Advanced Designs. Pocket Guide. Private Split-Dollar Life Insurance Designs AD-OC-724B

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1 Advanced Designs Pocket Guide Private Split-Dollar Life Insurance Designs AD-OC-724B

2 This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its distributors and their respective representatives do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. Investment and Insurance Products: Not a Deposit Not FDIC Insured Not Insured by any Federal Government Agency No Bank Guarantee May Lose Value

3 Table of Contents I. Introduction 1 II. Overview 2 A. The Need for Private Split-Dollar and Intra-Family Loans 2 B. Reduction of Gift to Irrevocable Life Insurance Trust (ILIT) 3 C. Private Split-Dollar and Intra-Family Loans 3 III. Private Split-Dollar (Economic Benefit Regime) 5 A. Practical Considerations 5 B. Private Split-Dollar Designs 8 C. Pertinent Tax Issues Questions & Answers Regarding Private Split-Dollar Arrangements Under the Economic Benefit Regime Is the premium payor making a gift of the premiums to the trust beneficiaries? Is the Reportable Economic Benefit (REB) income taxable to the premium payor? How does divorce or separation affect the private split-dollar arrangement? What is included in the premium payor s estate? Can the premium payor access the policy s cash value? Must the ILIT pay the REB? Does the ILIT s payment of the REB offset the amount owed to the premium payor at rollout? What is cash value for split-dollar purposes? 20

4 9. How is the split-dollar arrangement documented? 21 D. Planning for Rollout of Private Split-Dollar Arrangements Under Economic Benefit Regime Necessity for Rollout Rollout Options 23 IV. Intra-Family Loans (Loan Regime) 27 A. Practical Considerations 27 B. Intra-Family Loan Designs Non-Insured Spouse as Lender 32 C. Disadvantages Intra-Family Loans by Non-Insured Spouse 34 D. Intra-Family Loan Designs Insured(s) as Lender 36 E. Pertinent Tax Issues Questions & Answers Relating to Intra-Family Loans What is the interest rate used for testing sufficient interest on a demand loan? What is the interest rate used for testing sufficient interest on a term loan? Can the lender(s) gift an amount equal to the loan interest to the trust to pay the loan interest to the lender(s)? What are the benefits of using a demand loan versus a term loan and vice versa? Are the loan interest payments income taxable to the lender? Could the loan transaction be re-characterized as a transfer with a retained interest? Can the loan interest be capitalized into the loan rather than paid yearly? What are the benefits of using a single lump sum loan over a series of loans and vice versa? What is included in the client s estate? 46

5 10. How is an intra-family loan payable at the death of the insured treated? How is the intra-family loan arrangement documented? Does the de minimus rule contained in IRC Sec apply? 48 V. Conclusion 49 VI. Appendix A 50

6 I. Introduction A private split-dollar arrangement is not a special type of life insurance policy, but rather, a premium sharing arrangement used by individuals who wish to purchase a life insurance policy for estate liquidity purposes but want to minimize the gift tax cost of funding the life insurance policy. Private split-dollar is an agreement between an owner of a life insurance policy and a nonowner under which one party pays all or part of the premiums and in return is entitled to recover all or any portion of those premiums from or secured by, the proceeds of the policy. 1 On September 11, 2003, the Internal Revenue Service issued the final regulations on split-dollar, which provide the rules governing split-dollar arrangements entered into or materially modified after September 17, This pocket guide discusses only new private split-dollar cases entered into after September 17, It is imperative that individuals interested in entering into a split-dollar design seek the advice of legal and tax counsel familiar with these regulations. This material is not intended as, nor may it be considered, legal or tax advice. This pocket guide begins with a brief overview of the need for private split-dollar arrangements and a brief analysis of the two types of private split-dollar arrangements as provided by final split-dollar regulations. The balance of the pocket guide is divided into sections, each discussing the benefits and mechanics of the two different types of private split-dollar designs: private splitdollar designs under the economic benefit regime and private splitdollar designs under the loan regime (Intra-Family Loans). Each section provides an overview of the different designs available under the two regimes and ends with a discussion of the pertinent tax issues in a question and answer format. For simplicity, the remainder of this pocket guide will refer to designs subject to the economic benefit regime as private split-dollar arrangements and designs falling under the loan regime as intra-family loans. 1 Treas. Reg. Sec (b)(1). Page 1 of 50

