For high net worth and ultrahigh

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1 Understand Split-Dollar and Generational Split-Dollar Plans Split-dollar life insurance arrangements meet various wealth transfer needs of high net worth families. ROBERT W. FINNEGAN For high net worth and ultrahigh net worth clients, private split-dollar 1 is the most effective way to fund large dynasty trust-owned permanent life insurance policies. Generational splitdollar (GSD) also referred to as inter-generational split-dollar is a funding strategy where a senior generation, typically a parent of the insured, rather than the insured funds trust-owned life insurance. Although GSD is not new, with the recent Estate of Morrissette 2 case and the widescale promotion of aggressive GSD plans, GSD has entered the mainstream. Carrier underwriting guidelines and the Morrissette case make clear that it is essential (1) to establish a valid need for the life insurance and (2) that the plan strictly adheres to the split-dollar regulations. This article addresses the design, implementation, and administration of GSD plans where the insurance on the junior generation s life is purchased to meet a valid and longterm need. ROBERT W. FINNEGAN, J.D., CLU, is the senior vice president, advanced planning attorney at Highland Capital Brokerage. In this capacity, he provides advanced planning solutions for high net worth and ultra-high net worth clients. Copyright 2017, Robert W. Finnegan. 3 GSD framework GSD operates as follows: Parent (G1) creates a dynasty trust that is also a defective grantor trust with respect to G1 for the benefit of grandchildren and subsequent generations ( G3+ ). The trust purchases a substantial life insurance policy on the life of a child or children 3 (G2). Unlike the typical plan where the insured (G2) is the premium payer, G1 makes substantial upfront payments to the trust to fully fund the policy pursuant to a split-dollar agreement and holds a splitdollar receivable based on the premiums advanced or loaned to the trust. During G1 s lifetime or upon his or her death, G1 transfers the receivable to a second dynasty trust. Because the receivable will not be repaid until the death of G2 (actuarially, a long time in the future), the fair market value of the receivable can be substantially lower than its face value. At the outset, it is important to recognize that nothing is inherently aggressive about GSD. Recently, however designs based on extremely low valuations 4 have brought GSD squarely into the sights of the IRS, raising the following key questions: 1. Why recommend a plan that is almost certain to invite IRS scrutiny? 2. Is there a way to design, present, and administer GSD plans that take advantage of its

2 4 many benefits while minimizing the risks of IRS attacks? In answer to the first question, having G1 fund the policy frequently is advantageous. GSD acts as an estate freeze with respect to G1 s estate because the death benefit in excess of the receivable accrues to the dynasty trust. In answer to the second question, in evaluating the merits of a GSD plan, it is recommended to use the full value of the receivable, not a lower assumed valuation. If the plan has merit on the basis of the full value of the receivable, the perceived success of the plan will not be dependent on a lower value. Nevertheless, the plan should be designed to minimize value, so that in the future when the receivable is transferred, all options remain on the table. The typical private split-dollar agreement is between the insured/ grantor and a dynasty trust that is also a defective grantor trust established for the benefit of children and subsequent generations ( Trust ). Split-dollar plans can be designed under one of two regimes, the economic benefit regime 5 or loan regime. 6 Economic benefit regime split-dollar Under the economic benefit regime, the Trust is the sole owner and beneficiary of the policy. The Trust pays a portion of each premium 1 Private split-dollar is used here as a generic term referring to an economic benefit or loan regime split-dollar plan between an individual and an irrevocable trust, although the phrase is sometimes used to refer specifically to economic benefit regime split-dollar TC 171 (2016). 3 In some GSD designs, the life insurance is purchased on the lives of grandchildren. 4 Aggressive GSD plans, which typically involve extremely low valuations and early surrenders, are not the subject of this article. 5 Economic benefit regime split-dollar plans are governed by Reg Loan regime split-dollar plans are governed by Reg CB 398. Notice provides that in order for alternate term rates to qualify, equal to the one-year term cost (sometimes referred to as the economic benefit cost or EBC), and the grantor pays the balance of the premium. To the extent that the Trust does not pay the EBC, it is treated as an imputed gift to the Trust. The EBC may be reported based on the carrier s alternate one-year term rates if they meet the published and regularly sold requirements of Notice , 7 or based on the substantially higher Table 2001 rates (the IRS term rates). (See Exhibit 2 below.) One of the attractions of GSD is the potential to obtain a favorable gift or estate tax valuation when G1 s receivable is transferred. The imputed gift must be sheltered from the gift and GST taxes. 8 The Trust executes a restricted collateral assignment 9 in favor of the grantor (G1 in the case of GSD) equal to the greater of the policy cash value or the grantor s cumulative premium advances (the receivable ). The receivable is repaid upon the insured s death or upon the surrender of the policy. If the only economic benefit available to the trust is the current life insurance protection, a special rule (i) the insurer generally makes the availability of such rates known to persons who apply for term insurance coverage from the insurer, and (ii) the insurer regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurer s normal distribution channels. The phrase regularly sells is not defined. 