Estate of Waters v. C.I.R.

• Citation: 48 F.3d 838
• Decision Date: 06 March 1995
• Docket Number: No. 94-1731,94-1731
• Parties: -1356, 95-1 USTC P 60,191 ESTATE OF James H. WATERS, Jr., Deceased; William Roger Waters and John B. McMillan, Co-Executors, Petitioners-Appellants, v. COMMISSIONER OF the INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (4th Circuit)

Page 838

48 F.3d 838

75 A.F.T.R.2d 95-1356, 95-1 USTC P 60,191

ESTATE OF James H. WATERS, Jr., Deceased; William Roger

Waters and John B. McMillan, Co-Executors, Petitioners-Appellants, v. COMMISSIONER OF the INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 94-1731.

United States Court of Appeals, Fourth Circuit.

Argued Nov. 1, 1994.

Decided March 6, 1995.

ARGUED: John Craig Dorsey, Manning, Fulton & Skinner, Raleigh, NC, for appellants. Sara S. Holderness, Tax Division, U.S. Dept. of Justice, Washington, DC, for appellee. ON BRIEF: Loretta C. Argrett, Asst. Atty. Gen., Gary R. Allen, Jonathan S. Cohen, Tax Div., U.S. Dept. of Justice, Washington, DC, for appellee.

Before RUSSELL and WILLIAMS, Circuit Judges, and CHAPMAN, Senior Circuit Judge.

Affirmed in part, reversed in part, and remanded by published opinion. Judge WILLIAMS wrote the opinion, in which Judge DONALD RUSSELL and Senior Judge CHAPMAN joined.

OPINION

WILLIAMS, Circuit Judge:

This appeal concerns the interplay between state divorce law and federal estate tax law. In particular, we study the significant effect of supplanting common law marital rights with deferred community property principles on federal estate tax liability.

The Estate of James H. Waters, Jr. (Estate), acting by and through its co-executors, William Roger Waters and John B. McMillan, appeals the opinion and final judgment of the United States Tax Court in favor of the Commissioner. Mr. Waters (Decedent), a lifelong resident and domiciliary of North Carolina, died testate on July 3, 1988, from a subarachnoid hemorrhage. At the time of his death, Decedent was forty-eight years old and had been unmarried since August 1, 1984, when he and his former wife, Barbara S. Waters ("Ms. Waters"), divorced. The Estate filed a federal estate tax return (Form 706) on October 3, 1989, showing a gross estate of $5,681,720.15, a taxable estate of $4,521,345.34, and a tax liability of $1,596,749.26. In a statutory notice of deficiency, the Commissioner determined a gross deficiency in Decedent's federal estate tax in the amount of $399,519. The Estate petitioned the Tax Court for a redetermination of the deficiency.

Following the submission of joint stipulations of fact and a trial held on October 5, 1993, the Tax Court entered a decision for the Commissioner, finding an estate tax deficiency in the amount of $399,519. Specifically, the Tax Court found that Decedent's obligations enumerated in a "Support and Property Settlement" agreement executed by Decedent and Ms. Waters were not supported by adequate and full consideration pursuant to I.R.C. Secs. 2043(b) & 2053(c)(1) (1988) and, thus, were not deductible from Decedent's gross estate pursuant to I.R.C. Sec. 2053(a). The Tax Court further found that Decedent received no consideration for the transfer of a life insurance policy to Ms. Waters and, therefore, the proceeds of that policy were fully includable in Decedent's gross estate under I.R.C. Sec. 2035(a) (1988). For the reasons discussed below, we reverse in part, affirm in part, and remand to the Tax Court for further proceedings in accordance with this opinion.

I.

Decedent married Ms. Waters on November 23, 1961. They had two children, Jeanette Leigh Waters, born in 1966, and James H. Waters, III, born in 1969. At the time of their marriage, Decedent and Ms. Waters had no net worth, and substantially all the assets acquired during their marriage came from income Decedent earned through employment, business, and investment activities. Decedent was an officer of Boddie-Noell Enterprises, Inc. (Boddie-Noell) of Rocky Mount, North Carolina, and participated in Boddie-Noell's savings and retirement plan, as well as its deferred compensation plan. Decedent also held a minority share of Boddie-Noell stock.

Decedent and Ms. Waters separated on April 1, 1981, and thereafter lived apart from one another. In November of 1983, Ms. Waters brought an action against Decedent in the North Carolina General Court of Justice (State Court) seeking a divorce from bed and board. ¹ In January of 1984, Decedent filed an answer and counterclaim seeking an absolute divorce on the statutory ground of one year's separation. Both Ms. Waters in her action for divorce and Decedent in his counterclaim requested the State Court to determine their "marital property" and to make an equitable distribution of that property pursuant to the North Carolina equitable distribution statute, N.C. Gen.Stat. Sec. 50-20 (1987). On August 1, 1984, the State Court dissolved the marriage by a decree of absolute divorce. The divorce decree did not resolve the issues of permanent alimony, child support, attorney's fees, and equitable distribution of property; instead, the State Court retained jurisdiction over these issues for further action.

