Estate of Morrissette v. United States, 146 T.C. 11 (April 13, 2016), eliminated a significant Internal Revenue Service (“IRS” or the “Service”) challenge to the use of intergenerational split-dollar agreements (“SDAs”). Morrissette has been lauded as giving practitioners freedom to structure single premium SDAs governed by the economic benefit regime without fear of immediate gift tax consequences. While Morrissette is a welcome addition to the split-dollar landscape, the decision does leave several remaining issues unresolved. Morrissette was limited to a single consideration – whether “the split-dollar life insurance arrangements at issue [were] governed by the economic benefit regime” or the loan regime.1
Notwithstanding Morrissette, the IRS may challenge SDAs – both those governed by the economic benefit and loan regime – that it believes are “abusive.” Particularly in the context of intergenerational SDAs, practitioners can expect substantial IRS scrutiny. We recently settled estate tax litigation involving similar facts to those presented in Morrissette. Based on our experience, we believe the IRS may advance any one or more of the following arguments to challenge the validity of SDAs, none of which were resolved by the Court’s partial summary judgment in Morrissette:
- Depending on the facts of the case, that the SDA is a “sham” transaction and lacks a justified business or non-tax purpose;
- That, under the step-transaction doctrine, the decedent is treated as gifting the life insurance policy to the donee; and
- That the taxpayer owes a duty of consistency in valuing the SDAs for gift and estate tax purposes.
If a taxpayer prevails on the Service’s challenges, it is likely that the IRS will contest the discount of the SDA receivable. As others have noted, Morrissette does not rule on valuation of the SDA receivable included in the decedent’s gross estate, nor do the Treasury Regulations provide any guidance on valuation. In our case, the Service argued under IRC § 2703 that the SDA receivable should be valued without regard to the decedent’s restrictions on terminating the arrangement. Our litigation settled on the Service’s proposal to value the SDA receivable at a 35% discount – a figure which our appellate conferee determined by analogizing family limited partnerships and limited liability companies holding cash and marketable securities.
In 2006, Clara Morrissette (the “Decedent’) created three Dynasty Trusts, one for each of her children. The stock in the Morrissette family business – the Interstate Group – was held by the Decedent’s Revocable Trust (the majority shareholder) and by other trusts for the benefit of the Decedent’s children (the minority shareholders). The Revocable Trust, the Morrissette children, and all other trusts owning stock in the Interstate Group entered into a cross-purchase shareholder agreement (the “Shareholder Agreement”) whereby, upon the death of any of Decedent’s children, the child’s surviving siblings and their respective Dynasty Trusts were required to purchase the Interstate Group stock held by or for the benefit of the deceased sibling.
Each Dynasty Trust purchased two universal life insurance policies (one on the life of the other two siblings) to satisfy the buyouts required by the Shareholder Agreement. To this end, the Decedent’s Revocable Trust and each Dynasty Trust entered into separate SDAs where the Revocable Trust advanced to each Dynasty Trust approximately $10,000,000 to acquire the life insurance policies. Each Dynasty Trust acquired two policies, and each policy required a $5,000,000 single premium payment to maintain coverage for the insured’s projected life expectancy. At all times, record title to the policies was held by the Dynasty Trusts. The Revocable Trust never held an ownership interest in any of the policies.
Pursuant to the SDAs, upon the death of a child, the Revocable Trust would receive the greater of: (1) the cash surrender value of the policy, or (ii) the aggregate premium payments on that policy (i.e. the “SDA receivable”). The SDAs, therefore, gave the Dynasty Trusts no access to the cash value of the policies. After the SDA receivable was satisfied, each Dynasty Trust would retain the balance of the death benefit to satisfy the buyout required by the Shareholder Agreement. The Dynasty Trusts received only current life insurance protection under the SDAs.