8 An imputed gift does not qualify as a present interest gift and so a portion of lifetime gift and GST exemptions must be used to shelter it. 9 A restricted collateral assignment merely secures the insured s (or G1 s in the case of GSD) receivable equal to the greater of cumulative premium advances or cash surrender value. The assignee cannot access policy values or otherwise exercise or hold any incidents of ownership in the policy under Section allows collateral assignment economic benefit regime split-dollar between the grantor and an irrevocable trust. 10 In that case, for purposes of the regulations the grantor is treated as the owner and the trust as the non-owner, which becomes important relative to the transfer and valuation of the receivable discussed below. Income tax consequences. The policy should be designed to avoid classification as a modified endowment contract (MEC), 11 because the assignment of a MEC may be treated as a distribution 12 that is taxable to the extent of gain in the policy. This should not be an issue so long as the trust is defective with respect to G1 or as long as the policy cash value is less than G1 s cost basis. In the event that the trust and grantor (or the holder of the receivable) are separate taxpayers, the EBC paid by the trust to the grantor (or the holder of the receivable) is included in gross income. 13 As long as the trust is defective with respect to the grantor (or the holder of the receivable is defective with respect to the grantor) or as long as the imputed gift methodology is used, there should be no taxable income. Economic benefit regime GSD example. G1 is 80 years old; his son (G2), is age 50 and qualifies for preferred non-tobacco rates. Based on G1 s premium advances of $4 million per 10 In other words, the trust may not have any interest in the policy cash values. Reg (c)(1)(ii)(A)(2). 11 Section 7702A was implemented to discourage the purchase of single premium and short-pay life insurance policies. If a life insurance policy fails the seven-pay test of Section 7702A(b), it is classified as an MEC. Any distribution from a MEC is taxable to the extent that there is gain in the contract (policy cash value in excess of cost basis). This reverses the usual rule of the tax-free surrender of cash value to the extent of basis and tax-deferred policy loans. A 10% penalty may also apply. Section Section 72(e)(4)(A)(ii). Although it is not clear that this Section is directed at a split-dollar assignment, best practice suggests assuming that it does apply, and MECs should be avoided. E S T A T E P L A N N I N G A U G U S T V O L 4 4 / N O 8

3 5 EXHIBIT 1 Economic Benefit Regime GSD Example (A) (B) (C) (D) (E) (F) (G) (H) Insured (G2) Insured's Parent (G1) Split $ Death Dynasty Trust Imputed Gifts - Carrier Rates Year Age Premium Receivable Benefit on G2 Per $1,000 Gift ,000,000 4,000,000 72,000, , ,000,000 8,000,000 68,000, , ,000,000 12,000,000 64,000, , ,000,000 16,000,000 60,000, , ,000,000 60,000, , , ,000,000 60,000, , ,000,000 60,000, , ,000,000 60,000, , ,000,000 60,000, , ,000,000 60,000, , , ,000,000 60,000, ,800 1,196, ,000,000 60,000, ,200 2,030, ,000,000 60,000, ,400 3,433, ,000,000 60,000, ,208 5,814,928 EXHIBIT 2 Imputed Gift Comparison (A) (B) (C) (D) (E) (F) (G) (H) (I) Insured Trust (G2) Death Carrier Rates Table 2001 Rates Year Age Benefit Per $1,000 Gift Per $1,000 Gift ,000, , , ,000, , , ,000, , , ,000, , , ,000, , , , , ,000, , , ,000, , , ,000, , , ,000, , , ,000, , , ,600 2,472,800 year for four-years ($16 million total), the trust can purchase $76 million of fully guaranteed coverage insuring G2 s life. Upon G2 s death, G1 is entitled to receive the greater of the policy cash value or the premiums advanced (G1 s receivable). Because the policy is a fully guaranteed universal life contract, it has little or no cash value, so the receivable is equal to the $16 million premiums advanced. If G2 dies in year 1, G1 would be reimbursed the $4 million from the policy death benefit, while the trust would receive the balance or $72 million. The imputed gift to the trust in year 1 is $51,840 ($72 million 72 cents / $1,000 of death benefit). This amount must be sheltered from the gift and GST taxes. If the trust pays the portion of the premium equal to the EBC, then there is no gift or GST transfer, and G1 s share of premium as well as G1 s receivable would be reduced by that amount. Each year, the one- A U G U S T V O L 4 4 / N O 8 S P L I T - D O L L A R I N S U R A N C E

4 6 year term cost increases. The annual EBC based on one carrier s oneyear term rates in years 1 through 10 and cumulative EBCs in years 5 and 10 are illustrated in Exhibit 1. Some uncertainties with economic benefit regime GSD plans can be mitigated with the use of existing funded dynasty trusts or prefunding the trusts. Table 2001 versus carrier s alternate term rates. As illustrated in Exhibit 2, the difference between the imputed gifts based on the carrier s alternate term rates and the Table 2001 rates are substantial. Although most insurance carriers take the position that their rates meet the published and regularly sold requirements of Notice , no carrier will provide a firm written opinion to that effect. As a result, there is some risk in using the carrier s rates to measure the value of the imputed gift. This risk could be eliminated by simply using the Table 2001 rates. This would, however, significantly increase imputed gift and the gift and GST transfer costs of the plan. In the GSD context, although G1 is not the insured, it is still recommended to use a restricted collateral assignment, just in case the receivable is subsequently transferred to a trust of which the insured is a trustee or over which the insured holds a general or special power of appointment. 