Dr. James Stuart Pritchard had a pretty good resume. After graduating from the Toronto Medical School he moved across the border to Michigan and became a highly-regarded physician specializing in chest, lung and bronchial disorders. He was the president and general director of the prestigious W.K. Kellogg Foundation located in Battle Creek. Unfortunately he did not have a medical diagnosis to match.
After two unsuccessful surgeries for thyroid cancer he was discharged from the hospital on June 27, and told that both further surgery and radiation treatment would only prove “hopeless” in treating his spindle cell sarcoma.
Dr. Pritchard passed away on August 4. What is important to the insurance industry about these final days for the Pritchard family regards what happened on July 3.
The year was 1940 and at the time of his release Dr. Pritchard owned several policies on his life with death benefits totaling $50,000 and cash surrender values of around $10,500. He had federal estate tax concerns and any attempt to give the policy away to avoid taxation on the full benefit was subject to the three-year look-back rule, unless there was a bona fide sale for full and adequate consideration. There was no unlimited marital deduction at the time, so simply leaving them to Mrs. Pritchard would not have avoided taxation at his death. So instead he sold them to his wife for the cash surrender value and transferred ownership to her (oh, alright – it was technically a death bed assignment, but that wouldn’t have made for such a catchy title).
When the estate tax return was filed the second grim reaper visited the Pritchard household in the form of an IRS agent. His contention was that the full death benefit be included in the estate because, given the insured’s imminent death, the policies had not been sold for full and adequate consideration. At the time the cost of policy replacement at the time of the gift was authoritatively recognized as the value of a policy for gift tax purposes. This meant the price of new coverage given the amount of insurance and any extra premium needed to attain the policy values, all calculated at the current age and current medical condition of the insured.
The IRS successfully argued that Mrs. Pritchard purchased not just the right to policy values, but also the overriding economic benefit she would derive from the right to collect the death proceeds in what was sure to be a very short period of time (in fact, Dr. Pritchard had only 32 days to live at the time of the sale). Without providing formulas or determining the exact amount that would have constituted appropriate consideration, the Court did rule that the cash surrender value was not full and adequate consideration and found that the death benefit was includible in Dr. Pritchard taxable estate.
The occasions for the need to determine fair market value of a policy seem to be occurring with greater frequency in clients’ business and estate planning and the IRS has given little definitive guidance on what it will accept as adequate. For all the talk about interpolated terminal reserve, the PERC test or other measures of valuation, the Pritchard case is still a wild card in the deck when dealing with an unhealthy insured. In the 71 years since the decision it has not been overruled.
Look for further articles on how to assist the legal and tax advisors involved in your clients’ affairs to arrive at reasonable conclusions regarding a policy’s FMV. In the meantime call with questions.