Estate planning advisers have grown accustomed to taking special care in helping clients formulate arrangements involving property interests, knowing that an unintended estate inclusion can come from any of several quarters. Not only do such arrangements often fall prey to valuation controversies, but several provisions of the Code can ensnare estate plans where the decedent has failed, in the IRS's estimation, to relinquish all control. In particular, Sec. 2036(a) can cause an estate inclusion of property interests in which the decedent held at death any right to possess or enjoy property or income it generates.
This alone might be easy enough to avoid. But the provision also includes any right to designate another person to possess or enjoy the property or income from it. This right need not be unilateral on the part of the decedent because Sec. 2036(a)(2) also applies when the right is held "in conjunction with any person." Sec. 2038(a)(1), which governs powers to alter or terminate a transferred interest, similarly does not require that the right be solely in the decedent's control.
Both provisions have scuttled estate plans, including those involving family limited partnerships1 and, more recently, a case involving a less common vehicle, a split-dollar insurance agreement.
Split-dollar agreements are perhaps more common in a corporate setting, often between a company and one or more key officers or employees, or with major shareholders. The "split" in split-dollar insurance refers to sharing the costs and benefits of the insurance policy. Often, in a traditional split-dollar arrangement, an employer and an employee join in purchasing a cash-value insurance policy (or a similar type of policy, such as variable or universal life, containing an investment element) on the employee's life. The employer typically agrees to pay the portion of the insurance premiums equal to the annual increase in the cash surrender value (the investment portion) of the policy, and the employee agrees to pay the balance (the insurance portion), if any, of the premiums. Upon the employee's death or the cancellation of the agreement, the employer is entitled to receive an amount equal to the cash surrender value of the policy (representing a return of its investment), and the named beneficiary receives the balance of the death benefit payable under the policy.
Sometimes, split-dollar arrangements are used as an estate planning vehicle between family members and their trusts (often referred to as "private" split-dollar arrangements). One such plan was at the center of a recent controversy between a decedent's estate and the IRS. In Estate of Cahill,2 the Tax Court found that the cash surrender value of a split-dollar life insurance arrangement was includible in the decedent's estate.
Richard Cahill (the decedent) created two trusts — the revocable Richard F. Cahill Survivor Trust (Survivor Trust) and the irrevocable Morris Brown Trust (MB Trust). The MB Trust was formed just before the decedent's death. This trust purchased and took legal ownership of three whole-life policies — one insuring the life of Patrick Cahill (the decedent's son), and two insuring the life of Patrick's wife. Patrick was trustee of the Survivor Trust and was the decedent's attorney-in-fact. Patrick's cousin, William Cahill, was trustee of the MB Trust, and Patrick and his issue were the primary beneficiaries of that trust. The lump-sum premiums totaled $10 million for the three policies, and each policy guaranteed a minimum 3% return on the invested portion of the premium. The policy amounts totaled $79.8 million. Both the estate and the IRS agreed that all assets in the Survivor Trust on the decedent's date of death were includible in the gross estate.
Patrick, as trustee of the Survivor Trust, and William, as trustee of the MB Trust, executed three split-dollar agreements — which provided that the Survivor Trust would pay the premiums — to fund the acquisition of the three life insurance policies. The Survivor Trust raised the money to pay the premiums by borrowing $10 million from an unrelated third party. The decedent's involvement in the three split-dollar life insurance arrangements occurred solely through the Survivor Trust, directed by Patrick Cahill. The decedent (with Patrick signing for him as his attorney-in-fact) and Patrick (as trustee of the Survivor Trust) were the obligors on this loan.
Each of the split-dollar agreements provided that, when the insured died, the Survivor Trust would receive a portion of the death benefit equal to the greatest of (1) the remaining balance of the loan; (2) the total premiums the Survivor Trust paid on the policy; or (3) the cash surrender value of the policy immediately before the insured's death (decedent's death benefit rights). The MB Trust would retain any excess of the death benefit (MB Trust's death benefit rights). The trustees of the Survivor Trust and the MB Trust could agree in writing to terminate each split-dollar agreement during the insured's life. If one of the agreements were terminated during the insured's life, the MB Trust could opt to retain the policy or, instead, transfer its interest in the policy to the third-party lender ("termination rights"). The MB Trust needed the consent of the Survivor Trust to sell, assign, transfer, borrow against, surrender, or cancel a relevant policy.
In 2010, the year before he died, the decedent reported $7,578 in gifts to the MB Trust, based on a determination under the economic-benefit regime of Regs. Sec. 1.61-22. As of the date of death, the cash surrender value of the policies exceeded $9.61 million. The decedent's estate reported the value of his rights in the split-dollar arrangements as $183,700. In a deficiency notice, the IRS adjusted the total value of the decedent's rights in the split-dollar agreements to the aggregate cash surrender value. As a result of the adjustment, the IRS determined the estate had a deficiency of more than $6.28 million.
