I consider Pluris to be an industry leader in providing valuations for hard-to-value securities.
Mike Boswell
TriPoint Capital Advisors, LLC

Intergenerational Split Dollar Valuation Issues

By : Espen Robak | November, 8 2016
“As summarized by Lee Slavutin and Richard Harris in Estate Planning Newsletter #2443, no published case to date has addressed the issue of how to properly value the Intergenerational Split Dollar (IGSD) receivable. Appraisers have no authoritative guidance to go by in making such determinations. However, there is substantial evidence available to support IGSD valuations. Here, I intend to provide a very brief overview of (1) the proper valuation theory and methods to apply, and (2) the empirical valuation evidence available to support the individual judgments made in applying the valuation methods. This is based on my firm’s research and our (decade-plus) experience in valuing these and similar instruments.” In Estate Planning Newsletter #2443, Lee Slavutin and Richard Harris provided members with detailed commentary on the lessons planners can learn about intergenerational split dollar from the MorrissetteLevine and Neff cases. Now, noted valuation expert Espen Robak, CFA addresses the issue of how to properly value the IGSD receivable. Espen Robak, CFA, is founder and President of Pluris Valuation Advisors LLC, with offices in New York City, San Francisco, and Newport Beach, California. Pluris’ practice includes business valuations, fractional interests in real estate and investment holding companies, and other opinions for income, gift, and estate tax purposes; as well as portfolio valuations for investment funds and financial institutions. Mr. Robak is a frequent public speaker and contributor to books and professional journals on valuation, accounting, and taxation topics and his commentary has been quoted in the Wall Street JournalFinancial TimesThe New York TimesAmerican BankerBloombergAbsolute Return, and Accredited Investor, among others. He is on the editorial board for Trusts & Estates. Mr. Robak’s valuation experience encompasses the valuation of operating businesses, undivided interests, family investment holding companies (FLPs/LLCs), hedge funds and private equity funds, life insurance and life insurance receivables, stock options and restricted securities, and intangible assets. He is highly sought-after for litigation support services and has testified in depositions, court proceedings, and arbitration hearings regarding the valuation of private equity investments and portfolios, marketability discounts, restricted stock valuations and liquidity, bankruptcy claims and distressed debt, structured products, and patent infringement damages. He can be contacted at erobak@pluris.com. Before we get to Espen’s commentary, members should note that a new 60 Second Planner by Steve Oshins was recently posted to the LISI homepage. In his commentary, Steve reports on In Pfannenstiehl v. Pfannenstiehl, where the Massachusetts Supreme Judicial Court has held that a husband's beneficial interest in a discretionary support trust is too speculative to be included in the marital estate in a divorce proceeding. The Supreme Judicial Court's opinion can be found at http://tinyurl.com/z42uueh and members should click this link to listen the podcast. Now, here is Espen Robak’s commentary: EXECUTIVE SUMMARY:  As summarized by Lee Slavutin and Richard Harris in Estate Planning Newsletter #2443, no published case to date has addressed the issue of how to properly value the IGSD receivable. Appraisers have no authoritative guidance to go by in making such determinations. However, there is substantial evidence available to support IGSD valuations. Here, I intend to provide a very brief overview of (1) the proper valuation theory and methods to apply, and (2) the empirical valuation evidence available to support the individual judgments made in applying the valuation methods. This is based on my firm’s research and our (decade-plus) experience in valuing these and similar instruments.[i] The discussion below will apply more of less equally to economic benefit receivables and “note regime” receivables and I will make very little effort to distinguish between the two. While the instruments are of course different and express themselves in different cash flow forecasts, the methods and evidence for relating the future cash flows to their net-present Fair Market Value are essentially the same. Further, as a humble appraiser without legal training, I believe that it’s especially important for appraisers to steer clear of any legal issues. For example, the three issues covered by the above-mentioned commentary, are all issues I have no opinion about, in any client matter:
