Recent developments in estate planning.

• Author: Ransome, Justin

This article is the second installment of an annual update on recent developments in trust, estate, and gift taxation. The first installment appeared in the November issue, and the third installment will appear in the January 2023 issue. The update covers developments in estate and gift tax returns and planning during July 2021 through July 2022.

Estate tax--split-dollar life insurance arrangements Cash-surrender values not includible in decedent's estate

The Tax Court, in a fully reviewed opinion, (1) sustained an estate's position that the cash-surrender values of certain life insurance policies were not includible in the estate. Specifically, the court held that (1) a decedent who had entered into split-dollar life insurance arrangements that required her revocable trust to pay the policies' premiums possessed a receivable created by the arrangements; (2) Secs. 2036(a)(2) and 2038 did not require the policies' cash-surrender values to be included in the gross estate because the decedent had no right to terminate the policies; and (3) Sec. 2703 applied only to property interests the decedent held when she died.

Marion Levine launched several highly successful businesses and amassed a fortune of approximately $25 million by the time she died. Levine's business ventures began with a grocery store that she owned with her husband. After his death, she sold the grocery business and used the proceeds to branch into various real estate investments, stock portfolios, interests in Renaissance fairs and mobile home parks, and private lending. Her son, Robert, worked in the family business as an adult, but her daughter, Nancy, did not.

Planning for her older age, Levine gave her children statutory power of attorney in 1996 so they could manage her affairs if she became incapacitated. Because the relationship between her children was somewhat strained, Levine also gave a power of attorney to a family friend and business associate, Bob Larson.

Marion Levine, Larson, Robert Levine, and Nancy's husband, Larry Saliterman, had formed 5005 Properties and 5005 Finance to manage the family's real estate holdings and associated businesses. Larson, Robert, and Larry managed the day-to-day operations, and Marion Levine provided the funding. An accountant by training, Larson ultimately became president of both companies.

Levine began planning her estate in 1988, creating the Marion Levine Trust (a revocable trust), for which (1) she was the trustee; (2) Larson, Robert, and Nancy were successor trustees; and (3) Nancy, Robert, and their children were the beneficiaries. In 2005, Levine resigned as trustee and made Larson, Nancy, and Robert the sole co-trustees.

An estate planning firm worked with Levine between 1996 and 2007 to determine how best to handle her estate and pass it on to her children and grandchildren. The firm set up an intergenerational split-dollar life insurance arrangement under which she (via the Marion Levine Trust) would contribute money to a trust organized for the benefit of her children and grandchildren, and the trustees would use the contributed funds to purchase life insurance policies on her two children's lives. In return, the trust promised to pay Levine the greater of (1) the money she advanced or (2) the policies' cash value upon the earlier of the insureds' deaths or the policies' surrender. The right to repayment would be considered a receivable that the estate would have to report on the estate tax return. Levine ultimately loaned the trust $6.5 million to pay the life insurance premiums.

To orchestrate this set of transactions, the estate planning firm created the Marion Levine 2008 Irrevocable Trust (an insurance trust) to own the split-dollar life insurance policies; Levine's children and grandchildren were the trust's beneficiaries. Robert, Nancy, and Larson served as attorneys-in-fact, and the South Dakota Trust Co. LLC served as an independent trustee, with administrative obligations but no ability to choose investments for the trust. Larson was the sole member of the investment committee; South Dakota law defined certain fiduciary obligations the investment committee had to the insurance trust and its beneficiaries.

Larson approved the split-dollar life insurance arrangement on behalf of the insurance trust and was subject to a fiduciary duty to exercise his power to direct the insurance trust's investments "prudently." Because Robert had a preexisting health condition, the insurance trust decided to purchase two "last-to-die" life insurance policies on Nancy and Larry rather than on Nancy and Robert. In summer 2008, Nancy, Richard, and Larson, as attorneys-in-fact for Levine, executed (1) paperwork on several loans to borrow the $6.5 million needed to make the premium payments, and (2) documents to put the split-dollar arrangement into effect. Levine died six months later, on Jan. 22, 2009.

