• Tax Court rules Internal Revenue Code Sections 2036, 2038 and 2703 applicable to multi-generational split-dollar arrangements—In Estate of Richard F. Cahill v. Commissioner, T.C. Memo. 2018-84 (June 18, 2018), the Tax Court denied an estate’s motion for summary judgment that IRC Sections 2036, 2038 and 2703 were inapplicable to the multi-generational split-dollar arrangement at issue.
So-called “multi-generational split-dollar” arrangements typically involve a parent and child (or grandchild). An insurance trust buys a policy on the child (for example, age 45), and the parent (for example, age 80) and the trust enter into a split-dollar agreement. The parent will receive the greater of the cash surrender value (CSV) or premiums paid on termination, whether that occurs at the child’s death or earlier by agreement of both parties. The premium is often front-loaded so that the parent invests a large amount into the policy. Because the insured child is young, the Table 2001 value of the insurance, and thus the early-stage annual deemed gifts to the trust, are relatively low. Then, when the parent dies, his estate heavily discounts the parent’s payment rights under the split-dollar agreement (perhaps by as much as 90 percent or more) despite the policy’s large cash value because the right to payment doesn’t mature until the death benefit is paid at the child’s death (which may be 30 or 40 years in the future). Subsequently, the parent’s estate and the trust would likely agree to terminate the arrangement early, at which point the full CSV will pass to the parent’s beneficiaries (likely the trust or other trusts for the benefit of the same beneficiaries). So, the result is a discounted transfer of the cash value.
In Cahill, split-dollar arrangements were put in place in 2010, one year before Richard Cahill’s death. At that time, Richard was 90 years old and his son, Patrick, was managing Richard’s affairs as his attorney-in-fact and as trustee of his revocable trust. Through Patrick as attorney-in-fact, Richard established the Morrison Brown Trust (MB Trust), an irrevocable trust for the benefit of Patrick and Patrick’s descendants of which Patrick’s cousin/business partner was the trustee. The MB Trust acquired three whole life insurance policies, two of which were on Patrick’s wife’s life and one of which was on Patrick’s life, with death benefits totaling almost $80 million
and lump-sum premiums totaling $10 million.
To fund these premiums, the trustee of the MB Trust and Patrick, as trustee of Richard’s revocable trust, entered into a split-dollar agreement for each policy. Under each of these agreements, the revocable trust agreed to pay the premium as an advance to the MB Trust. The revocable trust obtained a $10 million bank loan with a 5-year term for this purpose. On the death of the insured, each split-dollar agreement provided that the revocable trust would receive a portion of the death benefit equal to the greatest of: (1) the remaining balance on the loan applicable to the policy; (2) the total premiums paid by the revocable trust with respect to the policy; or (3) the CSV of the policy immediately before the insured’s death.
Each split-dollar agreement also provided that it could be terminated during the insured’s life by written agreement between the parties (that is, the trustees of the revocable trust and MB Trust). If the MB Trust opted to retain the policy after such a termination, it would be required to pay the revocable trust the greater of: (1) the total premiums paid by the revocable trust, or (2) the policy’s CSV. If the MB Trust didn’t opt to retain the policy, it would be required to transfer its interest in the policy to the bank that extended the loan for the premium, and the revocable trust would be entitled to any CSV in excess of the loan balance.
As of the date of Richard’s death, the aggregate CSV of the policies was approximately $9.6 million, but his estate tax return reported a total value of only $183,700 based on his interest under the split-dollar agreements. The estate didn’t factor the potential for termination of the agreements during the insureds’ lives into its valuation because it alleged it would never make economic sense for the MB Trust to agree to such termination. Therefore, the revocable trust’s interest was the right to payment on the insureds’ deaths, which the estate heavily discounted due to Patrick’s and his wife’s relative youth.
In its notice of deficiency, the Internal Revenue Service increased the value of Richard’s interests in the split-dollar agreements to the full CSV of the policies (approximately $9.6 million), asserting the application of Sections 2036(a)(2), 2038(a)(1) and alternatively, Section 2703. The estate sought summary judgment on the grounds that these sections were inapplicable.
