June 27, 2018 Tax Court denies partial summary judgment for estate contesting determination that its interest in split-dollar insurance arrangements was cash surrender value In Estate of Richard E. Cahill, et al. v. Commissioner, the Tax Court has denied partial summary judgment to an estate that contested a deficiency notice in which the IRS adjusted the value of the decedent's rights in three split-dollar life insurance arrangements from $183,700 to more than $9.61m. The court declined to grant partial summary judgment on the estate's arguments that Sections 2036, 2038 and 2703 did not apply to the split-dollar arrangement, and that Reg. Section 1.61-22 did apply in valuing the decedent's interest in the split-dollar arrangements for estate tax purposes. Facts In 2010, when Richard Cahill was 90 years old and no longer able to manage his own affairs, his son, Patrick, entered into three split-dollar insurance agreements on his behalf. Richard (the decedent) lived in California at the time of his death in December 2011. Patrick, a Washington State resident, served as executor of the estate. The decedent had been settlor of two trusts — the revocable Richard F. Cahill Survivor Trust (Survivor Trust) and the irrevocable Morris Brown Trust (MB Trust). Patrick was trustee of the Survivor Trust and was his father's attorney-in-fact under California law. Patrick's cousin, William Cahill, was trustee of the MB Trust and the primary beneficiaries of that trust were Patrick and his issue. The MB Trust was formed on September 9, 2010 to take legal ownership of three whole life policies, two insuring the life of Patrick's wife and one insuring Patrick's life. Lump-sum premiums for the three policies totaled $10m; each policy guaranteed a minimum 3% return of the invested portion of the premium. Patrick, as trustee of the Survivor Trust, and William, as trustee of the MB Trust, executed three split-dollar agreements to fund the acquisition of the three life insurance policies. These agreements provided that the Survivor Trust would pay the premiums; the Survivor Trust did so by taking a $10m loan from an unrelated third-party. The obligors on this loan were the decedent (with Patrick signing for him as his attorney-in-fact) and Patrick as trustee of the Survivor Trust. As a general matter, the decedent's involvement in the three split-dollar life insurance arrangements occurred solely through the Survivor Trust, directed by Patrick. 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. 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 whichever of the following is greatest (referred to as the decedent's death benefit rights): (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. MB Trust would retain any excess of the death benefit (referred to as MB Trust's death benefit rights). Each split-dollar agreement could be terminated during the insured's life if the trustees of the Survivor Trust and the MB Trust agreed in writing. If one of the agreements terminated, the MB Trust could opt to retain the policy or transfer its interest in the policy to the third-party lender (referred to as "termination rights"). MB Trust could not sell, assign, transfer, borrow against, surrender or cancel a relevant policy without the Survivor Trust's consent. In 2010, the year before he died, the decedent reported $7,578 in gifts to MB Trust, based on a determination under the economic benefit regime under Reg. Section 1.61-22. Following his death, the decedent's estate reported the value of his rights in the split-dollar arrangements totaling $183,700. As of the date of death, the cash surrender value of the policies exceeded $9.61m. In its deficiency notice, the IRS adjusted the total value of the decedent's rights in the split-dollar agreements from the reported $183,700 to the aggregate cash surrender value, determining a deficiency of more than $6.82m, plus penalties for negligence and gross valuation misstatements. The estate argued that termination was so unlikely as of the date of the decedent's death that the termination rights had no value because: (1) the decedent's right to terminate the split-dollar agreements was held in conjunction with the trustee of MB Trust; and (2) it would never make economic sense for MB Trust to allow the split-dollar agreements to terminate. This meant, the estate asserted, 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 because the insureds (Patrick and his wife) were projected to live for many more years, and therefore the decedent's rights had only a small present value. In addition to arguing that the total value of the decedent's rights in the split-dollar agreements exceeded $9.61m, the IRS presented theories in the alternative under Sections 2036(a)(2), 2038(a)(1), and 2703(a)(1) and (2). The estate sought summary judgment on these issues, applying Reg. Section 1.61-22. Law and analysis A federal estate tax is imposed under Section 2001(a) on the transfer of a decedent's taxable estate, which consists of the value of the gross estate after applicable deductions (Section 2051). Section 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 Section 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). Similarly, Section 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 Section 2038(a) (i.e., a power that enables the decedent, either alone or in conjunction with another person, to alter, amend or terminate the transferees enjoyment of the property) that the decedent did not give up before death and that was not relinquished in the three years before the date of death. Section 2703 outlines certain rights and restrictions on the ability to acquire or use property for less than fair market value that may be disregarded for estate and gift tax purposes. Reg. Section 1.61-22 provides rules for split-dollar life insurance arrangements. These regulations define a split-dollar life insurance agreement as any arrangement between an owner and a non-owner 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 Reg. Section 1.61-22; the economic benefit regime and the loan regime. Which regime applies depends on which party owns