Every new tax proposal looks surprisingly similar with respect to the estate and gift tax. Each tax proposal seems to suggest a reduction in the estate and gift tax exemption of $5.125 million per taxpayer to $1-3.5 million per taxpayer along with an increase in the top marginal tax bracket to fifty percent or more. The expiration of the Bush tax cuts is scheduled for the end of 2012. This tax change is already law absent any legislative amendment to save the day! The result – a unified credit of $1 million and a 55 percent top marginal estate tax bracket.
Along with the proposal come serious dents or limitations to tried and true advanced estate planning techniques. Tax proposals look to limit the minimum term of GRATs to ten years. Additionally, proposals look to neutralize the benefits of tax valuation discounts. What’s left?
As tax planners, we should take a close look at split dollar life insurance as a powerful mechanism to leverage wealth transfers during lifetime (gifts). Most people have been of the belief that split dollar died a lonely death in 2003 with the additional of final split dollar regulations that eliminated equity split dollar. Not so fast!
This article will outline a technique that has many different marketing names such as inter-generational split dollar, private freeze split dollar et al. I have personal knowledge of large transactions using this technique. The average premium has been $10 million or more. This technique has a lot of variations but I am starting with the basic plan.
I Proposed Solution
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 policy that will be utilized will be a traditional single life or second-to-die policy issued by a life insurance.
Split dollar life is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, split dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives. Split dollar can also be used in a non-corporate setting and is referred to as private split dollar. Generally speaking, two forms of classical split dollar arrangements exist, the endorsement method and collateral assignment method.
In the endorsement method within a corporate setting, the corporation is the applicant, owner and beneficiary of the life insurance policy insuring a corporate executive. The company is the applicant, owner, and beneficiary of the life insurance policy. The company pays all or most of the policy’s premium. The company has in interest in the policy cash value and death benefit equal to the greater of the policy’s premiums or cash value. The company contractually endorses the excess death benefit (the amount of death benefit in excess of the cash value) to the employee who is authorized to select a beneficiary for this portion of the death benefit.
In the collateral assignment method, the employee is the applicant, owner and beneficiary of the policy. The employee’s family trust may also serve as the policy’s owner. The company pays all or most of the premium. The company retains an interest in the policy’s cash value and death benefit equal to the greater of the policy premiums or cash value. The employee collaterally assigns an interest in the policy to the employer for its contributions and interest in the policy.
In a private split dollar arrangement, private non-corporate individuals 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.
Restricted collateral assignment is the classical form of split dollar arrangement utilized by the majority shareholder of a closely held business. Under restricted collateral assignment split dollar, a restriction is added to the split dollar agreement which “restricts” the company’s access in the policy under the split dollar arrangement (greater of cash value or premium). The “restriction” limits the company’s access until the earlier of the death of the insured, termination of the split dollar agreement, or surrender of the policy.
The owner’s business purpose 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 business owner due to the owner’s control of the business as the majority shareholder. The proposed private split dollar arrangement would contain the same type of restriction contained in the classical split dollar arrangement.
Under split dollar, the employee is not taxed on the amount of premium paid by the corporation on its behalf 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. In the event the policy is owned by the employee’s trust, the same 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 business owner.
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 their discretion may decide to transfer by sale their 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 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.
The sales agreement between the patriarch and ILIT# 2 may be structured on an installment basis with an initial down payment of ten percent. Following the completion of the sale, the trustees of ILIT #1 and ILIT #2 may agree to terminate the split dollar arrangement. The trustee of ILIT #2 may elect to retain the coverage or alternatively, surrender the policy.
The mechanics of the proposed can be effectively illustrated in the example below.
Patriarch 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 $20 million. The policy has an initial death benefit of $45 million, the lowest allowable death benefit under the tax law definition of life insurance, IRC Sec 7702. The policy is a MEC.