The estate argued that the value of the decedent's interest in the split-dollar agreements was limited to the value of the decedent's death benefit rights, which were only $183,700 on his date of death. The estate went on to argue that the decedent's rights had only a relatively small present value because the insureds (Patrick and his wife) were projected to live for many more years. The estate also argued that the termination rights had no value on the basis that the termination was unlikely as of the date of the decedent's death because the decedent's right to terminate the split-dollar agreements was held in conjunction with the trustee of the MB Trust and it would not make economic sense for the MB Trust to allow the split-dollar agreements to terminate.
The IRS presented theories in the alternative under Secs. 2036(a)(2), 2038(a)(1), and 2703(a)(1) and (2). The estate sought summary judgment on these issues, arguing these sections were inapplicable under Regs. Sec. 1.61-22.
Sec. 2036 includes property in a gross estate if (1) the decedent transferred the property during life; (2) the transfer was not a bona fide sale for full and adequate consideration; and (3) the decedent kept an interest or right in the transferred property of the kind listed in Sec. 2036(a) (i.e., the right either alone or in conjunction with anyone to designate who will possess or enjoy the property or income from the property). Sec. 2038 includes transferred property in the gross estate if (1) the decedent made a gift during life; (2) the transfer was not a bona fide sale for full and adequate consideration; and (3) the decedent retained an interest or right in the transferred property of the kind listed in Sec. 2038(a) (i.e., a power that enables the decedent, either alone or in conjunction with another person, to alter, amend, or terminate the transferee's enjoyment of the property) that the decedent did not give up before death or that was relinquished in the three-year period ending on the date of death. Sec. 2703 outlines certain rights and restrictions on the ability to acquire or use property for less than fair market value (FMV) that may be disregarded for estate and gift tax purposes.
Regs. Sec. 1.61-22 provides rules for split-dollar life insurance arrangements. This regulation defines a split-dollar life insurance agreement as any arrangement between an owner and a nonowner of a life insurance contract in which either party pays any portion of the premiums, and at least one of the parties is entitled to recover all or part of the premiums from the life insurance contract. Two separate regimes for taxing split-dollar life insurance arrangements are described in Regs. Sec. 1.61-22: (1) the economic-benefit regime and (2) the loan regime. Which regime applies depends on which party owns or is deemed to own the life insurance policy at issue. Generally, the owner is the person named in the insurance contract as its legal owner. Applying this rule, the MB Trust would be the owner of the policies, and the loan regime would apply. A special ownership rule under Regs. Sec. 1.61-22(c)(1)(ii) contains an exception, however, providing that, if the only economic benefit provided to the donee (i.e., the MB Trust) under the split-dollar arrangement is current life insurance protection, the donor (i.e., the decedent) is deemed the owner of the contract, regardless of who is listed as owning the policy, and the economic-benefit regime applies.
Secs. 2036(a)(2) and 2038(a)(1)
The IRS claimed that part of the $10 million the Survivor Trust paid the insurance companies as lump-sum premiums for the benefit of the MB Trust was attributable to the cash surrender value remaining in the policies as of the date of death. The estate asserted that Secs. 2036(a)(2) and 2038(a)(1) did not apply because the decedent retained no rights to the amounts transferred sufficient to justify applying these Code sections.
Rights subject to Secs. 2036(a)(2) and 2038(a)(1)
The Tax Courtfound that Secs. 2036(a)(2) and 2038(a)(1) did apply to include the cash surrender value in the decedent's gross estate. In so finding, the Tax Court cited Estate of Powell3 (which applied Sec. 2036(a)(2) with respect to that decedent's limited partnership interests in a family limited partnership), and Estate of Strangi.4The court determined that "the 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 [Sec.] 2036(a)(2) and to alter, amend, revoke, or terminate the transfer under [Sec.] 2038(a)(1)." The court rejected the estate's contention that the decedent did not have the right to terminate the policy because the decedent held that right in conjunction with the MB Trust, which could have prevented him from terminating the split-dollar agreements. The court said this reasoning would mean that the words "in conjunction with any person" in Sec. 2036(a)(2) and "in conjunction with any other person" in Sec. 2038(a)(1) had no meaning. It seemed to the court that the estate was suggesting that, for Sec. 2036(a)(2) to apply, the decedent would have to have complete control of the MB Trust, but the court asserted that the language of the statute does not require unilateral control and that it was not aware of any case law or other authority supporting the estate's position.
