• Annuity contract purchased by a trust is taxed as annuity, not ordinary income—In Private Letter Ruling 202118002 (May 7, 2021), the taxpayer sought a ruling on whether an annuity contract purchased by a trust would be taxed as an annuity or as ordinary income.
The trust in question was an irrevocable, non-grantor trust for the sole benefit of the grantor’s child who was also a co-trustee along with the grantor’s other children. The beneficiary couldn’t transfer his interest in the trust. The co-trustees purchased a single premium deferred annuity contract of which the trust was the owner and beneficiary during the beneficiary’s life.
The PLR confirmed that the annuity contract held by the trust for the benefit of a natural person (the beneficiary) would be taxed as an annuity and not as ordinary income. Internal Revenue Code Section 72(u)(1) generally provides that an annuity contract held by a non-natural person isn’t taxed as an annuity contract, and instead, the income on the annuity contract is treated as ordinary income. However, IRC Section 72(u)(1) doesn’t apply if the annuity contract is held by a trust or other entity “as an agent for a natural person.”
The PLR confirmed that Section 72(u)(1) doesn’t apply to an annuity contract held by a trust for a natural person. The PLR considered whether a trust must be acting as agent for the natural person to meet this exception. However, the Internal Revenue Service stated that a trust relationship is incongruent with an agency relationship, and the phrase “as an agent” in Section 72(u)(1) pertains only to “other entity” and doesn’t pertain to “trust.” As a result, Section 72(u)(1) doesn’t apply to annuity contracts held by trusts for natural persons. The PLR also noted that the decision was consistent with the purpose of Section 72(u)(1), which was created to tax employers holding plans for employees.
This is a departure from prior rulings that delved into the terms of the trust to determine if the trust held the annuity contract as an agent for the beneficiary/annuitant. (See PLRs 9752035 (Dec. 24, 1997), 9639057 (June 24, 1996), 199933033 (Aug. 20, 1999), 199905015 (Feb. 5, 1999), 200449016 (Dec. 3, 2004) and 202031008 (July 31, 2020)). This ruling seems to say that if the trust beneficiary is a natural person, Section 72(u)(1) doesn’t apply regardless if the trust amounted to an agency relationship.
• Split-dollar premium payments not included in decedent’s estate—In Estate of Clara M. Morrissette v. Commissioner, T.C. Memo. 2021-60 (May 13, 2021), the Tax Court ruled on whether premium payments on split-dollar life insurance policies would be included in the estate under IRC Sections 2036 and 2038, and if not, how to determine the fair market value (FMV) of the split-dollar rights.
Clara Morrissette’s husband, Arthur Morrissette, established a large family business involved in moving, relocation and storage. Arthur’s three sons worked at the business with him. Unfortunately, tension increased among the family members, in part because of a lack of a viable succession plan and sufficient liquidity to pay estate taxes.
After Arthur’s death, the family decided to purchase life insurance using split-dollar agreements as part of a cross purchase plan. Clara’s revocable trust paid approximately $30 million in premiums for policies on her children’s lives. In exchange, her trust was entitled to receive the greater of the premiums paid or the cash value of the policies at the insureds’ deaths. When Clara’s estate tax return was later filed, the IRS and estate disagreed on whether the premium payments should be included in Clara’s estate under Sections 2036 and 2038 and how to value the split-dollar rights.
Sections 2036 and 2038 include property transferred during life if the decedent retained certain rights or powers over the transferred property; however, Sections 2036 and 2038 don’t apply if the transfer was a bona fide sale for full and adequate consideration. The Tax Court has interpreted this exception to mean that a transfer must have a legitimate and significant nontax purpose and adequate and full consideration for money or money’s worth to avoid inclusion.
The Tax Court found that the premiums weren’t includible in Clara’s gross estate because the transfers were bona fide sales for full and adequate consideration. The premium payments served the legitimate nontax purpose of financing the stock purchases to keep the business in the family, paying estate taxes without forcing a sale of the business and allowing for a smooth management transition. The additional purpose of reducing estate taxes didn’t preclude the finding of a bona fide sale because it was a secondary motive. The premium payments were made for full and adequate consideration because Clara’s revocable trust received financial benefits of retained family control over the business, a smooth management transition, organizational stability and protection of capital by funding estate taxes. The Tax Court noted that these financial benefits were significant considering Clara’s strong desire to keep the business in the family.
Although both parties agreed that the split-dollar rights were includible in Clara’s gross estate, they varied greatly on the valuation. The Tax Court discussed two factors of valuation: (1) whether the special rules of valuation under Section 2703 applied; and (2) the appropriate discounts to apply.
Section 2703 requires that the value of any asset in the estate is includible without discounting the value for certain restrictive agreements; however, that rule doesn’t apply if the restrictive agreement was a bona fide business agreement and not a device to transfer property to the decedent’s family for less than adequate and full consideration. The Tax Court found that Section 2703 didn’t apply because the split-dollar agreements were entered into for the valid business purpose of resolving current and future management issues, keeping the business in the family and planning for future liquidity to pay estate taxes. Further, the split-dollar agreements weren’t a device to transfer property for less than full and adequate consideration because the split-dollar agreements allowed repayment terms that a reasonable investor would accept, provided for tax deferral and allowed for the additional financial benefits of continued family control, management succession and avoiding uncertainty. The Tax Court was also confident that split-dollar agreements in similar businesses could contain the similar restrictions on similar employees even if the employees weren’t family members.
In assessing the FMV of the split-dollar rights, the Tax Court applied two discounts. The Tax Court discounted the values of the cash flows and repayment schedule of the split-dollar rights. The cash flows were discounted based on returns on corporate bonds and the debt of each insurance company. The repayment schedule was discounted based on the termination time frame, which the Tax Court ruled was approximately four years because the parties who could terminate the agreement were on both sides of the transaction.
• Decedent’s second wife was a surviving spouse eligible for marital deduction—In Semone Grossman v. Comm’r, T.C. Memo. 2021-065 (May 27, 2021), the Tax Court ruled on whether the decedent’s second marriage was valid for purposes of the marital deduction by assessing the marriage under New York law; however, the Tax Court noted that it wasn’t deciding whether it was required to apply New York law, a revenue ruling or a decision by the U.S. Court of Appeals for the Second Circuit.
The question of validity developed from the decedent’s multiple divorce attempts before his second marriage. After a New York court declared the decedent’s Mexican divorce invalid, the decedent obtained a religious divorce under rabbinical law. The decedent then married his second wife in Israel under Jewish law. The Israeli marriage certificate noted that the decedent was free to re-marry because he was divorced.
The IRS argued that the Tax Court should apply New York law to determine whether the second marriage was valid. The estate asserted that revenue rulings and a Second Circuit decision were the determinative law. Without indicating which standard was correct, the Tax Court briefly explained the three proposed tests for determining whether a marriage is valid. Under New York law, a marriage is valid as long as it’s valid in the place where it was celebrated, unless the marriage is contrary to public policy or unless the marriage violates “positive law” (for example, a statute). (See Van Voorhis v. Brintnall, 86 N.Y. 18, 24-26 (1881)). Under IRS revenue rulings, as long as the marriage is valid in the place of celebration, the marriage is valid, regardless of the law in the state where the parties lived.
The court applied New York law without deciding which standard was correct. Under New York law, the second marriage was valid because it was recognized in Israel, wasn’t contrary to public policy and didn’t violate any New York statute; therefore, the second wife qualified as a surviving spouse eligible for the marital deduction.