7 All references to income, gift or estate taxation shall refer only to federal tax implications as state taxation varies from state to state. Unless stated otherwise, all citations are to the Internal Revenue Code of 1986, as amended (the Code). For the sake of simplicity, the Internal Revenue Service will be referred to as the Service, and any reference to the masculine gender shall also include the feminine gender. II. Overview A. The Need for Private Split-Dollar and Intra-Family Loans Individuals enter into private split-dollar and intra-family loan arrangements when they want to buy a life insurance policy in an irrevocable life insurance trust (ILIT) at a reduced gift tax cost. Typically, wealthy individuals who want life insurance for estate liquidity purposes use ILITs to exclude the death benefit from their taxable estate. The insured gifts cash to the ILIT to provide the trustee with funds to pay the policy premiums. If the gift amounts are within the insured s available annual gift tax exclusions or lifetime exemption amounts, the gifts can be gift tax-free. However, the premiums for a policy with the requisite death benefit may greatly exceed those amounts. This situation typically arises where the insured seeks a policy with a large death benefit or the insured is already making gifts to the ILIT beneficiaries. In either situation, the insured might owe gift tax each time he or she transfers funds to the ILIT. This gifting limitation may cause the insured to settle for less death benefit than needed and leave the insured s estate without the necessary liquidity to pay estate taxes. 2 2 According to the American Taxpayer Relief Act of 2012, the federal estate, gift and generation skipping transfer (GST) tax exemption amounts are all $5,000,000 (indexed for inflation effective for tax years after 2011); the maximum estate, gift and GST tax rates are 40%. As of January 1, 2013, the annual gift tax exclusion is $14,000 per donee (indexed for inflation). Page 2 of 50

8 B. Reduction of Gift to ILIT Private split-dollar and intra-family loans can help significantly reduce gifts to the ILIT and thereby reduce or eliminate the payment of gift tax. In a private split-dollar and intra-family loan arrangement, the trustee of the ILIT and a donor (typically the insured or the insured's spouse) agree to share the policy premiums. 3 The donor agrees to pay the bulk of the premiums in exchange for an assignment of a portion of the cash value. If the arrangement is properly structured, the donor s payment of premiums should not be gifts to the trust because they are pursuant to the premium sharing arrangement. The insured would only need to gift a relatively small amount of funds to provide the ILIT trustee with the funds needed to pay its portion of premiums, which can be relatively small. Without private split-dollar or intrafamily loans, gifting concerns could limit the policy's death benefit. With private split-dollar or intra-family loans, an individual's needs can determine the appropriate death benefit. C. Private Split-Dollar and Intra-Family Loans Private split-dollar arrangements were originally designed around two private letter rulings issued by the Service which provided a road map to the use of private split-dollar planning: Private Letter Rulings and On September 11, 2003, the Service issued the final regulations on split-dollar that provide the rules for the tax treatment of private split-dollar arrangements entered into or materially modified after September 17, The final regulations provide that split-dollar arrangements fall under two mutually exclusive regimes: the economic benefit regime (private split-dollar) and the loan regime (intra-family loans). Private split-dollar arrangements split the costs and benefits of a life insurance policy and require the annual recognition of a 3 Someone other than the insured should serve as the trustee of the ILIT. If the insured serves as trustee, the policy proceeds would be includible in the insured s estate since the insured would be viewed as holding policy incidents of ownership. IRC Sec. 2024(2); Treas. Reg. Sec (c)(4). Page 3 of 50

9 reportable economic benefit amount (REB) for the cost of current life insurance protection provided by the premium payor. Alternatively, intra-family loans require sufficient loan interest be paid to the lender on the premiums paid rather than the aforementioned REB amounts. Generally, the determination of which regime applies is made by policy ownership. If the premium payor owns the policy, the economic benefit regime applies. If the non-premium payor owns 4 the policy, the loan regime applies. 5 In other words, traditional equity collateral assignment split-dollar arrangements are treated as loans under the final regulations while endorsement split-dollar arrangements are taxed as economic benefit split-dollar arrangements. A special exception to this general rule, however, applies the economic benefit split-dollar regime to nonequity collateral assignment split-dollar arrangements. This special rule treats the donor (premium payor) as the owner of the policy, even if the ILIT is the named policyowner under the policy if, at all times, the only economic benefits that will be provided to the ILIT is current life insurance protection. 6 Therefore, in the typical private split-dollar scenario, the ILIT is the named policyowner of the policy to avoid estate taxation of the death benefit 7 and is only entitled to the current life insurance protection. The balance (i.e., the entire cash value) is collaterally assigned to the donor (premium payor). The decision as to which design makes most sense for a particular client will depend on the specific facts of the case and will require a comparison of illustrations by the client's tax advisors. Generally, for younger insureds and for survivorship life insurance policy arrangements, a private split-dollar arrangement may 4 See footnote 3. 5 Treas. Reg. Secs (b)(3) and (a)(2). 6 Treas. Reg. Secs (c)(1)(ii) and (a)(2). 7 The final regulations provide that no matter who would be considered policy owner under the final regulations, the inclusion of the policy death benefit proceeds in a decedent s taxable estate will continue to be determined under normal estate tax rules of IRC Sec Page 4 of 50

