Decisions — Terms of the split

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Image source: Public domain image courtesy of taxrebate.org.uk

Image source: Public domain image courtesy of taxrebate.org.uk

Tax regulations finalized in 2003 (regulation 1.61-22) put paid to the old joke about insurance being a test of how creative it’s possible to be with the truth. The regulations provide only two sets of rules for the tax treatment of split-dollar life insurance arrangements.

These arrangements are essentially a contract between the owner of a life insurance policy and one or more others to split the cost of the policy premiums and share in the policy’s proceeds and other benefits. The arrangement is taxed either as an economic benefit or a loan, depending on who owns the policy.

Under the economic benefit rules, taxable benefits include present or future rights to the cash accumulation value and the value of the death benefit (or any other policy-provided benefits). Under the loan rules, when the non-owner pays premiums, the payments are considered loans to the owner and interest can be imputed on the loan. The imputed interest is generally taxable to the non-owner. In either case, the policy premiums are generally nondeductible, and the policy payouts are usually non-taxable.

Tax court case 146 T.C. No. 11 (Estate Of Clara M. Morrissette) involved split-benefit life insurance arrangements, and the question was who owned the policy?

In this case, a family matriarch wanted a family-owned moving company to remain in the family if one or more of her three sons should die. In 2006, when the family matriarch was 94 years old, the family established three perpetual trusts, one for each son. The matriarch also amended her revocable trust, which she had established in 1994, to allow her trust to pay premiums on life insurance policies and enter into split-dollar life insurance arrangements.

After the amendment, the matriarch’s revocable trust and the three perpetual trusts entered into split-dollar life insurance arrangements. The intention was for the revocable trust to fund each perpetual trust with money to pay the premiums for life insurance policies on each of the sons. Upon the death of any or all of the sons, the policy proceeds would be used to buy the stock of the family moving company in order to keep the business in the family.

The split-dollar life insurance arrangements stated that the parties intended for the agreement to be taxed under the economic benefit rules. In addition, the arrangements provided that the matriarch’s revocable trust would receive the greater of the cash surrender value of the respective policy or the aggregate premium payments on that policy upon termination of the split-dollar life insurance arrangement or the death of the insured (the sons). Each of the perpetual trusts would receive the balance of the death benefit under the policy it owned. The insurance proceeds would be used to buy the stock of the family moving company.

The arrangements also stated that if any of the split-dollar life insurance arrangements terminated for any reason while the insured son was still alive, the matriarch’s revocable trust would have the unqualified right to receive the greater of the total amount of the premiums paid or the cash surrender value of the policy. In that event, the perpetual trusts would not receive anything from the policy.

The perpetual trusts also executed collateral assignments of the policies to the matriarch’s revocable trust to secure payment of the amounts owed to her trust for the premiums paid. None of the trusts retained the right to borrow against a policy.

From 2006 to 2009, the matriarch reported gifts to the perpetual trusts. The value of the gifts was determined using the economic benefit rules. The amount of each gift reported was the cost of the current life insurance protection, less the amount of each premium paid by the respective perpetual trust.

After the matriarch’s death, the IRS questioned whether the economic benefit rules or the loan rules applied to the split-dollar life insurance arrangements. The trusts and the IRS agreed that the matriarch’s trust put $29.9 million into the perpetual trusts so each trust could purchase the policies, and that the perpetual trusts were the named owners of the policies.

The court said the determination of which rules applied depended on who owned, or was deemed to own, the life insurance policy subject to the arrangement – the matriarch’s trust or the perpetual trusts.

Generally, the person named as the owner in the insurance contract is treated as the owner of the contract. Under this general rule, the perpetual trusts would be considered the owners of the policies and the loan rules would apply.

However, the regulations contain an exception to the general rule. This exception says that if the only economic benefit provided under the split-dollar life insurance arrangement is current life insurance protection, then the non-owner (in this case the matriarch’s revocable trust) would be the deemed owner of the life insurance contract, irrespective of actual policy ownership. In that situation, the economic benefit rules would apply.

And one more twist: Even under the exception, if the perpetual trusts received any additional economic benefit, other than current life insurance protection, those trusts would be considered the owner and the loan rules would apply.

So the final question was: Did the $29.9 million lump-sum payment of premiums made on the policies indirectly by the matriarch’s trust generate any additional economic benefit other than current life insurance protection to the perpetual trusts?

Here’s what the court considered.

1. Current Access

The split-dollar life insurance arrangements were structured so that upon the termination of a split-dollar life insurance arrangement during the lifetime of the insured, 100% of the cash surrender value would be paid to the matriarch’s trust.