From 2006 to 2009, the Decedent reported gifts to the Dynasty Trusts, measured by the economic benefit (i.e. the cost of current life insurance protection determined by Table 2001, less the amount of each premium paid by the Dynasty Trusts) transferred to each Trust during the year. Upon her death, the Decedent’s estate obtained an independent valuation of the SDA receivables included in her gross estate. The Decedent’s Form 706 discounted the value of the SDA receivables to $7,500,000 – a 75% discount.
The IRS selected the Decedent’s 706 for audit and issued estate and gift tax Notices of Deficiency (herein, the “Gift Notice” and the “Estate Notice”). The Gift Notice computed total gifts of approximately $30,000,000 in 2006 (the year the SDAs were implemented). The Estate Notice then grossed up Decedent’s lifetime gifts by $30,000,000 and determined the additional corresponding estate tax liability.
Central to Morrissette was the Service’s argument that the SDAs should be governed under the loan regime of IRC §7872. This interpretation would have required the Decedent to report the value of the premium advances (the present value of all foregone interest for the life of each loan) as gifts in 2006.2 The Court, however, correctly ruled that the economic benefit regime applied since the Dynasty Trusts received only current life insurance protection in any given year. Under the terms of each SDA, all cash value was pledged to the Revocable Trust (i.e., the Revocable Trust was to receive the greater of cash surrender value or the aggregate of all premiums paid).
Under the final Treasury Regulations issued on September 17, 2003 (the “Regulations”), the determination of economic benefit versus the loan regime depends on the ownership of the policy. Generally, the “person named as the policy owner” is the owner of the contract.3 In Morrissette, each Dynasty Trust was the named owner of the policy, which would indicate the application of the loan regime. However, the Regulations provide an ownership exception, which the Morrissette Decedent relied upon in structuring the SDAs. Where, as in Morrissette, the SDAs provide the Dynasty Trusts (the donees) with only current life insurance protection (the entire cash value is pledged to the Revocable Trust), then the Revocable Trust (the donor) is the deemed owner, and the economic benefit regime applies.4 The Service argued in Morrissette that the exception is inapplicable because the Revocable Trust’s payment of a single, lump-sum premium provided some additional economic benefit beyond current life insurance protection.
The IRS advanced this same “prepaid premiums” argument in our recent litigation, and this was a point that the Service’s appellate conferee made repeatedly during settlement negotiations. Specifically, the IRS asserted: “The permanent setting aside of money in the life insurance policy to pay future life insurance costs is an economic benefit to the donee. The value of the economic benefit is to be determined but might approximate the value of the life insurance policy.” Morrissette addressed this “prepaid premium” argument directly and issued the correct opinion that single premium policies do not provide an additional economic benefit. This is an accurate analysis, as in our case and in Morrissette, the only benefit provided to the donees was current life insurance protection. In each instance, the donees had no current or future access to cash value, and all cash value was pledged to the donor under the respective SDAs.
Provided that a SDA is structured to give the donee no current or future access to cash value, the manner in which the donor elects to pay policy premiums (whether in a lump-sum or through installments) should be immaterial as the donee typically has no obligation to pay premiums. In our case, as in Morrissette, the SDAs were specifically structured to require only the donor to make premium payments. Morrissette correctly observed:
Thus, under the split-dollar life insurance arrangements, regardless of how the [Revocable Trust] elected to pay the premiums (whether in one lump sum or over any number of installments), the [Revocable] Trust would not relieve the Dynasty Trusts of any obligation to pay premiums because the Dynasty Trusts were not required to pay any premiums.5
The fact that policies subject to SDAs are structured as single premiums does not, and should not, change the result that the only benefit afforded to the donee in any given year is “current life insurance protection” as defined in Treas. Reg. § 1.61-22(d)(3).
Morrissette was a case of first impression and provides clarification to structuring intergenerational split-dollar transactions. However, we must be aware of its limitations. Morrissette resolved one issue, and we know from our prior experience litigating a similar fact pattern that the Service will advance any one or more of the arguments identified below to invalidate what it believes to be abusive SDAs.
