Ruling makes split-dollar arrangements less attractive and potentially impacts other planning techniques.
In Estate of Richard E. Cahill, et al. v. Commissioner,1 the Tax Court denied partial summary judgment to an estate that contested a deficiency notice in which the Internal Revenue Service adjusted the value of the decedent’s rights in three split-dollar life insurance arrangements from $183,700 to more than $9.61 million. The court declined to grant partial summary judgment on the estate’s arguments that Internal Revenue Code Sections 2036, 2038 and 2703 didn’t apply to the split-dollar arrangement and that Treasury Regulations Section 1.61-22 did apply in valuing the decedent’s interest in the split-dollar arrangements for estate tax purposes.
Although this case only denies the estate partial summary judgment regarding the IRS’ arguments under Sections 2036, 2038 and 2703, it does lay out the framework that the court may very well use in ultimately determining that the cash surrender value (CSV) of the policies at the time of the decedent’s death will be includible in the decedent’s estate. While the court addressed issues under Sections 2703, 2038 and 61 in addition to 2036(a)(2), we’ll focus primarily on the latter provision as it relates to the ongoing expansion of Section 2036(a)(2) in the context of family limited partnerships (FLPs) and, now, potentially other types of arrangements. As we saw in Estate of Powell v. Comm’r,2 just a year and a half ago, the Tax Court indicated that the mere ability of the decedent, in conjunction with others, to determine who’ll possess or enjoy the property or income from transferred property will trigger estate tax inclusion under Section 2036(a)(2). The court’s growing willingness to use these provisions to affect estate tax inclusion in expanded situations should serve as a cautionary reminder to estate planners to be careful about the rights retained by a transferor of property—especially with regard to rights in entities wherein some control or ongoing involvement, however minute, is retained. Cahill, however, suggests that the reach of Section 2036(a)(2) isn’t limited to family entities such as FLPs, but, can also be applicable to other types of arrangements. While the Cahill case had nothing to do with FLPs, but rather involved multigenerational split-dollar arrangements, the court’s reference to Powell highlights the potential for an even broader application of the statute, thus signifying some further erosion of the ability to structure planning in which the parent continues to hold on to different rights, even if only in connection with others.
Creation of Split-Dollar Agreements
In 2010, when Richard Cahill was 90 years old and no longer able to manage his own affairs, his son, Patrick, entered into three split-dollar insurance agreements on his behalf. Richard (the decedent) lived in California at the time of his death in December 2011. Patrick, a Washington state resident, served as executor of the estate.
The decedent had been the settlor of two trusts—the revocable Richard F. Cahill Survivor Trust (Survivor Trust) and the irrevocable Morris Brown Trust (MB Trust). Patrick was trustee of the Survivor Trust and was his father’s attorney-in-fact under California law. Patrick’s cousin, William Cahill, was trustee of the MB Trust, and the primary beneficiaries of that trust were Patrick and his issue. The MB Trust was formed on Sept. 9, 2010 to take legal ownership of three whole life policies, two insuring the life of Patrick’s wife and one insuring Patrick’s life. Lump sum premiums for the three policies totaled $10 million; each policy guaranteed a minimum 3 percent return of the invested portion of the premium.
Patrick, as trustee of the Survivor Trust, and William, as trustee of the MB Trust, executed three split-dollar agreements to fund the acquisition of the three life insurance policies. These agreements provided that the Survivor Trust would pay the premiums; the Survivor Trust did so by taking a $10 million loan from an unrelated third party. The obligors on this loan were the decedent (with Patrick signing for him as his attorney-in-fact) and Patrick, as trustee of the Survivor Trust.
As a general matter, the decedent’s involvement in the three split-dollar life insurance arrangements occurred solely through the Survivor Trust, directed by Patrick. Both the estate and the IRS agreed that all assets in the Survivor Trust on the decedent’s date of death were includible in the gross estate.
Provisions of Agreements
Each of the split-dollar agreements provided that when the insured died, the Survivor Trust would receive a portion of the death benefit equal to whichever of the following is greatest (referred to as the “decedent’s death benefit rights”): (1) the remaining balance of the loan, (2) the total premiums the Survivor Trust paid on the policy, or (3) the CSV of the policy immediately before the insured’s death. MB Trust would retain any excess of the death benefit (referred to as “MB Trust’s death benefit rights”).
