Economic Benefit “Split-Dollar” Transaction Passes Crucial Test in Tax Court
Estate of Morrissette Wins First Round in Court
Inter-generational 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 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 purchase. This would be a very bad outcome for the taxpayers in question to be sure.
Morrissette Split-Dollar
In the April 13, 2016 decision in Morrissette v. Comm’r (146 TC 11), the Estate of Morrissette won on partial summary judgment: that the Estate’s split-dollar life insurance arrangements, for valuation purposes, 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.
We may have more to say about this matter once the Court finally also rules on the valuation of the receivables (if it ever gets there). That part of the saga will likely be much more drawn out and the answers may vary from taxpayer to taxpayer. The valuation evidence available on illiquid and very infrequently “traded” assets like this is hard to get to and often difficult to analyze. But for now, the following takeaways seem important:
- First, the Court holds 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 question 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. This fairly categorical statement would seem to give Morrissette (which was reviewed by the entire Court) quite some impact beyond just this case.
- The Service also argued that the donee trusts in the Morrissette case 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 points out that the donor trust was a revocable trust 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 holds that these arrangements “bear no resemblance” to the transactions prohibited by Notice 2002-59.
- Finally, the Service argued that the premiums paid at the outset by the donor pay not only for current insurance protection but also for future protection. However, the Court also rejects this argument (which also relies on Notice 2002-59).
Procedural History
Clara M. Morrissette passed away on September 25, 2009. Her revocable trust (the CMM Trust) held economic benefit split-dollar receivables resulting from a set of transactions from tax year 2006 where the CMM Trust had contributed, in total, $29.9 million to pay the premiums on certain universal life insurance policies on each of the Decedent’s three sons.
The Estate retained a valuation firm to value the includible receivables as of the date of death and the Estate relied on the appraisals to report a total value of the receivables of $7.479 million on Form 706. The Service, in December 2013, issued two notices of deficiency:
- NOD for a gift tax liability for tax year 2006 with a deficiency of $13.8 million and a section 6662 penalty of $2.8 million.
- NOD for an estate tax liability, which included an adjustment of $32.1 million from the appraised value of the receivables as originally reported by the Estate. This NOD alternatively characterized the insurance arrangements by the CMM Trust as loans.
Some Caveats
While it does not appear to have been very important to the Court’s decision, it was apparently important to the Morrissette family and the Decedent to establish the policies in question for business succession purposes. The policies were explicitly acquired to fund the buy-sell provisions of the business succession plan of the family moving business (the Interstate Group). Already in 1994, Ms. Morrissette had contributed all of her stock in the Interstate Group to the CMM Trust. In distinguishing the Morrissette family’s split-dollar arrangement from the transactions described in Notice 2002-59, the Court finds:
“Mrs. Morrissette, who was 94 at the time she set into motion these arrangements, wanted the Interstate Group to remain in her family. To that end, she caused the CMM Trust to pay a lump-sum premium, through the Dynasty Trusts, on the life insurance policies held on the lives of her sons, the proceeds of which would be employed to purchase the stock held by each of her sons upon his death. Unlike the reverse split-dollar life insurance arrangements described in the notice, the receivables the CMM Trust obtained in exchange for its advances provided the CMM Trust sole access to the CSV of the policies.”
It remains to be seen whether (and, if so, how) the Tax Court will distinguish Morrissette from other cases with similar split-dollar arrangements. From reading Judge Goeke’s decision, it does not appear to have been a very important factor in its decision here, but time will tell.
Future Valuation Disputes
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. How the Tax Court will weigh the Estate’s analysis and evidence on this point remains to be seen.
Valuing illiquid assets like life insurance policies and/or split-dollar life insurance receivables is a complex analysis, particularly in the determination of the appropriate discount rate. A great wealth of relevant empirical data exists and should be considered in the appraisals. We have recently published a brief overview article in Trusts & Estates magazine on this topic. If you would like a reprint, please let us know via email to [email protected].