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1 Presenting a live 90-minute webinar with interactive Q&A Inter-Generational Split Dollar Insurance Arrangements After Cahill and Morrissette: Avoiding Revaluation Issues Restructuring Existing Economic Benefit Split Dollar Plans Under Sections 2036, 2038 & 2703 WEDNESDAY, SEPTEMBER 26, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Lawrence M. Lipoff, CPA, TEP, CEBS, Director, CohnReznick, New York Stephen Liss, Executive Director, UBS Wealth Management, New York Philip J. Michaels, Partner, Norton Rose Fulbright US, New York Melvin A. Warshaw, JD, LLM, Principal, General Counsel, Financial Architects Partners, Boston The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Intergenerational Split Dollar Plans After Cahill and Morrissette Strafford Webinars Wednesday, Sept 26, 2018 Lawrence M. Lipoff Moderator Philip J. Michaels Panelist Melvin A. Warshaw Panelist

6 Why Do Wealthy Individuals Buy Life Insurance? Protection *Replace lost income *Repay personal or business debt if obligation comes due *In business, provide liquidity to continue business (redemption/cross purchase) *Key man insurance Accumulation *Leveraged asset on personal balance sheet *Highly favorable tax treatment (no tax on inside build up, possible tax free withdrawal, no income/estate/gst tax if ILIT owned) 6

7 What is Split Dollar (SD)? Two parties split costs and benefits of a life insurance policy *In employer/employee context (not our focus) *In family context it is Grantor/Insured and ILIT (our focus) Remember it is temporary financing *Requires an exit strategy to repay premium advancer (typically Grantor/Insured) * When to roll out of SD? (during life of insured or death) *Can use policy cash value & death benefit or other assets *Can use traditional estate freeze techniques (GRAT/sale) 7

8 What is Generational Split Dollar In traditional SD, premium advancer and insured are the same In generational SD, there are at least 3 parties *Gen 1 Creates a dynasty ILIT *Gen 1 Advances lump sum or periodic advances to ILIT to pay life insurance premiums *Gen 2 Insured (child of Gen 1) *ILIT Beneficiary of policy; benefits Gen 3 Receivable not payable until Gen 2 dies; greater of premiums and cash surrender value If Gen 1 dies before Gen 2, receivable owned by Gen 1 included in estate and appraise at then FMV What is appropriate method to discount receivable at death of Gen 1? 8

9 Premium Finance and Split Dollar What is premium finance, and how does it relate to split dollar? Key terms Interest rate Payment schedule Duration Security Exit strategy 9

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11 Why Do Some Individuals Finance Policy? No gift tax when lender advances cash to G1 who then advances the cash to the ILIT for premiums Prefer to pledge personal collateral in lieu of liquidating assets or committing personal cash flow for large premiums Arbitrage; most sophisticated clients will retain illiquid high yielding/growth assets especially when their borrowing costs remain at historical lows Low cost and limited optionality to acquire life insurance (lock in death benefit while client insurable through loan that can carry policy for up to 10 years; thereafter loan is repaid and policy may be surrendered, personally financed, exchanged or placed on fully paid-up, reduced face amount status) 11

12 Liquid Client Profile Have accumulated significant liquid assets but large estate tax Want to enhance financial legacy for heirs Have already done estate freezing (GRATs/sales) Understand leverage of life insurance as wealth planning tool May be uninsurable (or fully utilized life insurance capacity) May be maxed out on gift/estate/gst tax exemptions (or now more likely that advisors want to use temporarily enlarged exemptions on other transactions) Not risk averse; sophisticated 12

13 Illiquid Client Profile Gen 1 is very wealthy Gen 1 has already used up his gift/gst exemptions Gen 1 is not particularly charitably inclined or has done enough charitable gifting Gen 1 has taken care of G2 (via GRATs or gifts) and wishes to benefit Gen 3 Gen 1 has illiquid assets and thus the need to finance the transaction (premium finance) 13

14 Carrier Views on Intergenerational Split Dollar Carriers want to know arrangement is good for industry as well as for client and producer (agent) High level carrier concerns *Persistency risk (will client keep policy in force indefinitely) *Portfolio risk (impact of outsized large single pay premium) *Possible litigation risk (so far no reported cases) Possible carrier red flags *Large single premium (short pay) *Maximum funding premium designs (maximize capacity) *Use of cash value enhancement rider *Premium not need drives death benefit design *Death benefit not supported by Gen 2 net worth *Policy is premium financed (especially after Cahill) 14

