The Demise of Equity Split Dollar in Estate Planning

First, a new and improved summary of the central findings of Morrissette II. 

On May 13, 2021, a Tax Court opinion clarified the treatment of split dollar transactions in Morrissette II. (T.C. Memo 2021-60)

In Estate of Morrissette v. Commissioner, 146 T.C. 171 (2016) (“Morrissette I”), the Tax Court ruled that the advancement of funds by Mrs. Morrissette to irrevocable dynasty trusts created for her sons for the purpose of purchasing life insurance policies were not considered to be a taxable gift because it was a legitimate split-dollar arrangement with a legitimate business purpose under the economic benefit regime.  Morrissette I did not address how to later value such arrangements.

Now, 5 years later, the Tax Court judge held that because the advancement of funds to an irrevocable trust for the purpose of paying life insurance premiums was treated as a bona-fide sale for full and adequate consideration under the economic benefit split dollar regulations, Sections 2036 and 2038 did not apply.

Second, the court held that the special valuation rules under Internal Revenue Section 2703 did not require that the cash surrender value of the policies be included in Mrs. Morrissette’s gross estate.

Finally, the judge determined that the fair market value of the decedent’s split-dollar rights would be valued for estate tax purposes using the discounted cash value method of valuation.

Practitioners may feel that equity split-dollar is no longer safe for estate and gift tax purposes, because the Tax Court required that the split-dollar arrangement must also have a legitimate and significant nontax purpose.

Factors Supporting the Use of the Loan Regime: Not By Jerry Hesch

1. It is simple to explain to a client.

2. The split-dollar loan regulations allow for the loan to be due at the death of the insured. The insured can be a child of the advancing party.

3. All interest can accrue and be due at the end of the note term.

4. The long-term AFR in effect at the time the loan is made applies for the life of the loan. Therefore a discount is automatic if the AFR has increased since the loan was made.

5. Market rates can be used to value the promissory note.

6. There is no need to calculate or report an annual gift that otherwise would be considered to have been made from the advancing party to the policy owner if equity split dollar rules applied.

A Discussion on the Use of Split-Dollar Arrangements Through the Lens of Morrissette II

Under the split-dollar life insurance rules an individual or entity can pay life insurance premiums for the benefit of an irrevocable life insurance trust or other policy owner and be repaid when the insured under the policy dies or the policy is cashed in or borrowed upon.

The Treasury Regulations with respect to split dollar life insurance permits the party that pays the premium to be repaid the amounts advanced, without interest, under what is called the “equity split dollar regime”, or at a lower than market rate interest rate under the “split dollar loan regime.”

When the equity split dollar regime is used the fact that there is no interest charged on the amounts advanced causes the life insurance trust or other life insurance policy owner to be considered to have received a gift based generally upon what the premium on a term life policy would cost for the equivalent arrangement.

When the loan value regime is used the applicable federal rate in effect at the time that each premium is paid can be locked in for the life of the policy.

If the life expectancy of the insured, or the second to die of two lives with a second to die life insurance policy is more than 9 years, then the applicable federal rate can be used. If the life expectancy of the insured, or the joint life expectancy of the insureds for a second to die policy is more than 3 years, but not more than 9 years, then the midterm applicable federal rate can be used.  And if the life expectancy of the insured or second to die of the insured is less than 3 years then the short term applicable federal rate can be used.

The loan agreement can provide that the applicable federal rate locked in with each payment will not change with respect to that part of the loan, and no payments will be due until the policy matures, is cashed in, or is borrowed upon.

Traditionally, when the insured or insureds under a policy are relatively young the cost of term life insurance coverage is relatively low. In such a case, equity split dollar was normally recommended, and it was generally assumed that the entity advancing the monies would not be considered to be the owner of the life insurance policy for estate tax purposes, and would only recieve back the advanced amounts, without interest, when the policy matured.

In the Morrissette case Mrs. Morrissette was in her nineties and had three sons in their 40’s who were owners in Interstate Movers, a large moving company that had been in the family for many years.

Mrs. Morrissette’s sons wanted to put a buy-sell agreement into place whereby irrevocable trusts for the benefit of each son’s descendants would own life insurance policies on the son’s siblings, to be used to buy the siblings out of the company upon their death.

In other words, the dynasty trust established for one son purchased life insurance on the life of his two siblings, and would be able to buy stock in the company from the estates of the siblings upon their death.

When Mrs. Morrissete died her estate valued the right to eventually be repaid a $30,000,000 value on the split dollar arrangements at $7,500,000, based upon what the appraisers determined that a willing buyer would pay a willing seller for the right to be repaid $10,000,000 upon the eventual deaths of each of her sons.

The IRS asserted that this valuation was significantly lower than what the repayment rights were worth, and also attempted to use Internal Revenue Code Section 2036(a) to attempt to include the total value of the life insurance policies in Mrs. Morrissette’s estate.

Under Section 2036(a) assets that are the result of a gift will be considered as owned by the grantor if the grantor retains certain rights over the assets, unless the transfer made by the decedent was considered to be a “bona fide sale for adequate and full consideration.”