14 Also with GSD, the grantor (G1) should not hold the unilateral right to surrender the policy. If the grantor held the right to surrender the policy or terminate the agreement, the ability to obtain a low value of the receivable would be compromised. Estate of Morrissette 15 Upon G1 s death or upon transfer of the receivable during G1 s lifetime, a low value may be proposed reflecting the fact that the receivable is not expected to be repaid until G2 s death. In the Morrissette case, in 2006 the client s revocable trust advanced $30 million 16 to fund life insurance (for a buy-sell) on the lives of her three sons owned by dynasty trusts for the benefit of grandchildren and future generations. The insurance was funded with an economic benefit regime split-dollar plan, and Mrs. Morrissette s trust held a receivable equal to the $30 million advanced. From 2006 to 2009 the dynasty trusts paid a portion of the EBC based on the Table 2001 rates, and the difference was an imputed gift. Mrs. Morrissette died in The estate valued her receivable at $7.5 million, 25% of its face value. The IRS asserted that the entire $30 million was a gift at inception of the policy and issued a deficiency notice to the estate equal to $13.8 million in gift taxes and $2.76 million in penalties. The full Tax Court granted partial summary judgment in favor of the estate, holding that the agreements were in fact economic benefit regime split-dollar agreements and that the only benefit conferred on the trusts was the one-year term cost. In reaching its holding, the court noted two important facts: 1. The agreements adhered to the economic benefit regime rules and in fact exactly followed an example in the Preamble to the split-dollar final regulations The agreements served a valid nontax reason, providing for the continuation of the business in the event of the deaths of the sons. 18 It is important to note that the IRS did not acquiesce to the court s ruling, and the court did not address the valuation of the receiv- 13 Reg (f)(2)(ii). 14 In any irrevocable trust, it is always advisable to prohibit a trustee or the beneficiary who may hold a power of appointment from exercising any incidents of ownership in a policy insuring his or her own life. 15 See Slavutin and Harris, Intergenerational Split Dollar: What Can We Learn from Morrissette, Levine and Neff? LISI Estate Planning Newsletter #2443 (8/9/2016), and Slavutin, A Post-Morrissette Roadmap for Drafting Intergenerational Split Dollar Agreements, LISI Estate Planning Newsletter #2414 (5/12/2016). 16 Mrs. Morrissette advanced $29.9 million to the trusts, rounded here for the sake of simplicity to $30 million. 17 The split-dollar final regulations are applicable to agreements entered into after 9/17/ See Estate of Levine, Docket No (7/13/2016) relying on the Morrissette case, but where a valid need for the life insurance was not required. 19 The policy values in Morrissette case are being negotiated for a possible settlement with the Service. See Jensen and Berselli, Estate of Morrissette: Unfinished Business, LISI Estate Planning Newsletter #2418 (5/23/3016), for a discussion of the Section 2703 issue. 20 See Akers, Estate of Morrissette vs. Commissioner, 146 TC No. 11 (April 13, 2016), Bessemer Trust (July 2016), outlining possible IRS lines of attack. 21 Some commentators have suggested that G1 s receivable should only be transferred at G1 s death. See LISI Estate Planning Newsletter #2443 (8/9/2016). It is the author s opinion that this is not necessary. It is important that a lifetime transfer not be part of a prearranged plan and the closer the transfer is to plan inception, the more likely the IRS will take this position. 22 Reg (c)(3). 23 Reg (a) provides the general rules for valuing a life insurance contract. That value may be based on sales of comparable contracts. That section also provides that if the policy requires ongoing premium payments the value may be approximated with the interpolated terminal reserve (ITR) plus unearned premiums. 24 If the receivable is transferred to the second trust, that trust continues to generate imputed transfers to the original trust. As a trust-totrust transfer, the imputed transfer should not trigger income taxation, although it may have GST tax implications if the second trust is not GST tax exempt and the first is. Also, if the receivable is transferred to G1 s spouse under the unlimited marital deduction, then the spouse would be presumed to make ongoing gifts and GST transfers to the original trust. 25 The same beneficiaries and broad trust-totrust transfer provisions in both the original and the second trusts are recommended. E S T A T E P L A N N I N G A U G U S T V O L 4 4 / N O 8

5 7 able in Mrs. Morrissette s estate. 19 Although many cases will likely be settled, further GSD litigation can be expected. 20 Putting valuation of the receivable in perspective One of the attractions of GSD is the potential to obtain a favorable gift or estate tax valuation when G1 s receivable is transferred, an event that is typically five or more years after placement of the policy and inception of the GSD plan. 21 The valuation methodology that will be available at that time is uncertain. As a result and due to the heightened (read, certain) scrutiny by the IRS, GSD plans should be promoted and evaluated assuming the full or at least a higher value of the receivable. If the plan is evaluated assuming full value, not only are client expectations managed, but a number of GST issues discussed below are minimized by planning for the higher value in advance. In the above example, evaluating the plan assuming full value (where G1 advances $16 million of premiums), the plan has frozen a $16 million portion of G1 s estate and moved $60 million of income tax-free death benefit into a dynasty trust, based on an ongoing imputed gift cost. This strategy makes tremendous sense even assuming full value. Nevertheless, the plan should still be designed to take advantage of the most favorable valuation methodology available at the time the receivable is transferred. Transfer the receivable to a second dynasty trust The economic benefit regime splitdollar regulations 22 provide that a transfer of the entire policy takes place when the non-owner (the original trust) becomes the owner, i.e., when the receivable is transferred to the original trust. In that case, the fair market value is determined under Reg (a) 23 as the value of the entire policy. The value of the entire policy may be substantially higher than the value of the receivable, i.e., G1 s right to be repaid at some uncertain time in the future (the death of G2). Therefore in order to keep the door open for a more favorable valuation, the receivable should be transferred to a second trust. It is recommended that there be real substantive differences between the original and the second trust so that the IRS cannot make a substance-over-form argument, i.e., that the second trust is identical to the first and was created solely to result in a more favorable tax outcome. Because it may be desirable to merge the two trusts in the future, however, the beneficiaries should be the same but with different dispositive provisions, trustees, and other distinguishing features. Although there is no authority on point, after the receivable is transferred to a second trust, the split-dollar agreement remains in place, and the only logical position is that the receivable continues to generate imputed transfers of the EBC to the original trust from the second. The second trust should therefore also be a dynasty trust so that those imputed transfers are from one GST exempt trust to another. 