March 9, 2022
In taxpayer-favorable decision, Tax Court holds insurance policies' cash-surrender values aren't included in taxpayer's estate where decedent had no right to terminate policies
In a fully reviewed opinion (Estate of Marion Levine, et al. v. Commissioner(158 T.C. No. 2)), the Tax Court has sustained an estate's position that the cash-surrender value of certain life insurance policies are not includable 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) IRC Sections 2036(a)(2) and 2038 do not require the policies' cash-surrender values to be included in income because the decedent had no right to terminate the policies; and (3) IRC Section 2703 applies only to property interests the decedent held when she died.
A child of the Great Depression, Marion Levine launched several successful businesses during her lifetime that generated significant wealth, amassing approximately $25m by the time she died. Levine's business ventures began with a grocery store and branched 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 involved a family friend and business associate, Bob Larson, to serve as a third power-of-attorney.
Levine, Larson, Robert, and Levine's husband had formed 5005 Properties and 5005 Finance to manage the family's real estate holdings and associated businesses. The four of them managed day-to-day operations and 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 (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 excess capital and pass her assets 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 lent the trust $6.5m to pay the life insurance premiums.
To orchestrate this set of transactions, the firm created the Marion Levine 2008 Irrevocable Trust (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 Company 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 pre-existing health conditions, the Insurance Trust decided to purchase two "last-to-die" life-insurance policies on Nancy and her husband Larry, rather than on Nancy and Robert. In the summer of 2008, Nancy, Richard, and Larson as attorneys-in-fact for Levine executed (1) paperwork on several loans to borrow the $6.5m needed to make the premium payments and (2) documents to put the split-dollar arrangement into effect. Levine died six months later, on January 22, 2009.
Larson and Nancy, as attorneys-in-fact, signed gift-tax returns for 2008 and 2009, reporting the value of the gift as the economic benefit transferred from the Revocable Trust to the Insurance Trust. Applying the bargain-sale regulations, 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 $2m. This amount represented the present value of the $6.5m receivable based on the last-to-die of Nancy and Robert — 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 the issue before the matter went to trial. It also objected to the approximately $2m receivable value, instead arguing that the cash-surrender values of the life insurance policies (approximately $6.2m) 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 $6.2m. The IRS issued Levine's estate a deficiency notice for more than $3m, most of which was attributable to adjusting the value of Levine's rights under the split-dollar arrangement. The agency also sought gross-misvaluation penalties under IRC Section 6662(h).
The parties litigated two issues before the Tax Court:
Tax Court decision
The Tax Court summarizes the key steps in the deal as follows:
For this deal to work, the court stressed, the Insurance Trust — rather than the Revocable Trust — had to own the policies. Further, the court found that only the Insurance Trust, and therefore only Larson, had the right to terminate the two split-dollar arrangements (one for each insurance company holding a policy). As will be discussed later, this was a critical distinction in the eyes of the court, in contrast to similar split-dollar arrangements addressed in the recent Morrisette cases.
The 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 his beneficiaries any remaining death benefit. Revenue Ruling 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 govern all split-dollar arrangements entered into or materially modified after September 17, 2003, and broadly define them as arrangements between an owner and nonowner of a life-insurance contract in which:
The 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 loan regime) to govern the income-tax and gift-tax consequences of split-dollar arrangements according to who owns the life-insurance policy, the court stated that, "[u]nder this general rule, the Insurance Trust would be the owner of the policies here, 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. "So," the court stated, "there's at least a threshold question here about whether the Insurance Trust received any economic benefit in addition to current life-insurance protection." Noting that IRC Section 2042 (Proceeds of Life Insurance) only applies "to life-insurance policies on a decedent's own life, not split-dollar arrangements where policies are taken out on the lives of others," the court found neither this IRC section nor its regulations were part of the requisite analysis here.
The IRS argued that the transaction at issue was "merely a scheme to reduce Levine's potential estate-tax liability and, if it was a sale, it was not bona fide because it lacked any legitimate business purpose." The estate should have reported the cash-surrender values of the policies, rather than the value of the receivables, the Commissioner asserted, reasoning that:
What rights were transferred/retained under IRC Sections 2036 and 2038?
The court found that life insurance policies cannot constitute the "property" at issue here because the Insurance Trust has always been the owner of the policies. The receivable also cannot constitute the "property," the court reasoned, noting that the property was essentially retained, as opposed to transferred, because it belonged to the Revocable Trust and now belongs to the estate.
Ultimately, the court found that Levine made a voluntary inter vivos transfer within the meaning of IRC Sections 2036(a) and 2038 when she (via the Revocable Trust) transferred $6.5m to the insurance companies.
Were rights retained?
Levine's transfer of $6.5m gave her the right to the greater of a refund of the $6.5m or the cash-surrender values of the policies after both Nancy and Larry died or the policies were cancelled. Distinguishing the instant facts from those at issue in Estate of Cahill v. Comm'r, T.C. Memo. 2018-84 (see Tax Alert 2018-1313), and Estate of Morrissette v. Comm'r (Morrissette II), T.C. Memo. 2021-60, the Tax Court stressed that, in "Levine's case, the split-dollar arrangements between the Revocable Trust and the Insurance Trust expressly stated that only the Insurance Trust had the right to terminate the arrangement." In Cahill and Morrissette II, the donor in conjunction with a second party could mutually agree to terminate.
