Looking Beyond the Morrissette Decision and Around the Corner for Inter-Generational Split Dollar
I have had the opportunity throughout my career to know top life insurance agents as well as several top estate planning attorneys. In my view, the best life insurance salesman are the best salesman for any product or service. After all, it is not easy to convince people to think beyond themselves. However, under the theory that when your primary tool is a “hammer”, every problem looks like a “nail”, e.g. when you sell life insurance, it is the solution to every planning problem including the common cold!
On the other hand, estate planning attorneys of the highest order, armed with a sophisticated (but complicated) arsenal of planning weapons tend to eschew the merits of life insurance as a planning solution. In my view, personally having walked on both sides of the road – the life insurance side and the estate planning side – in frequent to see an estate planning attorney who drinks the life insurance Kool Aid and lives to tell about it. In my view, it is extremely rare to find an attorney who truly understands the “ïns and outs” of life insurance products and planning techniques, regardless of the number of times it is explained.
In the late 1990s and early 2000’s split dollar life insurance got turned upside down at the highest level of the planning arena with Reverse Split Dollar for ultra-high net worth clients. On a personal level, I was aware of the viability of this technique for the older age ultra-high net worth client having bounced into it by accident in 1995 with an 82 year old client. Great fortunes were made by a few life insurance agents supported by one of the top estate planning attorneys of the last quarter century. It was controversial but the agents and attorneys lived to fight another day. I personally believed the technique worked. Ultimately, the Service issued Notice 2002-59 and ended the use and abuse of reverse split dollar.
Not unexpectedly, some of the characters from the prior era of Reverse Split Dollar emerged for the new chapter of split dollar – intergenerational split dollar. From my perspective, the technique has the greatest possible leverage to transfer wealth for estate and gift tax purposes for the taxpayer who is at the end of the road, literally, e.g. death. This taxpayer has used all available tax exemptions; given all of the money they are willing to give to charity and still have a large taxable estate, but cannot live long enough unless they are related to Methuselah. The estate planning arsenal for the best attorneys usually is empty by the time that you reach this point.
In my travels I have been able to meet estate planning attorneys, life insurance agents and valuation specialists that have been deeply immersed in inter-generational split dollar. Like Reverse Split Dollar during its moment in the Sun, I have asked myself why more planners and their clients have not availed themselves of the magic of inter-general split dollar. About five years, an attorney in a large law firm told me that he had been involved in twelve transactions with an average transfer of $27 million with a discount of 850-90 percent.
The top valuation firm in this space told me that they had been involved in over 100 valuation engagements with very few audits at that time, and with very few adjustments. The typical discounts on the transfer have gone from 90-95 percent, to 50-75 percent. Not bad, when you consider the typical valuation discounts for lack of marketability and control hover in the 20-25 percent range.
The recent Tax Court decision in Estate of Morrissette seems to leave a large door open for estate planners and life insurance agents. While the Tax Court has yet to resolve the valuation issue, my reconnaissance seems to suggest that the taxpayer is going to be just fine when the tax dust settles. They will have a discount of at least 50 percent. In the interim, it may take the Service a few years and a number of different Tax Court cases and losses before it proposes new legislation for Congress to pass or it issues a new IRS Notice.
As tax planners following Morrissette, 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 outlines the planning technique utilized in the Estate of Morrissette. This technique has several variations that I am aware of that will be reviewed in the article as well.
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. ld 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 The Strategy
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 (Dynasty Trust #1). The Dynasty Trust is generally created to be a Dynasty Trust for the benefit of multiple generations 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, and Dynasty Trust 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 Dynasty Trust to provide funding for the life policy. The trustee of the Dynasty Trust 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 Dynasty Trust 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 Dynasty Trust (Dynasty Trust #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 Dynasty Trust # 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 Dynasty Trust #1 and DYNASTY TRUST #2 may agree to terminate the split dollar arrangement. The trustee of DYNASTY TRUST #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.
Strategy Example #1
Patriarch, age 80, has existing investment assets of $40 million and a net worth of $75 million. Unfortunately, the $75 million is still in his taxable estate. He is in mediocre health with a life expectancy of 4-6 years. He has created a Dynasty Trust for the benefit of his children and grandchildren.
The Dynasty Trust 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 $30 million. The policy has an initial death benefit of $65 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 the Dynasty Trust 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 economic benefit for gift and generation skipping transfer tax purposes is measured by the lesser of the insurer’s term insurance costs or Table 38 costs.
The Patriarch makes his initial premium of $30 million for the first policy year.
In the beginning of Year 3. The Patriarch dies with the split dollar agreement in place.
The estate 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 75 percent discount from the amount of cumulative premiums paid by the Patriarch into the policy – $22.5 million. The discounted value of the Patriarch’s interest is $7.5 million ($30 million minus 75 percent discount).
Strategy Example #2 - GRAT Substitute
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.
Dynasty Trust 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 Dynasty Trust enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 2, the Patriarch approaches the trustee of Dynasty Trust 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 negligible. 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 Dynasty Trust #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 6, the Company approaches the trustee of Dynasty Trust #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 Dynasty Trust #2 to purchase the split dollar receivable.
Dynasty Trust #2 utilizes trust corpus to purchase the Company's split dollar receivable for $2 million. The two trusts (Dynasty Trust #1 and Dynasty Trust #2) merge following the transfer.
In most cases, taxpayers want some proof that nobody died (i.e. got audited and ripped to shreds by the IRS) as a result of tax planning. The decision in Morrissette is an indication in the current scenario that inter-generational split dollar has merit. The valuation issue may be a temporary question but needless to say, will result in a favorable benefit for the taxpayer.
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!