In a case of first impression, the United States Tax Court ruled in favor of a taxpayer whose estate planning focused on the preservation and succession of a 70-year-old family-owned business. In Estate of Clara M. Morrissette v. Commissioner, 146 T.C. No. 11 (April 13, 2016), the Tax Court held that money Mrs. Morrissette advanced to trusts she established for the benefit of her sons and future generations (known as “dynasty trusts”) to fund buy-sell arrangements designed to keep her company in her family, should not be regarded as loans still owed to her estate (the “Estate”).
The Morrissette Succession Plan Arthur Morrissette, Sr. started a moving company in the Washington, D.C., suburbs in 1943 with a single truck, but quickly grew his business to become an industry leader known as Interstate Van Lines. Over the next 70 years, Arthur and his wife, Clara, built a formidable empire.
In 2006, Clara Morrissette – now widowed – set into motion a plan to pass Interstate stock to her sons and, ultimately, to trusts for her grandchildren. First, Mrs. Morrissette made her sons trustees in her revocable trust; second, she created three dynasty trusts – one for each of her sons. The shareholder agreements set forth arrangements whereby the dynasty trusts would purchase the stock held by each of the Morrissette brothers when one of them died. In order to fund these buyouts, each dynasty trust would secure a life insurance policy on the lives of the two other brothers. Mrs. Morrissette, ever mindful that the only way she could make sure the insurance policies would not lapse and that the proceeds would be available to fund the buy-sell agreements, arranged to pay all the projected premiums for the policies in lump sums out of her own revocable trust, which she managed.
The lump-sum amounts Mrs. Morrissette advanced to pay premiums on the policies was sufficient to maintain them for her sons' projected life expectancies (which at the time ranged from approximately 15 to 19 years). Finalizing this plan, Mrs. Morrissette was confident that Interstate stock held by or for the benefit of her sons would be acquired by the dynasty trusts, and would eventually benefit her grandchildren and future generations of her family.
The Split-Dollar Life Insurance Policies In sum, Mrs. Morrissette advanced approximately $30 million to make lump sum premium payments on the insurance policies for her three sons. The financing for these life insurance policies was structured as “split-dollar arrangements,” meaning that the cost and benefits would be split between the trusts. In this case, while Mrs. Morrissette paid a lump sum amount to cover the premiums on these policies, the policies themselves were designed to pay out varying amounts to the trusts for both Mrs. Morrissette and her sons. Specifically, upon the death of any of her sons, Mrs. Morrissette’s revocable trust would receive the greater of either the cash surrender value of that policy or the aggregate premium payments on that policy, while each dynasty trust would receive the balance of the policy death benefit. The amounts Mrs. Morrissette retained are known as split-dollar receivables (the “Receivables”).
In a typical case, a company advances funds to a trust to pay premiums on insurance on the life of the owner of the company, and the split-dollar receivable is payable upon the death of that owner. What was unique in this case is that the split-dollar receivable wasn’t payable until the death of one of Mrs. Morrissette’s sons. Accordingly, in this case, the split-dollar receivable became an asset in Mrs. Morrissette’s estate. Given her sons’ life expectancies, this asset was not likely payable to the Estate for 20 years. So, a seminal issue arose upon filing the estate tax return: how should the Receivables be valued for gift and estate tax purposes?
The IRS Attacks the Split-Dollar Arrangements From 2006 through 2009, Mrs. Morrissette reported gifts made to the dynasty trusts based upon the cost of the current life insurance protection based on tables published by the IRS determined under the economic benefit regime. After Mrs. Morrissette’s death, her estate retained an independent valuation firm to value the Receivables includible in her gross estate as of the date of her death. The total value reported on her estate tax return for the Receivables was $7.48 million.
The Internal Revenue Service ultimately issued two notices of deficiency to the Estate. The first notice was for a gift tax liability for the tax year ending December 31, 2006, which determined that the Estate had failed to report total gifts in the amount of $29.9 million – the amount that Mrs. Morrissette paid in a lump-sum payment of policy premiums. The second notice grossed up Mrs. Morrissette’s lifetime gifts by $29.9 million, and determined additional estate tax liability attributable thereto.
The Estate moved for partial summary judgment on the threshold legal question presented by this scenario – specifically, whether the split-life arrangements should be governed under the economic benefit regime as set forth in section 1.61-22 of the Income Tax Regulations. If the arrangements were properly governed under this regime, then the Estate would have been correct that the total value reported for the Receivables should be based on the present value of the right to collect the Receivables in 15 to 20 years (again, based on the sons’ actuarial life expectancies).