10 provide lower cost to the client, especially in the early years of the arrangement. For older insureds, a loan arrangement may provide more desirable tax consequences, especially during periods of low interest rates, since interest rates may be lower than the cost of current life insurance protection. Please see the Private Split-dollar Decision Tree in Appendix A of this pocket guide. This pocket guide will discuss the advantages and tax issues to consider before choosing among the different types of private splitdollar designs. III. Private Split-Dollar (Economic Benefit Regime) A. Practical Considerations Private split-dollar is a premium sharing arrangement typically between an ILIT and an insured and/or spouse. In order to avoid estate taxation of the death benefit, the ILIT is the named policyowner. Private split-dollar, therefore, needs to be structured as a nonequity collateral assignment split-dollar arrangement under the special rules provided by the final regulations to be taxed as split-dollar rather than as a loan. As discussed previously, under the special rule, the premium payor pays all or most of the premiums and the ILIT must only be entitled to the current life insurance protection. 8 The balance, in other words the entire cash value, must be collaterally assigned to the donor as premium payor. 9 8 As discussed earlier, the donor (premium payor) must be assigned the entire cash value to qualify under the split-dollar economic benefit regime as defined in Treas. Reg. Sec (d)(1) pursuant to the special rule in Treas. Reg. Sec (c)(1)(ii)(A)(2). 9 Some commentators believe that a nonequity collateral assignment split-dollar arrangement should give to the premium payor the greater of premiums paid or cash value even though the final regulations provide that the special rules will apply so long as the only benefit provided to the ILIT is the current life insurance protection. The client s independent tax advisor should be consulted on this and all other issues. Page 5 of 50

11 Reportable Economic Benefit (REB) Because the ILIT s beneficiaries are being gifted current life insurance protection provided by reason of the payment of premiums by the premium payor, the ILIT must recognize this gift. Generally in private split-dollar, the ILIT will recognize this gift in the form of the cost of current life insurance protection as measured by the reportable economic benefit (REB). In the alternative, the ILIT can pay a portion of the policy premium equal to the REB using funds gifted by the insured. The REB amount is typically relatively small compared to the premium amounts, especially during the early years of the policy, and therefore should significantly reduce the gift amounts made by the insured. It is important to emphasize that if the ILIT does not pay a portion of the premium equal to the REB, the REB will be treated as a deemed gift to the ILIT by the premium payor that may not qualify for the annual gift tax exclusion. 10 The final regulations provide that the REB is measured by multiplying the amount of current life insurance protection provided to the ILIT multiplied by a life insurance premium factor that will be published by the IRS in the future. As of the date this pocket guide was written, these rates had not yet been published. The client s tax advisor should be consulted for any up to date information. Until this rate is published, Table 2001 rates, as provided by Notice , should generally be used as the measure of the REB. 11 Restricted Collateral Assignment In private split-dollar, the premium payor is typically the insured or the insured s spouse. While it is possible to have other premium payors (e.g., a relative or family business), additional tax 10 In order to qualify for the annual gift tax exclusion, the gift must be a present interest gift. IRC Sec. 2503(b). A deemed gift would not be a present interest. See note The use of any other rates, such as a life insurance company s lower published premium rates, should be carefully reviewed by a client s independent tax advisor to ensure that the rates satisfy the requirements set forth in Rev Rul and Notice Page 6 of 50

12 consequences must carefully be considered. This pocket guide will only discuss the most common type of private split-dollar arrangements where the premium payor is the insured or insured s spouse. If the insured is the premium payor, caution must be taken to avoid any incidents of ownership that may cause estate taxation of the death benefit. A collateral assignment that gives the insured as premium payor any rights over the policy s cash value would cause estate inclusion of the death benefit. Therefore, a restricted collateral assignment agreement and form should be used to restrict the insured s access to the cash value limiting the insured s right over the policy to a right of reimbursement upon termination of the arrangement only. Rollout A split-dollar arrangement can be terminated during the insured s lifetime or upon the insured s death. The termination of the arrangement during life is referred to as rollout because the trustee rolls the premium payor s interest out of the policy by reimbursing the premium payor an amount equal to the cash value. The REB amount increases as the insured gets older. From a gift tax perspective, therefore, the parties to the arrangement should consider terminating the arrangement before the REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the ILIT to fund the policy with the split-dollar arrangement than without and would therefore defeat the purpose of the splitdollar arrangement. If the parties knew that the insured would die before the REB exceeded the actual premium, they might not need to plan for a rollout. However, prudence dictates planning for a possible rollout because failure to plan could force a rollout that could strip the policy of its cash value and result in little or no death benefit payable to the ILIT. This unfortunate result occurs because the ILIT is required to pay to the premium payor an amount equal to the entire cash value upon termination of the split-dollar Page 7 of 50