  1. Whether or not a particular split-dollar arrangement has a business or other “legitimate” purpose, or needs one.
  2. Whether or not the initial premium should be treated as a gift.
  3. Whether or not there is a gift, or some other kind of taxable event, upon termination of the IGSD arrangement.
Here, as in my firm’s valuation reports, I will stick to appraiser judgments: what methods are best suited and which sources of data are most applicable to the subject instrument? I also have very little guidance to provide on what the appropriate discount should be. As will be apparent below, I don’t believe that a “valuation discount” is a particularly useful way of describing the valuation of an IGSD receivable. I will, however, dwell a bit on a very different valuation concept: discount rates. COMMENT: No court decision is – as of yet – available to serve as guidance for these valuations. Arguably, even if a few such decisions were handed down by the Tax Court or other courts, since valuation is a fact question and such decisions rarely expand to cover all the possible fact patterns we can expect to see, there would likely remain very substantial uncertainty about future receivable valuations. For now, the only true guidance is the definition of Fair Market Value in the Treasury Regulations: the price at which it would change hands between a willing buyer and a willing seller. This basic definition of value, as interpreted by the courts, governs for all tax purposes, unless there’s an exception, and can in certain circumstances apply even if there are other regulations, or revenue rulings, to the contrary. Some of the cases exemplifying the supremacy of the “willing buyer, willing seller” concept are also interesting from the perspective of valuing illiquid cash flow instruments that are similar, at least in some respects, to IGSD receivables. Lottery prize “receivables” can be valued with a valuation framework similar to the methods outlined herein for IGSD receivables. The cash flows (see below) are different – while the IGSD receivable is payable, with a certain probability in each future year, only once (at the maturity of the life insurance policy), the lottery receivable is payable as an annuity. The IRS considered such prizes to be properly valued only if the tables prescribed by Sec. 7520 had been used. However, those values were not reflective of what real-world buyers would pay and, thus, the government has had uneven results in court on this issue. Simplifying somewhat, the tables arrive at values that are greater than what a buyer would pay because they use discount rates that are based on risk-free Treasury rates. However, lottery prizes are illiquid (non-assignable) whereas Treasury bonds are completely liquid and, thus, any buyer of such an illiquid instrument would demand a higher return. Consequently, in two Appeals Court decisions, much greater discount rates were applied in the valuation, resulting in much lower values than those of the IRS tables. These decisions, Gribauskas[ii] and Shackleford,[iii] as well as the evidence from the broader market for such annuities, indicate discount rates from the low teens to the thirties.[iv] For cash flows projected quite some years out from the valuation date, the difference in value is very significant. Cash Flow Expectations The valuation framework that both works best for IGSD receivables and also best reflects how real-world buyers view similar investments is the discounted cash flow (DCF) method. In the DCF framework, the analyst projects the expected future cash flow of the subject investment and discounts those cash flows to the present, using a discount rate (which is the rough equivalent of an interest rate). The discount rate must reflect real-world investor behavior and preferences (for low risk, high liquidity, and other desirable investment characteristics). Particularly relevant to the valuation of IGSD receivables is the fact that such receivables are highly illiquid and that the timing of the receivable’s cash flow is uncertain. The DCF analysis of the expected future cash flows of an IGSD receivable requires two main inputs:
  1. Illustrations for the policy or policies supporting the receivable.
  2. Mortality tables reflective of the age, health, life expectancy, and other characteristics of the insured life or lives.
In other words, the expected cash flows are the probability-weighted cash flows, as determined by the policy and receivable. For an economic benefit regime receivable, the expected cash flow in any given future year equals (A) the estimated mortality rate for that year (B) multiplied by the greater of either (1) the net cash surrender value of the policy in that year or (2) the total premiums paid for the policy. For a receivable under the note regime, the expected cash flow equals the mortality rate times the projected principal of the note (including accrued interest). It is highly recommended to also get policy illustrations when valuing notes receivable to see whether the policy can be expected, under reasonable illustrations, to cover the note. What a Buyer Will Pay A purchase of an investment similar to an IGSD receivable can best be described by the yield, or discount rate, implied by the price paid. That, of course, is how investors typically think about such investments: in terms of what rates of return they can expect to earn on their portfolios. Luckily, there is a wealth of empirical data available on such transactions. In my firm’s practice, we use the following sources of transaction data, all of which contain empirical evidence collected over a long period of time:
  1. Lottery prize transactions (see above).
  2. Private note transactions.
  3. Structured settlement transactions.
  4. Life settlement transactions.
The three first items on this list are interesting as analogies to IGSD receivables, but not so closely comparable that they can play a starring role in the valuation report. The data on life settlement transactions, however, is immensely helpful for these valuations. Not only is there a wealth of data available for a valuation analyst to uncover and research, but the transactions themselves are in such closely related instruments that it should be hard to argue against using these discount rate indications when establishing the discount rate for a given IGSD receivable. In addition, the market for life settlements itself has a long history, is populated by a great number of buyers, including publicly traded companies, large investment funds, and other deep-pocketed investors. As a result, while not an efficient market compared with the traditional stock or bond markets, transactions in life settlements are competitive, with multiple bidders. As noted above, lottery prize purchases evidence discount rates ranging from low-teens to the thirties. Transaction evidence from private notes is not available from any organized data-source, but interviewing note brokers will yield information and given the competitive nature of this market, discount rates are not likely to vary too widely for the same or similar notes. Structured settlements represent provide further opportunities for research, both through interviewing brokers and buyers and through researching published data. Overall, discount rates from these “cash flow” markets range from the high single-digits to the thirties, with central indications typically in the mid-teens. Not coincidentally, this is also more or less where the market for life settlements is. With the very large pools of capital chasing any of these instruments, it would be strange indeed if we saw average prices being paid (thus smoothing out outliers) that were completely unrelated to the fundamental investment characteristics of the instruments, including their lack of liquidity. A Numerical Example As an example of how the DCF method works for a life insurance receivable, let’s assume that a note has been issued to pay a $1 million premium to purchase a universal life policy on the life of a 70-year-old man with a life expectancy of approximately 15 years. The note accrues interest at 4 percent.[v] But the note only matures upon the maturity of the policy. Thus, the expected cash flows on the note, in the DCF framework, can be projected for, say, the next 40 years as $1 million, plus accrued interest, multiplied with the insured’s expected mortality rate for each year, thus:
Year Note Value Mortality Expected CF
1 $1,000,000 0.585% $5,850
2 $1,040,000 0.910% $9,460
3 $1,081,600 1.241% $13,425
….. ….. ….. …..
40 $4,801,021 0.000% $1
Furthermore, let’s assume that the data on similar investments (see below) lead us to conclude at a discount rate of 12 percent. The value of the note is simply the sum of the discounted expected cash flows (i.e., their Present Values) for each year, as follows:
Year Expected CF PVDF Present Value
1 $5,850 0.9091 $5,381
2 $9,460 0.8264 $7,818
3 $13,425 0.7513 $10,086
….. ….. ….. …..
40 $1 0.0201 $0
In the preceding table the PVDF, or the Present Value Discount Factor is simply a function of the appropriate discount rate and time. It can be shown, fairly easily, that the total present value of the note, under these assumptions, is about $420,000, or a 58 percent discount from its face value. But it’s easy to imagine much different facts, and with a different set of assumptions, the exact same set of calculations would yield a very different result. For example, in the case of a 50-year-old woman with a life expectancy of about 35 years, and with a 20 percent discount rate instead of the more conservative 10 percent in the example above, the total fair market value of the note would be about $17,000. This results merely from the application of standard discounting and mortality math to the problem. The question remains, what exactly is the appropriate yield, or discount rate, for such investments? Life Settlements The cash flows associated with life settlements are long-dated, just as the cash flows typical for IGSD receivables. Life settlements are also backed by highly rated obligors (e.g., life insurance companies), and are illiquid due to the inability to accelerate the payments as well as regulations regarding transfer. For these reasons, life settlements are similar to the expected cash flows to the typical holder of an IGSD receivable. The timing and amount of future cash flows associated with life settlements are uncertain due to (i) the uncertain timing of the insured’s death, and (ii) future premiums which may be necessary to keep the policy in force. The timing of cash flows to the holder of an IGSD receivable is uncertain due to the uncertain timing of the death of the insured, and the ultimate amount expected to be received by the holder of the receivable may also be uncertain in some cases. Due to the sometimes very long life expectancy of the insured lives for a particular IGSD receivable, the ultimate timing of receipt of cash flows may be subject to a greater degree of variability than that of life settlements. In addition, the typical IGSD receivable is almost always completely non-transferrable. Conversely, the life settlement market has experienced significant