A recent Tax Court decision has potentially groundbreaking results. In Estate of Morrissette v. Commissioner, the Court ruled that the economic benefit regime applies to this split-dollar arrangement because the only economic benefit conferred upon three trusts was the value of current life insurance protection. The IRS sought to deny treatment under the economic benefit regime and to treat the $29M of funds advanced by the decedent as gifts.  If treated as a gift, the decedent, who died in 2009, would have had to file a gift tax return in 2006 and pay $13.8M of tax.

The details of the case

The decedent’s revocable living trust (RLT) advanced $29m to three trusts, described by the Court as Dynasty Trusts (DTs). The DTs used the $29m to make lump sum (one-time) premium payments for six universal life insurance policies. The lives of the decedent’s three sons were insured.  The trust for the descendants of Son A owned two policies, one each on the lives of Sons B and C. This pattern repeats itself for the other DTs. The DTs executed collateral assignments of the policies to RLT. The DTs owned the policies; however, neither the DTs nor the RLT retained the right to borrow against the policies. Upon death of an insured (son), the RLT would receive the greater of the cash surrender value of the policy or the aggregate premiums paid.  The DTs would receive the death benefit reduced by the payment to the RLT.  Each DT, would use the remaining proceeds to purchase stock in the family business held by the deceased brother.  Thus the buy-sell feature would be accomplished passing the family business down to the decedent’s grandchildren. There were three planning alternatives, some of which were impractical. First, the decedent would make an outright gift of $29M and pay gift tax at 40% of the gift. The second alternative would have the decedent or her RLT loan $29m.to the DTs (the “Loan Regime”).  The $29M loan would be an asset of the decedent’s estate and there would be interest charges so this option is unattractive for income tax and cash flow reasons. The third alternative was to confer upon the DTs only the value of current life insurance protection and utilize the economic benefit regime. Thus, each year before her death, the mother reported a gift equal to the cost of current life insurance protection.  In four years, she made gifts of $740,000 using Table 2001 under Treas. Reg. 1.61-22. Remember, neither the DTs nor the RLT retained the right to borrow against the policies.

Deemed ownership vs. legal title

In order to use Table 2001, the RLT would have to be deemed to be the owner of the policies.  Deemed ownership for split-dollar arrangements is different than legal title.  Deemed ownership by the RLT arises where the only benefit to the DTs is value of the current life insurance protection.  Taking away the DTs right to borrow from the cash surrender value of the policies caused the RLT to be the owner under the exception.  The DTs would have been treated as the owners of the policies if the DTs received any benefit other than current life insurance protection thus causing the loan regime to apply under the general rule. The result in this case is that $29M was made available to Dynasty Trusts at a tax cost that was fraction of the dollars advanced. The decedent’s estate was entitled to be paid, but the amount and timing were unknown at her death.  Each one of three individual insureds had a life expectancy in excess of twenty years.  Furthermore, the RLT could not access the cash surrender value at the mother’s death. The appraiser valued the right to be repaid at $7.5M, which was the value reported in the taxable estate.  Once must remember that without planning, $29M would have been subject to estate tax.

The significance of the decision

The case has game-changing implications for the tax, wealth planning and insurance sectors because it may lead to intergenerational split-dollar arrangements. This would make it easier for family assets to pass into dynasty trusts and through generations by extracting assets from the estate and gift tax system. Split-dollar arrangements have been used for decades as a method for paying life insurance premiums. A prime example of the use of a split-dollar arrangement occurs with a closely-held or family-owned company. To provide funding for a buyout and paying estate taxes on the stock in the company, the business owner would establish a trust so that money could be transferred to the trust from the company (or wealthy individual). The trust then purchases life insurance for the business owner and the company has a split-dollar receivable. In the event that the business owner dies, the trust would collect the death benefit and pay back the company. The trust may loan the remaining funds to surviving business owners to complete the purchase under the buy-sell agreement, purchase the shares itself or loan the money to the estate to pay death taxes. The keys are to utilize a cash rich person or entity at minimal tax cost  and to avoid having both the business and the proceeds included in the taxable estate.