Each split-dollar agreement could be terminated during the insured’s life if the trustees of the Survivor Trust and the MB Trust agreed in writing. If one of the agreements terminated, the MB Trust could opt to retain the policy or transfer its interest in the policy to the third-party lender (referred to as “termination rights”). MB Trust couldn’t sell, assign, transfer, borrow against, surrender or cancel a relevant policy without the Survivor Trust’s consent.
Deficiency Notice
In 2010, the year before he died, the decedent reported $7,578 in gifts to MB Trust based on a determination under the economic benefit regime pursuant to Treas. Regs. Section 1.61-22. Following his death, the decedent’s estate reported the value of his rights in the split-dollar arrangements totaling $183,700. As of the date of death, the CSV of the policies exceeded $9.61 million. In its deficiency notice, the IRS adjusted the total value of the decedent’s rights in the split-dollar agreements from the reported $183,700 to the aggregate CSV, determining a deficiency of more than $6.82 million plus penalties for negligence and gross valuation misstatements.
Estate’s Arguments
The estate argued that because: (1) the decedent’s right to terminate the split-dollar agreements was held in conjunction with the trustee of MB Trust, and (2) it would never make economic sense for MB Trust to allow the split-dollar agreements to terminate, termination was so unlikely that as of the date of the decedent’s death, the termination rights had no value. This meant, the estate asserted, that the value of the decedent’s interest in the split-dollar agreements was limited to the value of the decedent’s death benefit rights, which were only $183,700 on his date of death because the insureds (Patrick and his wife) were projected to live for many more years, and therefore, the decedent’s rights had only a small present value.
In addition to arguing that the total value of the decedent’s rights in the split-dollar agreements exceeded $9.61 million, the IRS presented theories in the alternative under Sections 2036(a)(2), 2038(a)(1) and 2703(a)(1) and (2). The estate sought summary judgment on these issues, applying Treas. Regs. Section 1.61-22.
Sections 2036(a)(2) and 2038(a)(1)
Section 2036 includes property in a gross estate if: (1) the decedent transferred the property during life; (2) the transfer wasn’t a bona fide sale for full and adequate consideration; and (3) the decedent kept an interest or right in the transferred property of the kind listed in Section 2036(a)(2) (that is, the right either alone or in conjunction with anyone to designate who will possess or enjoy the property or income from the property).
Similarly, Section 2038 includes transferred property in the gross estate if: (1) the decedent made a gift during life; (2) the transfer wasn’t a bona fide sale for full and adequate consideration; and (3) the decedent retained an interest or right in the transferred property of the kind listed in Section 2038(a) (that is, a power that enables the decedent, either alone or in conjunction with another person, to alter, amend or terminate the transferees’ enjoyment of the property) that the decedent didn’t give up before death and that wasn’t relinquished in the three years prior to the date of death.
The $10 million that the decedent paid the insurance companies as lump sum premium payments for the benefit of the MB Trust was accounted for in three parts as of the date of his death—part was paid as commissions and fees; part was used while the decedent was alive to pay the cost of current life insurance protection on the insureds; and part was attributable to the CSV remaining in the policies as of the date of death. The IRS and the estate disagreed over the third part, with the estate asserting that Sections 2036(a)(2) and 2038(a)(1) didn’t apply to include the CSV in the gross estate because the decedent retained no rights with respect to the amounts transferred sufficient to justify applying these IRC sections.
The court found, however, that “the rights to terminate and recover at least the cash surrender value were clearly rights, held in conjunction with another person (MB Trust), both to designate the persons who would possess or enjoy the transferred property under section 2036(a)(2) and to alter, amend, revoke, or terminate the transfer under section 2038(a)(1).”3 The court rejected the estate’s contention that the decedent’s right to terminate was negated by the fact that the MB Trust could prevent the decedent from terminating the split-dollar agreements, noting that this reasoning would mean that the words “in conjunction with any person” in Section 2036(a)(2) and “in conjunction with any other person” in Section 2038(a)(1) would have no meaning. The court cited to the recently issued Powell decision from May 18, 2017, which applied Section 2036(a)(2) with respect to that decedent’s limited partnership (LP) interests in an FLP, and cited to Estate of Strangi v. Comm’r,4 on which the Powell opinion relies heavily. The court rejected the estate’s argument that for Section 2036(a)(2) to be applicable, the decedent would need to have complete control, indicating that unilateral control isn’t required under either the statute or case law.
