If you’re looking for a hot new technique to pitch to your affluent clientele, here’s one to consider: the intergenerational private split-dollar arrangement. If it passes muster with the IRS and, ultimately, the courts, the technique could yield a substantial discount on the value of a life insurance policy placed in trust for the benefit of future generations.
The big question is “if.” During a general session of LIMRA International’s 2008 Advanced Sales Forum here, Donald Jansen, an attorney and now retired partner of Fulbright & Jaworski L.L.P., Houston, Tex., warned attendees the IRS could potentially disqualify the arrangement–and impose a stiff tax penalty–using any of several arguments.
“Some advanced sales professionals are now marketing this technique, but we don’t know if it’s a slam dunk,” said Jansen. “There are no court or IRS rulings to guide us. So you have to be prepared for the possibility that you might lose.”
In a typical intergenerational split-dollar arrangement, said Jansen, a grandparent establishes an irrevocable life insurance trust, the trustee for which buys a permanent life policy and names the grandparent’s child and grandchildren as the insured and beneficiaries, respectively. The grandparent pays the premiums and, some years later, transfers the cash value to the ILIT through a sale, gift or a testamentary bequest at a greatly discounted value. Result: Gift, estate and generation-skipping transfer taxes are minimized.
How might a discount be secured? Jansen said the keys lay in structuring the split-dollar contract as an economic benefit regime (as opposed to a loan regime) arrangement, and in restricting access to the cash value.
Jansen said a split-dollar contract in which the policy owner (in this case the ILIT) is not also the premium payor would normally be labeled a loan regime that regards the premium payments as a below-market interest loan, to be repaid using the applicable federal interest rate or AFR. But he noted that his example may qualify as a non-equity split-dollar exception because the premium payor, the grandparent, controls all of the economic benefits of the policy, including the cash value, except for the pure insurance coverage (i.e., the non-cash value component of the death benefit). Hence, the economic benefit regime applies.
As to restrictions, he said, the split-dollar policy prohibits the grandparent from accessing the cash value before the arrangement’s termination; and it precludes the grandparent from unilaterally terminating the contract. Only the trust, acting alone or by agreement with the grandparent, can end the arrangement.
Upshot: The cash value transfer is considered a term premium gift, for which the ILIT must reimburse the grandparent. And because of the insured child’s typically young age and long life expectancy, the transfer could qualify for a substantial discount.
“The argument for this technique is that restrictions on the grandparent’s access to the cash value are so severe that they qualify the transfer at the date of sale, gift or bequest for a discount,” said Jansen. “And most proponents agree that [a determination of the discount] requires projecting the cash value at the child’s life expectancy, then reducing the present value of the cash value by subtracting the present value of the term premiums. Of the illustrations I’ve seen, this discounted value is a small fraction of the policy’s actual value.”
The IRS, added Jansen, could potentially disqualify the discount by arguing that the technique: (1) does not qualify as a loan regime exception; that the (2) cash value restrictions should be ignored for gift, estate and GST valuation under IRC Section 2703; (3) is subject to a “step transaction doctrine” that views the multiple steps leading to the transfer as so interrelated as to constitute a single step intended to effect a gift; or (4) should be considered a non-equity split-dollar modification policy transfer.
Of these 4 lines of attack, said Jansen, the first 3 are the weaker ones in the IRS’ arsenal. Among other points, he observed a client could argue the contract restrictions do not yield a benefit to the trust–a discount killer–noting that similar non-equity private split-dollar arrangements the IRS had previously approved would be endangered by a ruling against the current scenario.
Citing prior court decisions, he also contended the discount split-dollar arrangement might qualify for a “safe harbor” exception to IRC Section 2703; and that the step transaction doctrine doesn’t apply to arrangements involving the risk of loss between the first and final steps–a risk that may exist for discount split-dollar arrangements funded with a variable life policy.
Turning to the IRS’s “strongest argument,” Jansen said the IRS might disqualify the discount by arguing the grandparent modifies the arrangement by transferring the policy to the trust, thereby merging in the trust all the contract’s economic benefits–the pure death benefit and the cash value. To prevail in court, he added, a client would have to argue the transfer is actually a termination of the arrangement, rather than a modification.
“The bottom line is that advisors need to know about, and explain to the client, all of the potential pitfalls and risks in moving forward with this technique,” said Jansen. “The tax consequences and litigation costs resulting from a loss to the IRS in court could be significant. But if the discount can be worked out, the transfer can also be very substantial.”