13 arrangement. 12 Section III.D of this pocket guide discusses various rollout strategies available. Cash Value Defined As discussed earlier, the premium payor must have an interest at least equal to the entire cash value in order for the arrangement to be treated as split-dollar. The final regulations provide that cash value for split-dollar purposes, is determined disregarding surrender charges or other similar charges or reductions. 13 Cash value for split-dollar purposes, therefore, is not the cash surrender value. Rather, the cash value must be at least as great as the accumulated value of the policy. Furthermore, the regulations provide that no artifice or device may be used to understate the cash value. 14 The client s independent tax advisor should be consulted to determine the appropriate cash value amount owed to the premium payor under the split-dollar arrangement. B. Private Split-Dollar Designs There are three common private split-dollar designs: (1) single life private split-dollar with a married insured, (2) single life private split-dollar with a single insured, and (3) second-to-die private split-dollar. The main difference between the three designs is that the second and third design must use a restricted collateral assignment agreement (i.e., limiting the premium payor s right in the cash value to a right of reimbursement at termination only) because the insured(s) is also a premium payor. Otherwise, the collateral assignment could give incidents of ownership that could cause the estate taxation of the death benefit. 12 Some commentators believe that a nonequity collateral assignment split-dollar arrangement should give to the premium payor the greater of premiums paid or cash value even though the final regulations provide that the special rules taxing nonequity collateral assignments split-dollar under the economic benefit regime will apply so long as the only benefit provided to the ILIT is the current life insurance protection. Treas. Reg. Sec (c)(1)(ii)(A)(2). The client s independent tax advisor should be consulted on this and all other issues. 13 Treas. Reg. Sec (d)(4)(i). 14 Treas. Reg. Sec (d)(5)(iii). Page 8 of 50

14 a. Benefits of Arrangement - Single Life Private Split-Dollar Married Insured Insured can minimize the gift to fund a trust-owned policy. The payment of premiums by the premium payor are not gifts to the ILIT because they are pursuant to the split-dollar arrangement. 15 Insured only needs to gift a relatively small amount of funds equal to the REB to the ILIT to allow the trustee to pay its portion of the premiums. Until the insured attains a certain age, that amount should be relatively small compared to the premium amount. Non-insured spouse can access the trust-owned policy's cash value. The collateral assignment can provide the non-insured spouse as premium payor with access to the policy's cash value. At retirement or in the event the family needs funds, the insured's spouse may take income tax-free withdrawals and loans from the policy's available cash value by exercising his or her rights set forth in the split-dollar and collateral assignment agreements. 16 While access to cash value may be an important benefit to this particular type of private split-dollar, it should not be the sole reason for establishing a private split-dollar arrangement. The primary reason for most private split-dollar arrangements is to reduce the gift amount that finances a policy owned outside of the 15 In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement,are not deemed gifts by the insureds to the ILIT. 16 Tax-free income assumes, among other things: (1) withdrawals do not exceed tax basis (generally, premiums paid less prior withdrawals); (2) policy remains in force until death; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC Secs. 72, 7702(f)(7)(B), 7702A. Any policy withdrawals, loans and loan interest will reduce policy values and may reduce benefits. Page 9 of 50

15 insured's estate. Indirect access to cash value may be obtained through other relatively simpler, drafting techniques. 17 The trust's portion of the policy's death benefit should pass to the trust beneficiaries free from estate tax. The trust's portion of the death benefit should pass to the trust beneficiaries free from estate tax. 18 This statement is true provided that the trust and agreements to effectuate the split-dollar arrangement are properly drafted so that the insured does not retain any prohibited power or benefit over the trust nor any incident of ownership over the policy that would cause the trust proceeds to be included in his or her estate. 19 Incomplete estate planning could, however, cause the trust's portion of the death benefit to be included in the insured's estate. The non-insured spouse s contractual rights under the split-dollar arrangement include rights that would cause the entire policy proceeds to be included in the insured's estate if held by the insured at or within three years of the insured s death. 20 Accordingly, the non-insured spouse s contractual interests must not pass to the insured at his or her death. The non-insured spouse should bequeath his or her interest to anyone other than the insured (e.g., his or her children or grandchildren) in his or her will or living trust. In addition, if the insured is the executor of the will or the trustee of the trust that distributes the non-insured spouse s contractual interest, the non-insured spouse's will or trust should designate a special executor or trustee to take all actions with respect to his or her contractual interest. Otherwise the insured will possess rights over the policy that could cause the entire policy proceeds to be included in his or her estate A competent estate planning attorney can draft an ILIT that should provide an insured's spouse with access to cash value during the insured's life without causing inclusion of the death benefit in either spouse's estate. 18 See footnote IRC Secs. 2036, 2038 and See Priv. Ltr. Rul IRC Secs and Id. Page 10 of 50

