An adage in the life insurance business has it that clients have no objection to life insurance, but they often have trouble finding the dollars to pay for it.

Through the years, planners have devised a number of innovative methods to help clients pay for their life insurance premiums. In this regard, private (aka "family") split dollar needs to be on the short list of every planner who considers him or herself sophisticated.

In this LISI, veteran commentator Howard Zaritsky provides subscribers with a timely discussion of a recent private ruling involving a post-final regulation, family split dollar arrangement.

Howard, author of Tax Planning With Life Insurance: Analysis and Forms: 2nd Edition, is well-known to LISI members. He has been a lecturer at major tax and estate planning institutes, including the New York University Institute on Federal Taxation and the University of Miami (Heckerling) Estate Planning Institute where he is a member of the advisory committee. He is the author or co-author of numerous articles and treatises, including Generation-Skipping Transfer Taxes: Analysis and Forms (with C. Harrington & L. Plainer); Structuring Buy-Sell Agreements (2d end); Structuring Estate Freezes After Chapter 14 (3d ed.) (with R. Alcott); Federal Income Taxation of Estates and Trusts (2d ed.) (with N. Lane); Tax Planning for Family Wealth Transfers (3d ed.); [all published by RIA Group].

EXECUTIVE SUMMARY:

In Private Letter Ruling 200910002, the IRS took the position that payments by the grantors of an irrevocable life insurance trust of part of the premiums on a second-to-die policy held by the trustee were not taxable gifts because of a family split dollar arrangement between the grantors and the trust. The Service also found that the grantors held no incidents of ownership over the trust's policy.

FACTS:

THE TRUST

Harry and Wanda, a married couple, created an irrevocable life insurance trust for their descendants, other than their children.  The trust required the trustee to distribute income annually to a class of beneficiaries consisting of the grantors' living issue excluding their children.

Each income beneficiary also had Crummy power – a non-cumulative power to withdraw their share of any contributions to the trust. The trustee also could distribute corpus to a member of the class to provide for the beneficiary's health, education, support, and maintenance.

If a member of the class died survived by issue, the surviving issue would become members of the class. The trust was to continue until the death of the later to die of Harry and Wanda or, if later, when the number of class members equaled 40.

The trust would terminate earlier if needed to avoid the application of the rule against perpetuities. Upon termination, the trustee would divide the trust fund into as many equal shares as there were then-living children of the grantors and deceased children who left issue then surviving.

Each share created on account of a living or deceased child would then be re-divided into as many equal shares as there were then living children of the child and deceased grandchildren who left issue then surviving.

Each share created for a grandchild that is age 35 at termination would be distributed outright. If a grandchild was not age 35, then the share would continue in trust for the grandchild.  If a deceased grandchild was survived by issue, then the grandchild's share was to be distributed outright, per stirpes.

Neither H nor W could be a trustee, and neither had any powers over the trust.

THE INSURANCE POLICY

The trust bought a second-to-die life insurance policy on the lives of Harry and Wanda.

THE SPLIT DOLLAR ARRANGEMENT

Harry, Wanda and the trustee proposed to enter into a split-dollar life insurance agreement. Under the terms of that agreement, the trust will continue to own the policy and will pay during the joint lives of Harry and Wanda, the value of the current life insurance protection, determined for this purpose as the insurance company's current published premium rate for annually renewable term insurance generally available for standard risks.

After the death of the first to die of Harry and Wanda, the trust's payments under the policy will be the lesser of:

1)       the applicable amount provided in Notice 2001-10, 2001-1 C.B. 549, or subsequent IRS guidance, or

2)       the insurer's current published premium rate for annually renewable term insurance generally available for standard risks.

Harry and Wanda would pay the balance of the premiums.

The trust will collaterally assign to Harry and Wanda the following rights:

1)       if the split-dollar agreement terminates on the death of the survivor of Harry and Wanda, survivor's estate would have the right to receive the greater of the cash surrender value of the policy or the cumulative premiums paid by Harry and Wanda; and

2)       if the agreement ends during the lifetime of Harry and Wanda, or the survivor, then within 60 days of termination, Harry and Wanda (or the survivor) will have the right to receive from the trust an amount equal to the greater of (a) the cash surrender value of the policy, or (b) the premiums paid by Harry and Wanda, to the extent that the trust had other assets sufficient to pay such amounts.