"This difference matters," the court emphasized, noting that the facts in Levine's case show "a carefully drafted arrangement that expressly gives the power to terminate only to the Insurance Trust." Absent a contractual right to terminate the life-insurance policies, the court could not conclude "that Levine had any sort of possession or rights to their cash-surrender values."
The court rejected the contention that Levine retained control under the principles of contract law, even though only the Insurance Trust has the express power to terminate the deal and pay income to the estate, because she could allow her estate to modify the terms of the arrangements. For the property at issue to be included in the estate under the broad language of IRC Section 2036(a)(2), "a power has to be in the instrument itself, not a speculative possibility allowed by general principles of law," the court stated.
The court rejected the Service'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." Because the Insurance Trust owned the life-insurance policies and the trustee was the South Dakota Trust, directed by the Investment Committee with Larson as its only member, the only person on both sides of the transaction was Larson.
In considering each of Larson's roles and how to apply IRC Sections 2036(a) and 2038, the court found that Larson could not surrender the life-insurance policies in his capacity as attorney-in-fact and did not retain any right to possession or enjoyment of the transferred property. Additionally, the court rejected the Service's contention that Larson retained control because he could, in his capacity as the sole member of the Investment Committee, designate who would possess or enjoy the cash-surrender value of the properties by either surrendering them or terminating the agreement. The court indicated that the Service's position failed to consider Larson's fiduciary obligations owed to the beneficiaries of the Insurance Trust.
Distinguishing the Levine facts from those at issue in other cases in which the court took issue with fiduciary duties in the context of a family limited partnership as being "illusory" (e.g., Estate of Strangi v. Comm'r and Estate of Powell v. Comm'r), the court noted that, here, Larson owed non-conflicting fiduciary duties both to the beneficiaries of the Insurance Trust and to Levine as an attorney-in-fact. In Strangi and Powell, the fiduciary's role as attorney-in-fact could have required him to act against his duties as trustee, the court explained. Finding it more likely than not that his fiduciary duties limited Larson's ability to cancel the life-insurance policies, the court concluded that the cash-surrender values of the life-insurance policies should not be included in Levine's estate under IRC Section 2036(a)(2).
Finally, the court rejected the Service's assertion that the special valuation rules under IRC Section 2703 applied to the split-dollar arrangement at issue. When Levine entered into the split-dollar arrangement, the IRS contended, she effectively restricted her right to control the $6.5m and the insurance policies, and this restriction on her right to access the $6.5m "is what should be disregarded when determining the value of the property under section 2703(a)(2)." Levine's estate argued that IRC Section 2703 only applied to property Levine owned when she died, and the court agreed.
The key to the estate's successful defense of the non-inclusion of the cash-surrender values of the life-insurance policies at Levine's death was that she did not have the power under the split-dollar arrangement, solely or in conjunction with others, to terminate the arrangement. Only the Insurance Trust had that power and Levine was not a trustee of this trust. In Cahill and Morrissette , the decedent held the power in conjunction with others, triggering the application of IRC Sections 2036(a)(2) and 2038. In Morrissette, the estate ultimately prevailed because the Tax Court determined that the bona-fide sale exception to IRC Sections 2036 and 2038 applied. Cahill involved a motion for summary judgement on the estate's arguments that IRC Sections 2036, 2038 and 2703 did not apply to the split-dollar arrangement, which the Tax Court denied (therefore, further proceedings will determine if the estate ultimately prevails). Levine provides an example of how to structure split-dollar arrangements to avoid IRC Sections 2036 and 2038 altogether — and not have to rely on the bona-fide exception to avoid estate tax inclusion of the cash-surrender values.
The IRS also raised the IRC Section 2703 issue in Morrissette and Cahill. In Morrissette, the Tax Court determined that the exception to the application of IRC Section 2703 was met under the facts of the case and, therefore, IRC Section 2703 did not apply. In Cahill, the Tax Court denied the estate's motion for summary judgement on the issue. In Levine, the Tax Court determined that it was not an issue because she did not own the life insurance policies at her death (because she had not retained an interest in the life-insurance policies via IRC Sections 2036 of 2038).
The Tax Court has questioned the strength of fiduciary duties in the context of family arrangements — distinguishing these arrangements from those at issue in the Supreme Court's holding in Byrum (respecting fiduciary duties that a majority owner of stock owes to its minority owners). This is especially true in the context of family limited partnerships and the fiduciary duties that a general partner (usually held by senior family members) has to its limited partners (usually junior family members). In Levine, the court suggests that if the fiduciary duties held by the fiduciary are "non-conflicting" (i.e., where the duties held in one fiduciary capacity would not require the fiduciary to act against his or her duties as a fiduciary in another capacity), they are not "illusory" and should be respected. Although Levine did not involve a family limited partnership, the opinion's discussion on fiduciary duties from an IRC Section 2036(a)(2) perspective may be a positive development for the evaluation of family limited partnerships.
Estate of Marion Levine, et al. v. Commissioner