First, the court ruled that Sections 2036(a)(2) and 2038(a)(1) did apply because the revocable trust’s “rights to terminate and recover at least the cash surrender value were clearly rights, held in conjunction with another person (MB Trust), both to designate the persons who would possess or enjoy the transferred property under section 2036(a)(2) and to alter, amend, revoke, or terminate the transfer under section 2038(a)(1).” The regulations to these IRC sections state that it’s immaterial: (1) whether the power was exercisable alone or only in conjunction with another person or persons, whether or not having an adverse interest; (2) in what capacity the power was exercisable by the decedent or by another person or persons in conjunction with the decedent; (3) whether the exercise of the power was subject to a contingency beyond the decedent’s control that didn’t occur before his death; or (4) at what time or from what source the decedent acquired his power. So, the fact that the revocable trust and the MB Trust could agree to terminate the agreement brought it within Sections 2036 and 2038.
Although a “bona fide sale for an adequate and full consideration” is excepted from both Section 2036(a) and Section 2038(a)(1), the court found this exception didn’t apply. Whether there was a bona fide sale turns on whether Richard had a legitimate and significant non-tax purpose for entering into the split-dollar agreements. The estate alleged that the agreements had the legitimate and significant non-tax purpose of ensuring liquidity when Patrick and his wife died (presumably decades from now) so as to facilitate the transfer of a business (that the court indicated didn’t even exist yet) to Patrick’s children. The court concluded that there were too many “unresolved factual questions” on this issue to make summary judgment appropriate.
Further, applying the estate’s valuation principles, the court concluded there couldn’t have been “adequate and full consideration” because in exchange for the payment of $10 million of premiums, the revocable trust received rights (to payment on the insureds’ deaths) worth only $183,700.
Next, the court turned to the IRS’ alternative position under Section 2703, that the requirement of the MB Trust’s approval to terminate the agreements during the insureds’ lives should be disregarded for purposes of valuing the revocable trust’s rights in the split-dollar agreements that were includible in Richard’s estate. That is, the revocable trust’s payment rights should be valued as though Richard (or more correctly, the trustee of his revocable trust) were able to unilaterally terminate the agreements as of his date of death and receive (at least) the CSV. Section 2703 says that the value of property for estate and gift tax purposes shall be determined without regard to: (1) any option, agreement or other right to acquire or use the property at a price less than the fair market value (FMV) of the property (without regard to such option, agreement or right), or (2) any restriction on the right to sell or use such property. In this case, the “property” was the revocable trust’s contractual right to the payment on termination of the split-dollar agreement, and the provisions in the agreements preventing the revocable trust from immediately withdrawing its investment are agreements to acquire or use property at a price less than FMV.
The parties didn’t address whether the Section 2703(b) exception to Section 2703(a) applied so the court didn’t consider it.
Finally, the court turned to the estate’s counterarguments under the Treasury regulations governing split-dollar life insurance arrangements. These regulations provide two different regimes for taxing split-dollar insurance arrangements: the loan regime and the economic benefit regime. The determining factor in which regime applies is who’s deemed to be the owner of the policy. If the only benefit that the recipient (in this case, the MB Trust) obtains from the agreement is life insurance protection (that is, no access to the cash value), then the donor (Richard) is considered the owner, and the economic benefit regime applies. If the recipient receives any benefit in addition to life insurance protection, then the recipient is the owner, and the loan regime applies. In this case, both parties were in agreement that the economic benefit regime applied.
The economic benefit regime generally treats the cost of current life insurance protection (as measured under Table 2001) as a transfer each year from the donor to the recipient, and Richard reported total gifts to the MB Trust of $7,578 in 2010 as a result. The estate argued that including the full CSV of the policies as part of the estate would double count that value between the gift and estate tax because this value would be accounted for as gifts to the MB Trust. The court characterized this argument as “difficult to follow,” stating the estate “seem[ed] to suggest” that the split-dollar agreements would continue and that the cost of current life insurance protection would therefore continue to be treated as gifts to the MB Trust. However, even if that were the case, these would be gifts from Richard’s trust beneficiaries rather than Richard, so there would be no double counting transfers by Richard.
Finally, the estate asserted that including the full cash value in the estate was somehow inconsistent with the Treasury regulations governing split-dollar life insurance arrangements. Although these regulations apply for gift tax but not estate tax purposes, the court noted that the gift tax and estate tax must be construed together, so these regulations should be considered in deciding this case. But, the court found no inconsistency between these regulations and the estate tax statutes at issue. The economic benefit regime under the regulations treats Richard as the owner of the CSV and the cost of current life insurance protection as a gift from Richard to the MB Trust out of the CSV. So, the court concluded that consistency would require that the CSV remaining at the time of Richard’s death be included in his estate.