16 b. Disadvantages of Arrangement - Single Life Private Split-Dollar Married Insured Payments of premiums by ILIT will not give tax basis in the policy. Pursuant to the final regulations, the ILIT will not receive any basis in the life insurance policy for the payment of the REB. 22 Rollout Issues The REB increases as the insured gets older. From a gift tax perspective, the insured should terminate the arrangement before the REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. If the parties to the arrangement fail to plan in advance, gifting concerns may force a rollout that could strip the policy of its cash value and result in little or no insurance death benefit payable to the trust since the premium payor is entitled to the entire cash value of the policy. 23 ILIT has no access to cash value. The final regulations provide that the ILIT must not have any access to cash value. 24 Pursuant to the final regulations, in order for the economic benefit regime to apply, the only economic benefit provided under the arrangement by the donor must be the current life insurance protection. 25 The arrangement, therefore, should provide the ILIT with no access to the cash value. 22 Treas. Reg. Sec (f)(2)(i). 23 The final split-dollar regulations provide that the term cash value shall mean the cash value of the policy, determined disregarding surrender charges or other similar charges or reductions, as defined in the insurer s policy form. Treas. Reg. Sec (d)(4)(i). 24 Treas. Reg. Sec (d). The final regulations provide that the non-owner must take into account the full value of all economic benefits provided by the owner. The value of economic benefits include the amount of policy cash value to which the nonowner has current access. Treas. Reg. Sec (d)(2)(ii). 25 Treas. Reg. Sec (c)(1)(ii)(2). Page 11 of 50

17 Cash value is includible in the premium payor s estate. Upon the death of the premium payor, the amount currently owed to him or her pursuant to the split-dollar agreement (i.e., the entire cash value) will be included in his or her estate. 26 Payment of the REB may be income taxable to premium payor. Pursuant to the final regulations, the REB actually paid by the ILIT will be income taxable to the premium payor. 27 Establishing the ILIT as a defective grantor trust as to the premium payor spouse may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 28 However, it is unclear whether or not the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private split-dollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. If the trust is drafted as a grantor trust to the premium payor spouse, the premium payor spouse should not be a beneficiary of the ILIT; otherwise, the trust proceeds, including the death benefit proceeds should the insured die prior to the spouse, may be includible in the premium payor spouse s estate under IRC Sec c. Benefits of Single Life Private Split-Dollar with a Single Insured Insured can minimize the gift to fund a trust-owned policy. The payment of premiums by the premium payor are not gifts to the ILIT because they are pursuant to the split-dollar arrangement. 29 The insured needs to gift only a relatively small amount of funds equal to the REB to the ILIT to allow the trustee to pay its portion of the premiums. Until the insured attains a 26 IRC Sec Treas. Reg. Sec (f)(2)(ii). 28 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement are not deemed gifts by the insureds to the ILIT. Page 12 of 50

18 certain age, that amount should be relatively small compared to the premium amount. The ILIT s portion of the policy's death benefit should pass to the ILIT beneficiaries free from estate tax. If structured properly, the trust's portion of the death benefit, as set forth in the private split-dollar arrangement, should pass to the trust estate tax-free 30 so long as the insured does not retain any prohibited power or benefit over the trust or any incident of ownership over the policy. 31 d. Disadvantages of Single Life Private Split-Dollar Single Insured Payments of premiums by ILIT will not give tax basis in the policy. Pursuant to the final regulations, the ILIT will not receive any basis in the life insurance policy for the payment of the REB. 32 Rollout Issues The REB increases as the insured gets older. From a gift tax perspective, the insured should terminate the arrangement before the value REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. ILIT has no access to cash value. The final regulations provide that the ILIT must not have any access to cash value See footnote IRC Secs. 2036, 2038, Treas. Reg. Sec (f)(2)(i). 33 Treas. Reg. Sec (d). The final regulations provide that the non-owner must take into account the full value of all economic benefits provided by the owner. The Page 13 of 50