or is deemed to own the life insurance policy at issue. Generally, the person named as the legal owner is the contract's owner. Applying this rule, MB Trust would be the owner of the policies and the loan regime would apply. A special ownership rule (Reg. Section 1.61-22(c) (1) (ii)) provides an exception, however, providing that, if the only economic benefit provided to the donee (i.e., 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 partnership, and the economic benefit regime applies. Sections 2036(a)(2) and 2038(a)(1) The $10m that the decedent paid the insurance companies as lump-sum premium payments for the benefit of the MB Trust was accounted for in three parts as of the date of his death — part was paid as commissions and fees; part was used while the decedent was alive to pay the cost of current life insurance protection on the insureds; and part was attributable to the cash surrender value remaining in the policies as of the date of death. The IRS and the estate disagreed over the third part, with the estate asserting that Sections 2036(a)(2) and 2038(a)(1) did not apply to include the cash surrender value in the gross estate because the decedent retained no rights to the amounts transferred sufficient to justify applying these code sections. The court found, however, 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 [Section] 2036(a)(2) and to alter, amend, revoke, or terminate the transfer under [Section] 2038(a)(1)." The court rejected the estate's contention that the decedent's right to terminate was negated by the fact that the MB Trust could prevent the decedent from terminating the split-dollar agreements, noting that this reasoning would mean that the words "in conjunction with any person" in Section 2036(a)(2), and "in conjunction with any other person" in Section 2038(a)(1), would have no meaning. The court cited the Estate of Powell v. Commissioner decision, which applied Section 2036(a)(2) with respect to that decedent's limited partnership interests in a family limited partnership, and also cited to Estate of Strangi v. Commissioner. The court rejected the estate's argument that, for Section 2036(a)(2) to apply, the decedent would have to have complete control, indicating that the language of the statue does not require unilateral control under the statute or case law. Next, the court addressed whether the "bona fide sale exception" under Sections 2036 and 2038 could apply. The court separately analyzed the two components of this exception, first addressing whether the decedent's transfer of $10m was a "bona fide sale" and, second, whether the transfer was for "adequate and full consideration." As to the "bona fide sale" prong, the court considered whether there was a "legitimate and significant non-tax reason" for transferring the $10m. The court indicated that a number of questions would need to be considered in connection with determining whether such reasons existed and consequently determined that summary judgment would not be appropriate. As for the "adequate and full consideration" prong, the court indicated that the question was whether decedent received "roughly equal the value" of what he transferred, and went on to conclude that such was not the case. Under the estate's admitted logic, the court noted, the MB trust's veto power over the termination of the split-dollar agreements rendered the decedent's rights at death at essentially zero, noting that the reported value on the estate tax return was less than 2% of the cash surrender value. From there, the court noted that, because the MB trust's veto power existed from inception, a 98% discount would have been present from that time, thus undercutting the estate's argument that the decedent received adequate and full consideration. In other words, the decedent only received consideration equal to roughly 2% of his $10m transfer, which by definition was not remotely close to "adequate and full consideration." Therefore, the court denied summary judgment on these issues. Section 2703 The IRS argued in the alternative that MB Trust's ability to veto termination of the split-dollar agreements should be disregarded under Section 2703(a)(1) or (2) for purposes of valuing the decedent's rights in those agreements. The court declined to grant the estate's summary judgment motion on this issue as well. The court found as lacking merit the estate's suggestion that the IRS was attempting to ignore the split-dollar arrangement and treat the policies themselves as assets of the decedent so as to look-through the split-dollar arrangement to the underlying insurance policies. The court also acknowledged that it had previously rejected such a look-through argument in Strangi, indicating that Section 2703 generally is not intended to function as a look-through provision. The court disagreed with the estate's contention that the IRS was making that argument. Rather, the court clarified that the IRS was looking at the decedent's interest under the split-dollar arrangement as the asset that was subject to valuation for estate tax purpose. The court clarified that the IRS's position was that Section 2703(a) applied for purposes of valuing the decedent's rights under the split-dollar agreement, rather than for valuing the underlying policies. After clarifying that both parties agreed that the decedent's rights under the split-dollar arrangement were the interests being considered, the court then concluded that the ability of the trustee of the MB Trust to restrict the decedent's access to the cash value of the policies by way of his termination right was a restriction that was subject to Section 2703 as "agreements to acquire or use property at a price less than fair market value." The court concluded that, under Section 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 fair market value. The estate claimed that the decedent paid $10m 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. Therefore, the MB Trust paid nothing but received the MB Trust's death benefit rights, 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). Further, the court noted that, under Section 