growth in recent years, and many qualifying life insurance policies may be sold relatively quickly and efficiently in the market. Oftentimes, therefore, an IGSD receivable is subject to a greater degree of risk and uncertainty, as well as to a greater degree of illiquidity than life settlements, and may consequently require at least somewhat higher discount rates as well, to compensate for these weaknesses. For our IGSD receivable valuations, we conduct, update, and review a survey of life settlement companies regarding completed purchases. From the transactions, we gather the terms and calculate the expected return based on the internal rate of return. We analyze the various data from these transactions as indications of the discount rate necessary for purchases of such instruments. In recent years, the majority of the indications have ranged from 14 to 18 percent. The difference in discount rates between male and female insureds is immaterial. Published studies have found similar results.[vi] I should pause to note, here, that at Pluris Valuation Advisors, we perform life insurance valuations of this nature not only for taxpayers, but also to help reporting entities (hedge funds and others) determine the fair value of their life settlement portfolios under generally accepted accounting principles, and reviewed by their auditors. I.e., these methodologies are not “just for tax purposes” but are applied much more broadly than that. Very helpfully, the data on life settlement purchases and portfolios is also available in public documents, filed with the Securities and Exchange Commission and available on their EDGAR filings service. This is particularly useful as evidence since this represents audited data. One example is Emergent Capitals, Inc. (NYSE: EMG), which owns and manages a portfolio of more than 600 life insurance policies acquired in life settlements transactions, with aggregate death benefits of approximately $3.0 billion at December 31, 2015. As of December 31, 2015, EMG discounted the projected cash flows from each of its life settlements using discount rates ranging from 15.0 percent to 24.5 percent. The weighted average discount rate for the entire portfolio was 17 percent.[vii] Concluded Values In my experience, the age and life expectancy of the insured lives of IGSD arrangements vary widely. Thus, even using discount rates that are the same or drawn from a relatively narrow range, values will vary widely. This is dictated by the math for compounding over shorter versus longer time periods (compounding being the opposite of discounting). The question of what a reasonable discount is (if the discount is measured as the difference between the premium paid and the fair market value of the receivable) is similarly hard to answer. Instead, let’s apply a thought experiment: what if you had two clients with similar note regime IGSD arrangements, but significantly varying life expectancies? Let’s say that one appraiser uses a 20 percent discount rate to value the short LE receivable at a 40 percent discount from face value. And the other appraiser uses a 12 percent discount rate to value the long LE receivable at an 80 percent discount from face value. From the IRS’s perspective of tax compliance, is the 40 percent discount a conservative (high) valuation while the 80 percent discount is an aggressive (low) valuation? I hope it’s clear from the foregoing that – based on all the market evidence we have seen – it could very well be the opposite. HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE! Espen Robak CITE AS:  LISI Estate Planning Newsletter #244X (August X, 2016) at http://www.leimbergservices.com  Copyright 2016 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission. Citations:

[i]Valuation of insurance policies – Pluris White Paper, available at www.pluris.com or on request from info@pluris.com.
[ii]See Estate of Gribauskas v. Commissioner, 342 F.3d 85 (2d Cir. 2003) (standard tables used to value lottery prize produce unreasonable result). Implied discount rates from valuation was 14 percent. [iii] Shackleford v. United States, 262 F.3d 1028 (9th Cir. 2001). Discount rate applied was 26 percent.
[iv] Evidence from published cases where assignments, or attempted assignments, of lottery prizes have been made indicate discount rates from 11 to 35 percent. There are also exceptions from the court’s allowing deviation from the tables, and a circuit split has arisen, which has never been remedied. See Negron v. United States, 553 F.3d 1013 (6th Cir. 2009) (lottery payments with transfer restrictions properly valued through using Sec. 7520 tables for estate tax purposes); Estate of Cook v. Commissioner, 349 F.3d 850 (5th Cir. 2003) (estate's lottery prize interest is private annuity; must be valued using Sec. 7520 annuity tables).
[v] Note that there are many simplifying assumptions made here: One is that we don’t need to account for the tax-implications of the “cost of insurance” provided by the donor in each case. If required, however, this is a relatively simple addition to the analysis. Also, I’m choosing to show projections for a note here, since that’s a simpler analysis than for an economic benefit receivable.
[vi] Afonso V. Januario and Narayan Y.  Naik. “Empirical Investigation of Life Settlements: The Secondary Market for Life Insurance Policy.” London Business School: June 10, 2013. [vii] Emergent Capitals, Inc. Annual Report for the Fiscal Year Ended December 31, 2013, Filed on Form 10-K.

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