The owners of a closely-held business confront several issues upon the death of any one of them:
- How will the decedent’s shares be valued?
- How will the decedent’s estate pay the resulting estate tax?
- To whom will the decedent’s shares be transferred?
- How will the acquiring party pay for such shares?
In most cases, the owners of the business will limit the universe of persons to whom the decedent’s shares can pass, for example, by entering into a shareholders’ agreement that requires the business or the surviving owners to purchase the shares from the decedent’s estate.
As to the funding for such a purchase, the owners of the business may decide to acquire life insurance upon the lives of the various shareholders, the proceeds from which would serve two purposes: to fund the purchase price for the shares, and to provide the decedent’s estate with liquidity for purposes of paying the estate tax.
Decedent and her late husband started a business that eventually grew into a total of eleven companies (“Group”). All companies in the Group were brother-sister corporations with identical ownership.
Decedent established a revocable trust (“Trust”) in 1994, appointed herself as trustee, and contributed all of her stock in each company in the Group to the Trust.
Decedent then established three “dynasty” trusts in 2006: one for the benefit of each of her Sons and that Son’s family (each a “Dynasty Trust”).
Also in 2006, the Trust was amended to permit the trustee to “(i) pay premiums on life insurance policies acquired to fund the buy-sell provisions of the * * * [Group’s] business succession plan, and (ii) make loans, enter into split-dollar life insurance agreements or make other arrangements.”
Additionally, the amendment authorized the trustee of Trust to transfer each “receivable” from the split-dollar life insurance arrangement, when paid by each Dynasty Trust, back to the Dynasty Trust that owed the receivable.
In late 2006, the Dynasty Trusts, the Sons and the Trust entered into a shareholders agreement. The agreement provided that upon the death of any Son, his surviving siblings and their respective Dynasty Trusts would purchase the Group stock held by the deceased sibling.
To provide the Dynasty Trusts with the resources to purchase the Group stock held by or on behalf of a deceased Son, each Dynasty Trust purchased two life insurance policies, one on the life of each other brother.
Split-Dollar Life Insurance Arrangements
To fund the purchase of the policies, each Dynasty Trust and the Trust entered into two split-dollar life insurance arrangements in 2006, to set forth the rights of the respective parties with respect to the policies. The Trust contributed almost $10 million to each Dynasty Trust, which then used that money to pay a lump-sum premium on each policy to maintain that policy for the insured Son’s projected life expectancy.
Under the split-dollar arrangements, upon the death of the insured Son, the Trust would receive a portion of the death benefit from the policy insuring the life of the deceased Son equal to the greater of (i) the cash surrender value (“CSV”) of that policy, or (ii) the aggregate premium payments on that policy (each a “receivable”).
Each Dynasty Trust would receive the balance of the death benefit under the policy it owned on the life of the deceased Son, which would be available to fund the purchase of the stock owned by the deceased Son. If a split-dollar arrangement terminated for any reason during the lifetime of an insured Son, the Trust would have the unqualified right to receive the greater of (i) the total amount of the premiums paid or (ii) the CSV of the policy, and the Dynasty Trust would not receive anything from the policy.
Additionally, the Dynasty Trusts executed collateral assignments of the policies to the Trust to secure payment of the amounts they each owed to the Trust. Neither the Dynasty Trusts nor the Trust retained the right to borrow against a policy.
The life insurance policies acquired by the Dynasty Trusts were universal life insurance policies, a form of permanent life insurance providing the owner with flexibility in making premium payments. Under the policies, the owner could pay premiums in a lump-sum, over a limited number of years, over an extended number of years, or over the life of the insured. The owner could determine the amount of premiums at the inception of the contract, change the amount of the future premium from time to time, stop paying premiums for any other reason, and resume paying premiums at a later date if desired.
The IRS’s Challenge
From 2006 to 2009, Decedent reported gifts to the Dynasty Trusts as determined using the so-called “economic benefit” regime. The amount of each gift reported was the cost of the current life insurance protection as determined using tables issued by the IRS.
After Decedent’s death in late 2009, her Estate retained an appraiser to value the receivables owing to the Trust and includible in Decedent’s gross estate as of the date of her death.
The IRS issued two notices of deficiency to the Estate. One sought to increase the value of the receivables payable to the Trust, as reported by the Estate. The other notice asserted that the Estate had failed to report almost $30 million of gifts in 2006 — specifically, the total amount of the policy premiums paid by Trust for the split-dollar insurance policies.
Split-Dollar Life Insurance
In general, split-dollar life insurance arrangements are governed by IRS regulations. These regulations define a “split-dollar life insurance arrangement” as an arrangement between an owner and a non-owner of a life insurance contract in which: (i) either party to the arrangement pays all or a portion of the premiums on the life insurance contract; and (ii) the party paying for the premiums is entitled to recover all or any portion of those premiums, and such recovery is to be made from the proceeds of the life insurance contract.
The split-dollar arrangements at issue were governed by these regulations. Trust paid the premiums on the policies; it was entitled to recover, at a minimum, all of those premiums paid, and this recovery was to be made from, and was secured by, the proceeds of the policies.
The regulations provide two mutually exclusive regimes for taxing split-dollar life insurance arrangements. The determination of which regime applies to a particular arrangement depends on which party owns the life insurance policy subject to the arrangement. Generally, the person named as the owner in the insurance contract is treated as the owner.
As an exception to the general rule, the regulations include a special ownership rule that provides that if the only economic benefit provided to the donee under the split-dollar arrangement is current life insurance protection, then the donor will be treated as the owner of the life insurance contract, regardless of who actually owns the policy.
