 due in ten years at 2% is precisely the same thing as an annuity certain of $2 for ten years combined with a promise to pay $100 without interest at the end of ten years. The discounted sums required to meet the annuity payments plus the discounted sum required to pay the $100 when due will always total $100, the amount of the loan.⁴ The same holds true if the loan is repayable at the death of the lender. The obligation of the borrower may be divided into a complete annuity of $2 combined with a whole life insurance of $100. One merely substitutes for the ten year term a series of probabilities of being alive (annuity) and of being dead (life insurance) in the future. The relation between these converse probabilities is such that the discounted sum required to provide the annuity plus that required to produce the life insurance will always be equal to the amount of the loan. We say always because the relation between the probabilities of living and dying is from the very nature of the mortality tables, on which they are calculated, constant, no matter what the age of the lender. So, an insurance company may borrow $100 at 2% from one doomed to die within ten minutes and issue in return a $2 annuity and a $100 life policy. By an actuarial tour de force (because the continuance of life is a matter of minutes, not probabilities) the amount of the loan advanced is split into the single premiums appropriate to each policy as if taken out by a normal person. In other words, the sure thing (loan) is artificially separated into doubtful bet (life insurance) and hedge (annuity). It is on this general principle that an uninsurable life becomes "insured". See Appendix to this opinion.

The transaction between Mrs. Keller and the insurance company was cast in the same mould. There are, to be sure, arithmetical ramifications. Life and annuity premiums were computed on different mortality tables at different rates of interest, and included "loading charges" to meet premium taxes and agents' commissions. These, however, present no essential point of dissimilarity. The two premiums, exclusive of loading charges, add up to $20,000, the face amount of the life policy. Apart from the effects of a slight miscalculation in loading charges, Mrs. Keller's death, no matter when it occurred, could never require the company to look to funds contributed by other policy holders in order to make the life insurance payment. That being so, we can detect no substantial economic distinction between the conjoint effect of the two policies issued, and that of an engagement to repay Mrs. Keller, or her order, $20,000 upon her death, with interest at almost exactly 2% per annum ($390.84 being payable under the annuity) in the meantime. It is plain, furthermore, that the economic consequences of a loan were intended. Mrs. Keller did not undergo a physical examination, and it is conceded that the company would not have issued the life policy without the annuity.

Nevertheless, Mrs. Keller died the holder of a paid up, standard form, life insurance policy, with a cash surrender value, a right to change the beneficiary, and all the usual paraphernalia of such contracts. Its proceeds were payable to her daughter. The legal problem, therefore, is whether those proceeds constitute an "amount receivable by * * * beneficiaries as insurance under policies taken out by the decedent upon his own life" within the meaning of the taxing statute.

We think the question turns upon whether the adverbial phrase, "as insurance" refers to the legal, or to the economic, method whereby the amount is received. The legal mechanism employed at bar is unquestionably a contract of life insurance. An action could be brought on that policy to recover its proceeds, without the annuity being in any wise involved. The annuity, on the other hand, is not only a cog but also an indispensible cog in the economic machine which produced the amount received by the beneficiary. That machine, therefore, fulfilled none of the composite functions of life insurance. Being in its essence a loan transaction it neither "built up an estate", nor caused the company to assume, on loose principles of indemnity, any risk of loss occasioned by premature death. Vance, Handbook of the Law of Insurance, pp. 80, 123 et seq.; Cooley, Briefs on the Law of Insurance p. 80. What is more important, such a risk, being non-existent, could not be so assumed pursuant to a plan of spreading it among a large section of the population, i. e., other policy holders. See An Analysis of "Insurance" and "Insurance Corporation", 36 Columbia Law Review 456 (note). Mrs. Keller merely paid $20,000 to obtain $20,000 at her death. We may observe parenthetically that promissory notes payable at the death of the obligor have long been countenanced in the law. 1 Daniel on Negotiable Instruments p. 45; 2 A.L.R. 1471, note. The makers of such engagements (to say nothing of the learned framers of the Uniform Negotiable Instruments Law §...