Estate of John J. Connelly, Sr. (deceased) and Ellen C. King, Executrix v. United States of America, Appellant, 551 F.2d 545 (3d Cir. 1977)

This is an appeal by the United States from a judgment of the United States District Court for the District of New Jersey granting the plaintiff, the Estate of John J. Connelly, Sr., a refund of $3,200.00, plus statutory interest, for federal estate tax paid under protest. The matter was submitted as though on cross-motions for summary judgment, on stipulated facts. The District Court concluded that the Commissioner erroneously included in decedent's gross estate the proceeds of a policy of group term life insurance. We affirm. The decedent did not possess any of the incidents of ownership of this insurance policy at the time of his death so as to require inclusion of the proceeds in the decedent's gross estate pursuant to Section 2042 of the Internal Revenue Code of 1954.

At the time of his death, on November 16, 1964, John J. Connelly, Sr. was covered by a non-contributory group term life insurance policy for which his employer paid.¹  The terms of the policy provided for the payment of a lump sum of $375.00 immediately upon the employee's death plus a monthly annuity of $248.44 for a period of 50 months.²  The beneficiaries of the policy were irrevocably fixed and were of three classes. Benefit payments went to the surviving spouse of the employee, if living at the time of his death, until they were exhausted or until her death. If there were no surviving spouse, or if a surviving spouse died before receiving all the payments, the payments were made to the next of the classes,³  who, like the spouse, would receive them until their exhaustion or the death of the beneficiary. Because payments terminated if no eligible beneficiaries lived to receive them, there was no assurance that the insurer would make any or all of the payments, and in no event would the payments ever be made to the estate of the insured.

At the time of his death, Connelly was a widower. The only member of the class of beneficiaries next entitled to the proceeds in the absence of a surviving spouse was his son, Robert. Thus, the lump sum payment and monthly annuities accrued to Robert.

The only substantive power Connelly possessed over the proceeds of the policy, at the time of his death, was to elect an optional mode of payment to the beneficiary.⁴  However, such an election would have required the mutual agreement of Connelly, his employer and the insurance company.⁵  This option would reduce the monthly payments by a selected percentage and increase the period of time over which the payments would be made. For example, he could arrange to have the monthly payments reduced by one-half and paid for twice as long. Regardless of which settlement option was utilized, the total amount paid to the beneficiary would remain the same. In the event that Connelly elected a settlement option as described and the beneficiary died before the payments were exhausted, the estate of the beneficiary would receive the difference between the amount actually received and the amount which would have been paid during the same period at the higher rate of payment had the option not been elected. Therefore, Connelly could not alter the amount that any beneficiary would receive; he possessed only the power to change the time at which the proceeds would be received. This constituted Connelly's entire power over the proceeds of the policy, which in no way could be exercised for his own economic benefit.

Section 2042(2) of the Internal Revenue Code of 1954 provides that the proceeds from life insurance receivable by any beneficiary other than his executor are includable in the decedent's gross estate, if immediately prior to his death he possessed any incident of ownership, exercisable either alone or in conjunction with any other person.⁶  Incidents of ownership are not defined by the Code, but Treasury Regulation section 2042-1(c) (2) repeats almost verbatim⁷  the legislative history of section 2042⁸ , and provides:"For purposes of this paragraph, the term 'incidents of ownership' is not limited in its meaning to ownership of the policy in the technical legal sense. Generally speaking, the term has reference to the right of the insured or his estate to the economic benefits of the policy. Thus, it includes the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy, etc. . . ."

Appellant contends that decedent's power to elect optional modes of settlement exercisable in conjunction with his employer and the insurer, and the right to assign this power, constituted incidents of ownership. We do not agree.

In 1937 the Board of Tax Appeals was confronted with this precise argument in Billings v. Commissioner, 35 B.T.A. 1147 (1937), acq. 1937-2 Cum.Bull. 3. Billings involved a large number of life insurance policies, three of which gave the decedent much wider options as to the modes of settlement than those involved here. The Board of Tax Appeals held that "(t)he mere right to say when the proceeds of the insurance policies should be paid to the beneficiary does not amount to a control of the proceeds. They irrevocably belonged to the beneficiary from the date the policies were taken out." (35 B.T.A. at 1152).⁹ 

The Commissioner acquiesced in the Billings decision¹⁰  and that acquiescence remained in effect until 1972 when it was "withdrawn and nonacquiescence (was) substituted therefor."¹¹ 

In 1970, the Sixth Circuit focused on the meaning of "incidents of ownership," in Estate of Fruehauf v. Commissioner, 427 F.2d 80 (6th Cir. 1970). There, decedent's wife paid all the premiums on several insurance policies written on the life of decedent. Mrs. Fruehauf predeceased her husband by fourteen months, leaving a will naming decedent co-executor of her estate, and co-trustee and life beneficiary of a trust to which the life insurance policies passed. Mr. Fruehauf was given broad powers in a fiduciary capacity over the insurance policies. The Tax Court held that Fruehauf possessed incidents of ownership in the policies, regardless of the capacity in which such incidents of ownership could be exercised, and included the proceeds in his gross estate.¹² 

Although the Sixth Circuit affirmed, it rejected the "Tax Court's broad per se rule" that the capacity in which powers are held should not be considered in determining whether such powers constitute incidents of ownership. The court stated that where the requisite powers over policies on his life have been transferred to a decedent, with no beneficial interest therein, "such arrangement can hardly be construed as a substitute for testamentary disposition on decedent's part."¹³  427 F.2d at 84.¹⁴  The court held that decedent's powers were sufficient to constitute incidents of ownership only because as lifetime beneficiary of the trust, he could exercise his powers in such a way as to receive economic benefit from the insurance.

