Intergenerational Economic Benefit Split-Dollar Transaction Passes Crucial Test in Tax Court
Estate of Morrissette Wins First Round
Intergenerational[i] split-dollar transactions have become a popular way for families to purchase life insurance, and to do so in a tax efficient transaction structure that minimizes transfer taxes on the senior generation’s estate. The interests retained by the senior generation in such transactions are completely illiquid and valued at discount rates that often result in valuations that are considered very favorable to the taxpayer.
The IRS has demonstrated its displeasure with these valuations, and with the transaction form itself, for a long time. Recently, in many ongoing disputed matters, the Service has produced arguments that would re-characterize such transactions in such a way that the entire upfront premiums paid by the senior generations – often in the tens of millions – become taxable gifts at the time of premium payment. This would be a very bad outcome for the taxpayers in question to be sure.
In the April 13, 2016 decision, Estate of Morrissette et al v. Commissioner, won on partial summary judgment: that the Estate’s split-dollar life insurance arrangements are governed by the economic benefit regime set forth in the income tax regulations (Sec. 1.61-22). To be sure, the Tax Court did NOT rule on the Estate’s valuation of the receivables. However, this is still a very good result for Morrissette and, perhaps, for other taxpayers in similar situations that are in front of the Court right now. Here are the important takeaways:
- The Court held that whether additional economic benefits are provided (by the senior generation putting up the premium and taking back the receivable) to the junior generation – other than current life insurance protection – is a purely legal question and does not involve triable issues of fact. The Service felt that this should be tried.
- Specifically, on the issue of additional economic benefits, the Court holds: “[W]here a donor is to receive the greater of the aggregate premiums paid or the CSV of the contract, the possibility of the donee receiving an additional economic benefit is foreclosed.”
- This neatly describes most such transactions and is one of the cornerstones of the entire plan. Importantly, because it was reviewed by whole court, the decision sets a precedent.
- The Service also argued that the donee trusts in Morrissette had a direct or indirect right in the cash values of the insurance policies because an amendment of the donor trust provided for the cash values to pass to the donee trusts after the Decedent’s death. However, the Court pointed out that the donor trust was a revocable trust (which could be changed at any time) so this “right” of the donee trusts is not legally enforceable and, thus, not really a right at all.
- The Service also argued that the arrangement here was a “reverse split dollar” arrangement as described in Notice 2002-59. The Court held in part that, since this arrangement used the Table 2001 as a measure of the economic benefit and not Table PS 58, these arrangements “bear no resemblance” to the transactions described in Notice 2002-59.
- Finally, the Service argued that premiums paid at the outset were actually prepayments of future premiums. The Court also rejected this argument.
There are some special facts that make this case different than many other intergenerational split-dollar arrangements:
- The purpose of the insurance was to fund a buy-sell for a family business.
- It was clear that the intent was to keep the business in the family. (While the court mentioned these two factors, they had no direct bearing on the decision.)
- The insureds were the sons of the funder.
- Morrissette was incompetent. Her conservator did the arrangement through her revocable trust.
- The beneficiaries who received the receivable in the revocable trust at Mrs. Morrissette’s death were either the trusts that were the receivers of the premium advances and/or her sons. The court noted that while this was specified in the trust it was not part of the split-dollar agreement and therefore had no bearing.
- If the arrangement was terminated during lifetime, the greater of the advances or the cash surrender value were payable to the revocable trust.
The battle – for Morrissette and perhaps also for other taxpayers – will now move to the valuation of the receivable, where it arguably belonged all along. The estate valued the receivable at death at roughly $7.5 million – versus a total amount paid a few years earlier just south of $30 million. That, of course, is a question of facts, valuation logic, and empirical support. If the case is not settled, how the Tax Court will weigh the Estate’s analysis and evidence on this point remains to be seen, so stay tuned.
[i] The arrangements are considered inter-generational because the premium funder (owner of the receivable) is either the parent or grandparent of the insured; the funder is likely to die before the insured; and the arrangement cannot be terminated before the insured’s death without the consent of both parties.