All incidents of ownership over the policy (including the sole right to surrender or cancel the policy, and the sole right to borrow or withdraw against the policy) would be vested in the trustees and not in H or W.

IRS BLESSES THE AGREEMENT

The IRS stated that the payments by Harry and Wanda of the premiums will not result in a taxable gift to the trust and that the life insurance proceeds payable to the trust will not be includible in either spouse's gross estate under Section 2042.

GIFT TAX TREATMENT

The IRS stated that the agreement is a split-dollar arrangement, under Treas. Rags. § 1.61-22(b)(1), and that it is taxed under the economic benefit rules, rather than the loan rules, because the arrangement is:

1)       entered into between a donor and a done (rather than an employer and employee); and

2)       the donor owns the life insurance contract.

The IRS also stated that Harry and Wanda would be treated as the owners of policy, because under the terms of the agreement, the only economic benefit that would be provided to them is current life insurance protection.  The trust would pay the portion of the premium equal to the cost of current life insurance protection and Harry and Wanda would pay the balance of the premium.

The IRS concluded that Harry and Wanda would be treated as making a gift to the trust if and to the extent that some or all of the cash surrender value was used (either directly, or indirectly through loans) to fund the trust's obligation to pay premiums.

Otherwise, their payments under the agreement of the excess of the premiums over the economic value of the current insurance protection, would not be a taxable gift to the trust or its beneficiaries.

ESTATE TAX TREATMENT

The IRS also stated that neither Harry nor Wanda retained any incidents of ownership over the policy.  Therefore, the only portion of the proceeds that would be included in Harry or Wanda's gross estates would be the amount actually payable to the estate of the survivor.  That amount would be includible as an amount receivable by an executor, under Section 2042(1).

COMMENT:

One of the most difficult aspects of the use of an irrevocable life insurance trust is providing the trustee with sufficient funds to pay the insurance premiums, without incurring significant gift tax liabilities.  Donors can always include Crummy powers in the trust instrument, to take full advantage of the gift tax annual exclusion to fund the trust, but this also often requires the allocation of GST exemption to prevent future GST taxes, and even then the trustee may not have enough money to pay the premiums.

The best solution to this problem is often a family or private split-dollar life insurance arrangement, under which the insured grantors pay all or part of the premiums, but are assigned the right to recover their premium payments from the policy cash values or death benefits.  When done correctly, this arrangement can permit the grantors to pay premiums without incurring a current gift tax liability.

Of course, the downside of this transaction is that the techniques by which the grantor assures that their payments will be returned can sometimes constitute an incident of ownership over the policy and cause the trust assets to be included in the grantors' gross estates.  The collateral assignment approach used in this private ruling avoided this potential problem, and made it possible for the grantors to fund the premium payments without incurring gift tax liabilities.

The Service has been relatively generous when dealing with both pre-and-post final regulation private/family split dollar arrangements. The proposed split-dollar arrangement in this PLR, like the one at issue in PLR 200825011 (See LISI Estate Planning Newsletter #1323), was entered into after the effective date of the final regulations. The arrangements in PLRs 200848002 (See LISI Estate Planning Email Newsletter #1382) and 200822003 were entered into before the effective date of the final regulations, and received what many consider to be relatively favorable tax results.

Before – or After – the final regulations – split dollar – if arranged, executed, and operated properly – is alive and well!

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE.

Howard Zaritsky

CITE AS:

LISI Estate Planning Newsletter # 1429  (March 9, 2009) at http://www.leimbergservices.com   Copyright 2009 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITES

PLR 200910002; PLR 200825011; Rags. §§ Treas. Rags. §§ 1.61-22(b)(1), 1.61-22(b)(3)(ii)(B); 1.61-22(c)(1)(ii)(A)(2)); 1.61-22(d)(1); 1.61-22(d)(2); 1.61-22(d)(3)(i); 1.61-22(d)(3)(ii); 1.61-22(d)(4)(ii); 20.2042-1(c)(2); Rev. Rul. 79-129, 1979-1 C.B. 306; Notice 2001-10, 2001-1 C.B. 549; Zaritsky and Leimberg, Tax Planning With Life Insurance: Analysis and Forms: 2^nd Edition¶ 3.03[9][b][iv] (Thomson-Reuters).