Taxpayers and tax planners scored a big win in the April 13, 2016, Tax Court decision Morrissette v. Commissioner (146 T.C. No.11). The decision clarified the treatment of an intergenerational split-dollar life insurance arrangement, removing doubts regarding a planning strategy which some practitioners found too risky due to the uncertainty of treatment.
Beginning in 1943 until the death of Mrs. Clara Morrissette in 2009 the Morrissette family owned, operated and expanded a group of interstate moving companies, ownership of which were consolidated into a holding company in 2002 (the “Company”). Prior to her death, Mrs. Morrissette, through a court appointed conservator, began structuring a split-dollar life insurance arrangement to provide for an effective and tax efficient way to fund a business succession plan for the Company.
In September of 2006, Mrs. Morrissette established dynasty trusts for each of her three sons, Arthur, Donald, and Kenneth (the “Dynasty Trusts”). Her longstanding revocable trust (the “Revocable Trust”) was amended to permit the payment of insurance premiums to fund the business succession plan and make loans, enter into split-dollar life insurance agreements or make other arrangements. Shortly thereafter, all shareholders of the Company entered into a shareholder agreement, providing that upon the death of any of the three sons, the surviving sons and their respective Dynasty Trusts would purchase the deceased son's shares in the Company.
To fund a future purchase of the stock pursuant to the shareholder agreement, the Revocable Trust entered into split-dollar life insurance arrangements with each of the Dynasty Trusts. The Revocable Trust contributed approximately $10 million to each Dynasty Trust ($30 million total) to pay lump-sum premiums in order to maintain a life insurance policy on the life of each other brother for his projected life expectancy. As part of the split-dollar agreements the Revocable Trust was entitled to a receive property equal to the greater of the total premiums paid or the cash surrender value of each policy upon the death of the insured.
Over the next four years, Mrs. Morrissette reported gifts to the Dynasty Trusts totaling approximately $640,000, based on the economic benefit regime set forth in the Treasury Regulation Section 1.61-22. Following her death in 2009, the estate reported the receivables due from the Dynasty Trusts on Mrs. Morrissette's federal estate tax return at a discounted value of $7,479,000 (a significant discount from the $30 million total contribution).
The IRS assessed a 2006 gift tax deficiency of $13,800,179 and a Section 6662 penalty of $2,760,036, under the theory that the $30 million in contributions to the Dynasty Trusts were gifts at the time they were made and gift tax was due on the value of the transfer at the time it was made.
Treatment under the split-dollar
The Tax Court discussed how, under the split-dollar regulations, the listed owner of the insurance policy (in this case each of the Dynasty Trusts) is generally treated as the owner of the policy, and the contributions would be considered loans to the owner (the “Loan Regime”), pursuant to Treasury Regulation Section 1.61-22©(1). However, an exception to the general rule provides that if the only economic benefit provided to the listed owner under a split-dollar life insurance arrangement is current life insurance protection, the donor (in this case the Revocable Trust) would be considered the owner of the policy and would be considered to make gifts only to the extent of the economic benefit provided in each year (the “Economic Benefit Regime”), pursuant to Treasury Regulation Section 1.61-22©(1)(ii)(A)(2).
The preamble to the final regulation includes an example structured identically to the Morrissette's structure, in which the Economic Benefit Regime was deemed to apply. While courts have, at times, found the preamble to final regulations unpersuasive, the Tax Court ultimately granted the preamble some deference and determined that the Economic Benefit Regime properly applied to the split-dollar arrangement.
Economic benefit provided
For purposes of determining the annual benefit, the donor (the Revocable Trust) is deemed to make a gift of the economic benefit less any consideration the non-owner (the Dynasty Trusts) paid for that benefit, pursuant to Treasury Regulation Section 1.61-22(d)(1). The economic benefit provided under a split-dollar arrangement is equal to the sum of (i) the cost of current life insurance protection, (ii) the amount of cash value to which the non-owner has current access during the year, and (iii) any economic benefits not otherwise described that are provided to the non-owner, pursuant to Treasury Regulation Section 1.61-22(d)(2).
The IRS asserted that the Dynasty Trust maintained a right to the cash value, as the terms of the Revocable Trust passed the interests in the cash value of the policies to the Dynasty Trusts or directly to the sons. The Tax Court disagreed, as the Dynasty Trusts had no right to the cash value during Mrs. Morrissette's life; furthermore the Tax Court found, that particular benefit was not provided to the Dynasty Trust under the split-dollar arrangement, and therefore should not be considered in the analysis of the benefit provided.
The Tax Court went on to reason that no additional economic benefit was provided to the Dynasty Trusts as the contract rights the Revocable Trust obtained in exchange for its contributions provided the Revocable Trust sole access to the cash surrender value. Further, due to the type of policy purchased there was no requirement for the Dynasty Trusts to make payments to maintain coverage, and therefore the initial premium payment did not provide a future benefit, beyond the current insurance coverage.
The Morrissette decision removes doubt as to the applicability of the Economic Benefit Regime in a properly structured split-dollar life insurance arrangement. The result unlocks a powerful estate planning tool and provides clarity on the gift tax treatment, which should increase use of intergenerational life insurance planning now that there is certainty as to the tax treatment (assuming the transaction is structured strictly in accordance with the Treasury Regulations).
While the valuation of the contract rights created by split-dollar arrangements in the hands of the estate is still undecided, the Morrissette case illustrates that significant benefits can be conferred and transfer taxes can be reduced through use of a split-dollar arrangement.