2703(a)(2), the MB Trust's ability to prevent termination significantly restricts the decedent's right to use the termination rights. The court found that the split-dollar agreements "clearly restrict decedent's right to terminate the agreements and withdraw his investment from the arrangements." Concluding that the requirements of Section 2703(a)(1) and (2) were each met, the court denied the estate's summary judgment motion with respect to Section 2703(a). The court also addressed and rejected the estate's counter arguments that the split-dollar arrangements are akin to either promissory notes or partnerships, to which, the estate argued, Section 2703(a) does not apply. With respect to the comparison to promissory notes, the court distinguished a promissory note, which represents a bargained-for agreement between two parties to lend and borrow money, from the split-dollar arrangements, which the court noted involved no such bargain; rather, the MB Trust received its rights under the contract for no consideration. In distinguishing the case from Strangi, which involved a family limited partnership, the court indicated that no such entity existed. Lastly, the court rejected the estate's argument that Section 2703(a) is limited in its application to buy-sell agreements, indicating that the plain meaning of the statute is not so limited. Double counting gifts The court also addressed the estate's argument that the difference between the policies' cash value of $9.61m and the reported value of the decedent's interest under the arrangement would already be accounted for as gifts, so that the application of Sections 2036(a)(2), 2038(a)(1) or 2703 would result in a double counting of those assets under both the gift and estate tax regimes. Rejecting the estate's argument, the court noted that no gift tax return was filed reporting such purported gifts, and both parties agreed that the value of the current cost of life insurance protection constituted a gift under the Reg. Section 1.61-22. Because the current cost of the life insurance protection had already been deducted from the policy to determine the remaining cash value, no part of the remaining cash value had been used to pay the cost of the insurance protection, and, therefore, no part of the cash value remaining as of decedent's death had been subject to gift tax. Thus, no double counting would result. Reg. Section 1.61-22 The estate sought summary judgment arguing that, under Reg. Section 1.61-22 the economic benefit regime applies to the split-dollar agreements. But the court concurred with the IRS's observation that these are gift tax rules, not directly applicable to estate tax. Nonetheless, because the gift tax is complementary to the estate tax, the court ultimately decided to look at the regulations for further consideration. The court rejected the estate's contention that it "should modify the approach required by [Sections] 2036, 2038, and 2703 so as to avoid inconsistency between these statutes and the regulations," finding no inconsistency between the estate tax statutes and Reg. Section 1.61-22. Furthermore, the court concluded, consistency "between the regulations and the estate tax Code sections would … demand that the cash surrender value remaining as of decedent's date of death be valued as part of, or included in, decedent's gross estate. In short, the consistency the estate demands would seem to require the result respondent seeks," making summary judgment inappropriate. Implications Although this case only denies the estate partial summary judgment regarding the IRS's arguments under Sections 2036, 2038 and 2703, it lays out the framework that the court will probably use in ultimately determining that the cash surrender value of the policies at the time of the decedent's death will be includible in the decedent's estate. This conclusion will certainly make the use of split-dollar policies less attractive as a way to shift wealth from one generation to the next. One might also determine that this is a bad-facts case because of the deathbed planning involved and the fact that Patrick, the decedent's attorney-in-fact, essentially effectuated 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 (i.e., the decedent stood on both sides of the transaction). As we saw in Powell, the court again concludes that the mere ability of the decedent, in conjunction with others, to determine who will possess or enjoy the property or income from the property will trigger estate tax inclusion under Section 2036(a)(2). The court went further to state that similar language in Section 2038(a)(1) would have the same result. The court's growing willingness to use these provisions to affect estate tax inclusion should serve as a further cautionary note to estate advisors to be careful about the rights retained by a transferor of property — especially with regard to rights in entities in which some control, however minute, is retained. The Cahill opinion suggests, however, that the reach of Section 2036(a)(2) is not limited to family entities, such as family limited partnerships, but rather, can apply to other types of arrangements. The court's argument regarding Section 2703 seems to be a bit of a stretch. If, under the economic benefit regime, all that the Survivor Trust is deemed to transfer each year is the cost of the death benefits rights (because the Survivor Trust (and, therefore the decedent) remains the owner under the exception in 1.61-22(c)(1)(ii)(A)(2)), it would seem that, if the MB Trust paid the Survivor Trust for the death benefit rights (whose value is determined under Reg. Section 1.61-22) (or as in this case, the decedent treated as a gift), Section 2703 would not apply. In one part of the decision, the court explains why Reg. Section 1.62-11 might apply for income and gift tax purposes but not for estate tax purposes. But if the transfers occurred during the decedent's life, only then would Section 2703 be triggered? If there is no transfer at death, it would seem that Section 2703 would not be triggered by death. ———————————————
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