IRS Argues Split-Dollar Is Not “Faire,” but Challenge Is Foiled

By Alexander Lyden-Horn and Justin Miller

Alexander Lyden-Horn is a managing director and the Director of Delaware Trust Services and Trust Counsel at Evercore Trust Company. Justin Miller is a partner and the National Director of Wealth Planning at Evercore Wealth Management. Justin also is the vice chair of the ABA RPTE Business Planning Group and vice chair of the Individual and Fiduciary Income Tax Committee.

In Estate of Levine v. Commissioner, 158 T.C. No. 2 (2022), the estate successfully parried an IRS challenge to the valuation of the decedent’s right to repayment of premiums under a splitdollar life insurance arrangement. The IRS argued that the value of such right should be equal to the cash surrender values of the life insurance policies— and their weapons of choice were sections 2036, 2038, and 2703. In an opinion full of dual—or one could argue “duel”—meanings, the court ultimately rebuffed the IRS’s valuation challenges because (1) the decedent retained no power to terminate the policies and (2) the person with the power to do so was constrained by fiduciary obligations.

Split-Dollar Arrangements Are Not Futile—or Feudal

A split-dollar life insurance arrangement is a structure in which one party provides funding for a life insurance policy on another’s life, with repayment to be made from—or secured by— that policy. The remaining proceeds of the policy after repayment of the premiums, if any, will pass to the beneficiaries. Thus, the “split” in split-dollar refers to the split interest between the funder and the beneficiaries in the proceeds of the policy.

The Estate of Levine involved a special type of split-dollar arrangement—often referred to as an intergenerational splitdollar arrangement—in which a parent loans money to pay for insurance on children’s lives, with the benefit passing to grandchildren. The parent’s right to repayment—a receivable—typically is the greater of (1) the total premiums paid and (2) the cash value on the death of the last surviving insured—which could be decades in the future—or the date of policy termination, if earlier. The main question with the split-dollar arrangement in the Estate of Levine case: What was the value of the receivable for estate tax purposes?

Pre-combat Background

The decedent, Marion Levine, was born in St. Paul, Minnesota, in 1920. One of 10 children growing up in the Great Depression, the court went to great lengths to describe her humble beginnings and subsequent business successes. Her rise began with a single family-owned supermarket in 1950, which eventually grew into a 27-store, multimillion-dollar company. After more than three decades of taking care of everything from the company payroll to the inventory, she sold the business for $5 million in 1981, which would be close to $16 million in today’s dollars. She reinvested the proceeds in a wide variety of investments, including real estate, mobile-home parks, and two Renaissance fairs—the latter of which inspired several medieval combat puns throughout the Tax Court opinion, written by Judge Holmes. Marion’s savvy investments ultimately grew her net worth to $25 million.

In June and July of 2008, Marion’s daughter Nancy, her son Robert, and her longtime friend and business associate Bob Larson, in their capacities as Marion’s attorneys-in-fact, executed the necessary documents to effect the split-dollar arrangement. They established an irrevocable life insurance trust under South Dakota law as a directed trust with a South Dakota corporate trustee and appointed Larson as the sole member of the trust’s Investment Committee, which had exclusive authority under the terms of the trust to make all decisions regarding the life insurance and split-dollar arrangement. Nancy and Nancy’s husband, Larry, were selected as the insured parties, as Robert was ruled out because of a preexisting medical condition. Two second-to-die policies were purchased by the insurance trust, with approximately $6.5 million in total one-time premiums. Marion raised the necessary cash to fund the premiums through a variety of loans and lines of credit. The insurance trust agreed to repay Marion’s revocable trust the greater of (1) the total premiums paid or (2) the cash value on the death of the last surviving insured or the date of policy termination, if earlier.

Nancy and Larson, in their capacities as Marion’s attorneys-in-fact, also signed gift tax returns for Marion for 2008 and 2009. Ordinarily, when a donor transfers property in exchange for less-valuable property, the gift is a “bargain sale” and the value of such gift is the difference in value between what is given and what is received. The Treasury Department, however, has issued specific regulations governing the gift tax valuation of split-dollar arrangements. See Treas. Reg. § 1.61-22(d)(2) (discussed below). Applying these regulations, Nancy and Larson determined that the value of the economic benefit transferred from the revocable trust to the insurance trust was $2,644—even though premiums of $6.5 million were advanced and might not be repaid for several decades until Marion’s daughter and son-in-law both passed away.

Marion died on January 22, 2009, and the estate filed a federal estate tax return (Form 706). The split-dollar receivable owned by the revocable trust was reported on Schedule G of Form 706 with a value (as of the alternate valuation date) of about $2 million. The parties later stipulated that if the estate was successful in its defense of the IRS challenges, then the value was slightly higher at $2,282,195. Note that, at the time of Marion’s death, the cash surrender value of the policies was close to $6.2 million. The reported value therefore represented a significant discount because it was theoretically possible that the estate’s receivable might not be paid until the death of the last surviving insured far in the future.