19 Premium payor has no access to cash value. Because the insured is also the premium payor, the insured should not be given any access to the policy's available cash value; otherwise, he or she may be deemed to possess an incident of ownership over the policy that would cause the policy death benefit proceeds to be included in his or her estate. 34 To prevent the insured from having incidents of ownership, a restricted collateral assignment agreement and form should be used that limits the insured s right in the policy to a right of reimbursement upon termination only with no current access to cash value. Cash value is includible in premium payor s estate. Upon the death of the premium payor, the amount currently owed to him or her pursuant to the split-dollar agreement (i.e., the entire cash value) will be included in his or her estate. 35 Payment of the REB may be income taxable to premium payor. Pursuant to the final regulations, the value of current life insurance protection actually paid by the ILIT will be income taxable to the premium payor. 36 Establishing the ILIT as a defective grantor trust as to the premium payor spouse may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 37 It is unclear, however, whether the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private split-dollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. value of economic benefits include the amount of policy cash value to which the nonowner has current access. Treas. Reg. Sec (d)(2)(ii). 34 See Rev. Rul , , C.B IRC Sec Treas. Reg. Sec (f)(2)(ii). 37 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 14 of 50

20 e. Benefits of Second-to-Die Private Split-Dollar Insureds can minimize the gifts to fund a trust-owned policy. The payment of premiums by the premium payors are not gifts to the ILIT because they are pursuant to the split-dollar arrangement. 38 The insureds only need to gift a relatively small amount of funds equal to the REB to the ILIT to allow the trustee to pay its portion of the premiums. Until the insureds attain a certain age, that amount should be relatively small compared to the total premium. The trust's portion of the policy's death benefit should pass to the trust beneficiaries free from estate tax. If the arrangement is structured properly, the trust's portion of the death benefit, as set forth in the private split-dollar arrangement, should pass to the trust estate tax-free. 39 Upon the first death of one of the insureds, only the value of the interest owed to the deceased spouse should be included in the deceased spouse's estate. 40 Upon the surviving spouse's death, only the value of the amount currently owed the surviving spouse pursuant to the private split-dollar agreement should be included in his or her estate In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement are not deemed gifts by the insureds to the ILIT. 39 See footnote The insureds may be able to delay the payment of estate tax due on the first death if their wills or trusts pass the first spouse to die's repayment right to the surviving spouse so that the interest may qualify for the marital deduction from estate tax. 41 IRC Sec Page 15 of 50

21 f. Disadvantages of Arrangement - Second-to-Die Nonequity Private Split-Dollar Payments of premiums by ILIT will not give tax basis in the policy. Pursuant to the final regulations, the ILIT will not receive any basis in the life insurance policy for the payment of the REB. 42 REB increases after the death of the first insured. The cost of the REB increases after the death of the first insured because the rates for a single life policy are higher than the rates for a second-to-die policy. Rollout Issues The REB increases as the insureds get older. The cost of current life insurance protection also increases at the first death of one of the spouses. From a gift tax perspective, the insured(s) should terminate the arrangement before the REB exceeds the actual premium cost. Otherwise, the insured(s) would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. ILIT has no access to cash value. The final regulations provide that the ILIT must not have any access to cash value. 43 Premium payors have no access to cash value. Since the insureds are also the premium payors in this type of design, the insureds should not be given any access to the policy's available cash value; otherwise, they may be deemed to possess an incident of ownership over the policy that would cause the policy 42 Treas. Reg. Sec (f)(2)(i). 43 Treas. Reg. Sec (d). The final regulations provide that the non-owner must take into account the full value of all economic benefits provided by the owner. The value of economic benefits include the amount of policy cash value to which the nonowner has current access. Treas. Reg. Sec (d)(2)(ii). Page 16 of 50

22 death benefit proceeds to be included in their estate. 44 This can be accomplished by using a properly drafted ILIT, a restricted collateral assignment agreement and restricted collateral assignment form. Cash value is includible in the insureds estate. Upon the death of the insureds, the amount owed to them pursuant to the split-dollar agreement (i.e., the entire cash value) will be included in their estate. 45 Payment of the REB may be income taxable to premium payors. Pursuant to the final regulations, any REB actually paid by the ILIT will be income taxable to the premium payors for any splitdollar arrangements entered into after September 17, Establishing the ILIT as a defective grantor trust as to the premium payors may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 47 However, it is unclear whether or not the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private splitdollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. C. Pertinent Tax Issues Questions & Answers Regarding Private Split-Dollar Arrangements Under the Economic Benefit Regime 1. Is the premium payor making a gift of the premiums to the trust beneficiaries? If the Service viewed the assignee's payment of premium pursuant to the split-dollar agreement as a gift to the trust beneficiaries, the 44 See Rev. Rul , , C.B IRC Sec Treas. Reg. Sec (f)(2)(ii). 47 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 17 of 50

