IRS Loses Big on Split-Dollar Life Insurance Estate Tax Case

(Parker Tax Publishing March 2022)

The Tax Court held that, at the date of her death, a decedent who had entered into split-dollar life-insurance arrangements which required a revocable trust to pay premiums for life-insurance policies taken out on certain relatives, possessed a receivable created by the arrangements and that receivable was the right to the greater of premiums paid or the cash surrender values of the policies when terminated. Further, the court concluded that (1) neither Code Sec. 2036(a)(2) nor Code Sec. 2038 required inclusion of the policies' cash-surrender values in the decedent's estate because the decedent did not have any right, whether by herself or in conjunction with anyone else, to terminate the policies because only an irrevocable trust had that right; and (2) Code Sec. 2703 applies only to property interests that the decedent held at the time of her death and there were no restrictions on the split-dollar receivable, so Code Sec. 2703 did not apply. Levine v. Comm'r, 158 T.C. No. 2 (2022).

Background

Marion Levine was born in St. Paul, Minnesota in 1920. She married George Levine and they had two children - Nancy and Robert. At a time when it was especially unusual, Levine nevertheless became a highly successful businesswoman. Her success began in 1950 when she and her husband opened Penny's Supermarket. This small family business eventually grew to a 27-store, multimillion-dollar company. Levine did almost everything at Penny's - she collected timecards, oversaw payroll, paid bills, and tracked inventory. She became the sole boss after George died in 1974 and she subsequently sold the business and used the proceeds as capital to hatch new businesses that increased her net worth to $25 million over the next 20 years.

In the late 1990s, Levine began to plan for her old age. Levine appointed her children, Nancy and Robert, as attorneys in fact to take care of her affairs if something happened, but the children did not always get along so Levine thought it was necessary to have a third attorney-in-fact to play the referee. This role was played by Bob Larson, who had been the in-house controller at Penny's and had become a friend of the family.

For her estate planning, Levine hired Shane Swanson, an attorney at Parsinen Kaplan Rosberg & Gotlieb, P.A. (Parsinen). He was referred to the Levine family by Levine's sister, who had been using Swanson and was extremely pleased with his work. The family and Swanson clicked, and in November 2007, they retained the Parsinen firm to review and revise Levine's estate plan. Swanson was the primary point of contact for Levine and her attorneys-in-fact, and he took the lead on the estate-planning work.

Levine wanted a plan that would invest her excess capital to provide her with a good return, while at the same time meshing with her children's needs for estate plans of their own. Swanson's solution was to use intergenerational split-dollar life insurance. While Swanson had done a split-dollar insurance arrangement before, he had never done a transaction like the one he was proposing for Levine - loans from a parent to her children to buy life insurance for them. He explained that the circumstances that might make this type of transaction attractive are very rare, and require that the client (1) has enough cash to buy a substantial amount of life insurance, and to live on for the rest of her life; (2) faces an estate-tax bill large enough to justify the costs of planning and execution; (3) has children whose lives would be insured, and who themselves have a sufficient net worth to qualify for large life-insurance policies; and (4) has children who are healthy enough to navigate the underwriting process successfully.

Levine's Estate Plan

Swanson explained that, under his plan, Levine could contribute money to a trust that would be for the benefit of Robert, Nancy, and her grandchildren. Its trustees would then use the money to buy life-insurance policies on Nancy and Robert's lives. This would not be purely a gift - the trust would get Levine's money only in exchange for a promise by the trust to pay her the greater of the money she advanced, or the cash value of the policies upon the earlier of the insureds' deaths or the policies' surrender. The right to this repayment would be held by Levine as a "receivable", or in other words an asset that the estate had to report on its estate-tax return. Swanson's proposal assumed that Levine would lend the trust enough to pay $10 million in premiums, but he said that the technique could be used at any premium level depending on the insured's insurability - i.e., "proof of good health of the insured." Levine herself approved the transaction, but limited the amount that she was willing to lend to the trust for premiums to $6.5 million.