Next, the court addressed whether the bona fide sale exception under both Sections 2036 and 2038 could be applicable. The court separately analyzed the two components of this exception, first addressing whether the decedent’s transfer of $10 million was “a bona fide sale” and, second, whether such transfer was for “adequate and full consideration.” As to the bona fide sale prong, the court considered whether there was a “legitimate and significant non-tax reason” for the transfer of the $10 million. The court indicated that a number of questions would need to be considered in connection with determining whether such reasons existed and consequently determined that summary judgment wouldn’t be appropriate.
As to the adequate and full consideration prong, the court indicated that the question was whether the decedent received “roughly equal the value” of what he transferred and went on to conclude that such wasn’t the case. The court noted that, under the estate’s admitted logic, due to the MB Trust’s veto power over the termination of the split-dollar agreements, such rendered the decedent’s rights at death at essentially zero, noting that the reported value on the estate tax return was less than 2 percent of the CSV. From there, the court noted that, because the MB Trust’s veto power existed from inception, such 98 percent discount would have been present from that time, thus undercutting the estate’s argument that the decedent had received adequate and full consideration. That is, the decedent only received consideration equal to roughly 2 percent of his $10 million transfer, so by definition, such wouldn’t have been remotely close to adequate and full consideration. Therefore, the court denied summary judgment with regard to this issue as well.
Section 2703
The IRS argued in the alternative that the MB Trust’s ability to veto termination of the split-dollar agreements should be disregarded under Section 2703(a)(1) or (2) for purposes of valuing the decedent’s rights in those agreements. The court declined to grant the estate’s summary judgment motion on these issues as well.
The court found as lacking merit the estate’s suggestion that the IRS was attempting to ignore the split-dollar arrangement in its entirety and treat the policies themselves as assets of the decedent so as to look through the split-dollar arrangement to the underlying insurance policies. The court also acknowledged that such a look-through argument had previously been rejected by the court in Strangi, indicating that such wasn’t the intent of the statute. The court disagreed with the estate’s contention that the IRS was making this argument. Rather, the court clarified that the IRS was looking at the decedent’s interest under the split-dollar arrangement as the asset that was subject to valuation for estate tax purpose. The court clarified that the IRS’ position was that Section 2703(a) was applicable for purposes of valuing the decedent’s rights under the split-dollar agreement, rather than the underlying policies. After clarifying that both parties agreed that the decedent’s rights under the split-dollar arrangement were the interests being considered, the court then concluded that the ability of the trustee of the MB Trust to restrict the decedent’s access to the cash value of the policies by way of his termination right was a restriction that was subject to Section 2703 as “agreements to acquire or use property at a price less than fair market value.”5
The court concluded that under Section 2703(a)(1), the split-dollar agreements, particularly the provisions that prevented the decedent from withdrawing his investment, constituted agreements to acquire or use property at a price below fair market value.
The court noted that, under Section 2703(a)(2), the MB Trust’s ability to prevent termination significantly restricts the decedent’s right to use the termination rights. The court found that the split-dollar agreements “clearly restrict decedent’s right to terminate the agreements and withdraw his investment from the arrangements.”6 Concluding that the requirements of Section 2703(a)(1) and (2) were each met, the court denied the estate’s summary judgment motion with respect to Section 2703(a).
The court also addressed and rejected the estate’s counter arguments that the split-dollar arrangements are akin to either promissory notes or partnerships, to which, the estate argued, Section 2703(a) is inapplicable. With respect to the comparison to promissory notes, the court distinguished a promissory note, which represents a bargained-for agreement between two parties to lend and borrow money, from split-dollar arrangements, which involve no such bargain. In contrast, the MB Trust received its rights under the contract for no consideration. In distinguishing the case from Strangi, which involved an FLP, the court indicated that no partnership existed in Cahill. Lastly, the court rejected the estate’s argument that Section 2703(a) is limited in its application to buy-sell agreements, indicating that the plain meaning of the statute isn’t so limited.