24 This also suggests that the second trust should have clear trust-to-trust transfer provisions 25 so that the trustee is authorized to make the ongoing imputed distributions (which, as shown, can be quite substantial). Trust-to-trust transfer provisions would also allow for the merger of the split-dollar interests into a single GST exempt trust in the future (e.g., after the fair market value of the receivable has been finally A U G U S T V O L 4 4 / N O 8 S P L I T - D O L L A R I N S U R A N C E

6 8 EXHIBIT 3 Private Financing Example (A) (B) (C) (D) (E) (F) (G) (H) Initial Loan: $6,567,510 Dynasty Trust Cash Flow & Value of Trust Assets Net to Family Ending Beginning of Year End of Year Side Fund Life Insured Loan Balance Value of % Value of Assets Insurance (G2) 2.12% Side Fund Annual Pre-Tax Note Side Fund Less Loan Death Age Accrued Assets Premiums Earnings Repayment Assets Balance Benefit 50 6,706,741 6,567,510 (240,000) 379, ,707, ,000, ,848,924 6,707,161 (240,000) 388, ,855,191 6,266 10,000, ,994,122 6,855,191 (240,000) 396, ,012,102 17,980 10,000, ,142,397 7,012,102 (240,000) 406, ,178,428 36,031 10,000, ,293,816 7,178,428 (240,000) 416, ,354,734 60,918 10,000, ,448,445 7,354,734 (240,000) 426, ,541,618 93,173 10,000, ,606,352 7,541,618 (240,000) 438, ,739, ,363 10,000, ,767,606 7,739,715 (240,000) 449, ,949, ,091 10,000, ,932,280 7,949,698 (240,000) 462,582 (7,932,280) 240, ,000 10,000, ,000 (240,000) (0) 0 (0) (0) 10,000, (0) 0 (0) 0 (0) (0) 10,000,000 determined for gift or estate tax purposes), eliminating ongoing imputed transfers/distributions of the EBC and simplifying administration. Finally, if the receivable is transferred during G1 s lifetime, the second trust should also be a defective grantor trust with respect to G1. Having both trusts defective with respect to G1 prevents the second trust from recognizing income should the first trust pay a portion of the EBC to the second trust. If the second trust is not GST exempt, these issues need to be considered: 1. The policy death proceeds paid to the original trust would not be GST exempt, unless the original trust paid the EBC with GST exempt funds. 2. Imputed transfers of the EBC from the second trust to the original trust could taint the GST exempt status relative to other assets held in the original trust. 3. Merging the two trusts would be inadvisable. Upon merger the non-owner (the original trust) becomes the owner and the non-gst exempt receivable would be valued as the entire policy. As a result, the death benefit would not be GST exempt. As discussed below, however, ensuring that the second trust is GST exempt is easier said than done. Valuation of the receivable As discussed above, the valuation regulations addressing the economic benefit regime do not apply if the receivable is transferred to a second trust. The receivable would therefore be valued under the willing buyer/willing seller standard of Reg , 26 not as the entire policy. In practice, low valuations in the range of 5% to 25% of the receivable have been proposed by advisors. 27 One valuation methodology has been reported as follows: 28 Based on a current mortality table 29 adjusted to reflect the insured s (G2) health at the time of the transfer, for each year the valuation calculates the amount G1 would likely be repaid by multiplying G1 s receivable times the probability of G2 s death. This is repeated for each year of the mortality table to create a stream of actuarially expected payments. That stream of payments is converted to a present value 26 Reg provides that The value of property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. 27 GSD plans valuing the receivable at 5% to 25% of its face value have been reported. A proposed value equal to 5% of the receivable was recently reported as being settled with the IRS at 65%. LISI Estate Planning Newsletter #2418 (5/23/2016). The author understands that a number of cases have been settled in the 50% range. 28 See Robak, Intergenerational Split Dollar Valuation Issues, LISI Estate Planning Newsletter #2444 (8/9/2016). 29 VBT 2008 provides mortality rates to age LISI Estate Planning Newsletter #2444 (8/9/2016), Pluris Valuation reports present value discount rates ranging from 14 to 18% based on surveys of investor s expected returns on completed life settlement purchases. E S T A T E P L A N N I N G A U G U S T V O L 4 4 / N O 8

7 9 based on the appropriate present value interest rate. 30 Based on the example above, assuming a 5% discount rate, a transfer of G1 s receivable in the eighth year and that G2 remains in excellent health at that time, the value of G1 s receivable is $4 million (25% of the $16 million receivable). Pre-funding the second trust Some uncertainties with economic benefit regime GSD plans can be mitigated with the use of existing funded dynasty trusts or pre-funding the trusts. First, the choice of carrier or Table 2001 term rates can have a significant impact on the transaction. For example, if the IRS disallowed a carrier s rates, the Table 2001 rates would apply, substantially increasing the gift and GST transfer costs of the plan. G1 might not have sufficient GST exemption to cover the larger imputed gifts, never mind the transfer value of the receivable discussed below. If the original trust has substantial assets and cash flow, some of the higher EBCs could be paid by the trust. That would, however, only partly solve the problem