Swanson created the trust that would own the split-dollar life-insurance policies - the Marion Levine 2008 Irrevocable Trust (Insurance Trust). Irrevocable life-insurance trusts are typically used as a vehicle to own life insurance policies to reduce gift and estate taxes. If done properly, a life-insurance trust can take a policy out of its settlor's estate and allow the proceeds to flow to beneficiaries tax free. Swanson settled the Insurance Trust in South Dakota because its laws are favorable - it has no rule against perpetuities, but does have a taxpayer-friendly state income tax and a favorable premium tax. South Dakota is also one of the few states with a "directed" trustee statute, which allows the separation of management and administration of a trust's investments. Levine's Insurance Trust named South Dakota Trust as its directed trustee, which was only the administrator and had no authority to choose what the trust would invest in. Swanson drafted the trust to have trustees whose job it would be to direct its investments. This was the "investment committee," and its membership consisted of one person - Larson. Between June and July 2008, Nancy, Robert, and Larson - in their capacities as Levine's attorneys-in-fact and as trustees of her Revocable Trust - executed several documents to put the split-dollar arrangement into effect.

The important parts of the deal were: (1) the Insurance Trust agreed to buy insurance policies on the lives of Nancy and Larry; (2) the Revocable Trust agreed to pay the premiums on these policies; (3) the Insurance Trust agreed to assign the insurance policies to the Revocable Trust as collateral; (4) the Insurance Trust agreed to pay the Revocable Trust the greater of (i) the total amount of the premiums paid for these policies -- $6.5 million - and (ii) either the current cash-surrender values of the policies upon the death of the last surviving insured or the cash-surrender values of the policies on the date that they were terminated, if they were terminated before both insureds died. It was very important, if this deal was to work, that the Insurance Trust and not the Revocable Trust own the policies.

Tax Reporting

Levine died on January 22, 2009. Swanson prepared gift-tax returns for 2008 and 2009. Larson and Nancy signed these returns in their capacities as Levine's attorneys-in fact. Each Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, reported the value of the gift as the economic benefit transferred from the Revocable Trust to the Insurance Trust. Gifts of valuable property for which the donor receives less valuable property in return are called "bargain sales." And the value of gifts made in bargain sales is usually measured as the difference between the fair market value of what is given and what is received. However, the IRS has issued guidance in Reg. Sec. 1.61-22(d)(2) that provides a different measure of value when split-dollar life insurance is involved. The regulations broadly define a split-dollar life-insurance arrangement between an owner and a nonowner of a life-insurance contract in which (1) either party to the arrangement pays, directly or indirectly, all or a portion of the premiums; (2) the party making the premium payments is entitled to recover all or a portion of those premium payments, and repayment is to be made from or secured by the insurance proceeds; and (3) the arrangement is not part of a group-term life insurance plan (other than one providing permanent benefits). The number Larson and Nancy came up with after applying the valuation rules in Reg. Sec. 1.61-22(d)(2) was $2,644.

Everyone involved also knew that the promise of the Insurance Trust to pay the Revocable Trust some amount sometime in the future was also valuable. It had to be reported on Levine's estate-tax return. On Levine's Schedule G, Transfers During Decedent's Life, of the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, the value of the split-dollar receivable, as owned by the Revocable Trust on the alternate valuation date, was reported as an asset worth about $2 million.

The shift of money from the Revocable Trust for the purchase of the life-insurance policies that benefited the Insurance Trust caught the IRS's attention. The IRS noticed two things in particular. The first was the small amount of $2,644 that Levine's return reported as the gift that her Revocable Trust had made to the Insurance Trust. The second was that the Insurance Trust had promised to pay the Revocable Trust the greater of $6.5 million or the policies' cash surrender value at either the death of both Nancy and her husband or upon termination of the policies. At the time of Levine's death, this value was close to $6.2 million, and the IRS suspected there was no insurmountable hurdle to the Insurance Trust's terminating the policies well before Nancy and her husband both died. This would mean that the Insurance Trust and Levine's descendants, as beneficiaries of the Revocable Trust, had ready access to $6.2 million, not just the $2.1 million + $2,644 that was reported on the estate and gift-tax returns. The IRS reasoned that even if the full values of the life-insurance policies are not includible in Levine's estate under Code Sec. 2036 or Code Sec. 2038, the restrictions in the split-dollar arrangement should be disregarded under the special valuation rules provided in Code Sec. 2703, which would force the estate to include in its taxable value the full cash-surrender values of the policies. Code Sec. 2703 provides that under certain circumstances property must be valued without regard to any right or restriction relating to the property that would result in the property's being valued at less than its fair market value.