Double Counting Gifts
The court also addressed the estate’s argument that the difference between the policies’ CSV of $9.61 million and the reported value of the decedent’s interest under the arrangement would already be accounted for as gifts, so that the application of Sections 2036(a)(2), 2038(a)(1) or 2703 would result in a double counting of those assets under both the gift and estate tax regimes. Rejecting the estate’s argument, the court noted that no gift tax return was filed reporting such purported gifts and that both parties agreed that the value of the current cost of life insurance protection constituted a gift under Treas. Regs. Section 1.61-22. Because the current cost of the life insurance protection had already been deducted from the policy to determine the remaining cash value, no part of the remaining cash value had been used to pay the cost of the insurance protection, and therefore, no part of the cash value remaining as of decedent’s death had already been subject to gift tax. Thus, no double counting would result.
Treas. Regs. Section 1.61-22
The estate sought summary judgment, arguing that under Treas. Regs. Section 1.61-22, the economic benefit regime applies to the split-dollar agreements. But, the court concurred with the IRS’ observation that these are gift tax rules, not directly applicable to estate tax. Nonetheless, because the gift tax is supplementary to the estate tax, the court ultimately decided to review the regulations for further consideration.
The court rejected the estate’s contention that it “should modify the approach required by Sections 2036, 2038, and 2703 so as to avoid inconsistency between these statutes and the regulations,”7 finding no inconsistency between the estate tax statutes and Treas. Regs. Section 1.61-22.
Furthermore, the court concluded, consistency “between the regulations and the estate tax code sections would . . . demand that the cash surrender value remaining as of decedent’s date of death be valued as part of, or included in, decedent’s gross estate. In short, the consistency the estate demands would seem to require the result respondent seeks,”8 making summary judgment inappropriate.
Implications
The Tax Court’s denial of the estate’s motion for partial summary judgment with respect to its Section 2036 and Section 2703 positions isn’t particularly surprising in light of the aggressive deathbed planning that was implemented in Cahill. While it wouldn’t be an inaccurate observation to conclude that Cahill is yet another example of aggressive planning coupled with bad facts leading to a bad result, what’s potentially concerning about this case is the Tax Court’s reference to the Powell opinion with respect to Section 2036(a)(2), just one year after its issuance. It’s important to note that this was only a Tax Court Memorandum opinion in connection with a motion for partial summary judgment. However, the court’s analysis as to the ability of Section 2036(a)(2) to treat the decedent’s co-termination right of the split-dollar arrangements as tantamount to his ability as a right “alone or in conjunction with others” to access the underlying cash value does provide some further insight as to the way the court views retained rights.
The origins of this evolution as applied to FLPs, trace back to the Strangi decision from 2003. That opinion, which involved a “bad facts” FLP, not surprisingly concluded that Section 2036(a)(1) applied when Albert Strangi contributed nearly all of his assets into an FLP and continued to have implied enjoyment of contributed assets, such as the use of the personal residence as well as distribution and use of assets for his living needs. While the Strangi court’s holding that Section 2036(a)(1) was applicable wasn’t at all surprising, what was surprising was the court’s additional and separate conclusion that the contributed assets were also included in Albert’s estate under Section 2036(a)(2) for two separate reasons: first, because Albert, who owned a 47 percent interest in the 1 percent corporate general partner (GP), retained the right, “alone or in conjunction with others” to designate who would enjoy distributions of income from the FLP (the “first application”); and, second, because Albert, in his capacity as a limited partner in the FLP, could participate with the other partners in connection with a vote to liquidate the FLP and, thereby, receive back his contributed assets (the “second application”).
The first application of Section 2036(a)(2) was considered controversial enough and was unexpected in that it suggested that retention of even a non-controlling interest in the GP of an FLP was enough to cause contributed assets to be included in the creator’s gross estate. Indeed, for years following the Strangi decision, this holding presented, and continues to present, a dilemma to estate planners attempting to strike the balance between a parent’s often expressed desire to have some ongoing involvement (albeit without actual majority control) in the management of an FLP following gifts of partnership interests versus the risk of inclusion in the gross estate as a consequence of such ongoing involvement. This holding was followed some years later in Estate ofTurner v. Comm’r,9 in which it was determined that Clyde Turner’s retention of the GP interest in an FLP triggered estate tax inclusion of assets he contributed under Section 2036(a)(2).