The IRS is not hesitant to plead in the alternative, and it may advance multiple arguments in the hopes one or more will succeed. Initially, the Service will likely attempt to invalidate the SDA entirely, and, if it is unsuccessful in doing so, the IRS may then challenge the appropriate discount rate for the SDA receivable included in the decedent’s gross estate.
1. Sham Transaction and Business Purpose:
In our case, the decedent (“Generation 1” or “G-1”) and several life insurance trusts for the benefit of G-1’s children (“Generation 2” or “G-2”) entered into separate SDAs, whereby G-1 advanced approximately $20,000,000 to fund the trusts’ purchase of life insurance on the lives of Generation 2. The Service argued that the SDAs amounted to a sham transaction because: (a) Generation 1 received inadequate consideration; and (b) the sole purpose for the SDAs was tax avoidance. Therefore, the Service sought to disallow the tax benefits of the SDAs on the basis that they lacked economic effect and substance other than the generation of tax benefits.
We disagreed with the Service’s analysis, and while we had arguably less favorable facts than those presented in Morrissette, we expected to prevail on the Service’s sham transaction argument. As in Morrissette, each policy was structured using a single premium. G-1 was the majority stockholder in the family real estate empire (G-2 were the minority owners), and the SDAs were implemented to provide liquidity for: (a) estate taxes at the Generation 2 level; and (b) to enable the surviving G-2 family members and their children (“Generation 3” or “G-3”) to purchase the shares owned by any deceased members of G-2.
Generation 1, due to her age and prior health history, was uninsurable. The SDAs were the only method to provide insurance liquidity at the death of G-2 family members to ensure that the business could remain under family ownership. Unlike Morrissette, our case did not involve a cross-purchase Shareholder Agreement, which would have bolstered the “business purpose” of the SDAs, but we believe the appellate conferee was persuaded that the death benefits provided by the SDAs were necessary to provide liquidity at the death of the G-2 family members. Despite the Service’s initial arguments to the contrary, G-1 did receive adequate “consideration” – it was important to her to enable the family business to continue for future generations, and the SDAs provided this flexibility to her descendants.
2. Step Transaction Doctrine:
As an alternative, the Service advanced the step-transaction doctrine to treat G-1 as transferring the life insurance policies directly to the trusts created for Generation 2. Therefore, in accordance with Treas. Reg. § 25.2512-6, the Service claimed that the value of the transferred policies equaled the single premiums paid by G-1. The step-transaction argument is another attempt by the Service to invalidate an SDA without having to resort to a valuation discussion on the amount of the receivable included in the decedent’s gross estate.
If SDAs are properly structured, the step-transaction argument should not favor the IRS. Taxpayers and their counsel go to great lengths to ensure that all events are coordinated appropriately to provide the desired insurance coverage. When SDAs are structured in technical compliance with the Regulations, the Service should fail in its efforts to invalidate an SDA on this basis.
3. Duty of Consistency:
One of the more interesting arguments presented in our case was the concept of a taxpayer’s “duty of consistency.” According to the Service, the “taxpayer owes a duty of consistency in the valuation of the very same promissory notes or other repayment rights for gift and estate tax purposes.” The Service contends that, if the taxpayer, under the economic benefit regime, reports a relatively minor gift amount at the outset of the arrangement, then the remaining value of the premiums advanced, without discount, should be included in the decedent’s gross estate.
Whereas, the Service’s consistency argument has the benefit of simplicity, it fails to account for the economics of the arrangement. In our litigation, we continually pressed the appellate conferee to tell us how the SDAs failed to comply with the Regulations. Our appellate conferee dismissed these questions out of hand without authority. In our view, provided that we complied with the Regulations (which we did), the valuation standard should be that of a debt instrument with no fixed term, not subject to payment on demand, and with no annual principal or interest payments.