On the other hand, if the donee receives any additional economic benefit, other than current life insurance protection, then the donee will be considered the owner, and the loan regime will apply.
Thus, the key question in the case – which determined which party owned, or was deemed to own, a life insurance policy – was whether the lump-sum payment of premiums made on the policies by the Trust generated any additional economic benefit, other than current life insurance protection, to the Dynasty Trusts.
If there was no additional economic benefit to the Dynasty Trusts, then the Trust would be the deemed owner of the policies, and the split-dollar life insurance arrangements would be governed by the economic benefit regime.
Economic Benefit Regime
For a split-dollar arrangement to be taxed under the economic benefit regime, the owner or deemed owner will be treated as providing an annual benefit to the non-owner in an amount equal to the value of the economic benefits provided under the arrangement, reduced by any consideration the non-owner pays for the benefits. The value of the economic benefits provided to the non-owner for a taxable year under the 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 other economic benefits that are provided to the non-owner.
To determine whether any additional economic benefit was conferred by the Trust to the Dynasty Trusts, the relevant inquiry was whether the Dynasty Trusts had current access to the cash values of their respective policies under the split-dollar arrangements or whether any other economic benefit was provided.
The regulations provide that the non-owner has current access to any portion of the policy cash value to which the non-owner (i) has a current or future right and (ii) that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.
For the Dynasty Trusts to have current access, they must first have had a current or future right to any portion of the policy cash value. The split-dollar arrangements, however, were structured so that upon the termination of the arrangement during the lifetime of the insured, 100% of the CSV would be paid to the Trust. Additionally, upon the death of the insured, the Dynasty Trusts would be entitled to receive only that portion of the death benefit of the policy in excess of the amount payable to the Trust.
Accordingly, the Dynasty Trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regulations.
The IRS argued that the Dynasty Trusts had a right to the cash values of the insurance policies by virtue of the terms of the 2006 amendment to the Trust. Under that amendment, the IRS argued, the Trust’s interest in the cash values of the policies would pass to the Dynasty Trusts or directly to the Sons or their heirs upon Decedent’s death.
However, because the Trust was a revocable trust with respect to Decedent, she retained an absolute right to alter the Trust throughout her lifetime. Accordingly, the Dynasty Trusts did not have a legally enforceable right to the cash values of the policies during the lifetime of the Decedent-grantor. Furthermore, the split-dollar arrangements did not require the Trust to distribute the receivables to the Dynasty Trusts. Rather, Decedent retained the right to receipt of the receivables.
The Court also noted that when the regulations state that “[t]he value of the economic benefits provided to a non-owner for a taxable year under the arrangement equals . . . [t]he amount of policy cash value to which the non-owner has current access. . .,” the regulations are referring to the split-dollar arrangement. The 2006 amendment to the Trust was not part of the split-dollar arrangements between the Trust and the Dynasty Trusts.
Under each split-dollar arrangement, the Court stated, upon the death of the insured-Son, the Trust would be entitled to receive a portion of the death benefit of the policies insuring the life of the deceased equal to the greater of (i) the CSV of the applicable policies or (ii) the aggregate premium payments made with respect to the applicable policies. The Trust obtained the receivables as a result of entering into the split-dollar arrangements. Thus, it was appropriate to execute the 2006 amendment to provide for the disposition of these assets. Importantly, the split-dollar arrangements did not address the disposition of the receivables by the Trust and did not require or permit the receivables be distributed to the Dynasty Trusts. Thus, the Dynasty Trusts did not have a right in the cash values of the policies by virtue of the 2006 amendment.
Other Economic Benefit?
The IRS argued that the circumstances of the split-dollar arrangements at issue prohibited the use of the economic benefit regime. Specifically, it compared the arrangements to certain abusive split-dollar life insurance arrangements under which one party holding a right to current life insurance protection uses inappropriately high current term insurance rates, prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The use of such techniques by any party to understate the value of these other policy benefits distorts the income or gift tax consequences of the arrangement, the IRS claimed, and does not conform to, and is not permitted by the regulations.
The Court found that the split-dollar arrangements between the Trust and the Dynasty Trusts bore no resemblance to the transactions described by the IRS. Decedent, who was 94 at the time she set these arrangements into motion, wanted the Group to remain in her family. To that end, she caused the 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 used to purchase the stock held by each of her Sons upon his death. Unlike the abusive insurance arrangements described by the IRS, the receivables the Trust obtained in exchange for its advances provided the Trust sole access to the CSV of the policies.
Because the Dynasty Trusts received no additional economic benefit beyond that of current life insurance protection, the Court held that the Trust was the deemed owner of the life insurance contracts by way of the special ownership rule under the regulations. Therefore, the economic benefit regime under the regulations applied to the split-dollar arrangements.
It should be noted that the preamble to the split-dollar regulations included an example that was structured identically to the split-dollar arrangements at issue. The preamble distinguished between a donor (or the donor’s estate) who is entitled to receive an amount equal to the greater of the aggregate premiums paid by the donor or the CSV of the contract and a donor (or the donor’s estate) who is entitled to receive the lesser of those two values.
In the former situation, as in the case above, the donor makes a gift to the donee equal to the cost of the current life insurance protection provided.
Thus, the issue remaining to be resolved in this case is the value of the receivable owing to the donor’s estate, which the IRS asserted was significantly understated.
Depending upon the outcome of this valuation, estate planners may, in the appropriate situation, be able to utilize split-dollar arrangements within a family-owned business to provide funds for a buyout and for the payment of the estate tax.