Additionally, if a split-dollar life insurance arrangement were to terminate as a result of the death of the insured, the perpetual trusts would be entitled to receive only that portion of the death benefit of the policy in excess of the amount payable to the matriarch’s trust.

The decision hinges on these facts: If the perpetual trusts have current access to any portion of the policy cash value, then the special ownership rule would not apply. The trusts would be considered the owners of their respective policies under the general ownership rule, and the split-dollar life insurance arrangements would be governed by the loan rules. For the perpetual trusts to have current access, the trusts must first have a current or future right to any portion of the policy cash value.

 

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2. Right to cash value

The IRS argued that the perpetual trusts had a direct or indirect right in the cash values of the insurance policies by virtue of the terms of the 2006 amendment to the matriarch’s revocable trust. Under that amendment, the matriarch’s trust’s interest in the cash values of the policies would pass to the perpetual trusts or directly to the sons or their heirs upon the matriarch’s death.

The decision hinges on these facts: The matriarch’s trust was revocable and she retained an absolute right to alter it throughout her lifetime. Under the terms of the split-dollar arrangement, upon the death of the one or all of the sons, the matriarch’s trust would be entitled to receive a portion of the death benefit of the policies, and the matriarch’s trust obtained receivables from the perpetual trusts to ensure this payment. The split-dollar life insurance arrangements did not require or permit her trust to distribute these receivables to the perpetual trusts and did not address the disposition of the receivables.

 

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3. Any Other Economic Benefit

The IRS argued that the “prepaid premiums” (the $29.9 million) paid not only for current insurance protection, but also for future protection, which was a benefit other than current life insurance protection and required that the arrangement be taxed under the loan rules.

The decision hinges on these facts: Under the split-dollar life insurance arrangements, the perpetual trusts were not required, but were permitted, to pay any portion of the policies’ premiums. The split-dollar life insurance arrangements were structured such that the matriarch’s revocable trust was obligated to pay all the premiums.

 

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***

Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

***

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The regulations provide that the nonowner has current access to any portion of the policy cash value to which the nonowner (i) has a current or future right and (ii) that currently is directly or indirectly accessible by the nonowner, inaccessible to the owner, or inaccessible to the owner’s general creditors.

For the perpetual trusts to have current access under the final regulations, the perpetual trusts must first have a current or future right to any portion of the policy cash value. The split-dollar life insurance arrangements are structured so that upon the termination of a split-dollar life insurance arrangement during the lifetime of the insured, 100% of the cash surrender value would be paid to the matriarch’s revocable trust.

Additionally, if a split-dollar life insurance arrangement were to terminate as a result of the death of the insured, the perpetual trusts would be entitled to receive only that portion of the death benefit of the policy in excess of the amount payable to the matriarch’s revocable trust.

Accordingly, under the split-dollar life insurance arrangements, the perpetual trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regulations.

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Right answer!

Under each split-dollar life insurance arrangement, upon the death of the insured, the matriarch’s trust would be entitled to receive a portion of the death benefit of the policies. The trust obtained the receivables as a result of entering into the split-dollar life insurance arrangements. Thus, it was appropriate to execute the 2006 amendment to provide for the disposition of these assets.

Importantly, the split-dollar life insurance arrangements do not address the disposition of the receivables by the matriarch’s trust and did not require or permit the receivables be distributed to the perpetual trusts. Thus, the perpetual trusts did not have a direct or indirect right in the cash values of the policies by virtue of the terms of the 2006 amendment.

Sorry, wrong answer :(
Right answer!

This argument relies on the proposition that prepayment of future premiums (by paying a single premium) confers policy benefits other than current life insurance protection. This assertion, however, assumes that the perpetual trusts would otherwise be required to pay the premiums.

Under the split-dollar life insurance arrangements, the perpetual trusts are not required, but are permitted, to pay any portion of the policies’ premiums. The split-dollar life insurance arrangements were structured such that the matriarch’s trust was obligated to pay all the premiums.

Thus, under the split-dollar life insurance arrangements, regardless of how the matriarch’s trust elected to pay the premiums (whether in one lump sum or over any number of installments), the matriarch’s trust would not relieve the perpetual trusts of any obligation to pay premiums because the perpetual trusts were not required to pay any premiums.

For the Taxpayer.

Because the perpetual trusts received no additional economic benefit beyond that of current life insurance protection, the matriarch’s trust is the deemed owner of the life insurance contract by way of the special ownership rule under section 1.61-22, income tax regulations.

Thus the economic benefit regime under section 1.61-25-22, income tax regulations, and not the loan regime of section 1.7872-15, income tax regulations, applies to the split-dollar life insurance arrangements.

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