23 split-dollar agreement would not serve its purpose of minimizing the gifts to the trust beneficiaries. Although the assignee is paying the majority of the premium under this arrangement, the premium payments should not be gifts to the trust beneficiaries they are pursuant to a private split-dollar arrangement Is the REB income taxable to the premium payor? Pursuant to the final regulations, the REB actually paid by the ILIT will be income taxable to the premium payor for any split-dollar arrangements entered into after September 17, Establishing the ILIT as a defective grantor trust as to the premium payor may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 50 However, it is unclear whether or not the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private splitdollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. If the trust is drafted as a grantor trust to the premium payor, the premium payor should not be a beneficiary of the ILIT; otherwise, the death benefit proceeds may be includible in the premium payor spouse s estate under IRC Sec How does divorce or separation affect the private split-dollar arrangement? Divorce or separation does not diminish the premium payor s right to reimbursement. Furthermore, if the premium payor spouse has 48 The Service has privately ruled that the insured's spouse's premium payments were not gifts to the trust where he or she would receive the cash value (net of spouse's loans or debt secured by the policy) if the arrangement was terminated during the insured's life or the greater of the cash value immediately before death (net of spouse's loans or debt secured by the policy) or premium paid (net of spouse's loans or debt secured by the policy) if the arrangement is terminated by the death of the insured. Priv. Ltr. Rul In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement are not deemed gifts by the insureds to the ILIT. 49 Treas. Reg. Sec (f)(2)(ii). 50 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 18 of 50

24 the ability to access cash value as premium payor and assignee on the policy, that ability would not be diminished by a divorce or separation. Accordingly, the premium payor may retain access to the policy's cash value after the couple divorces or separates. This issue should therefore be considered by the clients and their tax advisors before entering into a private split-dollar arrangement. 4. What is included in the premium payor s estate? Upon the death of the premium payor, only the amount currently owed to the premium payor pursuant to the split-dollar agreement (i.e., the entire cash value) should be included in his or her estate. 51 The portion of the death benefit ultimately payable to the trust should not be included in the insured(s)' estate Can the premium payor access the policy's cash value? The answer depends on whether the insured is also going to be the premium payor. If the insured is not the premium payor, the premium payor spouse would be able to access the cash value of the policy pursuant to his or her right under the split-dollar agreement and collateral assignment. On the other hand, where the insured is also the premium payor such as in a second-to-die private split-dollar arrangement the premium payor should not be given access to the policy s cash value. Since the insured is the premium payor, access to the policy's cash value would give the insured(s) incidents of ownership over the policy that would cause the death benefit to be included in his or her estate. 53 To prevent the insured from having incidents of ownership, the insured should not have any rights over 51 IRC Sec The final split-dollar regulations provide that the term cash value shall mean the cash value of the policy, determined disregarding surrender charges or other similar charges or reductions, as defined in the insurer s policy form. Treas. Reg. Sec (d)(4)(i). In addition, no artifice or device may be used to understate the cash value. Treas. Reg. Sec (d)(5)(iii). 52 Priv. Ltr. Rul See Rev. Rul , , C.B Page 19 of 50

25 the policy but only a right of reimbursement upon termination of the split-dollar arrangement. 6. Must the ILIT pay the REB? If the ILIT does not pay the REB, the premium payor is treated as making a deemed gift of the REB amount to the ILIT. The downside is that the deemed gift may not qualify for the annual gift tax exclusion because it is not a present interest. Thus, the premium payor would have to use his or her lifetime exemption amount and/or pay gift tax on that amount. 54 Since private splitdollar is intended to reduce the gift tax cost of funding a policy, the ILIT will typically pay the REB amount. The insured will gift cash in an amount equal to the REB to provide the ILIT trustee with the funds necessary to pay the REB. If the insured has sufficient annual exclusion gifts and/or lifetime exemptions available, the gift should be gift tax-free. 7. Does the ILIT s payment of the REB offset the amount owed to the premium payor at rollout? Any REB paid by the ILIT does not offset any amount owed to the premium payor at rollout. The REB paid by the ILIT is treated as being paid to the premium payor. 55 It, therefore, does not give the ILIT any basis in the policy and does not offset any amount owed to the premium payor. Rather, any REB contributed to the policy will be included in the basis of the premium payor What is cash value for split-dollar purposes? The final regulations provide that cash value for split-dollar purposes, is determined disregarding surrender charges or other similar charges or reductions and includes any amount attributable to paid-up additions. 57 Cash value for split-dollar purposes, therefore, is not the cash surrender value. Rather, the cash value 54 See footnote Treas. Reg. Sec (f)(2)(i). 56 Treas. Reg. Sec (f)(2)(ii). 57 Treas. Reg. Sec (d)(4)(i). Page 20 of 50

