Summary Judgment Denied in Tax Court Case Involving Split Dollar Life Insurance Arrangements

(Parker Tax Publishing July 2018)

The Tax Court denied an estate's motion for partial summary judgment in a case where the estate argued that the cash surrender value of three split dollar life insurance arrangements should not be included in the decedent's gross estate. The court concluded that the decedent retained rights in the arrangements and that the transfers of the three split dollar life insurance agreements were not bona fide and were not for full and adequate consideration. Estate of Cahill v. Comm'r, T.C. Memo. 2018-84.

Background

Richard Cahill died in December 2011. Cahill was the settlor of the Richard F. Cahill Survivor Trust (Survivor Trust), a revocable trust of which Richard Cahill's son, Patrick, was the trustee and attorney in fact. Richard Cahill was also the settlor of an irrevocable trust, the Morrison Brown Trust (MB Trust). Patrick Cahill created MB Trust as Richard Cahill's attorney in fact in September 2010, when Richard Cahill was age 90 and unable to manage his affairs. Patrick Cahill's cousin, William Cahill, was the trustee of MB Trust and the beneficiaries were Patrick Cahill and his issue. MB Trust was formed to take legal ownership of three life insurance policies, one for Patrick Cahill and two for his wife, Shannon. The premiums on the three insurance policies totaled $10 million. Each policy guaranteed an investment return on the premiums of at least 3 percent.

To fund the policies, three split dollar agreements were executed by Patrick Cahill as trustee of Survivor Trust and William Cahill as trustee of MB Trust. Survivor Trust funded the premiums, paid in lump sums, using a $10 million loan from Northern Trust, N.A., with Richard and Patrick Cahill as the obligors. The loan had a five year term and a variable interest rate. No principal payments were required during the life of the loan.

Through Survivor Trust, Richard Cahill received death benefit rights and termination rights under the split dollar agreements. On the death of the insured, Richard Cahill was entitled to the greatest of (1) any remaining balance on the loan relating to the relevant policy, (2) the total premiums paid on that policy, or (3) the policy's cash surrender value. MB Trust would retain any excess of the death benefit over the amount paid to Survivor Trust. Richard Cahill also had right to terminate the agreements in conjunction with the trustee of MB Trust. On termination, MB Trust could opt to retain the policy, in which case Richard Cahill would receive the greater of the premiums paid or the cash surrender value. If MB Trust declined to retain the policy, it would be transferred to Northern Trust to satisfy Richard Cahill's loan liability. In 2010, Richard Cahill reported gifts to MB Trust of approximately $7,500 as determined under the economic benefit rules in Reg. Sec. 1.61-22.

As of the date of Richard Cahill's death, the aggregate cash surrender value of the insurance policies was approximately $9.6 million. Cahill's estate tax return reported the value of Cahill's interests in the split dollar agreements as $183,700. The estate contended that (1) because Cahill's right to terminate was held in conjunction with the trustee of MB Trust, and (2) because it would never make economic sense for MB Trust to allow termination, the termination rights had no value. The estate therefore argued that the value of the split dollar agreements was limited to the death benefit rights, which the estate said were worth relatively little given that Patrick and Shannon Cahill were projected to live for many years.

The IRS issued a notice of deficiency adjusting the total value of the rights in the split dollar agreements from $183,700 to $9.6 million, the aggregate cash surrender value. In support of this adjustment, the IRS presented alternative theories applying Code Sec. 2036(a)(2), Code Sec. 2038(a)(1), and Code Sec. 2703(a)(1) and (2). The notice determined a deficiency of approximately $6.2 million and imposed a gross valuation misstatement penalty. The estate challenged the notice in the Tax Court and sought a partial summary judgment that Code Secs. 2036, 2038, and 2703 were inapplicable and that Reg. Sec. 1.61-22 applied in valuing Cahill's interests in the arrangements.

Analysis

The estate tax applies to the transfer of a decedent's taxable estate. The taxable estate consists of the value of the gross estate after deductions. The gross estate includes the fair market value of the property owned by the decedent on the date of death, or included in the estate under the Code.

Code Sec. 2036 includes the value of property in the gross estate if it was transferred before death but the decedent retained the right to designate who will possess or receive income from the property. Code Sec. 2038 similarly provides that a decedent's estate includes transferred property if the decedent kept the power to alter or terminate the transferee's enjoyment of the property. An exception applies to Code Secs. 2036 and 2038 for bona fide transfers for adequate and full consideration. Code Sec. 2703 disregards, in calculating the value of an estate, certain rights to acquire or use property for less than fair market value and restrictions on the right to sell or use the property.