because not all EBCs should be paid (if payment of EBCs was determined to be part of a pre-arranged plan, such payments could inflate the value of the receivable). Second, when the receivable is transferred, it is unlikely that G1 will have enough GST exemption to shelter the transfer. Continuing the example of a $16 million receivable being transferred in year five assuming a value equal to 25% of the receivable s face value, it would be valued at $4 million and G1 would need $4 million of GST exemption to shelter the transfer. This is a sizable amount of GST exemption, especially for an ultrahigh net worth client who has likely already used available exemptions. What if the parties settle with the IRS for a more reasonable value? Based on a 50% value, the $16 million receivable would be valued at $8 million. Based on a 65% value, the receivable would be valued at $10.4 million. Again, it is unlikely that a client would have that much exemption available, especially after using exemption to shelter the imputed transfers to the trust. If the second trust was pre-funded or was an existing funded dynasty trust, it would have assets with which to purchase the receivable from the estate. 31 If the trust is pre-funded assuming a full value for the receivable, then if a lower value prevails any additional assets not needed to terminate the GSD plan would accrue to the trust. At this point, the advisor and the client may be asking whether all of this complexity and risk are worth the effort a fair question indeed. Fortunately, loan regime split-dollar presents a better alternative. Loan regime split-dollar 32 Although the GSD plan in Morrissette was based on the economic benefit regime, nothing would prohibit the use of a carefully designed, implemented, and administered loan regime GSD plan. As discussed below, in the GSD context, the loan regime is superior to the economic benefit regime in important respects. The loan regime regulations define two general categories of loan, a demand or a term loan. The demand loan is payable in full at any time upon the demand of the lender. 33 In the GSD context, giving G1 the right to demand repayment of the loan at any point in time would likely eliminate the ability to obtain a lower valuation. Since it is desirable to keep a client s valuation options open, the balance of this article deals with term loans, which are defined as any split dollar loan other than a split dollar demand loan. 34 Before further addressing the loan regime in the GSD context, it is important to step back and review the loan regime split-dollar rules as they apply to lifetime term loans, private financing, and a loan of in-kind assets in the typical non- GSD scenario where the insured (G2/son/M50) funds the trustowned life insurance. 31 If the receivable is greater than premiums advanced, care should be taken to avoid violating the transfer-for-value rule by falling within one of the exceptions to the rule. 32 For an excellent discussion of loan regime split dollar, see Harris, Split-Dollar Loan to a Grantor Irrevocable Life Insurance Trust, 36 ETPL 3 (December 2009). 33 Reg (b)(2). 34 Reg (b)(3). A U G U S T V O L 4 4 / N O 8 S P L I T - D O L L A R I N S U R A N C E

8 10 EXHIBIT 4 Reducing The Loan (A) (B) (C) (D) (E) (F) (G) (H) Note Terms Policy Information Loan Note April 2017 AFRs Annual Years to Pay Death Amount Scenario Duration Term Rate Premium Premiums Benefit Needed 1 9 MidTerm 2.12% 240, $10.0M 6,567, Long Term 2.82% 145, $10.0M 3,864, Long Term 2.82% 125, $10.0M 3,044,844 4 Life Long Term 2.82% 100,000 Life $10.0M 2,021,855 5 Life Long Term 2.82% 324,826 Life $32.5M 6,567,510 With loan regime split-dollar, the trust is the owner and beneficiary of the policy and the insured/grantor lends funds to the trust to pay premiums. The regulations provide that a payment made pursuant to a split-dollar agreement is a loan for federal tax purposes if the payment is made directly or indirectly by the lender to the policy owner (the trust), the payment is a loan under general principles of federal tax law, and the repayment is to be made from or secured by the policy death benefit, cash value, or both. 35 Each premium payment is a new loan. The interest for each loan is tested for sufficiency by calculating the present value of all payments due under the loan 36 using a discount rate equal to the appropriate AFR in effect at the time the loan is made and based on the term of the loan. 37 If the loan amount is greater than or equal to that present value, the loan provides for sufficient interest; it will not be characterized as a belowmarket loan and it will be governed by the general rules for debt instruments under Sections 1271 through 1275 and the regulations thereunder. 38 If the loan amount is greater than the present value, it is a belowmarket loan under Section 7872; the excess is an imputed transfer, treated as a gift from the lender to the borrower and as interest income paid by the borrower to the lender. 39 A term loan where the borrower timely pays or accrues interest at the appropriate AFR will always meet the sufficient interest test. It is important to note that, even if a split-dollar loan provides for sufficient interest, loan interest paid or the annual increase in accrued interest will be subject to the original issue discount (OID) rules. 40 Under the OID rules, 41 if the lender and the borrower are separate taxpayers, the annual interest paid or the annual increase in accrued interest is taxed to the lender. Provided that the first trust (the borrower) is a defective grantor trust with respect to the lender, there would be no taxable income because for income tax purposes the lender is making the payments to himself or herself. Example. Son creates an irrevocable life insurance trust to own a policy insuring his own life. The policy requires 25 annual premiums of $100,000, and each year Son lends $100,000 to the trust as a 20- year term loan, creating 25 separate loans. Provided that loan interest for each loan is determined based on the long-term AFR in effect on the date made, each loan will provide for sufficient interest and will not be treated as a belowmarket loan. Each year, however, the interest paid or the increase in accrued interest will be taxable to G2, unless the trust is a defective grantor trust with respect to G2. 