15 Economic Benefit Split Dollar Under Reg Premium advancer receives back greater of premiums paid or cash surrender value, either when SDA is terminated or at death of insured An advance is NOT a loan Measure of gift is annual renewable term insurance rates based on amount of net death benefit coverage on insured(s) *Use lower of IRS Table 2001 rates or carrier annual renewable term rates regularly used by carrier (Notice ) *Favorable for survivor policies (at least until one spouse dies) 15

16 Split Dollar Loans Under Reg Requirements to satisfy loan split dollar *Loans in gift context specifically covered in Regs (e)(5)(iv) *Loan treatment can be assured, even for non-recourse loan (d) *Loan interest can be accrued (g)(4); (h)(5) *Loan repayment can be made from, or secured by, policy death benefit, policy cash value, or both (a)(2)(i)(C) 16

17 The Basics in Est of Morrissette Lump sum premium advance of $29.9M made by matriarch s courtappointed conservator on behalf of her Rev Trust to 3 dynasty ILITs Conservator created ILITs for each son and descendants Split dollar agreements between Rev Trust and ILITs Buy-sell agreement entered into between sons/insureds (shareholders) and family company (to provide liquidity for sons estates through at death corporate redemptions) Term insurance costs were reported on matriarch s gift tax returns as premiums advanced during her life Estate claimed a 75% discount in valuing receivable based on life expectancies of sons and illiquidity of such non-traded debt 17

18 Tax Court in Morrissette, 146 T.C On Estate s motion for summary judgment on validity of split dollar arrangement and gift tax reporting, Court granted motion as a matter of law (IRS unsuccessfully tried to argue it was a matter of facts) and determined the arrangement was not a gift *Matriarch properly reported annual gifts based on annual term costs of coverage on sons (not a large gift of premiums advanced to ILITs) *Economic benefit regime reporting will be respected for gift tax if final SD Regs ( ) followed Open issue: Tax Court has not yet ruled on value of receivable (i.e. discount) in matriarch s gross estate Also: Do IRC 2036 and 2703 apply for estate tax? 18

19 The Basics in Est of Cahill Son of incapacitated patriarch was 1) trustee of father s Rev Trust, 2) attorney-in-fact for father, and 3) executor of father s estate Acting as attorney-in-fact, son created ILIT for father naming son and son s descendants as primary beneficiaries *Son s cousin named as trustee Rev Trust and ILIT entered into 3 split dollar (economic benefit) agreements on WL policies with total face amount of $80M One policy insured life of son and two insured son s wife ILIT borrowed $10M from bank and used proceeds to pay premiums on all 3 policies in a lump sum 19

20 The Basics in Cahill (cont d) Split dollar provisions *ILIT could not borrow, sell, surrender or cancel policies without consent of Rev Trust *During patriarch s life, SDAs could be terminated by mutual written written consent of both Rev Trust and ILIT *On termination, Rev Trust had right to receive greater of cash value and premiums if policy were retained by ILIT or could cause ILIT to transfer policy to lender in full satisfaction of bank loan *At death of insured, Rev Trust entitled to greater of 1) balance on bank loan, 2) total premiums paid, and 3) policy cash value, with ILIT retaining excess death benefit Estate reported $7,575 in gifts under economic benefit reporting When patriarch died, total cash value was $9.6M but since termination of SDAs required consent of ILIT estate valued receivable at $183,700 20

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22 Tax Court in Est of Cahill, T. C. Memo Denied Estate s motion for summary judgment that IRC 2036, 2038 and 2703 would not apply to the SDAs and then foreshadowed likely outcome at trial on these legal issues Concerning IRC 2036 and 2038, Court found that decedent (through son) had power at any time to terminate the SDA in conjunction with ILIT by mutual written consent because 1) decedent (through son) had effective control over cousin as ILIT trustee, 2) bona fide sale requirement not met since son stood on both sides, and 3) value of what decedent received was not even close to the value of what decedent paid ($183,700 vs $10M, or a discount of over 98%) 22