The IRS Joust with the Estate

As the court described it, the “joust between the IRS and the Estate” began with an audit of the estate tax return and the commissioner’s issuing a notice of deficiency of slightly more than $3 million. The bulk of this deficiency represented an adjustment to the value of the estate’s repayment rights under the split-dollar arrangement. The commissioner also assessed a 40 percent gross understatement penalty under section 6662(h). The two parties worked together to “narrow the issues so their combat could be confined to a small tilt and not become a general melee.” As a result, only two issues remained for review by the court:

1. Was the value of the split-dollar receivable in the estate on the alternative valuation date $2,282,195, as listed on the estate tax return, or the policies’ cash surrender value of $6,153,478, as argued by the IRS?

2. Was any resulting underpayment subject to the 40 percent gross-misvaluation penalty under section 6662(h)?

The court first confirmed that Treasury Regulation § 1.61-22 does not apply to the estate tax consequences of a split-dollar arrangement. The court pointed out that the split-dollar arrangement was subject to the regulation’s “economic benefit regime” only for gift tax purposes, in which case the amount treated as being transferred for gift tax purposes was limited to the cost of current life insurance protection for each year the arrangement remains in place. See Estate of Morrissette v. Comm’r, 146 T.C. 171 (2016).

Having determined that the splitdollar regulations did not apply, the court then looked to the default estate tax rules to determine the effect of the split-dollar arrangement on the gross value of Marion’s estate. The estate’s position was (1) the only asset includible in the gross estate was the receivable payable to the revocable trust and (2) Marion had no other interest in the life insurance policies, which were owned solely by the insurance trust from the outset. The commissioner, however, argued that the full cash surrender value of the policies should have been included based on several factors. First, under section 2036, Marion effectively retained the right to income, or the right to designate who would receive income, from the split-dollar arrangement as a whole. Second, under section 2038, she also maintained the power to alter, amend, revoke, or terminate the enjoyment of aspects of the split-dollar arrangement. Finally, under the special valuation rules in section 2703, the restrictions in the split-dollar arrangement should be disregarded for valuation purposes, which would cause the full cash-surrender value of the policies to be included in her estate.

The court addressed the commissioner’s section 2036 and 2038 arguments in tandem because the same principles would determine whether either section would apply. The court acknowledged that Marion did receive something in exchange for the $6.5 million advanced to pay the premiums, which was the receivable under the split-dollar arrangement. Under the terms of that receivable, she had the right to receive the greater of the premiums paid—that is, $6.5 million—or the cash surrender value when terminated. The split-dollar arrangement, however, did not confer upon her the immediate right to receive the cash surrender value. Instead, the receivable would not be paid until the deaths of both insureds or the termination of the policies, if earlier.

Furthermore, under the terms of the split-dollar arrangement, only the trustee of the insurance trust had the power to terminate the arrangement. This is a major distinction in the split-dollar arrangement in this case compared to the arrangements in Estate of Cahill v. Commissioner, T.C. Memo. 2018-84 (2018), and Estate of Morrissette v. Commissioner, T.C. Memo. 2021-60 (2021), and may have been the key factor upon which the court relied in finding for the estate. In those previous cases, the donor and donee could jointly agree to terminate the agreement. Marion’s “carefully drafted agreement,” however, gave the power to terminate exclusively to the insurance trust. The court acknowledged that “if the contest between the Estate and the Commissioner were confined to the tiltyard defined by the transactional documents, we would have to conclude that sections 2036(a) and 2038 do not tell us to include the policies’ cash surrender values in the Estate’s gross value.”

The commissioner attempted “to unhorse the Estate’s argument with the pointed assertion” that the court should look beyond the documents to the transaction as a whole, so the court then examined the facts and circumstances of the overall split-dollar arrangement. The court hypothesized that the commissioner’s “first pass at the Estate in this part of their joust” would be to argue that the cash surrender value is a form of income and that the general principles of contract law would enable the revocable trust and the insurance trust to mutually agree to return such income to the estate. The court, in looking at Helvering v. Helmholz, 296 U.S. 93 (1935), and Estate of Tully v. United States, 528 F.2d 1401 (Ct. Cl. 1976), reasoned that a power to “alter, amend, or revoke” does not include “all speculative possibilities” that could lead to the modification of an agreement under general principles of law. The court therefore concluded that general principles of contract law that “might theoretically allow modification of just about any contract” are not the types of powers to which sections 2036 and 2038 are referring. Instead, such powers are only those “created by specific instruments.”

