Discounting Split-Dollar Receivables

In a typical private split-dollar plan, the insured funds a policy insuring their own life or another life by advancing or loaning funds to an irrevocable life insurance trust (ILIT) and, in exchange, holds a split-dollar receivable. [1] Frequently, increasing term costs (reportable economic benefits under an economic benefit regime plan) or loan interest (under a loan regime plan), make the termination or "rollout" of the plan advisable. Whether by a gift or sale, discounting the receivable results in a more efficient wealth transfer – especially when the insurance is owned by a dynasty trust. In the generational split-dollar (GSD) setting, the Morrissette and Levine cases introduced a favorable valuation methodology that results in meaningful discounts of split-dollar receivables.

Importantly, the GSD discounting methodology can be applied to the transfer of any split-dollar receivable, not just GSD plans. [2]

With a GSD plan, insurance on a younger generation (G2) is funded by an older generation, typically a parent or grandparent (G1). When G1 transfers the split-dollar receivable, typically, at G1’s death, it is discounted because it won’t be paid until the death of the insured (G2), which is, statistically, a long time in the future. In litigating GSD discounts, the IRS has asserted that there is a "gift at inception" of the plan arguing that the plan was only entered into for its tax avoidance benefits. In both the 2016 Morrissette gift tax case and the 2022 Levine estate tax case, the Tax Court soundly rejected this argument. Nevertheless, the IRS continues to assert this theory and can be

expected to examine the transfer of all GSD and non-GSD split-dollar receivables.

It is important to note that the Morrissette and Levine cases involved transfers of receivables at G1’s death while the transfer of a non-GSD receivable by the insured takes place during the insured’s lifetime. That distinction should not place the discount of a non-GSD receivable at risk.

The transfer of the receivable to an ILIT that owns the policy can cause the loss of the discount under either an economic benefit regime (EB regime) or a loan regime split-dollar plan. In the case of an EB regime plan, the regulations provide that, a transfer of the receivable where the ILIT becomes "the owner . . . of the entire contract" is treated as a transfer of the life insurance contract. [3] As a transfer of the entire contract, a discount based on the Morrissette and Levine cases would be unavailable. In the case of a loan regime plan, the IRS might argue that by transferring the receivable to the ILIT, the note should be appraised at full face value because in extinguishing the split-dollar loan, the ILIT has received the full benefit of the loan receivable.

Importantly, the discount can be preserved under either an economic benefit regime or a loan regime plan by transferring the receivable to a new trust other than the ILIT that owns the policy. To avoid GST tax inefficiencies, the new trust and the ILIT should each have the same GST characteristics. For example, both should be fully exempt from GST

taxes or fully non-exempt and have similar durations.

The following guidelines, gleaned from the Morrissette and Levine cases, support the discount of the receivable in the non-GSD setting:

1. It’s essential to carefully document that the policy was purchased for legitimate nontax planning purposes and that there was a clear intention to maintain the policy to maturity.
   

2. A truly independent trustee is needed.
   

3. The ILIT trustee must unilaterally control all plan decisions, including the right to terminate the split-dollar agreement.
   

4. The receivable holder can’t hold any powers to modify or terminate the agreement unilaterally or participate in any decision with the trustee to do so.
   

5. The ILIT trustee holds all incidents of ownership in the policy. [4] The trust secures premium advances or loans with a restricted collateral assignment of the policy.
   

6. Clients should engage highly qualified legal, tax, and insurance advisors who understand split-dollar plans as early in the planning process as possible.
   

7. It is essential to strictly conform to the split-dollar regulations and to adhere to the formalities of the agreement in implementing and administering the split-dollar plan.
   

8. To initiate the running of the three-year gift tax statute of limitations, a protective gift tax return that adequately discloses all material elements of the transaction should be filed in the year the receivable is transferred.
   

9. Discount discussions should only be held with client’s counsel so that they are protected by attorney client privilege, and potential discounts should not be put in writing. [5]

The IRS will continue to closely scrutinize the transfer of any split-dollar receivable. The Morrissette and Levine cases emphasize the importance of careful planning and design, clear communication with the family, strict compliance with the split-dollar regulations, and documentation of the long-term nontax reasons for the life insurance.

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[1] This article specifically addresses split-dollar plans implemented under the current economic benefit regime regulations (Treas. Reg. Sec. 1.61-22) and loan regime regulations (Treas. Reg. Sec. 1.7872-15) applicable to split-dollar plans issued after September 17, 2003.

[2] Estate of Clara M. Morrissette vs. Comm., 146 TC No. 11 (April 13, 2016) gift tax case and the Estate of Clara M. Morrissette vs. Comm’r, TC Memo 2021-60 (May 13, 2021) and Estate of Marion Levine vs. Comm’r, 158 T.C. No. 2 (February 28, 2022) estate tax cases.

[3] Treas. Reg. 1.61-22(c)(3)

[4] Code Section 2042. In Morrissette, incidents of ownership were not an issue because each dynasty trust only held policies insuring the brothers of the trustee, not the trustee. See Treas. Reg. § 20.2042-1(c).

[5] The Service may take those discussions as evidence of a prearranged plan in support of its “gift at inception” argument.

This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. To determine what is appropriate for you, please contact our firm. Information obtained from third-party sources are believed to be reliable but not guaranteed.

The tax and legal references attached herein are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.