We believe the IRS fails to recognize the import of its own Regulations and the typical “willing-buyer, willing-seller” standard for valuation. The Regulations permit an SDA to be structured under the economic benefit regime. Absent application of a special valuation rule (such as IRC § 2703 which, as discussed below, is inapplicable) a taxpayer should not then be required include full value of the SDA receivable in the estate to promote some duty of “consistency” advanced by the IRS. This is particularly true where, as in our case and presumably in Morrissette, no willing-buyer would pay that price to purchase the receivable, given the inability to access cash value and the fact that a buyer could not reasonably expect repayment for several years, if not decades.
Ironically, in our case, G-1 filed a gift tax return, which measured the gifts to the trusts under the economic benefit regime. The IRS audited the return and issued a no change letter. Since we settled the dispute, we never had an opportunity to explore the implications of holding the Service to “consistency” in the handling of the initial premium payments. It would be interesting to see their response. After all, if the taxpayer owes a duty of consistency, shouldn’t the IRS have that same obligation?
We know with near certainty that the Service will challenge valuation of an SDA. In our case, as in Morrissette, G-1’s ability to collect on the SDA receivable was severely constrained. Our SDAs could only be terminated through the mutual agreement of the parties or upon the death of an insured, in which case G-1 was then entitled to receive the greater of the aggregate premiums paid or the cash surrender value of the policy. We obtained an independent valuation of the SDA receivable, and based on our decedent’s restricted access to repayment as well as the actuarial life expectancy of each of the insureds, we reported a 95% discount on the SDA receivable.
The Service sought to value the SDA receivable without considering any of these limitations, arguing that under IRC § 2703, G-1’s restricted access to the life insurance policies and their cash surrender values are disregarded. The Service’s IRC § 2703 analysis was incorrect. IRC § 2703 disregards certain rights and restrictions in valuing an asset, but it was inapplicable in our case. The assets to be valued in G-1’s estate were the SDA receivables, which contained no restrictions. G-1 could have freely sold or granted options with respect to those receivables. All of the restrictions were contained in the SDA itself and related to G-1’s rights with respect to the policies. The SDAs themselves were not valued on G-1’s estate tax return, and IRC § 2703 is not relevant to the valuation of the SDA receivables as G-1 had unfettered control of those assets.
Assuming the Service does not prevail on IRC § 2703, it will continue to challenge the overall discount applied to the SDA receivable. Unfortunately, we suspect that Morrissette will not proceed to a decision on the merits of the valuation of the SDA receivable. There is simply too much at stake to be wrong – for the taxpayer and the IRS. We faced a similar dilemma and ultimately settled on a discount of 35% as opposed to our claimed 95%. During multiple settlement discussions, our appellate conferee analogized the valuation of an SDA receivable to that of a family limited partnership or limited liability company holding cash or marketable securities. Whereas, we cannot characterize this analogy as the “official” position of the IRS in determining an appropriate discount, it would not be surprising to see the IRS advance this same valuation position during future settlement negotiations, if not in legal pleadings.
Morrissette provides valuable guidance in structuring intergenerational SDAs. However, its holding is limited, and Morrissette does not provide a comprehensive road map to “safely” structure such arrangements for our clients. While the Court’s holding in Morrissette makes many of the Service’s arguments more difficult to assert or validate, we believe the IRS may advance any number of arguments to invalidate SDAs in their entirety. If the Service fails to do so, it will likely to challenge the discount claimed on the estate tax return. Counsel structuring SDAs, particularly in the donative context, must closely adhere to the Regulations and should be prepared to defend their position and highlight the non-tax justifications for the arrangement. Of course, the Service could bring more certainty to the valuation of SDAs through future Regulations or notices providing guidelines for the valuation of an SDA receivable. It has failed to do so, and we believe its efforts to attack SDAs structured for a legitimate business purposes, other than solely tax avoidance, should be unsuccessful.