I am reading
a case where the Tax Court just entered a “partial” summary judgement. This means
that at least one issue has been decided but the remaining issue or issues are
still being litigated.
And I think
I see what the attorneys are up to.
We are
talking about split-dollar life insurance.
This had
been a rather humdrum area of tax until 2002. The IRS then issued new rules which
tipped the apple cart and sent planners scrambling to review – and likely
revise – their clients’ split dollar arrangements (SDAs). I know because I had
the misfortune of being point man on this issue at a CPA firm. There is a
certain wild freedom when the IRS decides to reset an area of tax, with revisions to previous interim Notices,
postponed deadlines and clients who considered you crazed.
To set-up
the issue, a classic split dollar arrangement involves an employer buying a
life insurance policy on an employee. The insurance is permanent – meaning cash
value build-up - and the intent is for the employee to eventually walk away
with the policy or for the employee’s estate to receive the death benefits. The
only thing the employer wants is a return of the premiums it paid.
Find a
policy where the cash value grows faster than the cumulative premiums paid and
you have a tax vehicle ready to hit the highway.
Our case
involves the Morrissette family, owners of a large moving company. Grandmom
(Clara Morrissette) had a living trust, to which she contributed all her
company stock. She was quite concerned about the company remaining in the hands
of the family. She had her attorney establish three trusts, one for each son.
The sons, trusts and grandmom then entered into an agreement, whereby each son
– through his trust – would buy the company stock of a deceased brother. If one
brother died, for example, the remaining two would buy his stock. In the jargon,
this is called a “cross purchase.”
This takes
money, so each trust bought life insurance on the two other brothers.
This too takes
money, which grandmom forwarded from her trust.
How much
money? About $30 million for single-premium life policies.
Wow.
Obviously
the moving company was extremely successful. Also obviously there must have
been a life insurance person celebrating like a madman that day.
The only
thing grandmom’s trust wanted was to be reimbursed the greater of the policies’
cash value or cumulative premiums paid.
Which gets
us to those IRS Regulations from back when.
The IRS had decreed
that henceforth SDAs would be divided into two camps:
(1) The employee owns the policy and the
employer has a right to the cash value or some other amount.
This works fine until the premiums get expensive. Under this
scenario the employee either has income or has a loan. Income of course is taxable,
and the IRS insisted that a loan behave like a loan. The employee had to pay
interest and the employer had to report interest income, with whatever income
tax consequence followed.
And a loan has to be paid back. Many SDAs are set-up with the
intent of the employee walking away someday. How will he/she pay back the loan
at that time? This is a serious problem for the tax planners.
(2) The employer owns the policy and the employee
has a right to something – likely the insurance in excess of the cash value or
cumulative premiums paid.
The employee has income under this scenario, equal to the
value of the insurance he/she is receiving annually. The life insurance
companies publish tables, so practitioners can plan for this number.
But this leaves a dangerous possible tax issue: what happens
once the cash value exceeds the amount to which the employer is entitled (say cumulative
premiums)? Let’s say the cash value goes up by $250,000, and the employer’s
share is met. Does the employee have $250,000 in income? There is a lot of
lawyering on this point.
The Court
decided that the grandmom had the second type – type (2) of SDA, albeit of the “family”
and not the “employer” variety. The sons’ trusts had to report income equal the
economic benefit of the life insurance, the same as an employee under the
classic model.
This doesn’t
sound like much, but the IRS was swinging for a type (1) SDA. If the sons’
trusts owned the policies, the next tax question would be the source of the
money. The IRS was arguing that the grandmom trust made taxable gifts to the
sons. Granted the gift and estate tax exclusion has been raised to over $5
million, but $30 million is more than $5 million and would trigger a hefty gift
tax. The IRS was smelling money here.
The partial
summary was solely on the income tax issue.
The Court
will get back to the gift tax issue.
However,
having won the income tax issue must make the Morrissette family feel better
about winning the gift tax issue. According to the IRS’ own rules, grandmom’s
trust owned the policies. What was the gift when the trust will get back all
its money? The attorneys can defend from high ground, so to speak.
And there is
one more thing.
Grandmom
passed away. She was already in her 90s when the sons’ trusts were set up.
She died
with the sons’ trusts owing her trust around $30 million.
Which her
estate will not collect until the sons pass away or the SDAs are terminated. Who
knows when that will be?
And what is
a dollar worth X years from now?
One thing we
can agree on is that it not worth a dollar today.
Her estate
valued the SDA receivables at approximately $7 million.
And the IRS
is coming after her. There is no way the IRS is going to roll-over on those split
dollar arrangements reducing her estate by $23 million.
You know the
IRS did not think this through back in 2002 when they were writing and
rewriting the split dollar rules.
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