111 / When life insurance proceeds are required under the terms of a property settlement agreement or a divorce decree to be paid to certain beneficiaries, is an offsetting deduction allowable?

Where insurance proceeds payable to a divorced spouse are required to be included in the insured's estate, it is sometimes possible to secure an offsetting deduction either (1) on the basis that the beneficiary's right to the proceeds amounts to a claim against the estate representing a personal obligation of the decedent existing at the time of death¹ or (2) on the basis that the beneficiary's interest in the proceeds amounts to an indebtedness against the proceeds included in the estate.²

A deduction is not allowed on either basis, however, if the claim or indebtedness is founded on an agreement between the spouses in the nature of a property settlement agreement not supported by "adequate and full consideration in money or money's worth."³ Where (i) property is transferred from a decedent or from a decedent's estate to a former spouse of the decedent pursuant to a property settlement agreement, (ii) divorce occurred within a three-year period measured from the date one year before the agreement was entered into, and (iii) the property is includable in the decedent's gross estate, the transfer is considered to be made for an adequate and full consideration in money or money's worth.⁴ A relinquishment or promised relinquishment of marital rights in property is not consideration in money or money's worth.⁵ Although one court held that a wife's right to support is a "marital right in property,"⁶ the IRS has declined to follow the decision⁷ and declares instead that a release of support rights by a spouse constitutes consideration in money or money's worth.⁸ The Tax Court has consistently agreed that a spouse's relinquishment or promised relinquishment in a separation agreement of support rights is consideration in money or money's worth.⁹

Even though it is found that the relinquishment or promised relinquishment of support rights is consideration in money or money's worth, it also must be found that the claim or indebtedness against property was "contracted bona fide and for an adequate and full consideration in money or money's worth."¹⁰ It must be found, in other words, that that which is sought to be deducted from the estate was bargained for in exchange for support rights. Thus, the executor of the estate must be prepared to show, according to applicable local law, the value of the support rights at the time the separation agreement was entered into. If the executor is unable to establish a dollar value by any reasonable approach, such as taking into account the value of the marital assets and the former spouses' incomes and their expenses, the deduction sought will be denied.¹¹ If a dollar value of the support rights is established, the deduction allowed cannot exceed that amount or, if less, the amount of the claim.

If insurance proceeds are payable to a former spouse pursuant to the terms of a property settlement agreement (but not pursuant to a court decree), the insured's estate may be permitted an offsetting deduction to the extent of the value of any support rights relinquished by the former spouse under the agreement.¹² But to the extent the proceeds exceed the value of such support rights, no deduction is allowable if the only other consideration given by the former spouse was relinquishment or promised relinquishment of inheritance rights in the decedent's property. For information on how to value support rights, see Revenue Ruling 71-67¹³ and Estate of Fenton v. Commissioner.¹⁴

When a property settlement agreement is incorporated in a divorce decree, and when the divorce court is free to ignore the allowances made in the agreement and to set different allowances in its own discretion instead, the obligations of the parties are not "founded upon a promise or agreement" but upon the divorce decree. In this case, a deduction of a proper claim or indebtedness under IRC Section 2053 is allowable without regard to the nature of the consideration given by the former spouse.¹⁵ Even if both the agreement and the court decree provide that the covenants in the agreement shall survive any decree of divorce that may be entered, the obligations of the parties are still founded on the court decree, not on a promise or agreement.¹⁶

On the other hand, where a property settlement agreement is incorporated in a divorce decree, but under applicable state law the divorce court is not free to disregard the provisions of a valid property settlement agreement, the obligations of the parties are held to be founded upon a promise or agreement and not upon the divorce decree. In such case, the availability of the offsetting estate tax deduction is limited as previously explained.¹⁷

Also, the IRS has ruled that where life insurance proceeds were payable to an insured husband's minor children pursuant to a divorce decree, the deduction was not allowable because (1) the decree exceeded the support obligation imposed by state law in requiring the spouse to maintain insurance on his life payable to his children, and (2) the maintenance of the insurance was not contracted for a full and adequate consideration.¹⁸