Overview
The tax time bomb is due to explode. On January 1, 2013, the top estate tax bracket increases from 35% to 55%. The exemption equivalent drops from $5.25 million-$1 million per taxpayer. Tax payers in the California, Massachusetts, New York and New Jersey will see their combined marginal tax bracket exceed fifty percent.
This is the second part of an earlier article on New Age Split Dollar. I wanted to outline a few planning examples to “get the wheels” turning for you.
Strategy Review
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What is New Age Split Dollar
The basic solution proposes the use of a private restricted collateral assignment non-equity split dollar arrangement between the patriarch and matriarch of the family (Assignee), i.e. the family members that are looking to transfer wealth, and an irrevocable life insurance trust (ILIT #1). The underlying life insurance policy that will be utilized will be a traditional single life or second-to-die policy issued by a life insurance.
I strongly suggest the use of private placement life insurance (PPLI) as the underlying life insurance product in the arrangement. The combination of institutional pricing and customized investment options make PPLI the best investment vehicle to maximize tax-advantaged wealth accumulation benefits of life insurance. The mantra of life insurance benefits – tax-free free accumulation; tax-free loans and income and estate-tax free death benefits.
In a private split dollar arrangement, private individuals (Patriarch and Matriarch) are the parties to the split dollar arrangement. In a typical private split dollar arrangement, an ILIT will be the applicant, owner, and beneficiary of the policy. The patriarch or matriarch or both will enter into the split dollar arrangement with the ILIT to provide funding for the life policy.
The trustee of the ILIT will collaterally assign an interest in the policy cash value and death benefit to the patriarch equal to the greater of the cash value or premiums. The excess death benefit is paid to the ILIT during the course of the arrangement. The proposed insured(s) are the children and/or their spouses.
Under restricted collateral assignment split dollar, a restriction is added to the split dollar agreement which “restricts” the Patriarch’s access in the policy under the split dollar arrangement (greater of cash value or premium). The “restriction” limits the Patriarch 's access to the cash value until the earlier of the death of the insured, termination of the split dollar agreement, or surrender of the policy.
The taxpayer's business purpose for adding the restriction is driven by concerns of the estate tax inclusion of the death proceeds for the business owner under IRC Sec 2042. The incidents of ownership under IRC 2042 over the policy would be imputed to the patriarch due to the owner's control of the policy. The Split dollar restriction is contractually in effect until the earlier of the death of the insured or termination of the split dollar arrangement.
The Patriarch at his discretion decides to transfer by sale his interest in the split dollar arrangement, aka the split dollar receivable. The patriarch and matriarch establish a second ILIT (ILIT #2) to purchase the split dollar receivable.
The split dollar receivable is valued based upon a third party valuation. The right of recovery under the split dollar arrangement is limited until the earlier of the death of the insured, or the termination of the split dollar arrangement. The sales price based upon an independent valuation provides for a heavily discounted sales price – 75-90 percent.
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How is Split Dollar Taxed?
Under private split dollar arrangement, the patriarch is not taxed on the amount of premium paid by the patriarch to the trust gift tax purposes but rather on the value of the economic benefit as measured by the lower of Table 2001 or the insurer's one year term insurance cost.
The economic benefit is the measure for gift tax purposes for the deemed gift of the “economic benefit” to the trust. The economic benefit theory of taxation for split dollar creates significant tax leverage for the patriarch and matriarch.
In Rev. Rul. 82-145, the Service ruled that the corporations' right to borrow from the policy under a collateral assignment split dollar arrangement involving a majority shareholder would result in estate tax inclusion of the policy proceeds.
In AALU Bulletin Notice 94-51, AALU counsel referenced a favorable estate tax audit involving the use of restricted collateral assignment split dollar. It became clear from this ruling that it is absolutely necessary to restrict the corporation's access to any of the policy's incidents of ownership in order to avoid estate tax inclusion for a majority shareholder of a closely held business.
PLR 9511046 involves the use of restricted collateral assignment split dollar in the context of a corporate split dollar arrangement. The ruling involves majority shareholders of a S corporation. The favorable ruling states that the “restriction” in the split dollar arrangement limiting the Assignee's (premium payor) access in the policy to the earlier of the insured's death, termination of the split dollar arrangement, or surrender of the policy, would not result in estate tax inclusion.
