In a split-dollar life insurance policy, a third party pays the insurance premiums for an insured person but retains the right to a refund of some or all of the premiums. Although these insurance packages were originally used in the employer-employee context, taxpayers have begun to use them in other contexts, such as estate planning. So it’s no surprise that the U.S. Tax Court has recently had to answer questions about the estate tax consequences of these transactions.

As explained below, these are the three decisions –Cahill’s legacy, Estate of MorrissetteAnd Levine’s Estate—had many things in common. In addition to the split-dollar agreements, the IRS attacked all three agreements under sections 2036 and 2038 of the Act, which, if applicable, require the inclusion of the transferred property in the decedent’s gross estate.

§§ 2036 and 2038

The inheritance tax system levies a tax on the transfer of the property. It works in parallel with the gift tax. To ensure that taxpayers cannot avoid the two, Congress has included provisions in the law that require the inclusion of certain assets in a deceased person’s estate, even if the deceased did not own the property. Two of these provisions are sections 2036 and 2038.

For Section 2036 or Section 2038 to apply, the deceased must among the living Transfer of property. In addition, the transfer of property must not have been a bona fide sale for fair and full consideration (more on that later). If both of these requirements are met, Section 2036 applies if the deceased was in possession or enjoyment of the property at the time of his death or had a right to income from the property. Alternatively, Section 2038 applies if, in addition to the above requirements, the deceased had the right to modify, add to, revoke, or terminate enjoyment of the property transferred at the time of his death or for three years before his death.

Importantly, sections 2038 and 2038 apply even if the prescribed rights are held jointly with another person.

Similarities in the three cases

The tax court analyzed the intersection of sections 2036 and 2038 with split-dollar contracts in Cahill’s legacy, Estate of MorrissetteAnd Levine’s estateAll three cases have many similarities.

In each case, the taxpayers (later the deceased) created revocable and irrevocable trusts. The revocable trusts were used to pay the premiums for life insurance policies, all of which had a cash surrender value. The irrevocable trusts, in turn, owned the policies. All of the policies insured the taxpayers’ children or their children’s spouses.

In addition, all revocable and irrevocable trusts entered into split-dollar life insurance contracts. Under these contracts, in exchange for their premium payments, the revocable trusts received the right to cash in hand—generally the greater of the premiums paid or the cash surrender value upon the death of the insured or upon termination of the contracts.

There were significant differences in the termination agreements and the reasons why taxpayers entered into the split-dollar agreements.

Cahill’s legacy

In Estate of Cahill, TC Memo. 2018-84The taxpayer entered into the split-dollar life insurance agreement when he was 90 years old. According to the contract, the trustee of the revocable trust (iethe trust that pays the insurance premiums) and the trustee of the irrevocable trust (iethe policyholders) could terminate the split-dollar agreement by mutual consent. In other words, neither party could terminate the contract unilaterally and alone.

Under this arrangement, the revocable trust paid $10 million in premiums for the policies. Because of applicable gift tax rules for split-dollar life insurance, the taxpayer reported the premium payments as gifts valued at $7,500. One year later, the taxpayer died when the surrender value of the policies was $9.6 million. The executor claimed on Form 706 that the revocable trust’s rights to the split-dollar contracts should be valued at $183,000. After an audit, the IRS disagreed and concluded that the fair market value of those rights should be equal to the surrender value of the policies, which was $9.6 million.

On summary judgment, the estate argued that sections 2036 and 2038 were not applicable as a matter of law. The Tax Court disagreed, arguing that both provisions were applicable because the decedent had the right to terminate the split-dollar contracts jointly with another party (iethe trustee of the irrevocable trust).

Estate of Morrissette

In Estate of Morrissette, TC Memo. 2021-60The taxpayer and her husband started a successful transportation and moving company. As their children (three brothers) grew older, they began working for the company and eventually rose to become its directors. However, the children have always not gotten along and regularly argue about the company and its business decisions.