Bona fide sale exception
Having determined that the decedent retained rights in the amounts transferred to which Secs. 2036 and 2038 could apply, the Tax Court addressed whether the "bona fide sale exception" included in Secs. 2036(a)(2) and 2038(a)(1) excepted the transfers. Under this exception, neither subsection applies to a transfer that is a "bona fide sale for an adequate and full consideration in money or money's worth." The court separately analyzed the two components of this exception with respect to the decedent's transfer.
Adequate and full consideration: The court concluded that the decedent did not receive roughly equal value of what he transferred. According to the estate, the MB Trust's veto power over the termination of the split-dollar agreements rendered the decedent's termination rights at death essentially worthless, and the value of the decedent's death benefit rights was less than 2% of the cash surrender value (as the estate reported on its estate tax return). Because the MB Trust's veto power existed from inception, and the terms of the split-dollar agreements had not been altered before the decedent's death, the court found that a 98% discount would have been present from the moment the decedent entered into the split-dollar arrangements. Thus, under the estate's valuation theory, the decedent had not received adequate and full consideration in the transfer because he had received consideration worth at least 98% less than the $10 million he transferred.
Bona fide sale: The court stated that whether a bona fide sale had occurred depended on the business purpose of the transfer, i.e., whether the decedent had a legitimate and significant nontax reason, established by the record, for transferring the $10 million. The court indicated that a number of factual questions would need to be answered to determine whether such a reason existed. Consequently, granting summary judgment on whether the decedent's transfer was a bona fide sale would not be appropriate.
Therefore, finding that while the requirements of Secs. 2036(a)(2) and 2038(a)(1) were met, and that it could not determine if the decedent's transfer was a bona fide sale, the court found that the estate was not entitled to summary judgment that Secs. 2036 and 2038 were inapplicable.
The Tax Court also refused to grant summary judgment that Sec. 2703(a) did not apply. The estate argued that MB Trust's ability to veto termination of the split-dollar agreements should be disregarded under Sec. 2703(a)(1) or (2) for purposes of valuing the decedent's rights in those agreements.
The Tax Court disagreed with the estate's assertion that the IRS was attempting to ignore the split-dollar arrangement and treat the policies themselves as assets of the decedent. The IRS argued that it was not ignoring the split-dollar agreements but was instead viewing the property interests owned by the decedent in the light of all relevant facts and circumstances, including the split-dollar agreements. The court found that because both parties agreed that the decedent's rights under the split-dollar arrangement were the interests being considered, and the estate did not dispute that the decedent owned the termination rights and the decedent's death benefit rights, the "estate's criticism of [the IRS's] position is ill-founded."
The Tax Court concluded that under Sec. 2703(a)(1), the split-dollar agreements, particularly the provisions preventing the decedent from withdrawing his investment, constituted agreements to acquire or use property at a price below FMV. The estate claimed that the decedent paid $10 million to the insurance companies for the benefit of the MB Trust and received the termination rights and the decedent's death benefit rights in return, while the MB Trust paid nothing but received the MB Trust's death benefit rights.
Under the court's understanding of the estate's valuation theory, these death benefit rights were allegedly worth at least the cash surrender value minus the value of the decedent's death benefit rights ($9,611,624 - $183,700 = $9,427,924). The court noted that nothing in the parties' filings indicated that MB Trust ever paid or was obligated to pay anything to the decedent for the trust's "acquisition and use of this amount." Further, the court found that, under Sec. 2703(a)(2), the MB Trust's ability to prevent termination significantly restricted the decedent's right to use the termination rights.
The Tax Court also rejected the estate's counterarguments that Sec. 2703(a) did not apply because the split-dollar arrangements were like promissory notes or partnerships. The court first distinguished promissory notes, saying they represent bargained-for agreements between two parties to lend and borrow money, while split-dollar arrangements involve no such bargaining. The MB Trust received its rights under the contract for no consideration, the court said. In addition, the split-dollar arrangements were not analogous to partnerships. In distinguishing the case from Estate of Strangi,5which involved a family limited partnership, the court indicated that no such entity existed in this case.
The estate also argued that Sec. 2703(a) applies only to options or buy-sell agreements. The court determined it did not, saying the estate cited no authority, and the plain language of Sec. 2703(a) is not so limited. Citing Holman,6 the estate then claimed that Sec. 2703(a)(2) applies only to arrangements involving a restraint on alienation, but the court stated that Holman did not stand for this proposition. Moreover, the statute covered restraints on use as well as sale, and the trust's ability to veto a termination was a restraint on use.
Finally, the estate, citing Elkins,7 contended that Sec. 2703(a)(2) applies only to arrangements where the property interest (in this case, the termination rights) exists or is created separately from the restriction (in this case, MB Trust's ability to prevent termination). The court found that Elkins did not say, and nothing in the statute suggests, that Sec. 2703(a)(2)'s application was limited in this way.
