22-Aug-22
Split-Dollar Life Insurance Planning
Take-Away: A sophisticated planning technique is for a wealthy individual to fund an Irrevocable Life Insurance Trust (ILIT) taking back a ‘right to be repaid’ at a point far into the future. The present value of the right to be repaid is then included in the wealthy individual’s taxable estate, at a value far less than the amount originally advanced to pay the insurance premiums held in the ILIT.
Background: In the last three of years a couple of significant Tax Court cases have commented upon the effectiveness of a split-dollar life insurance funding strategy. One case, Levine, was successful, while another, Morrissette was one that could be categorized as ‘winning the battle, but losing the war.’
Morrissette v. Commissioner: In this case the decedent had created three separate dynasty-type trusts, one for each son. The sons were the trustees of the decedent’s revocable trust. Each dynasty trust obtained a life insurance policy on that son’s life. Each trust provided that shares of stock owned by the insured son in the family business would be purchased by the other’s respective dynasty trusts. The key underlying fact was that the three brothers, while all involved in the family business, and acting as trustees of their parent’s revocable trust, had a long-standing acrimonious relationship with one another. As such, life insurance was purchased to fund this stock buy-back obligation on one son’s death. The decedent paid the premiums on the insurance policies in a lump sum. The dynasty trusts entered into split-dollar agreements with the parent’s revocable trust so that the decedent’s revocable trust would be reimbursed at the greater of the cash advanced by the revocable trust or the life insurance policy’s cash surrender value on the insured-son’s death. The decedent died and the split-dollar obligations were included in the decedent’s taxable estate, but at significant valuation discounts when compared to the death benefit ultimately to be paid to the dynasty trust.
Estate Wins: The rights of the decedent under the split-dollar agreements were valued at $7.5 million in the aggregate. The IRS claimed estate inclusion of the cash surrender value of the three life insurance policies was mandated under IRC 2036, 2038, and 2703 (with the latter, the consent right of the decedent was restricted and had to be ignored under IRC 2703.) With regard to the application of IRC 2036, the Tax Court surprised everyone and found that the decedent had a legitimate non-tax purpose to enter into the split-dollar agreements- to manage business succession purposes in light of the sons not able to get along with one another in the family business. The Tax Court also held that IRC 2038 did not apply to include the cash surrender values of the 3 policies in the decedent’s gross estate. Finally, IRC 2703 did not apply since the split-dollar agreements prevented the decedent from withdrawing the cash surrender value and such provisions were comparable to agreements in third party transactions in light of the family dynamics.
Estate Loses: The estate lost on the valuation question with respect to the decedent’s interest under the split-dollar agreements. Each of the brothers were to be paid $30 million for their shares in the family business. They may have paid $30 million for the stock (i.e. the life insurance insurance policies and the split-dollar rights), but whether a gift occurred at that time was determined under IRC 7872, valued under fair market value principles. What the battle was over was the data used to derive the present value discount rate and the assumption regarding the possible early termination of the split-dollar agreement when valuing the decedent’s right to be repaid far into the future under the split-dollar agreements. The Tax Court rejected life settlement statistics and yields to determine the present value of the decedent’s rights. Instead, the Tax Court adopted the assumption that the policies would only be in place for about 4.5 years because the family and their advisors had discussed cancelling the policies, and one advisor had even insisted to not cancel the insurance policies until past the 3-year IRS audit period. It also did not help that both the estate planning attorney and the insurance agent had marketed the plan as an ‘estate planning strategy’ and the attorney had made recommendations to the appraiser to find a reduced value for the retained rights. With these background facts, the Tax Court had no problem in imposing a penalty with regard to the underpayment of the estate’s federal estate tax liability.
Take-Away: With Morrissette, the full cash surrender value of each policy was not included in the decedent’s gross estate under the split-dollar agreements, but the value of her rights under the three split-dollar agreements was woefully undervalued ($7.5 million) in light of the policy cash surrender values ($30 million death benefit) that existed at the time of her death when compared to the lump sum payment of the policy premiums when the 3 policies were initially acquired.