With this decision, the Tax Court may have signaled the elimination of the transfer tax benefit thought to be achieved from multi-generational split-dollar arrangements—the discount on the cash value of the policies in the donor’s estate. Although this was only a denial of the taxpayer’s motion for summary judgment, the court made its positions fairly clear. Although many practitioners held out the Tax Court’s decision in Estate of Morrissette, 146 T.C. 11 (April 13,
2016) as proof that multi-generational split dollar was a viable strategy, that decision didn’t consider the estate tax consequences of the arrangement to the donor, Clara Morrissette. The IRS issued two notices of deficiency to Clara’s estate: one for gift tax liability for a year prior to Clara’s death and one for estate tax liability. The sole issue in the 2016 decision was in regards to the gift tax deficiency. Specifically, the court determined that the economic benefit regime applied to the multi-generational split-dollar arrangements in that case, such that only the cost of current life insurance protection (rather than the total premiums paid by the donor) constituted gifts.
Following the Cahill decision, the Tax Court quickly addressed the estate tax issues in Morrissette. On June 21, 2018, the Tax Court issued an order denying the Morrissette estate’s motion for summary judgment that Section 2703 doesn’t apply for purposes of the valuation of Clara’s rights under the split-dollar arrangements for estate tax purposes. Like the split-dollar arrangements in Cahill, those in Morrissette could be terminated during the insureds’ lives on the mutual agreement of both parties. Citing Cahill, the Morrissette order states that the restriction on Clara’s termination rights (the restriction being the requirement that the recipient trusts agree to any such termination) is a restriction for purposes of Section 2703(a)(2). (The order also notes that the IRS had advanced alternative arguments under Sections 2036 and 2038, as it did in Cahill, but these arguments weren’t addressed in the estate’s motion for summary judgment and thus remained at issue for trial.)
At first glance, one might speculate that a better result could have been achieved had the donor in either of these cases (Richard or Clara) transferred his/her rights to payment of the cash value under the split-dollar arrangements to their heirs prior to death. However, if Section 2703 applies with respect to the valuation of the donor’s rights at death, it would also apply to value the transferred rights for gift tax purposes, resulting in a transfer of the policies’ full cash value at the time of the lifetime transfer. And, even if Section 2703 didn’t apply, under the Treasury regulations governing split-dollar life insurance arrangements, such transfers would be deemed to be transfers of the policies’ full cash value (see Treasury Regulations Section 1.61-22(c)(1)(B), (g)). Moreover, if such transfers occur within three years of the donor’s death, IRC Section 2035 would apply to pull the cash value back into the donor’s estate.
• North Carolina statute taxing New York trust’s income was unconstitutional—In The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, (No. 307PA15-2, June 8, 2018), the Supreme Court of North Carolina affirmed the North Carolina Court of Appeals decision that a state statute taxing a trust’s income based solely on the residence of the beneficiaries in North Carolina was unconstitutional under the U.S. Constitution and North Carolina Constitution.
The Joseph Lee Rice III Family 1992 Trust (the Family Trust) was created in New York in 1992 for the benefit of the children of Joseph Lee Rice III, the settlor of the Family Trust. The Family Trust was governed by New York law. On Dec. 30, 2002, the Family Trust was divided into three sub-trusts, one each for the benefit of Joseph’s three children. One of the resulting subtrusts, the Kimberley Rice Kaestner 1992 Family Trust (the Kimberley Trust), was for the benefit of Joseph’s daughter, Kimberley Rice Kaestner, and Kimberley’s three children who all resided in North Carolina. David Bernstein, a Connecticut resident, was the sole trustee of the Kimberley Trust during 2005-2008, the years at issue. The beneficiaries of the Kimberley Trust didn’t have any right to distributions from the trust, which were solely in the discretion of the trustee. From 2005 to 2008, the assets held by the Kimberley Trust consisted of various financial investments, and the custodians of those assets were located in Boston. The Kimberley Trust’s financial books and records, legal records and other documents were all kept in New York, and the trust’s tax returns and accountings were prepared in New York.
The sole issue in this case was whether the North Carolina Department of Revenue (NCDR) could tax the income of the Kimberley Trust pursuant to N.C.G.S. Section 105-160.2 during tax years 2005 through 2008. N.C.G.S. Section 105-160.2 allows for the taxation of trust income “that is for the benefit of a resident of [North Carolina].”