In the Morrissette II decision the judge went into lengthy discussion of what would be considered to be a bona fide sale for adequate and full consideration, and found that the business arrangement between the sons coupled with Mrs. Morrissette’s desire to see a deceased son bought out of the company in the event of his death was a sufficient bona fide purpose so that Internal Revenue Code Section 2036(a) did not apply.

It is nevertheless of concern to many estate tax experts that the judge appeared to believe that there would not be a bona fide business purpose for a typical equity split dollar arrangement, where the advancing party is not receiving any compensation under the arrangement.

For this reason, many experts believe that split dollar arrangments that involve estate tax planning can only be safely entered into under the loan regime, so that interest is paid to the advancing party, so that the loan arrangement can be considered to be a bona fide transfer for good and valuable consideration, which includes the interest paid on the loan.

In the Morrissette II case the IRS also attempted to use Internal Revenue Code Section 2703, which indicates that the valuation of certain arrangements that are entered into between family members will not take into account certain discounts if certain requirements are not met.

One way to escape Section 2703 treatment is to assure that the arrangement is a bona fide business arrangement.

In the Morrissette case the judge ruled that the equity split dollar arrangement was a bona fide sale for adequate consideration for  § 2703 purposes.

A final lesson learned from Morrissette II is that the court allowed very little if any discount in valuation, despite the fact that Mrs. Morrissette would of had to wait for her sons to die to be repaid, in large part because her revocable trust that owned the right to be repaid gave the trustee discretion to simply transfer the repayment rights to the three trusts that owed the policies, and the trustee of Mrs. Morrissette’s revocable trust transfered these rights to the three trusts within two months after she died, thus effectively cancelling their obligation to repay the loan.

While the judge’s conclusion on this may have been incorrect, split dollar repayment arrangements should probably be structured to be payable to trusts or other entitites that do not merge with the exact same parties who are benefitted by life insurance trusts or other entities that own life insurance policies that the split dollar arrangements are established to benefit.

Split dollar life insurance can still be very advantageous for families who wish to facilitate having premium paid on life insurance policies without having to make large gifts to irrevocable life insurance trusts.

For example, large gifts of cash to an irrevocable life insurance trust will not be as effective for estate and gift tax planning as gifting non-voting or minority interest corporate stock, LLC interests, or limited partnership interests, and corporations, LLC’s, and limited partnerships can advance monies to irrevocable life insurance trusts under split dollar arrangements so that the family has the best of both worlds – full use of annual gifting under the $15,000 per person per year exemption, and funding life insurance that will not be subject to federal estate tax on the death of an insured or insureds.

Advantages of Using a Split-Dollar Loan Where the Trust Uses the Loan Proceeds to Insure the Life of a Child: Not By Jerry Hesch

Assume Senior loans $1,000,000 to an irrevocable grantor trust where the trust uses the loan proceeds to pay the premium on a policy insuring the life of Senior’s child who is 30 years younger than Senior.

Using the 2.08% long-term Applicable Federal Rate (AFR) for June 2021 all interest accrues. All principal and accrued interest is due at loan maturity (the death of the insured child).

Senior dies six years later when principal and accrued interest are $1,131,472. At the date of Senior’s death, the child’s life expectancy is 30 years. Therefore, the value of the note is the present value of the right to collect the principal and accrued interest for another 30 years. Using the 2.08% AFR, in 30 years the principal and accrused interest will total $2,098,281.

Assume that at the date of Senior’s death, the long-term AFR is 4.0%. Using the 4.0% AFR as the discount rate, the present value of the right to receive $2,098,281 in 30 years is $646,939. In valuing newly issued debt obligations Section 1274 uses the AFR. However, the AFR is only used to determine the value of a debt obligation when it is issued. In valuing promissory notes, numerous court decisions use a variety of factors, such as market rates. Because the AFR is recognized in the legislative history of Section 1274 as a below market rate, the court decisions justify the use of market rates in valuing existing promissory notes. Instead of using the existing 4.0% AFR, then a market rate of 5.0% might be used as of the date of this article. At a 5.0% discount rate the present value of the right to receieve $2,098,281 in 30 years would be $485,495.

At Senior’s death, principal and accrued interest were $1,131,472. Using the AFR in effect at Senior’s death, the note is valued at $646,939. That is an effective valuation discount of 42.8%.

If a market rate is used as the discount rate, the value in the estate would be $485,495. That is an effective discount of 76.8%.

Much more can be written about the Morrissette II case, but the above is hopefully helpful for those who are planning with life insurance. As always, please do not Heschitate to reach out to us with any questions.


§ 2036. Transfers with retained life estate.
(a) General Rule
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transger (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death, or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shalll possess or enjoy the property or the income therefrom.

Alan Gassman Alan Gassman

Alan Gassman of Gassman, Crotty & Denicolo, P.A., located in Clearwater, Florida, was founded in 1987 to provide legal representation to physicians, business owners, and successful retirees with an emphasis on wealth preservation, estate and estate tax planning, taxation, and business and health law matters. Our team’s first and foremost goal is to provide effective representation in a timely and result-oriented manner. We often refer to outside Co-Counsel with subspecialist lawyers in many areas to provide the best solutions and results for our clients.