Reg. Sec. 1.61-22 provides rules for split-dollar life insurance arrangements for purposes of income, gift, and employment taxes. A split dollar insurance arrangement is any arrangement between an owner and a nonowner of a life insurance contract, where either party pays a portion of the premiums and at least one of the parties is entitled to recover some or all of the premiums from the insurance proceeds. Split dollar arrangements are taxed under either an economic benefit regime or a loan regime. Under the economic benefit regime, if the only economic benefit provided to the donee is current life insurance protection, then the donor is deemed the owner, irrespective of formal policy ownership. The cost of current life insurance protection is then treated as a transfer each year from the donor/owner to the donee/nonowner.

Cahill's estate asked for summary judgment that Code Secs. 2036 and 2038 did not apply to include the cash surrender value in the gross estate. The estate argued that Richard Cahill's termination rights were valueless because MB Trust could prevent him from terminating the split dollar agreements. The estate asserted that the $10 million transfer was bona fide and for adequate and full consideration. Patrick Cahill argued that his father would have wanted to ensure sufficient liquidity for his grandchildren when Patrick and Shannon died. The estate further contended that Code Sec. 2703 did not apply to the split dollar arrangements because the arrangements were similar to promissory notes and partnership interests, to which Code Sec. 2703 was inapplicable.

The estate argued that the difference between the $10 million Richard Cahill paid and the $183,700 that he allegedly received in return should be accounted for as gifts, and that to count the difference as part of the estate would essentially double count that amount. The estate therefore asked that the application of Code Secs. 2036, 2038 and 2703 be modified so as to avoid inconsistency with Reg. Sec. 1.61-22.

The IRS argued that the transactions were not bona fide sales because Patrick Cahill stood on both sides of the transactions. The IRS also questioned whether what MB Trust gave, if anything, constituted adequate and full consideration. Alternatively, the IRS argued that under Code Sec. 2703, MB Trust's ability to veto the termination of the agreements should be disregarded, and that the agreements should be valued as if Richard Cahill had been able to unilaterally terminate them. With respect to Reg. Sec. 1.61-22, the IRS argued that the regulation did not apply for estate tax purposes.

The Tax Court denied the estate's motion for summary judgment. First, the court found that Code Secs. 2036 and 2038 applied because Richard Cahill's right to terminate and recover at least the cash surrender value was clearly a right, held in conjunction with MB Trust, both to designate the persons who would possess or enjoy the transferred property and to alter or terminate the transfer. The court also found that the bona fide sale exception did not apply because the value of what Richard Cahill received was not even close to what he paid. The court noted that by the estate's own theory, the $10 million transfer could not have been in exchange for property worth that amount because the rights received in return were worth only $183,700.

The Tax Court found that summary judgment on Code Sec. 2703 was also inappropriate because the provisions in the split dollar agreements preventing Richard Cahill from immediately withdrawing his investment were agreements to acquire or use property at a price less than fair market value. The court reasoned that MB Trust paid nothing and received death benefit rights which the estate appeared to argue were worth at least the cash surrender value ($9.6 million) minus the value of Richard Cahill's death benefit rights ($183,700). The split dollar arrangements also clearly restricted Richard Cahill's right to terminate and withdraw his investment under Code Sec. 2703(a)(2). The court also rejected the estate's argument that the arrangements were like promissory notes or partnership interests.

The court was unconvinced that the difference between the $10 million paid and the $183,700 Cahill allegedly received in return would be double counted in the estate and as gifts. Cahill did not report any of that amount as a gift to MB Trust, and the parties agreed nothing other than the cost of current life insurance protection was a gift under Reg. Sec. 1.61-22. The cost of current life insurance was deducted from the cash surrender value of each policy, and the cash surrender value remaining as of Cahill's death was therefore composed of funds that had not yet been used to pay for the insurance. Accordingly, the court found that no part of the cash surrender value was a gift, and counting the difference in the gross estate would not double count any amount.

While the Tax Court acknowledged that Reg. Sec. 1.61-22 did not apply for estate tax purposes, it found the regulation relevant because the gift and estate tax provisions had to be construed together. The court found no inconsistency because none of the cash surrender value was treated as a gift, and if any of the cash surrender value might be treated as gifts after the estate was distributed to Richard Cahill's heirs, those gifts would not be attributable to Richard Cahill. The court concluded that because Cahill was clearly the owner of the cash surrender value under the economic benefit regime, consistency between the regulations and estate tax Code sections required including that value in the gross estate.

For a discussion of inclusions in a gross estate of transfers with a retained life interest, see Parker Tax ¶225,510. For a discussion of inclusion of revocable transfers in a gross estate, see Parker Tax ¶225,910. For a discussion of the valuation of property subject to restrictive arrangements, see Parker Tax ¶223,530.

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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