The Pleadings The Estate filed its motion for partial summary judgment January 2, 2015. Over the next 11 months, and at the direction of the Tax Court, the parties filed in total four cross pleadings on the petitioner’s operative motion. The hallmark of the respondent’s pleadings was the Internal Revenue Service’s argument that the petitioner’s motion should be denied because it was factually unclear as to whether or not the revocable trust had conferred upon the dynasty trusts an economic benefit apart from the current cost of the life insurance protection obtained. Petitioner maintained throughout all of the pleadings that summary judgment was appropriate in this case as the only question in dispute – whether or not any additional economic benefit was provided other than current life protection – was legal, not factual. The Tax Court ultimately agreed with the petitioner.
With respect to the arguments raised by petitioner and respondent, respondent maintained its position in its pleadings that the lump-sum premium payments made by the revocable trust should be treated as loans owed back to the Estate and valued under the Internal Revenue Regulations referred to as the loan regime. Petitioner relied on other Internal Revenue Regulations issued in 2002 on how to treat, for tax purposes, split-dollar arrangements. Notably, petitioner reasoned that since the split-dollar arrangements at issue were executed in accordance with provisions in the Regulations under the economic benefit regime, the split-dollar arrangements were not governed by the loan regime, and the Estate was not liable for the 2006 gift tax deficiency determined by the IRS.
The Tax Court’s Analysis The Tax Court sided with petitioner as a matter of law.1 On the specific legal question of whether the split-dollar arrangements were governed by the loan regime or the economic benefit regime, the Tax Court applied the final Income Tax Regulation 1.61-(1)(ii)(A)(2),which provides that if “the only economic benefit provided under the split-dollar life insurance arrangement to the donee is current life insurance protection, then the donor will be the deemed owner of the life insurance contract, irrespective of actual policy ownership, and the economic benefit regime will apply.”2
Then, in order to determine if any additional economic benefit was conferred by the revocable trust to the dynasty trusts, the Tax Court considered whether or not “the dynasty trusts had current access to the cash values of their respective policies under the split-dollar life insurance arrangements or whether any other economic benefit was provided.”3 Because the split-dollar arrangements were carefully structured to only pay the dynasty trusts that portion of the death benefit of the policy in excess of the Receivables payable to the revocable trust, the Tax Court concluded that the dynasty trusts could not have any current access under the final regulations. Further, the Tax Court also agreed with petitioner that no additional economic benefit was conferred by the revocable trust to the dynasty trusts on account that (i) the lump sum premium payment advanced by the revocable trust assured the revocable trust had sole access to the cash surrender value of the life insurance policies (which was essential to accomplish Mrs. Morrissette’s goal to assure that life insurance proceeds would be available to buy the stock held by any of her sons at death) and; (ii) the fact that the revocable trust made the lump sum payments did not obviate the dynasty trusts of any obligation to pay the premiums on an ongoing basis because the dynasty trusts were not required to do so.
The Impact of the Morrissette Decision In sum, the Tax Court’s decision marks a groundbreaking moment in estate tax jurisprudence and is most welcomed by the wealth planning and insurance communities for its beneficial application to high-net-worth individuals and owners of closely held businesses like the Morrissette family. Moreover, the Tax Court’s resounding affirmation that the final regulations would control under these facts provides practitioners with the assurance that similarly or identically structured split-dollar arrangements would be governed by the economic benefit doctrine.
This decision is important because we now know that compliance with the economic benefit split-dollar regulations (the “EB Regulations”) protects clients from gift tax liability, with the result that the value of the Receivables would be determined based on typical valuation principles (i.e., the amount a third party would pay to purchase the Receivables).
An insurance policy is a valuable asset, as long as you own both the death benefit and the cash surrender value. The EB Regulations realign this bundle of rights, separating the death benefit from the cash surrender value, and imposing significant gift and income tax liabilities on the parties attributable to the reallocation of the death benefit. These rules benefit the government through the income tax treatment of economic benefit split-dollar arrangements.
However, the EB Regulations severely impair the value of the Receivables. The Receivables are unsecured promises to pay uncertain amounts at an uncertain time (which could be many years in the future), with no current return, and substantial ongoing tax liabilities. A valuation, VSI, expert appraised the Receivables by (i) appreciating the cash surrender value of the policies by the crediting rate projected by the insurance companies, (ii) subtracting ongoing tax liabilities, and (iii) discounting that sum back to present value. VSI determined the appropriate discount rate by reference to the discount rates used to purchase life insurance policies in the vibrant secondary market. VSI took these factors into account, and determined the value of the Receivables includable in the Estate to be $7.48 million, resulting in an effective “discount” of approximately 77 percent (by comparison to the cash advanced to pay premiums).
The Tax Court’s decision now opens the door to intergenerational split-dollar arrangements – providing a blueprint for the wealth management community for passing family assets (like closely held businesses) through the generations, with predictable estate and gift tax consequences for the original owners.
The Estate of Clara M. Morrissette is represented by Reed Smith LLP attorneys James E. McNair, Eric Wang, and Kelley C. Miller.
A copy of the Tax Court’s Opinion may be found here.