In Estate of Skifter v. Commissioner, 468 F.2d 699 (2d Cir. 1972), decedent made an irrevocable assignment of nine insurance policies on his life to his wife, more than three years before his death. His wife predeceased him and under her will the policies became part of a testamentary trust with the insured as trustee. Although Skifter's powers to effect changes in the beneficial ownership of the policies or their proceeds were broad, he could not exercise any power for his own economic benefit.

The Second Circuit, affirming the Tax Court, held that where powers which may not be exercised so as to benefit the decedent are conferred upon him in his capacity as trustee, the "incidents of ownership" test of section 2042(2) is not met. The court concluded that while non-beneficial powers retained in connection with a transfer of the beneficial interest in the policies might constitute incidents of ownership, it distinguished that situation from Skifter, where decedent received a grant of non-beneficial powers.

The only case since Billings in 1937 to directly consider the issue whether the right to select a settlement option is an "incident of ownership" is Estate of Lumpkin v. Commissioner, 474 F.2d 1092 (5th Cir. 1973). The Lumpkin court considered the same insurance policy involved here. However, the decedent in Lumpkin possessed certain powers which Mr. Connelly did not: in Lumpkin, the decedent was still employed when he died and thus could quit his job thereby cancelling the policy; Mr. Connelly was retired. The decedent in Lumpkin was survived by a widow and under the terms of the policy had the power to unilaterally exercise a settlement option; Mr. Connelly had no unilateral powers. In Lumpkin, the decedent was found to have the right to assign the power to exercise the settlement option; under the law of New Jersey, Mr. Connelly did not have that right.¹⁵ 

Relying on Billings and the language of Treasury Regulation 20.2042-1(c) (2), the Tax Court held that the non-beneficial power possessed by decedent was not an appropriate predicate for the estate tax.¹⁶  The Court of Appeals reversed, holding that Lumpkin possessed an incident of ownership in the insurance policy.

The Fifth Circuit inferred from the legislative history of section 2042 that Congress was attempting to tax the value of life insurance proceeds over which the insured at death still possessed a substantial degree of control. The court framed the question of incidents of ownership in terms of the "right to alter the time and manner of enjoyment." Relying on an analogy to two trust cases, Lober v. U. S., 346 U.S. 335, 74 S. Ct. 98, 98 L. Ed. 15 (1953)¹⁷  and United States v. O'Malley, 383 U.S. 627, 86 S. Ct. 1123, 16 L. Ed. 2d 145 (1966),¹⁸  the court concluded that elements leading to inclusion in the gross estate there were also indicators of incidents of ownership under § 2042. The court stated: "(i)n view of the Congressional intention to make the estate tax treatment of life insurance roughly analogous to that bestowed upon other types of property, somewhat of an anomaly would be created if power over the time and manner of enjoyment was said to impart enough control to activate §§ 2036 and 2038 yet not enough to make it an 'incident of ownership' within the context of § 2042." 474 F.2d at 1097.

Appellant argues that Lumpkin controls the instant appeal.¹⁹  We disagree for a number of reasons. First, in our opinion, Lumpkin does not accurately reflect the applicable law. Second, the rights possessed by the decedent in Lumpkin were greater than those possessed by Mr. Connelly.

The courts in Skifter and in Lumpkin concluded that Congress intended to give life insurance policies estate tax treatment roughly equivalent to that accorded other types of property under related sections of the Code. Thus, both courts examined the treatment given other property under sections 2036, 2037 and 2038, in defining "incidents of ownership."

The federal estate tax is imposed on the privilege of transferring property at death coupled with "taxes upon other types of transfers that have some of the aspects of a testamentary transfer and would otherwise be resorted to in order to escape a tax limited to strictly testamentary transfers."²⁰  Therefore, whether the right to exercise a settlement option is an incident of ownership depends in part upon whether the retention of such right is a "substitute for testamentary disposition of property." See Porter v. Commissioner, 288 U.S. 436, 444, 53 S. Ct. 451, 77 L. Ed. 880 (1933); Commissioner v. Chase Nat'l Bank, 82 F.2d 157, 158 (2d Cir. 1936); H.R.Rep. No. 767, 65th Cong., 2d Sess. 22 (1919). In the instant case, Mr. Connelly did not purchase the insurance. It was a group term life insurance policy provided solely by his employer. The power to select an alternative mode of settlement, here, is not a substitute for testamentary disposition of property.