The second application of the Section 2036(a)(2) holding in Strangi at that time received very little attention by the estate-planning community, presumably because the practical implication of such a holding seemed so inconsistent with commercial and practical realities of structuring and operating a partnership. While the planning community was aware of this part of the Strangi decision, planners didn’t appear overly excited about this aspect, which was generally viewed as an even further stretch of the law than the first application of Section 2036(a)(2).
For several years following Strangi, the second application of Section 2036(a)(2) was an issue that was rarely given much consideration for the reasons mentioned above. In short, most planners considered it as a bit of a “nothing burger” based on what was perceived as one rogue case interpretation of the law; that, and the fact that the court didn’t need to decide the issue because it had already decided inclusion of the assets transferred to the FLP in the decedent’s estate under Section 2036(a)(1). Consistent with the industry’s view of this issue, for some 14 years, this issue went dormant, having not been raised in any cases following Strangi. As it turned out, in 2017 this perception evolved into what turned out to be a false sense of security as a consequence of the Powell decision in 2017, in which it was held that the decedent’s retention of only LP interests in an FLP (her sons owned all of the GP interests from inception) triggered the inclusion of the contributed assets into her estate under Section 2036(a)(2). It should be noted, however, that this holding wasn’t arrived at as a result of the issue being litigated by the parties but, rather, as a consequence of an admission by counsel for the estate that before Nancy Powell’s attempted transfer of her LP interests into a charitable lead trust (CLT) (by way of exercise of a power of attorney by her sons), her ownership of such LP interests constituted retained control under Section 2036(a)(2). Unfortunately for the estate and for the estate-planning community, the Tax Court concluded that the purported gift of the decedent’s 99 percent LP interest to the CLT was ineffective because the power of attorney didn’t actually authorize gifts to charities. Therefore, the court determined that by the estate’s own admission, Nancy retained control of the contributed assets under the statute. In addition, the court also noted that even had the attempted gift of the LP interests been effective, the 3-year rule under Section 2035(a) would have still resulted in Section 2036(a)(2) applying because Nancy certainly didn’t outlive the transfer by three years (she died six days following the transfer).
The Powell court did, however, provide a lengthy discussion with respect to the application of Section 2036(a)(2), in which it relied heavily on Strangi, thus giving renewed life to the second application in Strangi, which had been regarded by the estate-planning community at large as a bit of a “that can’t possibly be the right answer” issue. The Powell court, further relying heavily on the analysis of the Strangi decision, included a lengthy discussion with respect to United States v.Byrum10 and why the protections against inclusion of assets under Section 2036(a)(2) afforded by Byrum didn’t apply in the context of an FLP, with the Powell court indicating that the types of fiduciary duties involved in Byrum were distinguishable from the types of “illusory” fiduciary duties that are typically present in the context of FLPs. What’s troubling about the Powell decision is the presumption that appears to be made that fiduciary duties will necessarily be ignored in the family context. Quite to the contrary, litigation in the closely held business context often involves disputes between family members.
In Powell, we have the situation in which an aggressive deathbed planning arrangement resulted in bad law. Certainly, the end result reached in Powell, inclusion of the contributed assets in the gross estate, wasn’t an unjust one. However, it’s the determination of the application of Section 2036(a)(2) rather than 2036(a)(1) that’s caused issues of concern to planners at large with respect to the potential impact on legitimate family transactions. Interestingly, the estate also didn’t argue that the so-called “bona fide sale exception” to the general application of Section 2036(a) was applicable.
In the wake of Powell, diverging views have emerged. On the one hand, Powell could be viewed as an isolated case involving really bad facts resulting in inclusion in the decedent’s gross estate, which is a result that feels right on the merits, and nothing further should be read into this opinion other than this being another abusive case. On the other hand, because of the holding as to Section 2036(a)(2), in which only limited partner interests were owned by the decedent, the case could be viewed as a further expansion of the application of the statute (recalling that, in Strangi, Albert had owned both GP and limited partner interests). Note, however, under the Estate of Bongard v. Comm’r11 standard for determining whether Section 2036(a) is applicable, a court must first determine that the bona fide sale for full and adequate consideration in money or money’s worth exception doesn’t apply.