Concluding that the requirements of Secs. 2703(a)(1) and (2) were each met and finding no merit in the estate's various arguments against its application, the court denied the estate's summary judgment motion with respect to Sec. 2703(a).
The estate also contended that any part of the difference between the policies' cash surrender value of $9.61 million and the reported value of the decedent's interest under the split-dollar arrangement had been, or would be, already accounted for as a gift. As a result, application of Sec. 2036(a)(2), 2038(a)(1), or 2703 would constitute a double-counting of those assets under both the gift and estate tax regimes. The court, however, found that (1) the decedent did not report any part of the difference as a gift to MB Trust, and (2) both parties agreed that the value of the current cost of life insurance protection was a gift under Regs. Sec. 1.61-22. Thus, no part of the cash value remaining as of the decedent's death had been subject to gift tax because the current cost of the life insurance protection had already been deducted from the policy to determine the remaining cash value and no part of the remaining cash value had been used to pay the cost of the insurance protection.
Regs. Sec. 1.61-22
Regarding the estate's argument that, under Regs. Sec. 1.61-22, the economic-benefit regime applied to the split-dollar agreements, the Tax Court agreed with the IRS that these are gift tax rules and do not directly apply to estate tax. Nonetheless, because the gift tax is complementary to the estate tax, the court ultimately chose to look to the regulations in making its decision.
The Tax Court rejected the estate's contention that it should modify the approach required by Secs. 2036, 2038, and 2703 to avoid inconsistency between these statutes and Regs. Sec. 1.61-22. The court concluded that consistency between the regulations and the estate tax would require that the cash surrender value remaining as of the decedent's date of death be valued as part of, or included in, the decedent's gross estate. In short, the court determined that the consistency the estate argued for would require the result the IRS sought, making summary judgment inappropriate.
Estate of Cahill might be considered a bad-facts case because Patrick Cahill, the decedent's attorney-in-fact, essentially effected the creation of the MB Trust and the execution of the split-dollar life insurance arrangements within one year of the decedent's date of death. However, the case lays out the framework that the Tax Court will probably use in any fact pattern to ultimately determine that the cash surrender value of policies at the time of a decedent's death is includible in the decedent's estate. As a result, split-dollar policies are less likely to be used when shifting wealth from one generation to the next.
On the heels of its decision in Powell, the Tax Court has again determined that the mere ability of a decedent, in conjunction with others, to determine who will possess or enjoy his or her property or income triggers estate tax inclusion under Sec. 2036(a)(2). The Cahill opinion also suggests that the reach of Sec. 2036(a)(2) is not limited to family entities such as family limited partnerships but, rather, can apply to other types of arrangements. In addition, the court went even further to state that similar language in Sec. 2038(a)(1) would have the same result.
The Tax Court's argument regarding Sec. 2703 seems a bit of a stretch. If, under the economic-benefit regime, all that the Survivor Trust had been deemed to transfer each year was the cost of the death benefit rights (because the Survivor Trust (and, therefore, the decedent) remained the owner under the exception in Regs. Sec. 1.61-22(c)(1)(ii)(A)(2)), and the MB Trust had paid the Survivor Trust for the death benefit rights that had a value determined under Regs. Sec. 1.61-22 (or that the decedent had properly treated as a gift), Sec. 2703 would not apply. In one part of the decision, the court explained why Regs. Sec. 1.61-22 might apply for income and gift tax purposes but not for estate tax purposes. But if the transfers had occurred during the decedent's life, would Sec. 2703 only then be triggered? If there were no transfer at death, it would seem that Sec. 2703 would not be triggered by death.
1See, e.g., Estate of Turner, 151 T.C. No. 10 (2018), discussed in Ransome, "Recent Developments in Estate Planning: Part 2," 50 The Tax Adviser 776 (November 2019).
2Estate of Cahill, T.C. Memo. 2018-84.
3Estate of Powell, 148 T.C. 392 (2017).
4Estate of Strangi, T.C. Memo. 2003-145, aff'd, 417 F.3d 468 (5th Cir. 2005).
6Holman, 130 T.C. 170 (2008), aff'd, 601 F.3d 763 (8th Cir. 2010).
7Estate of Elkins, 140 T.C. 86, 114 (2013).
Contributors Justin Ransome, CPA, J.D., is a partner, and Todd Angkatavanich, J.D., LL.M., MBA, is a principal, both in the National Tax Department of Ernst & Young LLP in Washington, D.C. For more information on this article, contact firstname.lastname@example.org.
Justin Ransome, CPA, J.D., is a partner, and Todd Angkatavanich, J.D., LL.M., MBA, is a principal, both in the National Tax Department of Ernst & Young LLP in Washington, D.C. For more information on this article, contact email@example.com.