The End of The Road for Economic Benefit Split-Dollar Transactions?
There are a great number of disputes, at varying stages of audit, appeals, or litigation, making their way towards Tax Court. Two of the estates tangling with the IRS on this topic are the Estate of Cahill (TCM 2018-84) and the Estate of Morrissette. This week, both got some unwelcome news. It will be some time before we understand quite how bad the news is for them – and other similarly situated taxpayers – but this was not a good week for this insurance strategy.
First, a summary of the decisions. Both matters are nowhere near the finishing line yet, and the decisions this week were both on motions for partial summary judgment. The motions were:
- Cahill asked the Court for summary judgment that sections 2036, 2038, and 2703 do not apply and that section 1.61-22, Income Tax Regulations, does apply to the valuation.
- Morrissette asked the Court for summary judgment that section 2703 does not apply.
Similar requests, in other words, although the facts are not quite the same. Both matters, however, are economic benefit intergenerational split-dollar transactions where the older generation advances money for the purchase of a life insurance contract (often with a single, upfront, premium) on the lives of their children, for the benefit of their grandchildren. In return for his investment, the premium payer takes back a receivable, payable upon the death of the insured.
Given the illiquidity of this receivable, and the very substantial uncertainty (and often lengthy life expectancy) around when the policy will mature, the receivable is typically valued at a steep discount from the premium paid. In fact, with standard insurance contract related discount rates, there is almost no way that these receivables can be valued close to the premium paid. That’s potentially great news for the taxpayer’s valuation on future tax returns, but not so great for surviving challenges under sections 2036 and 2038, as it turns out.
Valuation and Restrictions
Split-dollar receivables are illiquid and have no active trading market. However, they are backed by life insurance policies with significant cash values. The lack of liquidity is caused by the requirement, in the split-dollar agreement, that the policy can only be surrendered with the consent of both parties, receivable holder and policy owner. The Court refers to this provision as the “termination restriction.” Without this provision, the receivable holder could just surrender the policy and take back an amount very close to its initial investment. As it turns out, this clause is key to the Court’s understanding of these arrangements for its analysis of the applicability of sections 2036, 2038, and 2703, alike.
Sections 2036 and 2038
Both sections 2036 and 2038 pertain to retained rights, by a transferor, to control or enjoy the property transferred post-transfer. In the split-dollar context, as argued by the IRS, the property transferred is the cash premium paid (which remains with the policy in the form of its cash surrender value) and the right retained is the right to control the surrender of the policy.
But the transferor (i.e., the receivable holder) does not control the surrender. That’s the whole point of the split-dollar agreement is it not? Ah, says the Court, such a retained right only requires that the transferor retains the right to control alone or in conjunction with any other person. And since the receivable holder and policy owner together can decide to surrender the policy and divvy up the money, this is a retained right.
Two comments here: First, this is an odd retained right as this term is usually applied in FLP valuation cases. It usually pertains to control over the enjoyment or use of property in an ordinary entity (i.e., where “control” has a pretty well-established and understood meaning). But more importantly, it usually applies to a right to jointly control something where both parties stand to gain something from exercising control. In split-dollar arrangements, the policy owner would tend to lose all his rights by surrendering the policy early (before it matures).
This issue is not very thoroughly discussed in Cahill. The Court correctly points out that the existence of a retained right does not require unilateral control. However, it seems like this analysis ought to also consider incentives. If the other side of the deal (the “in conjunction with” side) has no incentive whatsoever to help you exercise control, what control do you have?
Sections 2036 and 2038 have exceptions for bona fide sales for full and adequate consideration. In Cahill, there are many “bad facts” here that may have been part of the Court’s analysis and which may not quite so clearly doom future taxpayers.
- Business purpose for the deal. The taxpayer claimed the arrangement had the purpose of providing liquidity decades into the future. However, the policies were purchased with a 5-year loan, with no obligation of the lender to refinance.
- Value of receivable. The receivable was valued at less than 2 percent of the premium paid. This is lower than normal for split-dollar cases, but these valuations are always very low compared with the premiums paid.
Section 2703
Section 2703 pertain to restrictions that are disregarded for valuation purposes. These split-dollar agreements, holds the Court in Cahill (and the Morrissette court agrees), are “agreements to acquire or use property at a price less than fair market value.” And the agreements clearly restrict the right of the receivable holder to terminate the agreement and withdraw his investment.
The estate counterargues that section 2703 was never intended for such interests and that these agreements are more like promissory notes. Noting the lack of interest and defined term the Court is unpersuaded by the argument that the receivable is analogous to a note. (It’s also somewhat interesting that the first phase of the Morrissette case involved the Estate specifically attempting to ensure that their receivables were considered economic benefit receivables, and not notes.)
Exeunt Economic Benefit Regime; Enter Note Regime?
The $10 million question right now, for many planners and their clients, will be if these two cases in and of themselves should provide further impetus towards using note regime transactions rather than the more traditional economic benefit split-dollar. Notes are clearly much simpler instruments. And there is no “joint control” applicable between lender and borrower in such cases. There is a defined maturity date (the maturity of the policy) and a set interest rate.
However, two notes of caution: First, the fat lady is barely warming up her vocal cords with respect to both Cahill and Morrissette. There’s a whole trial left to go. And note regime transactions might have other challenges – certainly the IRS will have significant room to maneuver also there.