The recent Estate of Cahill tax court case gives us a glimpse into the court’s view of intergeneration split dollar arrangements (GSD). In particular, the court focused on, among other things, the valuation of the loan repayment for estate tax purposes, as well as the appearance of the transaction as a vehicle for below market transfers to family members. Although the tax court did not issue a summary judgement and the case will now move to trial for a decision, the comments of the tax court are telling.
Despite the bad case facts in Cahill, below are 6 key planning considerations based on the court’s comments and opinions:
- A client should plan before becoming incompetent, despite the existence of a durable power of attorney.
- Independent trustees on both sides of the transaction should be used, and as many elements as possible that indicate the ‘arm’s length’ nature of the transaction should be included.
- Consider a bona fide loan arrangement in the form of a promissory note as an alternative to a GSD. For discount purposes, the tax court specifically mentioned their preference for the use of a promissory note and that, in their view, the GSD arrangement is not a promissory note. Therefore, using a promissory note and taking care to avoid referring to it as split dollar ‘loan regime’ may make a valuation discount viable.
- The use of a third party commercial loan in the transaction may not be ideal since it is likely that the lender would require that the donor have the right to terminate the agreement, in which case the IRS may construe this as further evidence of a retained right to terminate. Further, the presence of a commercial loan with a 5-year term does not align with the long-term nature of the GSD. This misalignment may indicate to the IRS the donor’s intention to access the cash surrender value of the policy prior to termination.
- An egregious discount will not be tolerated by the courts, regardless of the life expectancies of the insureds and the inherent restrictions included in the agreement.
- Substance over form always rules. A non-tax, business purpose for the GSD life insurance agreement can go a long way in illustrating to the IRS and the courts that the transaction is a bona fide, arm’s length business succession transaction, and not intended to transfer assets to family members at a value below fair market.
The following is a brief and general summary of the intergenerational split dollar structure and the Estate of Cahill case (based on the limited information we have.)
Intergenerational Split Dollar (GSD), also referred to as discount private split dollar, is a funding strategy used to minimize gift and estate taxes associated with large premium payments. Generally, mom and/or dad, referred to as Generation 1 (G1) will make premium payments to an Irrevocable Life Insurance Trust (ILIT) they establish, in which the trustee purchases policies on the life or lives of G2, typically a child or children (and/or their spouses) of G1. The estate of mom/dad gets repaid at death, or during lifetime, the cumulative premiums paid, or the cash surrender value, whichever is higher. GSD is particularly indicated when G2 has a large life insurance need but G1 has the funds to pay for the policies and already intends to transfer those funds to the next generation in the most cost-efficient way possible.
Economic Benefit Regime Lowers Gift Tax Costs of Premium Payments
The GSD strategy is set up as an ‘economic benefit’ split dollar arrangement governed by Treasury Regulations Sections 1.61-22. Typically, the plan is structured so that mom/dad are making a loan of the premium, the gift tax value of which is calculated annually based on the term cost of the life insurance protection (typically the term cost of the death benefit protection based on an insurer’s term table or Table 2001)—and not based on the premium. The arrangement is appealing because the term costs (the economic benefit) can be extremely low, and in turn, the gift tax value of the premium payments remain low. Economic benefit split dollar is especially indicated when an insured is rated since the term cost does not take into account the rating. GSD is also very helpful when a survivorship policy is needed since the term costs on such a policy are extremely low while both insureds are alive. The tax court in the Cahill case, as it did in the Estate of Morrissette case (146. T.C. 171 (2016)), reaffirmed its support for the use of economic benefit as the measure of the annual gift inured to the trust by G1’s premium payments. However, the more pressing issue in the Cahill case, which is still outstanding, is the tax court’s view of the discounted valuation of the loan repayment in the estate at G1’s death.
At Issue: The Value of the Loan Repayment in the Estate
The premium loan is repaid to G1 at some time in the future, typically at death. Because the policies are on the life or lives of G2, who has a relatively long life-expectancy compared to G1, it is expected that G1 will pass many years prior to G2 but that the split dollar loan itself will not be repaid until G2’s passing. In a GSD arrangement, the valuation of the loan repayment (referred to as the receivable, the property or the debt instrument) in the estate of G1 at his death is assumed to be discounted since it will not be repaid until many years later. The low valuation of the estate’s receivable is based on the delay in repayment due to the long life-expectancy of G2, as well as G1’s inability to terminate the agreement to accelerate the repayment. The valuation also takes into account what fair market value a third party would be willing to pay for the receivable (with all its restrictions) if it were to be transferred during the term of the note, as any other debt instrument might. The lower the valuation, the lower the estate tax attributable to that valuation.