26 must be at least as great as the accumulated value of the policy. Furthermore, the regulations provide that no artifice or device may be used to understate the cash value. 58 The client s independent tax advisor should be consulted to determine the appropriate cash value amount owed to the premium payor under the split-dollar arrangement. 9. How is the split-dollar arrangement documented? To create a private split-dollar arrangement, the trustee of the ILIT and the premium payor spouse working with their attorney execute a private split-dollar agreement and submit a collateral assignment form to the life insurance company. In split-dollar cases where the insured is also the premium payor (such as in a second-to-die scenario or in a single life policy for a single person scenario), a restricted collateral assignment agreement and form should be used to avoid any incidents of ownership to limit the donor/assignee s rights to a right of reimbursement only with no access to the cash value. A written split-dollar agreement setting forth the rights and obligations of the trustee and premium payor spouse is necessary to prevent the Service from arguing that the premium payor spouse's payments of premium were gifts to the trust beneficiaries. 59 The split-dollar agreement should be carefully drafted not to give the ILIT any current access to the cash value of the policy. 60 Moreover, if the insured is also the premium payor, the agreement should be drafted as a restricted collateral assignment agreement to limit the insured s right to the policy s cash value to a right of reimbursement only with no access to the cash value in order to avoid any possible incidents of ownership. 58 Treas. Reg. Sec (d)(5)(iii). 59 If there is no proof that the spouse would be reimbursed for his or her premium advances, the Service could argue that the spouse made gifts to the trust. IRC Sec. 2512(b). 60 Treas. Reg. Sec (d). If the ILIT is given any access to the cash value, the regulations provide that the amount to which the non-owner has current access will be taxed as a gift to the ILIT. Page 21 of 50

27 In a single life private split-dollar agreement for a married insured where the non-insured spouse is the premium payor and is given access to the cash value, the non-insured spouse should use his or her separate property to pay for his or her portion of the premium to ensure that the death benefit payable to the trust is excluded from the insured s estate. Accordingly, depending upon the particular state law, the insured and spouse might also need to enter into an agreement transmuting community property funds to separate property funds prior to using such funds to pay their respective premium. 61 If the attorney is concerned that the release of a collateral assignment consequent to a split-dollar agreement is a potential transfer for value causing the life insurance proceeds to be income taxable, he or she might consider drafting the trust as a grantor trust to the insured. 62 If the trust is a grantor trust, arguably, the transfer at the time of the rollout would be considered to be made to a party exempt from the transfer for value rule; the insured In Private Letter Ruling , the taxpayers, who resided in a community property state, specifically indicated that the insured gifted separate property to the trust for the trust to pay its share of the premiums and the insured's spouse paid his or her portion of the premium using his or her separate property. While not specifically addressed in the ruling, each spouse's use of separate property is vital to excluding the portion of the death benefit payable to the trust from both spouses' estates. If the non-insured spouse uses community property funds to pay his or her portion of the premium, the insured might be a deemed assignee over the policy, giving him or her incidents of ownership over the policy, causing inclusion of the entire death benefit in his or her estate under Sec Furthermore, if the non-insured spouse is also a beneficiary of the ILIT, the insured spouse should gift separate property to fund his or her portion of the premiums in order to avoid inclusion of trust proceeds in the non-insured spouse s estate under Sec Some commentators argue that the transfer-for-value rule would not apply to collateral assignment split-dollar because, pursuant to Treas. Reg. Sec (b)(4), the "...assignment of a policy as collateral security is not a transfer for a valuable consideration..." It is posited that, given this regulation, the reverse should be true; i.e., the release of a collateral assignment should also not be a transfer for value. One must remember, however, that this regulation addressed assignments apparently for loans whereas, in the private split-dollar scenario, the assignee's interest in the policy is not a loan. 63 W. Clark Swanson, Jr., v. Comm'r., 518 F.2d 59 (8th Cir. 1975). Page 22 of 50

28 D. Planning for Rollout of Private Split-Dollar Arrangements Under Economic Benefit Regime 1. Necessity for Rollout A split-dollar arrangement may terminate during the insured's lifetime or upon the insured s death. The REB cost, however, increases as the insured gets older. From a gift tax perspective, the parties should terminate the split-dollar arrangement before the value of the REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. If the parties knew that the insured would die before the REB exceeded the actual premium, they might not need to plan for the rollout. However, prudence dictates planning for a possible private split-dollar rollout. If the parties to the arrangement fail to plan in advance, gifting concerns may force a rollout that could strip the policy of its cash value and result in little or no insurance death benefit payable to the trust. This unfortunate result occurs because only nonequity collateral assignment split-dollar arrangements where the ILIT is only entitled to the current life insurance protection qualify under the special rules provided by the final regulations for split-dollar treatment. This means that the entire cash value must be assigned to and paid to the premium payor upon rollout. 2. Rollout Options a. Pre-funding the Rollout One solution to the rollout dilemma is to "pre-fund" the rollout. If there is a spread between the value of current life insurance protection and the amount that the insured could gift to the trust beneficiaries gift tax-free using annual exclusion gifts and lifetime exemption amounts, the insured and/or spouse can gift the Page 23 of 50

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