Before her husband’s death, the taxpayer and her husband shared a desire for their children and grandchildren to take over the business. In accordance with that desire, they created estate plans that would ensure their property would pass to their children and grandchildren upon their deaths. However, after her husband’s death, the family became concerned that the taxpayer’s remaining estate plans did not provide enough liquidity for her estate to pay the estate tax upon her death. The family spoke with a life insurance agent who advised them to consider a split-dollar life insurance policy.

The split dollar life insurance agreement in Estate of Morrissette was similar to that in Cahill’s legacy. The taxpayer used a revocable trust to pay the life insurance premiums on policies held by three irrevocable trusts (one for each brother). Each of the children was named as the insured, with the other two children entitled to a portion of the proceeds upon death. And similar to Cahill’s legacythe revocable and irrevocable trusts had an agreement under which they could terminate the split-dollar contracts by mutual consent.

But in addition to the split-dollar contracts, the three brothers entered into shareholder agreements. These agreements contained restrictions on the transfer of the company’s stock and also purchase and sale rights that could be exercised upon the death of each brother. To finance the purchase and sale rights, the parties intended to use the proceeds from the split-dollar life insurance policy.

With these arrangements, the revocable trust paid about $30 million in premiums. When the taxpayer died, the policies had a surrender value of about $32 million. On Form 706, the executor valued the split-dollar rights at $7.5 million (but later admitted in tax court that the amount should have been increased to $10.5 million). After an audit, the IRS argued that the estate should have valued the split-dollar rights at their surrender value, which was $32 million.

Even if the facts are similar to those in Cahill’s legacythe Tax Court held that Sections 2036 and 2038 did not apply. Rather, the Court concluded that the bona fide sale exception exempted the surrender values ​​of the life insurance policies from tax because the decedent had a legitimate and significant nontax purpose for entering into the split dollar arrangement. In addition, the Court reasoned that she received adequate and full consideration in money or money’s worth for the premium payments. For example, the Court found that there was sufficient evidence that the decedent had always intended to keep ownership of the business in the family and that the arrangement provided for a smooth transfer of that ownership between generations of the family. Regarding the full and adequate consideration requirement, the Court reasoned that the decedent received tax-free appreciation in the value of the life insurance policies and other intangible benefits.

Notably, the estate did not win a complete victory. The court later ruled in part in favor of the IRS on issues relating to the valuation of the split dollar rights, concluding that those values ​​were higher than the $10.5 million admitted by the estate. Because of these erroneous valuations, the court also ruled that penalties should be imposed.

Levine’s estate

In Estate of Levine, 158 TC 58 (2022)The taxpayer had a gross estate of approximately $25 million. She visited an estate attorney who advised her to take out split-dollar insurance. This arrangement was very similar to those in Cahill’s legacy And Estate of Morrissette with one crucial difference: the revocable trust had no right to terminate the split-dollar contract. Rather, the irrevocable trust had this right only through a third party acting as the investment committee of that trust.

Through the split-dollar agreement, the revocable trust paid $6.5 million in insurance premiums. When the taxpayer died, the insurance policies had a cash surrender value of $6.2 million. On Form 706, the executor valued the revocable trust’s split-dollar rights at $2 million. Predictably, the IRS argued that the estate had undervalued those rights and they should be valued at the $6.2 million cash surrender value.

The tax court disagreed with the IRS. Unlike the split-dollar contracts that were at issue in Cahill’s legacy And Estate of Morrissettethe termination provision in Levine’s estate only allowed the Investment Committee of the irrevocable trust to terminate the contract. In this context, the Court found that the Investment Committee –iethe third party—had fiduciary duties to act in the best interests of the trust’s beneficiaries. Accordingly, the court found that neither Section 2036 nor Section 2038 applied. Moreover, because there was no dispute over the valuation reported on Form 706, the court ruled in favor of the estate and confirmed the split valuation of $2 million.

Diploma

The three recent Tax Court decisions on split-dollar life insurance contracts provide notable examples of the applicability and limitations of sections 2036 and 2038. Because the IRS will likely continue to fight these types of contracts, tax professionals would be well advised to Levine’s estate as accurately as possible if their clients want to use split-dollar contracts for estate planning.