23 Tax Court in Est of Cahill (cont d) Concerning 2703, Court found *Property rights retained by decedent included valuable termination rights *Value of restrictions on termination of SDAs should be ignored as it was not clear SDAs were part of a bona fide business arrangement, not a device to transfer property for less than full consideration and comparable to similar arrangements entered into in an arm s length transaction Concerning distinction with promissory notes, Court found SDAs not bargained for, ILIT contributed nothing to fund and ILIT did not agree to repay decedent with interest 23

24 Tax Court in Cahill (cont d) Court questioned third party loan used to finance premiums *Policy guaranteed return (3%) lower than third party loan interest rate (one month LIBOR plus 1.14%); would this arrangement be capable of providing liquidity decades later (what if LIBOR increases in years to come?), what if bank loan interest rate exceeds policy guaranteed return? *If Gen 1 is a prudent business person, why fund a long-term obligation to provide future liquidity years after initial funding with a short-term (5 year) balloon loan? 24

25 Tax Court in Est of Morrissette, Order Entered June 21, 2018, Joint Status Report Aug 15, days after entry of decision in Cahill, in an Order, Court denied estate s post-trial motion for summary judgment, holding matriarch s SDA termination rights held with ILITs is a restriction under 2703(a)(2) Court relied on Cahill decision (also mutual termination rights) Case will proceed to trial on 2703 and 2036/2038 issues regarding the discounts At trial IRS will contend that if 2703 applies Court should disregard termination restrictions and value matriarch s rights as if she had right to unilaterally terminate SD plans If successful, IRS will preclude valuation of $30M SD receivable at matriarch s death applying a 75% discount as reported by estate 25

26 Est of Cahill (Joint Stipulation of Settled Issues, August 16, 2018) In early Sept 2018, Est of Cahill was settled Estate paid $9.6M in estate taxes and acquiesced to payment of an additional $1.9M as a 20% accuracy related penalty Taxpayer capitulated on bad facts IRS emboldened under 2703 and perhaps 2036/2038? 26

27 Takeaways After Cahill Settlement and Morrissette Order Morrissette still pending; better taxpayer facts than Cahill Pigs get fat, hogs get slaughtered (In Cahill, an incompetent man attempted to transfer $10M to a trust and claim he only made a transfer of $200,000 for FGT/FET really??) Court held that the value of decedent s termination of rights in SDA here is the policy cash value because the restrictions on decedent s ability to access the cash value at any time (the need to obtain consent of the ILIT) should be ignored for estate tax valuation under IRC 2036, 2038 and 2703 Possible broad application of Est of Powell, 148 T.C. No 18 (2017), extending in conjunction with analysis to a contractual arrangement? Eliminating need for donor consent to early termination of SDA (third party lender would be uncomfortable if ILIT could unilaterally terminate SDA prior to insured s death); IRS still may apply IRC 2703 which does not depend on in conjunction with language 27

28 Takeaways after Cahill (cont d) Better facts may help *A competent donor who can act for him or herself * A legitimate business purpose; in Morrissette, SDA was used to fund sons buy-sell agreements with family company to facilitate transfer of ownership of business to younger generation; may overcome 2703 by demonstrating a bona fide business arrangement *Use an independent trustee to make transaction more credible as arm s length *While a third party loan is not inappropriate, lender likely required decedent have right to terminate SDA; loan suggests donor anticipates accessing cash out of policy when loan is due (well before death of Gen 2) *Donor has no right to terminate SDA 28

29 Takeaways from Cahill (cont d) Loan Regime Intergenerational SDAs? (Yes for new transactions) *Trend toward structuring new transactions as split dollar loans from outset (loan treatment assured even if nonrecourse, loan for life of insured locks in AFR through life expectancy and thereafter it is demand rate on date loan was originally made, loan interest can be accrued (no OID if loan to grantor trust), can secure loan with just death benefit *No known report of active IRS auditing of loan regime arrangements *Discounts not as high as under economic benefit but loan interest rate may still be much lower than discount rate appraiser will use in valuing the note *Remember, if note is successfully discounted at Gen 1 death, when note is later paid at death of Gen 2, excess of payments over note s basis (discounted value at Gen 1 death) is ordinary income to recipient (albeit decades later) 29