Levine v. Commissioner: The decedent created a life insurance trust (ILIT) in 2008. South Dakota Trust was named as the ILIT trustee. Beneficiaries of the ILIT were the decedent’s children and grandchildren. A split-dollar arrangement was entered into in which the decedent’s revocable trust advanced $6.5 million in funds to the ILIT that the ILIT trustee then used that amount to pay premiums on two life insurance policies, one taken out on the decedent’s daughter and one policy taken out on her son-in-law. The policies were thus purchased and held by the ILIT. Mrs. Levine’s revocable trust negotiated the right to be repaid under a split-dollar agreement for the greater of the cash surrender value of the policies or the premiums that were paid by her. The decisions with regard to the investments within the ILIT could only be made by the ILIT’s investment committee, which consisted of only one individual, Mrs. Levine’s long-time friend and business partner, Larson. When Mrs. Levine died the policies had not terminated or paid out at that time, since the daughter and her husband (the insureds) were still living. Mrs. Levine’s estate included her contractual rights under the split-dollar agreement in her taxable estate, valued at about $2.0 million.
Legal Question: The question before the Tax Court was what amount was to be included in Mrs. Levine’s gross estate: her right to be repaid in the future the funds she advanced for the premium payments ($2,282,195) or the cash surrender values of the two life insurance policies that existed at the time of Mrs. Levine’s death ($6,153,478.)
IRC 2036 and IRC 2038: Because the split-dollar agreement provided that only the ILIT owned the 2 policies, and it also expressly gave the right to terminate the split-dollar agreement only to the ILIT’s investment committee (Larson), neither IRC 2036(a)(2)- the general ‘catch-all’ statute for estate assets, nor IRC 2038- the claw-back provision for some estate assets transferred before the transferor’s death- required inclusion of the policy cash surrender values in Mrs. Levine’s estate. That was because Mrs. Levine did not possess any right, either by herself or in conjunction with anyone else, to terminate the policies, the split-dollar agreement, or the ILIT.
IRC 2703: The Tax Court also held that there was no impermissible restriction where IRC 2703 could be invoked. Because Mrs. Levine’s estate only held a right under the split-dollar agreement, and she never held any rights in the insurance policies, IRC 2703 could not apply to disregard a restriction as to the insurance as she never held any right to, ever, nor cause the full value of the insurance policies in her taxable estate.
Legitimate Non-Tax Purpose: The Tax Court found that this split-dollar arrangement was not a ‘scheme to reduce Mrs. Levine’s potential estate tax liability.’ Rather, there was a legitimate non-tax purpose to the arrangement, since her estate planning attorney and the family all assessed the need for her children to have planning done and life insurance to provide estate liquidity to them, and thus there were valid reasons for the insurance coverage apart from the impact of the split-dollar agreement on Mrs. Levine’s taxable estate.
No Retained Control: Under South Dakota law, the ILIT’s investment committee, i.e. Larson, owed fiduciary duties to the ILIT and its beneficiaries, but not to Mrs. Levine, her daughter or her son-in-law. In addition, Mrs. Levine held no power to alter, amend, revoke or terminate the ILIT, such that its assets were not includible in her taxable estate. Consequently, neither IRC 2036(a)(2) nor IRC 2038 applied to cause the cash surrender value to be included in her taxable estate. Unlike Morrissette, Mrs. Levine did not possess any deemed right to control the beneficial enjoyment of the transferred asset, either alone or in conjunction with another person.
Larson: Larson, who was the investment committee under the ILIT, also was a co-agent of Mrs. Levine under her power of attorney with her two children. The IRS argued that this put Larson on both sides of the transaction, similar to the infamous Cahill decision of a couple of years ago, which resulted in a taxpayer split-dollar agreement loss. This was probably a close call for Mrs. Levine’s estate, but the Tax Court did not discuss it. Frankly it is hard to distinguish Larson’s role as a business partner and probable employee of Mrs. Levine who held the critical control in his capacity as the investment committee, from the facts in Cahill, where the son’s cousin and business partner was the ILIT trustee, thus triggering the retained control ‘in conjunction with another’ principle of IRC 2036.
Conclusion: Surprisingly, the Tax Court in Levine told the IRS that it should rewrite all of its split-dollar Regulations to change the gift tax valuation consequences under the gift tax Regulations. Apparently the IRS did not argue an implied gift on the funding of the split-dollar arrangements by Mrs. Levine, so that issue was not technically before the Tax Court. But that invitation clearly implies that there may be some taxable gift upon funding a split-dollar agreement that these 2 case and earlier split-dollar cases have not yet to confront. The point in covering these two recent decisions is that substantial sums were advanced to ILITs to purchase life insurance on lives other than the lender. When the lender dies, the discounted present value of the right to be repaid, albeit far into the future, is what is taxed in the lender’s gross estate. The mismatch between the amount lent, and the value of what is taxed, is why this planning strategy is getting a lot of attention.