Larson and Nancy, as attorneys-in-fact, signed gift tax returns for 2008 and 2009, reporting the gift's value as the economic benefit transferred from the revocable trust to the insurance trust. Applying valuation rules in the regulations applicable to split-dollar life insurance arrangements, (2) Larson and Nancy placed the value at $2,644.

The estate reported the value of the split-dollar receivable owned by the revocable trust to be approximately $2 million. This represented the present value of the $6.5 million receivable based on the date of death of the last to die of Nancy and Larry--the date on which the receivable would be due.

The IRS objected to the small amount reflected on the gift tax return but ultimately resolved that issue before the matter went to trial. It also objected to the approximately $2 million receivable value, instead arguing that the cash-surrender values of the life insurance policies (approximately $6.2 million) should be included in the estate. The IRS reasoned that the insurance trust had the power to terminate the split-dollar arrangement at the time of Levine's death. Therefore, the insurance trust and the beneficiaries of the revocable trust already effectively had access to $6.2 million. The IRS issued Levine's estate a deficiency notice for more than $3 million, most of which was attributable to adjusting the value of Levine's rights under the split-dollar arrangement.

The Tax Court summarized the key steps in the split-dollar arrangement as follows:

* The insurance trust agreed to buy insurance policies on the lives of Nancy and Larry;

* The revocable trust agreed to pay the policy premiums;

* The insurance trust agreed to assign the insurance policies to the revocable trust as collateral; and

* The insurance trust agreed to pay the revocable trust the greater of (1) the total premiums paid for these policies ($6.5 million); and (2) either (a) the current cash-surrender values of the policies upon the death of the last surviving insured or (b) the cash-surrender values of the policies on the date they were terminated, if they were terminated before both insureds died.

The Tax Court explained that split-dollar life insurance arrangements began as a means for employers to pay life insurance premiums for their employees, retain an interest in the policy's cash value and death proceeds, and pass on to the employee or beneficiaries any remaining death benefit. Rev. Rul. 64-328 clarified that the death benefit portion of the policy would be included in the recipient's income as an economic benefit. Estate planners wanted to help clients utilize the economic and tax benefits of life insurance, essentially using the policies as tax-advantaged savings. Final regulations from 2003 (3) govern all split-dollar arrangements entered into or materially modified after Sept. 17, 2003, and broadly define them as arrangements between an owner and nonowner of a life insurance contract in which:

1. Either party pays (directly or indirectly) all or part of the premiums;

2. The premium-paying party may recover all or part of the 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 (unless the plan provides permanent benefits). (4)

The Tax Court concluded that the split-dollar arrangement at issue met these requirements. Noting that the final regulations create two distinct regulatory regimes (the economic-benefit regime and the loan regime) to govern the income and gift tax consequences of split-dollar arrangements according to who owns the life insurance policy, the court concluded that the insurance trust owned the policies, and the loan-regime rules would apply. However, an exception to the general rule provides that the donor is treated as the owner of the contract if the only right or economic benefit the donee receives under a split-dollar life insurance arrangement is an interest in current life insurance protection. Noting that Sec. 2042 (regarding the inclusion of life insurance in the estate of a decedent) applies to life insurance policies only on a decedent's own life, not split-dollar arrangements on the lives of others, the court found that neither Sec. 2042 nor its regulations were part of the requisite analysis in this case.

The IRS argued that the transaction at issue was a scheme to reduce Levine's estate tax liability and, if it was a sale, was not a bona fide transaction because it lacked a legitimate business purpose. The estate should have reported the cash-surrender values of the policies rather than the value of the receivable, the IRS asserted, reasoning that:

* Under Sec. 2036, Levine retained the right to income, or the right to designate who would possess the income, from the split-dollar arrangement;

* Under Sec. 2038, she maintained the power to alter, amend, revoke, or terminate the enjoyment of aspects of the split-dollar arrangement; and * Even if the full values of the life insurance policies were not includible in Levine's estate...