From August 1983 through April 1987, Decedent and Ms. Waters, through their respective attorneys, periodically engaged in settlement negotiations relating to alimony, child support, and the division of their property. In 1986, however, Ms. Waters became concerned about how she would support herself and her children if Decedent were to die before they finalized their support and property agreement. At Ms. Waters's request, Decedent, on April 3, 1986, transferred to her a $200,000.00 life insurance policy issued to Decedent in 1983 by Southwest Life Insurance Company (Southwest). Ms. Waters did not give Decedent, or relinquish her entitlement to, any property or money in return for this life insurance policy.

Finally, on April 28, 1987, Decedent and Ms. Waters executed an agreement, entitled "Support and Property Settlement" (Agreement), in the presence of a notary public for Wake County, North Carolina. By its terms, Decedent agreed to the following: (1) the assignment to Ms. Waters of $125,000.00 of Decedent's $250,000.00 deferred compensation plan; (2) the assignment to Ms. Waters of $12,869.13 of Decedent's $206,345.00 savings and retirement plan account; (3) the issuance of a promissory note in the amount of $220,000.00 to Ms. Waters; (4) the maintenance of $270,000.00 in life insurance, naming as beneficiary a trust for the benefit of Ms. Waters; (5) the payment of the children's college expenses; and, (6) the payment of the children's medical insurance expenses. The Tax Court found, and the parties do not contest, that the negotiations culminating in the Agreement between Decedent and Ms. Waters were adversarial in nature, and the resulting settlement constituted a bona fide arm's length transaction. Decedent's obligations as specified in the Agreement were carried out following his death in July of 1988. ²

The Estate timely filed its federal income tax return on October 3, 1989. The return included $125,000 in the gross estate as the value of Decedent's interest in his deferred compensation plan and $191,794 as the value of Decedent's savings and retirement plan. ³ These values only included the amounts paid to the Estate; they did not include the amounts paid to Ms. Waters. With respect to Decedent's remaining obligations under the Agreement, the return deducted as claims against the Estate: (1) $270,000 representing the proceeds of Decedent's Aetna life insurance policy paid to the trust for the benefit of Ms. Waters; (2) $17,656 representing the estimated college expenses of Decedent's son; ⁴ (3) $5,349 representing the estimated health insurance expenses of Decedent's son; and, (4) $220,000 representing the amount Decedent owed to Ms. Waters on the promissory note. The return also did not include any amount in Decedent's gross estate with respect to the life insurance policy transferred to Ms. Waters during the settlement negotiations in 1986.

In a statutory notice of deficiency, the Commissioner disallowed the deductions claimed with respect to Decedent's obligations under the Agreement on the ground that they were not supported by adequate and full consideration in money or money's worth as required by I.R.C. Sec. 2053(c)(1). ⁵ The Commissioner also determined that, in accordance with I.R.C. Sec. 2035(a), the proceeds from the life insurance policy transferred to Ms. Waters in 1986 were fully includable in the Decedent's gross estate. As a result of these adjustments, the Commissioner determined a gross deficiency in Decedent's federal estate tax in the amount of $399,519.

The Estate petitioned the Tax Court for a redetermination of the deficiency. However, in an opinion filed on April 28, 1994, the Tax Court agreed with the Commissioner and determined that because Decedent and Ms. Waters failed to effectuate an equitable distribution pursuant to North Carolina law, N.C. Gen.Stat. Sec. 50-20, they necessarily relied on "traditional common law rules of property law" as consideration for the Agreement. ⁶ In support of this conclusion, the court reasoned that although Decedent and Ms. Waters initially invoked the North Carolina statutory provisions for equitable distribution, such distribution was never effectuated by the divorce court but was waived by Decedent and Ms. Waters. Thus, because the rights at issue in the Agreement were mere marital rights as described in I.R.C. Sec. 2043(b), rather than vested property rights, the court concluded that the Agreement failed for lack of consideration. Furthermore, because the Tax Court recognized no right to equitable distribution, it failed properly to determine the character of this statutory prerogative under I.R.C. Sec. 2043(b) and the consequent value of deductions from the gross estate in accordance with I.R.C. Sec. 2053. We disagree with the Tax Court's understanding of the Agreement under North Carolina law and its concomitant determination of the Estate's tax liability in accordance with federal tax law. As to the Southwest life insurance policy, the Tax Court agreed with the Commissioner, holding that the proceeds of the policy were includable in the Estate under Sec. 2035(a). We agree with the reasoning of the...