35 Reg (a)(2). 36 Reg (e)(4)(ii). 37 If the loan term is for three years or less, the short-term AFR applies; longer than three years but not longer than nine years, the midterm AFR applies; and for greater than nine years, the long-term AFR applies. Section 1274(d). 38 Reg (a)(1). 39 Regs (e)(4)(ii), (iv), and (v). 40 Reg (f). 41 Section 1272(a) applies to original issue debt instruments issued after 7/1/1982. See also Reg Reg (c) citing Sections 163(h) and 264(a). 43 Reg (d). 44 Reg (e)(5)(ii). 45 Reg (e)(5)(ii)(C). 46 Reg (e)(5)(ii)(D). That section refers to the appropriate AFR for the reissued loan is the AFR determined on the day the loan was originally made. If the appropriate AFR referred to the date of the reissued loan, the latter reference would have said on the day the reissued loan was made. (Emphasis added.) 47 It is the author s opinion that this double life expectancy methodology was implemented in order to provide a workable test of the sufficiency of interest in the lifetime term-loan scenario. 48 The side fund return is determined based on a conservative estimate of the expected investment performance of the trust investments. E S T A T E P L A N N I N G A U G U S T V O L 4 4 / N O 8

9 11 EXHIBIT 5 Private Financing Lifetime Term Loan Example (A) (B) (C) (D) (E) (F) (G) (H) Initial Loan: $15.0M Dynasty Trust Cash Flow & Value of Trust Assets Net to Family 2.82% LT AFR Beginning of Year End of Year Side Fund Life Thru LE (A83) Value of Premiums 6.00% Value of Assets Insurance G2 then Side Fund Payable for Pre-Tax Note Side Fund Less Loan Death Year Age 2.12% MT AFR Assets Life Earnings Repayment Assets Balance Benefit ,423,000 15,000,000 (600,000) 864, ,264,000 (159,000) 60,000, ,857,929 15,264,000 (600,000) 879, ,543,840 (314,089) 60,000, ,305,122 15,543,840 (600,000) 896, ,840,470 (464,652) 60,000, ,764,927 15,840,470 (600,000) 914, ,154,899 (610,028) 60,000, ,237,698 16,154,899 (600,000) 933, ,488,193 (749,505) 60,000, ,406,305 21,144,856 (600,000) 1,232, ,777,547 (1,628,757) 60,000, ,910,700 29,484,231 (600,000) 1,733, ,617,285 (293,415) 60,000, ,782,382 30,617,285 (600,000) 1,801, ,818,322 35,940 60,000, ,910,800 55,857,159 (600,000) 3,315, ,572,588 11,661,788 60,000, ,951,073 91,648,679 (600,000) 5,462,921 (61,951,073) 34,560,526 34,560,526 60,000,000 It is important to note that neither interest nor OID is deductible by the borrower. 42 Also, if the loan is nonrecourse (a term that is not defined in the regulations), in order for it not to be treated as a contingent payment, the parties to the split-dollar agreement must represent in writing on their respective tax returns in the year the splitdollar plan is implemented that a reasonable person would expect that all payments under the loan will be made. 43 Lifetime term loan The regulations allow for the use of a term loan payable not later than the death of an individual (a lifetime term loan ). 44 The initial term of the loan is the insured s life expectancy as determined under Reg That term is used to determine the appropriate AFR at inception of the loan and to test whether the loan provides for sufficient interest. In the event that the insured survives to his or her life expectancy, the loan is assumed to be re-issued based on the current loan balance, but interest is not re-tested for sufficiency. The term of the re-issued loan is based on the insured s life expectancy as determined at that time under Reg The appropriate AFR is based on the AFRs in effect on the day the loan was originally made, 46 the re-calculated term being used only to determine whether the original short-, mid-, or long-term AFR applies. Once the AFR is redetermined, it is applied to the loan for the balance of the insured s life. 47 Example. On 4/1/2017, Son (M50, the insured) makes a $100,000 lifetime term loan with accrued interest to a trust for the benefit of his children. His initial life expectancy under Reg is 33.1 years and the appropriate AFR is 2.82%, the April 2017 long-term AFR. If G2 lives to age 83.1, the loan is reissued in the amount of $251,055 (the loan balance including interest accrued at 2.82%). Under Reg , G2 s life expectancy at that time is 7.9 years. The appropriate AFR for the re-issued loan is, therefore, 2.12%, the April 2017 midterm AFR, applicable for the balance of G2 s life. Private financing Private financing is the common name given to a lump-sum, splitdollar term loan that locks in the current AFR and eliminates the need to administer multiple loans. The amount of the loan is calculated such that, at a reasonable assumed investment return (e.g., 5% or 6%), 48 the loan proceeds plus earnings are sufficient to pay each annual premium as it becomes due and repay the loan plus accrued interest at the end of the loan term. If AFRs are low and less than the return on the trust side fund assets, accrual of loan interest acts as a soft freeze. The loan proceeds are invested by the trust in a side fund. Provided that the trust is a defective grantor trust with respect to G2, trust earnings are taxed to G2 while the accrued loan interest is not subject to taxation. The success of the plan depends on the positive spread between the investment A U G U S T V O L 4 4 / N O 8 S P L I T - D O L L A R I N S U R A N C E

