Some advisors are combining PSD valuation methods in the clients’ plans, then establishing an irrevocable life insurance trust to purchase a survivorship policy. (Photo: iStock)

Most clients’ estates will fall well within the current million federal tax exemption. Consequently, private split-dollar (PSD) life insurance plans have lost some of their appeal as an intergenerational wealth transfer method.

Doug Peete, ChFC and a Million Dollar Round Table member with Douglas R. Peete & Associates in Overland Park, Kansas, says PSD and other gift-leveraging techniques are still valuable planning strategies but generally only for ultrawealthy clients. “The vast majority of our clients are going ahead and just making gifts against their exemption equivalent because their law firms feel that’s a better method of doing it,” he says.

Tax regulations allow PSD to use either an “economic benefit regime” or a “loan regime” to determine applicable income taxes. Under the economic benefit regime, gift taxes on premiums paid are based on the value of the life insurance protection, which can be much lower than premium expenses. In loan regimes, premium payments are treated as loans. Under IRS regulations: “The repayment is to be made from, or is secured by, the policy’s death benefit proceeds, the policy’s cash surrender value, or both.”

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Peete shares an example of using PSD with second-to-die coverage with a wealthy couple who own a profitable business and want to take advantage of gift tax leverage. The husband is age 65, the wife is 60, and the life survivorship policy pays a $15 million benefit on the second death. He estimates the policy’s annual premium would be about $150,000, and the policy would be owned by an irrevocable trust to keep the proceeds out of the clients’ estates.

The business’s value is increasing, pushing the clients’ estate values higher, so the couple wants to transfer company stock to their children up to the allowable legal limits. Valuation discounts on the transferred stock provide gift leverage, as do the imputed gift amounts for the policy’s premiums, which are less than the annual premium expense under the economic benefit regime. “On a $15 million insurance contract, the imputed gift (for the premiums) is less than $2,000 a year based on the 2001 tables,” he explains. Instead of using up their annual gift tax exemption on the premium and filing a gift tax return, the lower imputed PSD gift lets the couple retain most of their annual exemptions for stock transfers.

Peter McCarthy, senior advanced marketing consultant with Voya Financial’s insurance solutions business says that some advisors are combining PSD valuation methods in the clients’ plans. He cites clients establishing an irrevocable life insurance trust to purchase a survivorship policy. While both spouses are alive, they pay the premiums through an economic benefit regime to keep gift taxes low. After the first spouse dies, however, the economic benefit cost will rise dramatically, he notes. To prevent this, the trustee terminates the economic benefit method and replaces it with the loan method. All premiums paid before the first spouse’s death are converted into a loan to the trust.

McCarthy reports that his group is seeing the loan method used more often because it’s easier to understand and less costly to implement. Interest rates are low, which has made clients more comfortable with the method, and “although the annual interest costs can’t be ignored, clients can choose among several viable strategies to handle them,” he said via email.

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Cautions

Private split-dollar arrangements are used often between generations, as well as when a parent funds the insurance premiums on an adult child’s policy. An April 23, 2016, court decision, Estate of Morrissette v. Commissioner, clarified the economic benefit regime’s use in intergenerational cases. The case involved Mrs. Morrissette’s revocable trust paying life insurance premiums to fund the cross-puchase buy-sell agreement implemented by her three sons, who co-owned the family business. Mrs. Morrissette’s trust funded the policies, which were held in dynasty trusts, with lump sum premiums totaling $29.9 million. The PSD agreement called for the aggregate premiums (or policy cash values, if greater) to be repaid to the revocable trust upon the insured sons’ deaths.

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Following Mrs. Morrissette’s death, her estate valued those premium repayment rights at roughly $7.5 million, a significant discount from the $29.9 million premiums paid.  The economic benefit method of accounting for the SDA is specifically allowed by the Regulations. Nevertheless, the IRS argued that the full $29.9 million premium advance was a gift, not just the discounted value.

J. Alan Jensen, partner with law firm Holland & Knight LLP in Portland, Oregon, says that his firm recently went through an IRS audit for an intergenerational case with similar facts to Morrissette, and the IRS contested the discount applied. He cautions that clients taking discounts under the economic benefits regime for intergenerational valuation discounts can still expect a challenge from the IRS.

“In our case we tried to argue what was argued in Morrissette and were dismissed out of hand,” he says.  “The Service acknowledged that the economic benefit is a permitted exception to determine how annual benefit should be measured, and it was reflected in the ultimate settlement we got.  If you’ve got some agent pushing intergenerational private split-dollar insurance and the G1 (the first generation, i.e., the premium payer) is on their deathbed, you’re probably going to lose.  It will not be recognized because there is no business purpose here.”

“When you get into intergenerational and you structure it as you can under the economic benefit, you necessarily are factoring in a huge discount because you’re dealing with the measuring life being much younger,” he adds. “And, so, in that setting, you’d better have a business purpose… The old saw of diversification of assets, protection of liquidity amounts and so forth, you’ve got to do better than that.”

Looking Ahead

Although leveraged gift tax strategies are currently less applicable, Peete suggests that advisors be prepared for their possible return to favor.

“It’s no secret that with this election coming up, one candidate is wanting to repeal the estate tax; the other candidate wants to bring back the more punitive estate tax,” he says. “Now, if that’s the case, I would just say stand by because if you want to defend your property and keep your business in your family, you’re going to have to do some things like this. So, it could be extremely relevant this time next year.”

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