The court held that the Kimberley Trust didn’t “purposefully avail itself of the benefits of the economic market” of North Carolina to an extent such that it had “minimum contacts” with North Carolina that would be sufficient to satisfy due process requirements of the Fourteenth Amendment to the U.S. Constitution (as well as a similar provision contained in Article I, Section 19 of the North Carolina Constitution), citing Quill Corp. v. North Dakota, 504 U.S., 298, 307 (1992). Therefore, it would be unconstitutional for North Carolina to tax the trust. The court reasoned that a trust is a separate entity from its beneficiaries, and the Kimberley Trust, which North Carolina seeks to tax, has no connection to North Carolina. Its beneficiaries reside in North Carolina, but that’s inconsequential, as taxation of an entity can’t be established by a third party’s minimum contacts with the taxing state. The NCDR argued that the Kimberley Trust’s communications with Kimberley were equivalent to the trust “purposefully availing” itself of North Carolina, but the court dismissed this argument by distinguishing between contacts with the forum state itself and persons who reside there.
The NCDR challenged the court’s rationale, citing two decisions in which other jurisdictions reached the opposite result. In Chase Manhattan Bank v. Gavin, the Supreme Court of Connecticut held that taxation of an inter vivos trust because the beneficiary of a trust was a Connecticut domiciliary didn’t violate due process. The Supreme Court of California reached a similar conclusion in McCulloch v. Franchise Tax Bd. The North Carolina court stated that the Connecticut Supreme Court, in deciding Gavin, “erroneously failed to consider that a trust has a legal existence apart from the beneficiary . . . .” Moreover, in both of these cases, the trusts had greater contacts with the forum states in question than just domicile of the beneficiaries. In Gavin, the settlor of the inter vivos trust at issue was a Connecticut resident when the trust was established. In McCulloch, the beneficiary of the trust was also one of the trustees.
• IRS rules that gift of a remainder interest in artwork is completed gift for tax purposes—In Private Letter Ruling 201825003 (March 9, 2018), the IRS held that a gift of a remainder interest in artwork (when the donor retained use of the art for life) is a completed gift for gift tax purposes. In the PLR, the taxpayer transferred title to the artwork to a museum, but retained a life estate. The deed of transfer that effectuated the transfer of the artwork imposed certain conditions subsequent which, if weren’t satisfied, would have the effect of giving the taxpayer the option to revoke the transfer of the artwork. However, the PLR noted that because these conditions subsequent were outside the donor’s control, none of them amounted to the donor retaining “dominion and control” over the property so as to negate a completed gift. Treasury Regulations Section 25.2511-2(b) provides that a transfer of property is a completed gift if the donor has so parted with dominion and control as to leave him no power to change its disposition, whether for his own benefit or for the benefit of another. Accordingly, the IRS held that the taxpayer’s grant of title to the museum in the artwork, while retaining a life estate, would be a completed gift for gift tax purposes.
While not addressed in the ruling, such a gift wouldn’t qualify for the gift tax charitable deduction. (This is probably why the transfer to the museum was contingent on obtaining an IRS ruling that it wouldn’t be a completed gift.) Under IRC
Section 2522(c)(2), if property is transferred in part to charity and in part to another person or retained by the donor, no gift tax charitable deduction is allowed unless the transfer is in the form of a charitable remainder trust (CRT) or a charitable lead trust (CLT). Since this transfer wasn’t in the form of a CLT or CRT, the interest given to the museum (charity) wouldn’t qualify for the gift tax charitable deduction and would be a taxable gift.
The legal result should be the same if, instead of transferring title to artwork and retaining a life estate, a donor retains title and makes a binding commitment to give/leave the art to the museum in the future. In contrast, if a donor makes a binding pledge to donate a dollar amount to charity (rather than a specific asset), a taxable gift may not be triggered because the donor didn’t transfer an interest in any identifiable property and only promised to give a dollar value. In that case, the donor could spend all of his money before death, in which case the charity gets nothing. On the other hand, if a donor contributes money to a trust that will pay the donor the income for life and the remainder to charity, that would be a completed gift without a deduction because the money has been legally set aside and not subject to transfer or consumption by the donor.
Finally, IRC Section 170(a)(3) would treat the art remainder donation as a current donation of a future interest, and for income tax deduction purposes, the donation isn’t made until the donor’s retained interest ends. That is, the deduction is obtained when full title to the art passes to the charity. (See Example (2) of Treas. Regs. Section 1.170A-5(b)).
This ruling may be problematic for charities such as art museums that wish to obtain binding commitments from donors to leave certain, identified assets to the charity at death; such a commitment could trigger gift tax (or use gift tax exemption).