10 12 return and the loan rate. If all goes as planned, after the loan has been repaid, the dynasty trust owns a paid-up policy free and clear. An assumed loan of $6.567 million that will support only $10 million of death benefit supports $31.5 million of death benefit as a lifetime term loan/ life-pay policy. Example. Son (G2, age 50, preferred non-tobacco) wants to purchase $10 million of guaranteed survivorship UL in a dynasty trust that is also a defective grantor trust. The annual premium is $240,000/year for ten years. Son lends $6,567,510 to the trust in exchange for a nine-year note, with loan interest accruing at 2.12% (April 2017 mid-term AFR). If the loaned assets earn 6% in a trust side fund, the loan proceeds plus investment earnings will be sufficient to pay each annual premium and repay the loan plus accrued interest at the end of the nine-year term. (See Exhibit 3.) Relative to the death benefit, $6.57 million is a large amount. However, the loan amount plus accrued interest is repaid at the end of the nine-year term, so that son is only giving up a portion of the earnings on those assets for the term of the loan. Because son is the lender and the trust is defective, son will include the trust earnings in income. The accrued loan interest, however, will not be taxable to son. The plan acts as a soft freeze with respect to son s estate, while the appreciation in the form of the policy death benefit will be paid to the dynasty trust. Reducing the loan As Scenarios 1 through 4 in Exhibit 4 illustrate for a given $10 million death benefit, by extending the term of the note and the number of premium payments, the loan can be reduced substantially despite switching from the mid-term to the long-term AFR. Scenario 4, a lifetime term loan and a life-pay policy, provides the lowest required loan ($2.0 million) to support the $10 million death benefit. An assumed loan of $6.567 million that will support only $10 million of death benefit (Scenario 1) supports $31.5 million of death benefit as a lifetime term loan/lifepay policy (Scenario 5). The longer loans do present the following considerations: 1. The longer the loan term, the longer the lender will have to wait to be repaid. 2. With a lifetime term loan, unless the loan is retired early, the lender s estate rather than the lender will be repaid. 3. With the longer term loans, there are many years in which the loan plus accrued interest is less than the assets in the trust side fund (see example below). That shortfall could be made up from policy cash values or death benefit. Making a larger initial loan minimizes this risk, while providing a hedge against the trust assets earning less than the assumed 6%. For example, the loan could be sized assuming a 5% or 5.5% return when it is expected that the assets will return 6%. Loan of in-kind assets The Frazee 49 case stands for the proposition that the grantor may lend in-kind assets to the trust. The court states, Nowhere does the text of section 7872 specify that section 7872 is limited to loans of money. When the trust is defective with respect to the grantor, the built-in gain on the in-kind loan will not be realized. Lending a client s existing brokerage account of appreciated marketable securities should be fine because those assets are easily valued and they are liquid. A loan to the trust of an interest in real estate, a closely held business, or an LLC, may be problematic because those assets are hard to value and are typically illiquid. The valuation risk is significant because, if there is a dispute with the IRS and a higher value for the loaned assets is established, a higher value for the loan could cause it to retroactively fail the sufficient interest test and be characterized as a below-market loan. 50 This will create forgone interest/imputed transfer with negative gift and income tax ramifications. As an alternative, if sufficient cash is available or can be borrowed from a commercial lender, it may be preferable for the grantor to lend cash to the trust, allow those loan proceeds to season in the trust, and then purchase discounted assets from the grantor as the trust side fund investment. 51 Finally, care must be taken to avoid locking highly appreciated TC 554 (1992). 50 It seems unlikely that a defined value clause that would adjust the loan amount would work. 51 The new proposed regulations under Section 2704 could seriously curtail the discounting of assets. 52 Section 675(4)(C) substitution power. 53 If G2 is a beneficiary of the trust, G2 should not gift assets to the trust in order to avoid violating Section This is no different from the original trust repaying the note with the estate and then transferring those proceeds to the trust. 55 Because G1 s receivable equals the greater of premiums paid or policy cash values, a low or no cash value policy arguably keeps the basic value of the policy low. With guaranteed universal life policies, it is essential that all premiums be paid in a timely manner. Missed premiums, premiums paid after the grace period, and (counter-intuitively) even premiums paid before the due date can seriously undermine policy guarantees. E S T A T E P L A N N I N G A U G U S T V O L 4 4 / N O 8

11 13 assets in the trust when grantor trust status is terminated by swapping assets of equivalent value 52 prior to such termination. Highly appreciated commercial real estate that has been fully depreciated resulting in a zero cost basis and that may in fact have negative capital accounts can be especially problematic in this respect because those assets are best held by the grantor upon death in order to obtain a stepped-up cost basis. Loan regime split-dollar and GSD Having reviewed the application of loan regime split-dollar in the non- GSD setting, now consider the loan regime GSD. With GSD, G1 (parent of the insured) rather than the G2 (insured/son) lends funds to the trust. The private financing lifetime term loan not only locks in current low AFRs, it also produces the greatest death benefit for a given loan amount and keeps the door open for a more favorable valuation. Loan regime GSD is best illustrated by an example. G1 lends $15 million to the trust in a lump-sum lifetime split-dollar term loan to fund the purchase of insurance on G2. The trust purchases a $60 million policy with an annual premium of $600,000 payable for lifetime as shown in Exhibit 5. The loan plus earnings is sufficient to pay each annual premium and repay the loan in the future. As illustrated in the example (Column G), it is important to note that in the first 25-years based on an assumed 6% trust side fund return, after paying each annual premium the side fund returns are insufficient to keep pace with the accrued loan interest, creating a shortfall should G2 die. This shortfall has been minimized by overfunding the loan. The greatest shortfall is in year 16, and then begins to shrink until year 27 when the side fund exceeds the loan plus accrued interest, creating a surplus in the trust side fund. In later years this surplus can be quite substantial (see Exhibit 5, Column G, Year 