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Tax Court – donee received only life insurance protection, so split dollar economic benefit regime applied

Estate of Morrissette, (2016) 146 TC No. 11

The Tax Court has examined the terms of a split dollar life insurance arrangement, determined that the party that received the funds to pay the premiums from the other party received no economic benefit other than current life insurance protection, and therefore ruled that the “economic benefit regime” was the appropriate regime for taxing the arrangement.  Click here for the Opinion of the Court.

Background. Regs define a split-dollar life insurance arrangement as an arrangement between an owner and a nonowner of a life insurance contract in which: (i) either party to the arrangement pays, directly or indirectly, 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, or is secured by, the proceeds of the life insurance contract. (Reg. § 1.61-22(b)(1))

The regs provide two mutually exclusive regimes for taxing split-dollar life insurance arrangements, the economic benefit regime and the loan regime. (Reg. § 1.61-22(b)(3)(i)) The determination of which regime applies to a split-dollar life insurance arrangement depends on which party owns, or is deemed to own, the life insurance policy subject to the arrangement. Generally, the person named as the owner in the insurance contract is treated as the owner of the contract. (Reg. § 1.61-22(c)(1)) A nonowner is any person other than the owner who has any direct or indirect interest in the contract. (Reg. § 1.61-22(c)(2))

As an exception to the general rule, the regs include a special ownership rule that provides that, where the split-dollar arrangement is between a donor and a donee, and the only economic benefit provided under the split-dollar life insurance arrangement to the donee is current life insurance protection, the donor will be the deemed owner of the life insurance contract, irrespective of actual policy ownership, and the economic benefit regime will apply. (Reg. § 1.61-22(c)(1)(ii)(A)(2))

The value of the economic benefits provided to the nonowner for a tax year under a split-dollar arrangement is equal to the sum of (i) the cost of current life insurance protection, (ii) the amount of cash value to which the nonowner has current access during the year, and (iii) any economic benefits not otherwise described that are provided to the nonowner. (Reg. § 1.61-22(d)(2))

The cost of the current life insurance protection takes into account the life insurance premium factors that IRS publishes for this purpose. (Reg. § 1.61-22(d)(3)(ii)) The amount of the current life insurance protection is the death benefit of the life insurance contract (including paid-up additions) reduced by the sum of the amount payable to the owner plus the portion of the cash value taxable to (or paid for by) the nonowner. (Reg. § 1.61-22(d)(3)(i)) The amount of the insurance policy cash value is determined disregarding surrender charges or other similar charges or reductions and including insurance policy cash value attributable to paid-up additions. (Reg. § 1.61-22(d)(4)(i))

The regs provide that the nonowner has current access to any portion of the policy cash value (i) to which the nonowner 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. (Reg. § 1.61-22(d)(4)(ii))

Facts. Mrs. Morrissette created three Dynasty Trusts, each of which was for the benefit of one of her sons.

She also created the CMM Trust, a revocable lifetime trust. A 2006 amendment to that trust permitted the trustee to “(i) pay premiums on life insurance policies acquired to fund the buy-sell provisions of [the family business’s] business succession plan, and (ii) make loans, enter into split-dollar life insurance agreements or make other arrangements.” Additionally, the 2006 Amendment authorized the trustee to transfer each receivable from the split-dollar life insurance arrangement when paid by each Dynasty Trust back to the Dynasty Trust owing the receivable or directly back to each son.

Each Dynasty Trust purchased two universal life insurance policies, one on the life of each other brother.

To fund the purchase of the policies, each Dynasty Trust and the CMM Trust entered into two split-dollar life insurance arrangements, to set forth the rights of the respective parties with respect to the policies. The CMM Trust contributed approximately $10 million to each of the Dynasty Trusts. The Dynasty Trusts then used that money to pay a lump-sum premium on each policy.

Under the split-dollar life insurance arrangements, upon the death of the insured, the CMM Trust would receive a portion of the death benefit from the respective policy insuring the life of the deceased 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, and collectively, receivables). Each Dynasty Trust would receive the balance of the death benefit under the policy it owned on the life of the deceased, which would be available to fund the purchase of the stock owned by or for the benefit of the deceased. If a split-dollar life insurance arrangement terminated for any reason during the lifetime of the insured, the CMM 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.

The only issue to be decided by the Court was whether the economic regime applied.

The economic benefit regime applied. The Court held that the Dynasty Trusts received no economic benefit other than current life insurance protection and thus ruled that the economic benefit regime was the appropriate regime for taxing the arrangement.

The Court said that the key question in this case was whether the lump-sum payment of premiums made on the policies indirectly by the CMM 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 CMM Trust would be the deemed owner of the policies by way of the special ownership rule, and the split-dollar life insurance arrangements would be governed by the economic benefit regime. If any additional economic benefit was conferred, then the Dynasty Trusts would own the policies and the loan regime would apply.

It said that, to determine whether any additional economic benefit was conferred by the CMM Trust to the Dynasty Trusts, the first inquiry was whether the Dynasty Trusts had current access to the cash values of their respective policies under the split-dollar arrangement.

For the Dynasty Trusts to have current access under the final regs, the Dynasty Trusts would first have to have a current or future right to any portion of the policy cash value. 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 CSV (including CSV attributable to premiums paid by the Dynasty Trusts) would be paid to the CMM Trust. Additionally, if a split-dollar life insurance arrangement were to terminate as a result of 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 receivable payable to the CMM Trust. Accordingly, under the split-dollar life insurance arrangements the Dynasty Trusts had no current or future right to any portion of the policy cash value, and thus, no current access under the regs.

IRS argued that the Dynasty 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 CMM Trust. Under that amendment, the CMM Trust’s interest in the cash values of the policies would pass to the Dynasty Trusts or directly to Mrs. Morrissette’s sons or their heirs upon her death. However, because the CMM Trust was a revocable trust with respect to Mrs. Morrissette, she retained an absolute right to alter the CMM 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 grantor. Furthermore, the split-dollar life insurance arrangements did not require the CMM Trust to distribute the receivables to the Dynasty Trusts. Rather, Mrs. Morrissette retained the right to receipt of the receivables.

IRS also argued that the “prepaid premiums” paid not only for current insurance protection, but also for future protection, which is a benefit other than current life insurance protection and requires that the arrangement be taxed under the loan regime. This position relied on Notice 2002-59, 2002-2 CB 481, for the proposition that prepayment of future premiums (by paying a single premium) confers policy benefits other than current life insurance protection.

The Court said that this assertion assumed that the Dynasty Trusts would otherwise be required to pay the premiums. Under the split-dollar life insurance arrangements, the Dynasty 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 CMM Trust was obligated to pay all the premiums. Thus, under the split-dollar life insurance arrangements, regardless of how the CMM Trust elected to pay the premiums (whether in one lump sum or over any number of installments), the CMM Trust would not relieve the Dynasty Trusts of any obligation to pay premiums because the Dynasty Trusts were not required to pay any premiums.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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