The Cahill decision, while merely reflecting a motion for partial summary judgment and a Tax Court Memorandum decision, nonetheless is relevant in that it reflects a further evolution of the case law and the court’s views with respect to the application of Section 2036(a)(2) in additional circumstances, such as retention of only LP interests or, in this case, the retention of co-termination rights in split-dollar arrangements.
Where From Here?
For many “old and cold” family entities that have been created over the past decade or two, the Powell decision, which has now been cited just one year later in Cahill, will serve as a prompt for families and family offices to revisit these structures. Of course, the landscape with respect to FLPs is always changing, and there’s an ongoing evolution in the way that these structures are viewed by both the IRS and the Tax Court. Unfortunately, the practical application of this dynamic is that FLPs that may have been regarded as safe at the time they were established, and perhaps subsequent thereto, may become less certain as the law develops, through no fault of the decisions that were made when originally structuring the vehicle.
Thus, it’s a good idea to periodically re-evaluate the structure. In light of the Tax Court’s expansion of Section 2036(a)(2), now might be an appropriate time to conduct such a “stress test.” An evaluation of an existing FLP should take into consideration an honest assessment of the relative strengths and weaknesses of the partnership as it exists and has been administered to date. It’s important to keep in mind with this evaluation that, if it can be successfully established that the bona fide sale exception to the application of Section 2036(a) was satisfied when the LP was created, then, technically, this takes Sections 2036(a)(1) and (2) “off the table,” and from a technical perspective, such should make the development in Powell and Cahill of no consequence. Of course, the practical reality with respect to this exception is that there’s no hard and fast litmus test, but, rather, it’s a facts-and-circumstances based determination; whether this exception is satisfied is only determined once the client has passed away and the merits of this argument are being evaluated in the context of an estate tax audit and possibly litigated.
If, after an evaluation of the FLP, it’s concluded that enough uncertainty exists with respect to whether the bona fide sale exception should be satisfied, and the client doesn’t wish to maintain the LP with the uncertainty of what ownership of LP interests could mean, then certain types of decontrolling actions should be considered.
For instance, consider using the new generous $11.18 million gift tax exemption per person so as to make gifts of any remaining LP interests. If this exemption is doubled between spouses, this would largely provide enough “cover” for many families so as to rid themselves of the LP interest gift tax free. In the case of larger partnerships, such additional gift could also provide significant additional seed capital to support a sale of additional remaining LP interests in connection with a promissory note. Importantly, it’s critical to be mindful of the possibility that the 3-year rule will apply under Section 2035 to the extent that it’s determined that such LP interests while in the hands of the donor constituted retained strings under Section 2036(a). Of course, sales for full and adequate consideration could be structured in an attempt to satisfy the exception to this rule, although there’s some uncertainty as to what constitutes full and adequate consideration for these purposes.
—The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.
Endnotes
1. Estate of Cahill v. Commissioner, T.C. Memo. 2018-84 (June 18, 2018).
2. Estate of Powell v. Comm’r, 148 T.C. 18 (May 18, 2017).
3. Cahill, supra note 1, at p. 13.
4. Estate of Strangi v. Comm’r, T.C. Memo. 2003-145 (May 20, 2003), on remand from Gulig v. Comm’r, 293 F.3d 279 (5th Cir. June 17, 2002), aff’d, 417 F.3d 468 (5th Cir. July 15, 2005).
5. Cahill, supra note 1, at p. 21.
6. Ibid., at p. 22.
7. Ibid., at p. 30.
8. Ibid., at p. 33.
9. Estate of Turner v. Comm’r, T.C. Memo. 2011-209 (Aug. 30, 2011).
10. United States v. Byrum, 408 U.S. 125 (June 26, 1972).
11. The court cited to the Bongard case for this proposition. See Estate of Bongard v. Comm’r, 124 T.C. 95 (March 15, 2005).