Transactions in which an older person advances money to a trust to pay premiums for a life insurance policy on a child or children using a split-dollar arrangement are often used in estate planning. Because the receivable is not payable until the child’s death and therefore fair-valued at a discount, the parent’s estate is often greatly reduced when the parent dies before the child.
The IRS has repeatedly attempted to assess additional taxes on these transactions by claiming they were not split-dollar arrangements as defined in the Internal Revenue Code (IRC). Until Estate of Morrissette v. Comm’r (146 T.C. No. 11), none of these cases was ever tried. Instead, the ultimate settlement involved negotiating the discount of the receivable. In Morrissette, the estate asked for partial summary judgment that the arrangement was split-dollar. The court found that the arrangement was indeed split-dollar, both in documentation and operation. As a consequence, the IRS has lost leverage in litigating or settling other similar cases.
A private split-dollar insurance arrangement is one in which two parties join in purchasing insurance on the life of a single person or two spouses. In the estate planning context, this typically involves the insured and an irrevocable life insurance trust (ILIT), but it is not limited to this approach. One party funds most or all of the costs, while the other is entitled to the death benefit over and above what is owed to the funder. There are two flavors of split-dollar arrangements: 1) the economic benefit regime under Treasury Regulations section 1.61-22 and 2) the loan regime under Treasury Regulations section 1.7872-15.
In a private economic benefit split-dollar arrangement, the ILIT typically pays only the term cost of the life insurance, which is modest in the early years of the arrangement. Another party, such as a family member (often the insured) or a family trust [e.g., an existing funded marital (QTIP) or dynasty trust] pays the remaining portion, which is typically the bulk of the insurance cost in the early years of the arrangement. This arrangement can substantially reduce the amount of current gifts the donor/insured is required to make to the ILIT to purchase the insurance, but nevertheless can ensure that the insurance proceeds are removed from the donor/insured’s taxable estate. With a $5 million inflation-adjusted exemption, most taxpayers will not need this reduction in current gifts, although it will remain important for high–net-worth taxpayers or those who have used their exemption. In many planning situations, using a split-dollar arrangement to reduce estate value has become a sought-after benefit. Split-dollar arrangements may become even more important to planning if other techniques are restricted by a new president or Congress after the upcoming elections.
An Estate Planning Challenge
A common estate tax challenge is determining how to quickly reduce the value of an estate, especially for an elderly client, whose viable estate planning options are limited. While grantor retained annuity trusts (GRATs) and other techniques can shift value out of an estate, these techniques often take years to have a significant impact. These techniques can be useful for ultra high–net-worth clients and can be applied in a myriad of ways to accomplish unique planning goals, but split-dollar planning can be an incredible tool for more moderate-sized estates as well.
Consider the following example: Jane is 88 years old and has a taxable estate. Jane’s assets consist almost entirely of highly appreciated stocks she has held for many decades. Jane borrows from her bank using her appreciated assets as collateral. The cash borrowed is loaned to an insurance trust for Jane’s 48-year-old son Tom, and his children. The funds are used to purchase a permanent life insurance policy on Tom’s life. The loan is structured as a split-dollar loan so that interest can be accrued until the loan matures. The split-dollar loan term is not limited to the life of the lender, Jane; in fact, it matures when Tom dies and the life insurance policy pays off. Upon Jane’s death, her estate is reduced by the debt she owes the bank. The split-dollar loan is included in Jane’s estate, but the fair value of that loan, which pays no interest or principal until Tom dies, is significantly less than its face value. No independent party would pay much for a loan made at current low interest rates that pays nothing for potentially four or more decades. The difference between the face value of the loan and its fair value reduces the value of the estate for tax purposes, potentially providing a significant estate tax savings. If Tom had no estate planning, retirement plan, or life insurance in place before this, the split-dollar plan can in a single step create a robust financial safety net for him and his family.
The Morrissette Case
The Morrissette case, mentioned above, legitimizes the use of split-dollar plans like the one described above. Morrissette was in her 90s and incapacitated at the time of her death. She had previously created a revocable trust (the payor) that was later amended by her court-appointed conservator to allow funds to be used for premium payments for life insurance owned by three dynasty trusts (also formed by her conservator) under an economic benefit split-dollar arrangement. Each child had a dynasty trust, and that trust used the funds received from Morrissette’s revocable trust to buy a life insurance policy on the two other siblings. The insurance was to be used as part of the succession plan for the family-owned businesses, which included Interstate Van Lines. Family members entered into a buy/sell/cross-purchase shareholders’ agreement that required the surviving children or their trusts to purchase shares held by a deceased child. Morrissette’s revocable trust contributed approximately $10 million to each of the three dynasty trusts, for a total of $30 million. This money was used immediately for insurance premiums, which was sufficient to cover the anticipated cost of the insurance for each child’s lifetime.
The IRS argued in part that the entire $30 million transfer was a taxable gift. Morrissette’s position was that the unreimbursed “economic benefit cost” was a gift each year, and therefore the amount of taxable gift was very modest. Some of the other issues in the case included the following:
- If the split-dollar arrangement terminated during either the life of the insured child, or at the insured child’s death, the revocable trust/payor would have to receive the greater of the premiums paid or the cash value of that policy and nothing else.
- The advance was only repayable at the death of the insured unless both parties to the transaction agreed to terminate it sooner.
- The dynasty trusts and their beneficiaries could only receive the benefit of the life insurance protection, not other benefits, such as the cash value. Therefore, the dynasty trusts had to be prohibited from borrowing on the policy, and they were. The IRS argued that by paying all of the premiums at one time, the payor revocable trust gave a further benefit to the dynasty trusts, namely that they did not have to pay future premiums. Because the split-dollar agreement made the payor revocable trust solely responsible for premiums, the dynasty trusts had no obligation to pay premiums and therefore could not realize another benefit by the payment of the premiums at inception.
- The IRS also argued that the arrangement was an impermissible reverse split-dollar agreement. The court rejected that argument.
- On Morrissette’s death, her revocable trust/payor owned the right to receive the greater of the premiums paid or the cash value of each policy on the death of the child. The revocable trust was included in her estate, so that right had to be valued. The estate’s appraiser valued this approximately $30 million advance at $7.5 million, about a 75% discount. Unfortunately, the court did not rule as to whether this value was correct.
- The revocable trust left the receivable to the dynasty trusts or the children. The IRS said that this was made the arrangement not split-dollar. The court pointed out that the revocable trust could be amended at any time during Morrissette’s life. It further stated that the trust was a separate entity and not part of the split-dollar arrangement.
- There was also a non-tax reason for the split-dollar arrangement and insurance. It was mentioned in the decision, but had no bearing on the court’s ruling. Courts in future cases might view an arrangement without non-tax motives differently.
While the court ultimately found in Morrissette’s favor, this is the first case of its kind, and the IRS may yet appeal the case. A similar case, Estate of Levine v. Comm’r (U.S. Tax Court Docket No. 9345-15, Jul. 13, 2016), follows and affirms Morrissette, which strengthens its impact on tax law.
Split-dollar arrangements are a creature of the tax regulations that created them. As the Morrissette case proves, adherence to those regulations is vital. Now that this versatile tool has been strengthened by the Tax Court’s ruling, CPA estate planners would be well served to advise clients about it whenever appropriate.