PLR 9745019 involved the use of private split dollar and an irrevocable life insurance trust (“ILIT”). Under the arrangement the taxpayers entered into a split dollar arrangement with the trustee of their ILIT. Under agreement, the taxpayers would pay the premiums and had a “restricted” security interest in the policy cash value and death benefit equal to the greater of cumulative premiums and death benefit. The Service ruled that no part of the death proceeds would be included in the taxable estate of the taxpayers.
The Service has also ruled favorably for taxpayers regarding the use of restricted collateral assignment split dollar arrangements in several other private letter rulings – PLR 9651017, PLR 9651017, PLR 9651030, and PLR 9709027. The reasonable conclusion must be that the Service understands and respects the use of restricted collateral assignment split dollar as having a legitimate business and tax purpose. The valuation question is a non-tax question. In the proposed case, the valuation is supported by a third party valuation based upon accepted financial methods, mortality considerations, and comparable sales.
IRS Notice 2001-10 and IRS Notice 2002-8 (revoking IRS Notice 1001-10) radically changed split dollar life insurance. New treasury regulations were added. Treas. Reg. 1.61-22. Split dollar arrangements after September 17, 2003 must qualify for tax treatment under the economic benefit regime or the loan regime. Under the loan regime, the policy owner is considered the owner and the non-owner (premium payor) is considered the lender. The below market rate rules of IRC Sec 7872 are considered. If the split dollar loan is considered as a below market loan, then interest will be imputed at the applicable federal rate (AFR) with the owner and the non-owner of the policy considered to transfer imputed amounts to each other.
The restricted collateral assignment non-equity split dollar arrangement is taxed under the economic benefit tax regime.
If the split dollar arrangement is not treated as a loan, the contract's owner is treated as providing economic benefits to the non-owner. Economic benefit treatment will generally occur in an endorsement arrangement and also in a collateral assignment arrangement where the only economic benefit interest to the employee is a death benefit. The proposed plan qualifies for tax treatment using the economic benefit doctrine of taxation.
Under the new regulations, the employee is taxed on the value of the economic benefit he receives from the employer's participation in the split dollar arrangement. The IRS revoked the P.S. 58 Table rates and introduced Table 2001. If the insurer publishes standard rates that are lower than the Table 2001 rates, the taxpayer may use the lower rate. Only the standard rates of the insurer may be used.
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Strategy Examples
Example 1
Patriarch, age 80, has existing investment assets of $40 million and a net worth of $75 million. ILIT #1 is the applicant, owner and beneficiary of a policy issued by Acme Life, a New York -based life insurer. The policy will insure Patriarch’s son and daughter-in-law who are both age 50.The policy funding strategy calls for single premium of $35 million. The policy has an initial death benefit of $55 million.
The Patriarch and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 2, the Patriarch approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement.
The valuation study reflects a 90 percent discount from the amount of cumulative premiums paid by the Patriarch into the policy - $35 million. The discounted value of the Patriarch's interest is $3.5million ($20 million minus 90 percent discount). The Patriarch creates a second ILIT, ILIT #2 to purchase the split dollar receivable. ILIT #2 utilizes trust corpus to purchase the Patriarch's split dollar receivable for $3.5 million.
Example 2- GRAT Substitute
Same facts as Example 1. In this example, the split dollar arrangement is used as a GRAT to transfer property outside of the taxable estate with a maximum amount of gift tax leverage.
Patriarch owns a valuable collection of fine art that he would like to transfer to his heirs without estate taxation. The collection is valued at $10 million.
ILIT #1 is the applicant, owner and beneficiary of a policy issued by Acme Life, a New York -based life insurer. The trustee will use premium financing for the policy to finance a $10 million single premium. The policy insures Patriarch’s son Junior and his wife.
The Patriarch provides a personal guarantee for the loan as well as additional collateral. The policy has an enhanced cash value rider in order to minimize the collateral requirements.
The Patriarch and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 2, the Patriarch approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement. The Patriarch sells the “split dollar receivable”, i.e. the right to recover the greater of the policy cash value or cumulative premiums at the death of the insured, at a price determined by a third party valuation firm. The price is $500,000.