41). If trust investments outperform the assumed return, it may be possible to retire the loan early, taking care to reserve amounts needed to fund future premiums. However, if the locked-in loan rate is low (e.g., 2.82%) and the assets that would be used to repay the loan are earning a greater amount (e.g., 6% or 7%) then it makes economic sense to leave the loan in place until maturity. If, on the other hand, the trust side fund investments underperform the assumed return, assets could be gifted to the trust (by G1 or G2 53 ), additional loans could be made (based on the then-current AFR), assets could be sold to the trust, or policy cash values could be accessed. Unlike the economic benefit regime, the loan receivable may be transferred to the original trust whether during G1 s lifetime or upon G1 s death. If G1 does not have sufficient GST exemption to shelter the transfer of the entire receivable and the trust provides for the handling of non-gst exempt assets, then it should be possible to allocate a portion of the note to a non- GST exempt sub-trust. 54 One benefit of transferring the note to the original trust is that interest will cease to accrue, avoiding taxation of the annual increase in accrued interest when the obligor and obligee are separate taxpayers. Regarding the income taxation of trust side fund returns, as long as the original trust is defective with respect to G1, G1 will pay the income taxes on trust investments. Once the trust is no longer defective, the original trust will be responsible for taxes on trust investments. Valuation of the loan regime GSD receivable Under a loan regime GSD plan, G1 s receivable is a loan for feder- A U G U S T V O L 4 4 / N O 8 S P L I T - D O L L A R I N S U R A N C E

12 14 al tax purposes secured by a promissory note. As such, the receivable is valued as a note. The fair market value of the note will be determined under the willing buyer/willing seller standard. The valuation methodology discussed above, the present value of the actuarial likelihood of repayment of the receivable in each year, would be applicable. Based on this methodology and assuming that the discount rate for present value purposes is greater than the loan rate, the shorter the loan period, the higher the value of the receivable, because the discount term will be that much shorter (consider the present value of a loan repayable in nine years versus one repayable in 30 years). A lifetime term loan, therefore, has the benefit of not only maximizing the death benefit for a given loan amount, but also minimizing the value of the note. The loan regime provides the added benefit in that Reg , Valuation of Notes, provides a statutory basis for a lower valuation on the transfer of a note. That regulation provides that the value of a note for gift tax purposes is presumed to equal principal plus accrued interest unless it can be shown by satisfactory evidence that the note is worth less. Surely a note that is a loan for federal tax purposes, that is fully compliant with the splitdollar regulations, that will not be repaid until some indefinite but actuarially determinable time in the future, and that is valued based on a supportable present value rate provides satisfactory evidence of being worth less. Loan regime versus economic benefit regime The loan regime is preferable to the economic benefit regime for these reasons: 1. As discussed above, the economic benefit regime could lead to significant GST tax issues due to the imputed transfers of EBCs to the dynasty trust as well as to the transfer of the receivable. With the loan regime, there is no gift because all of the costs are accounted for in the loan and the accrued interest. As a result, there is no need to transfer the receivable to a fully GST-exempt dynasty trust. 2. The loan regime split-dollar is easier for clients to understand. Most ultra high net worth clients understand loans and accrued interest, as well as the trust investing loan proceeds and paying premiums from investment returns. 3. The side fund investments provide G1 with greater security in that, should it become advantageous or desirable, the plan may be unwound and the loan repaid. A strong cash value policy will further enhance G1 s security in the event that the trust side fund does not perform as expected. 4. Finally, whereas the best type of policy to use with the economic benefit regime is a fully guaranteed or partially guaranteed (i.e., a policy with low cash value) 55 policy, loan regime split-dollar can be used with any policy: guaranteed, current assumption, indexed, variable, single life, or survivorship universal life policies as well as with all forms of whole life. In comparison to economic benefit regime, loan regime split-dollar has two negatives: 1. Upon transfer of the receivable the valuation may be higher than a comparable economic benefit regime GSD plan. 2. The income taxation of trust side fund investments and accrued loan interest must be taken into account. Generally with the economic benefit regime, all of the premium advances are paid into the policy, so those funds do not generate taxable income on trust earnings. (The one exception is when EBCs paid by the trust generate taxable income but only if the parties to the split-dollar agreement are separate taxpayers.) Nevertheless, the higher income taxes with the loan regime is a small price to pay when compared to the GST issues of the economic benefit regime. As long as there is arbitrage between trust side fund investments and the appropriate AFR, loan regime splitdollar is the superior design. Conclusion Generational split-dollar is an extremely powerful planning strategy that can act as an estate freeze with respect to G1 s estate. It is important to establish a legitimate long-term need for the life insurance and observe all of the formalities of the split-dollar plan. Evaluating the merits of and designing the plan based on the full value of the receivable can manage the client s expectations, avoid pitfalls, and minimize valuation/tax risk. As long as AFRs remain favorable, loan regime splitdollar designs will prove to be more attractive than economic benefit regime designs. E S T A T E P L A N N I N G A U G U S T V O L 4 4 / N O 8