The tax court did not make a final decision on the merits of the Cahill case and the estate will now move to a full trial to address the valuation of the receivable as well as the other tangential issues. However, like in the Morrissette case, the comments made by the court in the Cahill case indicate support for the use of economic benefit to value the gift tax cost of death benefit protection of the arrangement. On the other hand, the court seems to lean toward valuing the loan repayment (the receivable) at G1’s death as having no discount, citing the interplay of IRC §2036, §2028 and §2703.
To review, Richard Cahill (G1), the father, was age 90 and not competent when his son Patrick, (G2), established an ILIT in 2010 on his behalf as his father’s agent under a valid durable power of attorney (POA). Patrick needed a life insurance policy on his life and two policies on the life of his wife, Shannon, in order to transition the family business to the next generation upon their demise. Patrick and his children were named beneficiaries of the ILIT. Patrick’s cousin, William, was the trustee of the ILIT, and also a business partner of Patrick’s.
Some years prior, Richard had established a revocable survivor trust for which Patrick served as trustee. In 2010, the ILIT and Richard’s revocable survivor trust entered into an economic benefit split dollar arrangement in which the survivor trust would make premium payments to the ILIT on the three whole life policies (on the lives of Patrick and Shannon) with a total of $80M in life insurance protection. In return, the ILIT would repay the survivor trust the loan at G2’s death. During the term of the loan, Richard would be subject to gift tax based on the term cost (economic benefit) of the total death benefit protection of the three policies.
Richard’s survivor trust, through Patrick’s POA, borrowed $10M as a commercial loan from Northern Trust to pay premiums as a lump sum on each of the policies in the ILIT. The term of the note was 5 years. Richard was personally liable for the loan per Patrick’s signature under the POA. The amount of the total gift reported in the first year by Richard based on the premium payment to the ILIT was approximately $7,500; thus, highlighting the gift tax benefit of the arrangement.
Richard died in 2011. Patrick, as executor of the estate, valued the split dollar receivable, for purposes of estate tax, at $183,700, a 98% discount to account for the present value of the receivable based on the long life-expectancy of the insureds, Patrick and Shannon, and on its inherent restrictions. The value of the policies in the aggregate was approximately $9.6M. Consequently, the IRS issued a notice of deficiency claiming that the “rights” in the split dollar agreement were worth $9.6M and not $183,700; thus, the estate’s appeal to the tax court. The tax court did not issue a judgement on the case and the estate will now need to go to trial to address, among a number of issues, the valuation.
The Tax Court’s Thinking
Although an in-depth analysis of the tax court’s comments is beyond the scope of this discussion, a few cursory points may provide context for what the Cahill case portends for GSD arrangements moving forward.
The tax court focused on the concept of ‘retained interest’ for estate inclusion under IRC §§2036 and 2038, as well as valuations of inter-family transactions based on the inherent restrictions in a property interest (namely the receivable) under IRC §2703.
Regarding §2036 and §2038, the estate contended that these two sections do not apply because the split dollar arrangement was a bona fide sale in which $10M of cash was exchanged for ‘rights’ in the split dollar agreement, essentially the right to the loan repayment. The tax court disagreed saying that §2036 and §2038 do apply, arguing that there was no bona fide sale since there was no negotiation by unrelated, independent parties in an arm’s length transaction, and no loan interest charged. It also said that there was no full and adequate consideration either since repayment of $183,700 in 30 years following a $10M loan today — with no interest — is not considered full and adequate consideration of money or money’s worth.
With regard to valuation of inter-family arrangements under IRC §2703, the tax court seems to take the position that the restrictions on G1’s ability to terminate the agreement should be disregarded and therefore no discount of the receivable should be made. The court’s thinking on this could very well be different if a promissory note with a fair market rate of interest were used.
Finally, although each of the son’s roles in the arrangement– as insured, trustee, beneficiary, agent of the grantor, executor and sole decision maker– is allowed by the code in and of themselves, it appears that the court may be looking at the combination of the roles as facilitating tax free transfers between family.
If it looks like a duck and walks like a duck… Stay tuned.