The IRS's estate-and-gift-tax attorney, Scott Ratke, conducted an extensive audit, and in the end the IRS issued a notice of deficiency to the estate for slightly more than $3 million. This reflected several adjustments, but the adjustment to the value of Levine's rights under the split-dollar arrangement was by far the biggest. The IRS also determined that the estate was liable for a 40 percent gross-misvaluation penalty under Code Sec. 6662(h) because the value that it had reported for the split-dollar receivable was way too low. The estate disputed the IRS's findings and asserted that the only asset from the split-dollar arrangement that Levine's Revocable Trust owned at the time of her death was the split-dollar receivable. The case proceeded to trial.

Two questions remained for the Tax Court to resolve: (1) Was the value of the split-dollar receivable in Levine's estate on the alternative valuation date $2,282,195, or the policies' cash-surrender value of $6,153,478?; and (2) Was any resulting underpayment subject to the 40 percent gross-misvaluation penalty under Code Sec. 6662(h)?

Tax Court's Decision

The Tax Court sided with the estate. The court concluded that the split-dollar arrangement in the estate's situation met the requirements of Reg. Sec. 1.61-22 but that Reg. Sec. 1.61-22 governs only the gift-tax consequences of a transaction and does not cover the estate-tax consequences of split-dollar arrangements at all. That left the court to look to the default rules of the Code's estate tax provisions to figure out how to account for the effect of the split-dollar arrangement on the gross value of Levine's estate. The court agreed with the IRS that the two snippets of the Code that it had to decrypt in this situation were Code Sec. 2036 and Code Sec. 2038. The estate argued that (1) it made no transfer of its property that could trigger these sections, (2) it retained no interest in the property that it did transfer, and in any event, (3) the bona fide sale for adequate and full consideration exemption applied. The Tax Court agreed with the estate and concluded that the IRS didn't win on this point as a matter of law.

With respect to the Code Sec. 2703 argument, the court found that the reference to "any property" in Code Sec. 2703 is to the property of an estate, not some other entity's property. In this case, the court noted, the property to be valued is the property in Levine's estate, i.e., the split-dollar receivable she held at the time of her death and there were no restrictions on that property as Levine could do with the receivable what she wanted. Thus, the court concluded, Code Sec. 2703 did not apply.

The court also rejected the IRS's contention that Levine - through her attorneys-in-fact - stood on both sides of these transactions and therefore could unwind the split-dollar transactions at will. The court agreed with the estate that Robert, Nancy, and Larson - as Levine's attorneys-in-fact - stood in the shoes of Levine with respect to this split-dollar arrangement. That is the point of giving someone a power of attorney, the court noted. The court pointed out that the Revocable Trust was the entity that paid the $6.5 million, and its cotrustees were Nancy, Larry, and Larson. The Insurance Trust, however, owned the life-insurance policies, and its trustee was South Dakota Trust. South Dakota Trust, the court noted, was directed by the investment committee, and the investment committee's only member was Larson. To the Tax Court, this meant that the only person that stood on both sides of the transaction was Larson - in his role as the investment committee and as one of Levine's attorneys-in-fact.

The court then looked at each of Larson's roles in this transaction to consider how to apply Code Sec. 2036(a) and Code Sec. 2038. The Insurance Trust's instrument, the court observed, states that the Insurance Trust is irrevocable and the court found no reason to doubt that this meant what it said. And that consequence, the court said, was that Levine irrevocably surrendered her interest in the Insurance Trust and had no right to change, modify, amend, or revoke its terms. The court concluded that once the trust was created Levine had no legal power over its assets and did not retain any right to possession or enjoyment of the property transferred to the trust. Finally, the court also stressed that the fiduciary duties that Larson owed to the beneficiaries of the Insurance Trust did not conflict with the fiduciary duties that he owed Levine as one of her attorneys-in-fact.

For a discussion of split dollar life insurance arrangements and Reg. Sec. 1.61-22, see Parker Tax ¶221,330.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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