In the beginning of Year 4, the trustee cancels the policy and receives the cash surrender. The cash surrender value of the policy exceeds the initial premium. The Patriarch is personally obligated to repay the Bank and borrows $10 million from the trustee on an arms-length basis and repays the Bank.
At this point, the Patriarch owes the Bank $10 million plus interest at the short-term applicable federal rate (AFR). The Patriarch transfers $10 million of fine art to the trustee to as repayment for the loan.
The tax cost of the transaction is neglible. The economic benefit costs are measured by the insured lives – Junior and his wife – not the Patriarch. The sales price of the split dollar receivable is discounted 95 percent. Unlike the GRAT, there is no risk of premature death. In the event of Patriarch’s death, the estate could enter into a sale of the split dollar receivable.
Example # 3 – Dividend Substitute
Same facts as Example 1. Patriarch owns a C corporation that has $10 million of retained earnings that he would like to transfer out of the corporation and out of his estate with minimal income and estate taxation. Patriarch uses the restricted collateral assignment technique to transfer the retained earnings.
The policy insures his son, age 50, who is the CEO of the company. The premiums are $4 million per year targeted for five years. The death benefit is $50 million.
The Company and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 6, the Company approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement.
The valuation study reflects a 90 percent discount from the amount of cumulative premiums paid by the Company into the policy - $10 million. The discounted value of the Company's interest is $1 million ($10 million minus 90 percent discount). The CEO creates a second ILIT, ILIT #2 to purchase the split dollar receivable.
ILIT #2 utilizes trust corpus to purchase the Company's split dollar receivable for $2 million. The two trusts (ILIT #1 and ILIT #2) merge following the transfer.
Example 4 – GRAT Substitute with In Kind Premium Payments
Same facts as Example 1. In this example, the split dollar arrangement is used as a GRAT to transfer property outside of the taxable estate with a maximum amount of gift tax leverage. The premiums are made using in kind (non-cash) premium payments to the life insurer.
ILIT #1 is the applicant, owner and beneficiary of a policy issued by Isla Bonita Life, a Cayman -based life insurer. The policy will insure Patriarch’s son and daughter-in-law who are both age 50.The policy funding strategy calls for single premium of $10 million. The policy has an initial death benefit of $35 million.
The premiums are made through the transfer of an investment portfolio to the life insurer. The assignment is a “sale or exchange” for tax purposes triggering any gain on appreciated assets. Following the transfer to the life insurer, the assets are placed into the insurer’s separate account within a customized insurance dedicated fund. The investment manager of the fund will have complete investment discretion preventing any indication of the application of the investor control doctrine.
The Patriarch and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 2, the Patriarch approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement.
The valuation study reflects a 90 percent discount from the amount of cumulative premiums paid by the Patriarch into the policy - $10 million. The discounted value of the Patriarch's interest is $1 million ($10 million minus 90 percent discount). The Patriarch creates a second ILIT, ILIT #2 to purchase the split dollar receivable. ILIT #2 utilizes trust corpus to purchase the Patriarch's
Summary
It is highly unlikely that anything will stop the expiration of the Bush tax cuts. The result is a steep increase for both income and estate tax purposes. New Age Split Dollar is an excellent technique to transfer wealth out of the taxable estate to leverage the exemption equivalent. Less well known is its ability to serve as a mechanism to transfer a corporate dividend at a low tax cost.
The combination of the restricted collateral assignment and permanent life insurance provides significant tax and wealth accumulation benefits to your client.
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Split Dollar Taxation – The client is not taxed on the amount of proposed premium payments. Instead the client is taxed on the economic benefit (term insurance cost) of coverage provided under the arrangement for income and gift tax purposes.
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Tax-Advantaged Wealth Accumulation – Permanent life insurance provides the vehicle for shifting an investment portfolio that is currently taxable within the Patriarch into a structure which enjoys all the tax advantages of life insurance – (a) Tax-free accumulation of the policy cash value (b) Income tax-free death benefit (c) Investment flexibility (d) Ability to access the cash value on a tax-free basis through policy loans.
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Asset Protection – The policy's assets are not subject to the claims of the life insurer's creditors or the policyholder's creditors.