The commissioner then switched to “shorter, sharper weapons forged from the particular facts of particular cases,” specifically, Estate of Strangi, 85 T.C.M. (CCH) 1331, and Estate of Powell v. Commissioner, 148 T.C. 392 (2017). The commissioner used Strangi and Powell to support the argument that the decedent, through her attorneys-in-fact, stood on both sides of the transaction and could therefore unwind the split-dollar arrangement at will, which would entitle the revocable trust to the full cash-surrender values of the policies at any time. The court acknowledged that Larson stood on both sides of the transaction—as both attorney-in-fact and the sole member of the investment committee—but also acknowledged the presence of two important limitations. First, as attorneyin-fact, Larson held only the powers possessed by the decedent, which, as stated above, did not include the ability to terminate the arrangement. Second, as the sole member of the investment committee, the trust expressly provided that Larson was serving in a fiduciary capacity, and, therefore, under both the terms of the trust and South Dakota law, he had a fiduciary duty to act in the best interest of the trust beneficiaries—and could be held liable for acting otherwise. In response, the commissioner argued that, as Robert and Nancy are beneficiaries of both the insurance trust and the estate, Larson could terminate the split-dollar arrangement without violating his fiduciary duties because the children would benefit either way. The court was quick to point out the estate’s “blunt parry” to this “subtle thrust”—the decedent’s grandchildren were also beneficiaries under the insurance trust but would not receive anything from the estate if the arrangement was terminated. As a last gasp, the commissioner argued that the grandchildren should be disregarded as beneficiaries, as their interest can be “extinguished” by their parents’ exercise of a testamentary power of appointment. But the court rightly pointed out that a testamentary power of appointment is not effective until the death of the holder of the power. Until that time, the grandchildren are still considered beneficiaries and Larson would owe a fiduciary duty to them.

Therefore, the court found that the fiduciary duties owed by Larson were not merely illusory. His ability to terminate the split-dollar arrangement could not be characterized as being a right retained by the decedent, which precludes the inclusion of the policies’ cash surrender value in the decedent’s gross estate under either section 2036(a)(2) or 2038(a)(1).

As a backup to the section 2036 and 2038 arguments, the commissioner also argued that the split-dollar arrangement was merely a restriction on the decedent’s right to access the funds transferred to the insurance company and should therefore be disregarded under the special valuation rules of section 2703.

As with the section 2036 and 2038 arguments, the application of section 2703 hinged on the definition of “property.” The estate argued that section 2703 applies only to property actually owned at death and not property that was gifted during life—or property that was never owned. Consequently, even if the inability to surrender the life insurance policies is considered a “restriction” under section 2703, it is not a restriction on property owned by the decedent. The commissioner pushed the court to focus instead on the rights held as a whole rather than the specific property in question—a similar premise as the section 2036 and 2038 arguments that both parties could consent to the termination of the split-dollar arrangement. The commissioner argued that, without this restriction—that is, the requirement that the insurance trust consent to the termination—the value of the decedent’s retained right would be equal to the cash surrender value.

The court flatly disagreed with this argument, stating that the “property” to which section 2703 refers is the property of an estate, not some other entity’s property. The court noted that this interpretation has been upheld by numerous court decisions, including Strangi. Thus, the property in question here is the receivable held by the estate. The court concluded that there were no restrictions on the receivable—because the decedent had unfettered control and was free to transfer or sell it. Therefore, section 2703 had no application to the split-dollar arrangement.

Court Declares Victory for the Taxpayer

Because the commissioner did not prevail under any of the section 2036, 2038, or 2703 arguments, the commissioner was bound to the previously stipulated value of $2,282,195 for the estate’s receivable without any accuracy-related penalties—that is, a 65 percent discount for the $6.5 million receivable. In other words, premiums of $6.5 million were advanced, the value for gift tax purposes was only $2,644, and the decedent’s estate was required to include only $2.3 million the following year for estate tax purposes—even though the estate was entitled to repayment by an insurance trust with a cash surrender value of $6.2 million at death.

Ultimately, the court argued that the tax windfall in favor of the taxpayer was the result of a problem with the regulations. The court concluded, “If there is a weakness in this transaction, it lies in the calculation of the value of the gift between Levine and the Insurance Trust—the difference between the value that her Revocable Trust gave to the Insurance Trust and what it got in return. But the gift-tax case is not this estate-tax case. And the problem there is traceable to the valuation rule in the regulations. No one has suggested that this rule is compelled by the Code and, if it isn’t, the solution lies with the regulation writers and not the courts.”

Conclusion

From a planning perspective, there are certain key lessons in this case. First, the power to terminate a split-dollar arrangement must be vested exclusively in the owner of the policy. Under sections 2036 and 2038, any power held by the decedent, even if held jointly with another, may be sufficient to cause estate inclusion. Second, all parties with the ability to terminate a split-dollar arrangement must be acting in a fiduciary capacity. This is important when drafting the irrevocable trust because state laws may vary as to whether power holders, by default, are serving in a fiduciary capacity. Finally, the donor’s retained right to be repaid should be clearly defined as a distinct “receivable,” ideally in the form of a promissory note rather than a bundle of rights under the split-dollar arrangement.

Published in Probate & Property, Volume 36, No 4 © 2022 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.