30 Existing Economic Benefit SD Plans: What Exit Options Are Available? Keep economic benefit SD plan in place until Gen 1 dies? * Amend SDA to eliminate Gen 1 rights to terminate SDA? * Other changes? Sell the economic benefit SD receivable to a grantor trust? * Before selling SD receivable, what if Gen 1 first contributes receivable to a grantor trust Rev Living Trust and RLT sells receivable to - the ILIT (also a grantor trust) for a note (no cash)? - a dynasty trust (also a grantor trust) for cash? - convert to Loan Regine SD What is the tax reporting requirement? 30

31 Existing Economic Benefit SD Plans: What Can IRS Argue (Material Modification?) If IRS fails to succeed on 2703 and 2036/2038 after Morrissette, and Gen 1 sells or gives the receivable away a few years after original transaction, will IRS apply the split dollar Regs and try to argue that such lifetime sale or gift of receivable by Gen 1 is treated as though Gen 1 transferred entire policy not just collateral assignment? Discounted private split dollar is based on exception in Regs where ILIT owns policy subject to non-equity SDA; Gen 1 is deemed as owner for economic benefit purposes *In such deemed ownership situations, Regs say that if SDA is modified and immediately afterwards Gen 1 is NOT the owner under Regs, Gen 1 is treated as having made a transfer of the entire contract [policy] to the [ILIT] trust. Reg (c)(1)(ii)(B)(2). 31

32 Existing Economic Benefit SD Plans: What Can IRS Argue (Material Modification?) (cont d) Does such sale or gift of receivable (collateral assignment interest) trigger a modification of the SDA? What if the receivable is sold or given to the ILIT and the SDA is therefore terminated by merger of obligor and obligee; although Gen 1 is no longer a deemed owner after sale or gift, will IRS contend that a merger is a modification under the Regs? No tax authority on whether a voluntary termination of a SDA during life of Gen 1 is modification under the Regs? Arguably death of Gen 1 is involuntary and change of ownership must occur so presumably death time change of deemed owner is not a modification of an existing SDA causing a taxable policy but no tax authority 32

33 Existing Economic Benefit SD Plans: Taxpayer Legal Position The only relevant tax authority governing economic benefit regime is Reg which applies for BOTH income and gift/estate tax purposes (not addressed elsewhere in Code) *In Morrissette (gift tax), Tax Court held matriarch properly reported the gifts annually because she followed *In Morrissette (estate tax), Tax Court may determine after trial that 2703 is inapplicable because of legitimate non-tax business purpose to support death time redemption *Tax Court will have to determine FMV of receivable held at death of matriarch (Gen 1) 33

34 New Generational SD Programs Will Likeley Be Safe Harbor Split Dollar Loans Discount at Gen 1 death should not drive transaction Satisfying safe harbor loan treatment in Regs requires that a) a reasonable person would expect the loan to be repaid in full, and b) submission of written representations of lender (Gen 1) and borrower (ILIT) to IRS when each loan is made If safe harbor loan requirements are met, loan may be payable at death of Gen 2, loan interest may be accrued, sole collateral may be death benefit (not cash value) and no need for pre-loan seed gift to ILIT to backstop loan (policy sole asset of ILIT to secure loan) 34

35 New Generational SD Program Will Likely Be Safe Harbor Split Dollar Loans (cont d) Final Regs treat a safe harbor SD loan as a loan for all federal tax purposes (income, gift and estate) *IRS precluded from contending lack of intent How would a valuation expert value a safe harbor SD loan? *Different than a traditional note because tied to mortality *Reasonable discount rate of 8% to 10% (time value of money analysis; must forecast mortality of insured Gen 2)) *Note itself is non-marketable *What is collateral? (If policy cash value goes to 0, risk of policy lapse is real) *If loan interest accrued, no interim return and must wait till death *Baseline is carrier s corporate debt (carrier publicly traded bonds often trade at 5% yield but one policy has no diversification) 35

36 The views expressed herein are those of the moderator, Lawrence M. Lipoff and panelists Philip J. Michaels and Melvin A. Warshaw and may not necessarily reflect the views of their firms CohnReznick LLP and Norton Rose Fulbright US LLP. Attendees should consult with their legal and tax advisors regarding particular circumstances. 36