Overview

Recently I wrote an article on JD Supra called Split to Be Tied (May 4, 2016) regarding the Tax Court decision in Estate of Morrissette, (Estate of Clara M. Morrissette v. Commissioner, 146 T.C. No. 11 (April 13, 2016)). Once again, the IRS has lost a significant inter-generational split dollar case - Estate of Marion Levine, Deceased v. Commissioner of Internal Revenue, case number 9345-15.

Over the course of the last of the last five-seven years, I have watched a valuation firm working with a few life insurance producers and without the benefit of case precedent successfully transfer large amounts of taxpayer wealth at 85-95 percent discounts using inter-generational split dollar. During this timeframe they successfully prevailed in audits without any changes, but without the benefit of a big test.

During this same time period, I recall a conversation with a trust and estates lawyer with a Big Law firm that had personally been involved in 12 cases (in 2012) with an average transfer of $30 million each and discounts of 75-95 percent.

Needless to say, the IRS does not like these results and it remains to be seen what the IRS’ next move might be. In the past, it took a number of years for Treasury to issue regulations in order to destroy its former split dollar nemesis, equity split dollar. One of the observations that seems to emerge is the possibility that the IRS does not understand split dollar.

However, they do understand valuation from its many battles with taxpayers and the use of family limited partnerships. Regardless, the two cases as precedent establish a pretty clear path for inter-generational split dollar. This article review the most recent decision and analyzes the advantages of the split dollar approach in Levine versus Morrissette.

I  Estate of Morrissette

In Morrissette, the taxpayer Clara Morriseete, had established a revocable living trust. At age 93, she become legally incompetent and the conservator of her estate created three Dynasty Trusts for each of her three sons. Her living trust was amended in the same year to allow the trustee to purchase life insurance in each of three Dynasty Trusts to fund a buy-sell agreement. The living trusts paid approximately $30 million for policies on each of the three sons.

Under the split-dollar life insurance arrangements, upon the death of the insured the Living Trust would receive a portion of the death benefit from the respective policy insuring the life of the deceased equal to the greater of (i) the cash surrender value (CSV) of that policy, or (ii) the aggregate premium payments on that policy (each a receivable). Each Dynasty Trust would receive the balance of the death benefit under the policy it owns on the life of the deceased, which would be available to fund the purchase of the stock owned by or for the benefit of the deceased.

If the split-dollar life insurance arrangement terminated for any reason during the lifetime of the insured, the Living Trust would have the unqualified right to receive the greater of (i) the total amount of the premiums paid or (ii) the CSV of the policy, and the Dynasty Trust would not receive anything from the policy.

Under the Agreement, the right to recovery was delayed until the earlier of the death of the insured, termination of the split dollar agreement or cancellation of the policy.

Under the split-dollar life insurance arrangements the Dynasty Trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regulations and did not receive anything from the policy. Neither party to the split dollar agreement had any right to borrow from the insurance policy.

After Mrs. Morrissette passed away, the estate valued the receivables includible in the gross estate on the estate tax return at $7,479,000 includible in the gross estate. The total premiums paid were almost $30 million, reflecting a discount of almost 75 percent.

The IRS issued two notices of deficiency to the estate. One notice of deficiency was for gift tax liability for tax year 2006 and determined a deficiency of $13,800,179 and a section 6662 penalty of $2,760,036. In the notice respondent determined that the estates had failed to report total gifts of $29.9 million, the total amount of the policy premiums paid for the six split dollar life insurance policies in 2006.

II Estate of Marion Levine

The IRS argued that the estate of Marion Levine owned $2.9 million in back gift taxes and a $1.1 million accuracy penalty related to a gift to the taxpayer’s irrevocable trust. The estate arranged the split dollar arrangements with the irrevocable trust in a collateral assignment non-equity split dollar arrangement. The trust owned a John Hancock policy which was funded with a $2.5 million single premium. A second Pacific Life policy was funded with a single premium of $4 million.

The IRS attempted to treat the $2.5 million and $4 million transfers for the two policies as gifts. The taxpayer reported gifts in 2008 of $1, 689 and $955, the amount of the economic benefit, respectively for the almost $6.5 million in premium payments into the two policies as a result of the split dollar arrangement. While the policies were not described in great detail, the amount of the reported economic benefit suggests that both policies were second to die policies.

The Tax Court granted the taxpayer’s motion for summary judgement as the IRS notice of deficiency had run after the three year statute of limitations for assessment had run its course. The Tax Court judge Mark Holmes recognized Morrissette as the controlling precedent. 

III Where Do We Go From Here?