The Patriarch and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. Under the arrangement, the Patriarch will have an interest in the policy cash value and death benefit equal to the greater of its premium payment or cash value. The excess death benefit is payable to the Client. Under the split dollar agreement, the Patriarch’s access to its interest in the split dollar arrangement will be restricted until the earlier of the insured’s death, termination of the split dollar agreement, or surrender of the policy.
The Patriarch makes his initial premium of $20 million for the first policy year.
In the beginning of Year 3. The Patriarch approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement. The Patriarch hires Acme Valuation, an independent valuation firm to value its interest under the split dollar arrangement. The valuation focuses not only on the present value of the Patriarch’s right to recovery at the death of the insured who is age 50 (with a 35 year life expectancy), but also the discount rate for the analysis based upon “comparable” sales of life insurance policies as well as the probability of death. The valuation study reflects a 90 percent discount from the amount of cumulative premiums paid by the Patriarch into the policy – $20 million. The discounted value of the Patriarch’s interest is $2 million ($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 $2 million. Following the sale, under the theory of merger of legal interests, the split dollar agreement terminates once the sale is completed. At that point, Trust#2 owns the insurance on an unencumbered basis. Following the sale, Trust #2 owns a policy with a $45 million death benefit and a cash value of $25 million.
During the initial four years of the split dollar agreement, the approximate value of the economic benefit taxed to the Client under Table 2001 for gift tax purposes was $2,500 -$5,000 per year. The approximate gift tax cost to the client under the arrangement is $15,000. The split dollar arrangement has an advantage of approximately 90 percent.
Tax and Legal Authority
The original split dollar ruling was Rev. Rul 55-747 which introduced the economic benefit theory of taxation for split dollar arrangements using the P.S. 58 tables. Rev. Rul 64-328 introduced the two methods of split dollar – the endorsement and collateral assignment methods and reconfirmed the economic benefit theory of taxation. Rev. Rul. 66-110 allowed the use of the insurer’s cost of one year term insurance is it was lower than the P.S. 58 rate. Rev. Rul 76-490 and Rev. 78-420 treat the economic benefit as the measure for gift tax purposes when the policy is owned by an entity such as a trust or someone other than the insured.
Rev. Rul 76-274 involved a restricted collateral assignment non-equity split dollar arrangement. The Service rules that the policy proceeds were not attributable to the majority shareholder (insured) due to the corporation’s restriction to accessing the policy’s incidents of ownership and therefore not included in the estate of the business owner. 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 incidents of ownership in order to avoid estate tax inclusion. PLR 9511046 involves the use of restricted collateral assignment split dollar in the context of a private split dollar arrangement. 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.
Current Split Dollar Regulation
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 be qualify for either tax treatment under the economic benefit regime or the loan regime. Under the loan regime, the policyowner 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 Treasury regulations were designed to eliminate the use of “equity” split dollar arrangements. In an “equity” split dollar arrangement, the corporation had an interest in the policy equal to the less of cumulative premiums or cash value. Cash value in excess of cumulative premiums accrued on a tax-free basis for the employee. The only taxation to the employee was the economic benefit. As a result, equity split dollar arrangements conferred significant benefits to taxpayers. Depending upon the relationship between the owner and non-owner, the economic benefit may be treated as compensation income, a dividend or a gift. The value of the economic benefit is equal to the cost of the life insurance protection to the non-owner; the amount of cash value the non-owner has access to, or the value of other benefits provided to the non-owner.
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.
Under the split dollar arrangement, the employer may not deduct the premium payment. IRC sec 264(a)(1). Upon the dearth of the employee, the portion of the death benefit received by the employer and employee are exempt from federal income tax as life insurance proceeds. . IRC Sec 101(a) .
The combination of the restricted collateral assignment and permanent life insurance provides significant tax and wealth accumulation benefits to your client. New Age Split Dollar combines the leverage of life insurance along with the leverage of split dollar. This technique provides a powerful vehicle for inter-generational wealth transfer while using a tax-advantaged product. The second part of this series will provide several examples on how to use New Age Split Dollar.