The Lumpkin court strongly relied on what it viewed as the intent of Congress to tax life insurance and other types of property equivalently. However, Lumpkin's construction of § 2042 would make it the only section in the Code that could reach property in which the decedent had no beneficial interest and over which he had no power exercisable for his own benefit.²¹  It is clear that Congress does not consider life insurance to be inherently testamentary.²²  Thus if Lumpkin is correct in concluding that Congress meant to have the tax consequences of life insurance conform to other types of property, it would certainly seem more logical that Congress intended to equate incidents of ownership with the right to economic benefits of the policy. Indeed, there is a long line of cases which explicitly makes that equation. See, e. g., Estate of Skifter v. Commissioner, 468 F.2d 699 (2d Cir. 1972); Estate of Fruehauf v. Commissioner, 427 F.2d 80 (6th Cir. 1970); Chase Nat'l Bank v. United States, 278 U.S. 327, 49 S. Ct. 126, 73 L. Ed. 405 (1929); Prichard v. United States, 397 F.2d 60 (5th Cir. 1960); Commissioner v. Chase Manhattan Bank, 259 F.2d 231 (5th Cir. 1958).

Furthermore, Treasury Regulation section 2042-1(c) (2) specifically provides that "incidents of ownership" refers "to the right of the insured or his estate to the economic benefits of the policy." Mr. Connelly had no rights whatsoever to the economic benefits of the policy.

Lumpkin's reliance upon Lober and O'Malley in defining section 2042 is misplaced. The facts of Lober and O'Malley were specifically covered by other sections of the Code. Moreover, the powers involved in Lober and O'Malley are directly parallel to explicit provisions of the regulations for life insurance, Reg. 20-2042-1(c). If the same powers which were involved in Lober and O'Malley were translated to the parallel provisions for life insurance, the explicit language of the regulations would require inclusion. Both decisions are controlled by explicit regulations. Such is not the case here. Lumpkin erroneously extended Lober and O'Malley to a fact situation foreign to both and controlled by different statutory provisions.

The decedents in both Lober and O'Malley possessed the power to alter the time of the payments, which could be exercised to change the beneficiary of the proceeds. In Lober the decedent retained the power to accelerate the remainder of the trust, thereby cutting off the remaindermen and ensuring that the income beneficiaries would receive the entire corpus of the trust. In O'Malley the decedent reserved the power to accumulate income and add it to the principal, thereby reducing the payments to the income beneficiaries and increasing the benefits of the remaindermen. Possession of the power to change the beneficiary has long been held to constitute an incident of ownership.²³  In this case, however, the decedent could change neither the beneficiaries themselves, nor the amounts the designated beneficiaries would receive. Regardless of the time of the payments, the designated beneficiary or his estate would receive the same amount. Connelly, therefore, unlike the decedents in Lober and O'Malley, could not alter the amount that any beneficiary would receive; he possessed only the power to change the time at which the proceeds would be received.

Connelly could, by electing to prolong the time of the payments, attempt to ensure that a designated beneficiary's estate, rather than the beneficiary himself, would receive a percentage of the insurance proceeds. However, this speculative power is so insignificant as compared with the power to change the beneficiaries, retained by the decedents in Lober and O'Malley, that it should not be considered an incident of ownership.

Lumpkin cited Skifter as authority for the proposition that Congress intended estate taxation of all property to be analogous, yet it subverted the crux of the Skifter opinion. Skifter focused on whether the property would be taxed under other sections of the Code if it were not life insurance. Lumpkin focused on whether the power held by the decedent would have been sufficient under those sections to result in inclusion. Skifter properly required that the nature and source of the power, the way in which it is held, and whether the retention of power is a substitute for testamentary disposition of the property, be examined. Lumpkin completely ignored the distinctions between the type of property involved.

Moreover, as discussed above, Mr. Connelly's rights were not as broad as those possessed by the decedent in Lumpkin. The Lumpkin court found it important that the decedent "could easily have assigned the right to elect optional settlements, thereby completely divesting himself of control over the insurance proceeds and avoiding inclusion of their value within his gross estate." 474 F.2d at 1097-98. Here, decedent had no power to assign his rights under the contract. It was forbidden by New Jersey law.

Mr. Connelly's sole power to select a settlement option with the mutual agreement of his employer and the insurer did not give him a substantial degree of control sufficient to constitute an incident of ownership. Landorf v. United States, 408 F.2d 461, 187 Ct. Cl. 99 (1969); Old Point National Bank, Executor, 39 B.T.A. 343 (1939); Estate of Chester H. Bowers, 23 T.C. 911 (1955). The power gave him no rights to the economic benefits of the policy. He had no power which by itself has ever been held to constitute an incident of ownership. Notwithstanding withdrawal of acquiescence by the Commissioner, Billings²⁴  remains viable and controls the instant case as held by the District Court. The proceeds of the insurance should not have been included in decedent's gross estate.

The judgment of the District Court will be affirmed.