A significant benefit to the approach in Levine is the fact that the planning was designed in a manner so that the three year statute of limitations for the gift tax had already run by the time the IRS attempted to assess and collect the gift tax.

In inter-generational split dollar, the taxpayer’s irrevocable trust is the applicant, owner and beneficiary of the life insurance policy. The trustee enters into a split dollar arrangement with the taxpayer using a restricted collateral assignment non-equity split dollar arrangement. The taxpayer retains an interest in the policy cash value and death benefit equal to the greater of the cumulative premiums paid or cash value.

However, the taxpayer’s interest is restricted until the earlier of the insured(s) death or termination of the split dollar arrangement. The taxpayer in the private split dollar context is treated as making a transfer for gift and GST purposes equal to the amount of the economic benefit which is measured using the lesser of the insurer’s one year term cost or Table 2001.

In spite of the disadvantages of MEC treatment within the policy, policies are typically funded on a single premium basis. The principal objective is wealth transfer for an older taxpayer who has already used his/her unified credit. The primary downside of MEC treatment is the taxation of lifetime distributions from the policy as ordinary income. The typical client utilizing inter-generational split dollar to this point in time is so wealthy that they have plenty of money outside of the trust-owned policy to access for income purposes.

The statute of limitations for gift is three years under IRC Sec 6501(a). The statue is extended to six years if there is an omission of more than 25 percent of the gifts. In the split dollar scenario, the gift is the amount of the economic benefit. For gifts after August 5, 1997, the value of a prior gift that was adequately disclosed on a gift tax return is final after the statute of limitation expires.

Example

Jane, age 75, is the sponsor of a split dollar arrangement with her family trust. The trustee is the applicant, owner, and beneficiary of a policy insuring the life of children, age 45 and age 44. The policy features a single premium of a $10 million. Jane pays the premium on December 1, 2016.The policy death benefit is $45 million. Jane’s interest in the policy under the split dollar arrangement is the greater of the policy cash value or premiums.

However, her interest is restricted until the earlier of the death of the insured, termination of the split dollar arrangement, or surrender of the policy. The approximate economic benefit treated as an imputed gift is approximately $11, 250 per year in Years 1 (2016) and $11,250 in Year 2 2017.

Jane’s CPA files Form 709 reporting her imputed gift of $11, 250 related to the split dollar arrangement on April 14, 2017. Jane files a second Form 709 on April 14, 2018 related to the imputed gift equal to the economic benefit in Year 2. The statute of limitations for assessment of a gift tax related to the transaction should expire on April 15, 2020, the date after the return was filed.

In Year 2 (2017) of the arrangement, Jane transfers her interest in the split dollar arrangement by sale to a family trust. The family hires a valuation firm to provide an estimate of the fair market value of the split dollar receivable at the time of sale in Year 2 of the arrangement. The joint life expectancy at that time is 39.6 years using the 2000 CM mortality table.

The valuation firm uses a 5 percent discount rate and values the split dollar at $1.8 million for sale purposes. After completion of the sale, the split dollar arrangement remains in effect between the two family trusts outside of Jane’s taxable estate. The trustees of the family trusts subsequently terminate the arrangement in Year 3.

Jane dies in 2021. In the audit of her estate, the IRS auditor notices the transfers made in 2016 and 2017 and the filed gift tax returns. He questions the transfers and the valuation but realizes that the statute of limitations has run.

Summary

Presidential candidate Donald Trump has gained a certain amount of notoriety for his often bombastic remarks and his tendency to “double down” on those remarks after getting everyone’s attention. I am following The Donald’s lead on doubling down on inter-generational split dollar. Two favorable results from Tax Court on a somewhat esoteric strategy is a pretty good indication that the strategy works.

As a result of these two cases, the only issue remaining is valuation. The taxpayer claims that something is worth “X” while the IRS claims that it is worth “2X”. This is the case with any advanced estate planning technique. The only question that remains is the valuation question. Does the taxpayer take a 35 percent discount or an 85 percent discount? Based on my discussions with the valuation firm which performed most of the valuation studies in these cases, the IRS valuation methodology has been weak. Based on the result in Levine, the methodology of the approach may always place the IRS outside of the statute of limitations for assessment.

The inter-generational split technique as a strategy to transfer wealth at a substantial discount (50-75 percent) for the older ultra-high net worth taxpayer has no equal among strategies. Considering the basic planning premise that I presented at the beginning of the article, the older taxpayer who has run out of exemptions and options, the strategy is heaven-sent. It is also important to point out that the need for life insurance is also not an important consideration, but rather the vehicle used to transfer wealth. Move this technique to the top of your planning list today!