Decedent’s Estate Did Not Include Cash Surrender Values of Split-Dollar Life Insurance

A decedent’s estate did not include the cash surrender values of split-dollar life insurance arrangements because the decedent did not have the right to terminate the policies. Instead, in M. Levine Est., the Tax Court concluded that the estate included the value of the “split-dollar receivable.”

Executing the Split-Dollar Life Insurance Arrangements

Throughout her life, the decedent invested in real estate, a stock portfolio, interests in two Renaissance Fairs, and several mobile home parks. She also made loans to real estate partnerships and mobile home park residents. 

The decedent wanted her real estate assets to stay in her gross estate so that her children would inherit them with stepped-up bases. Her attorney suggested intergenerational split-dollar life insurance as a way for the decedent to invest her excess capital while benefiting her children’s own estate plans.

To carry out the plan, the attorney first established an irrevocable life insurance trust (the Insurance Trust) that would own the policies. The decedent’s children and her accountant, acting as her attorneys-in-fact and trustees of her Revocable Trust, then carried out the following steps:

1. The Insurance Trust agreed to buy the split-dollar life insurance policies.
2. The Revocable Trust agreed to pay the premiums.
3. The Insurance Trust assigned the policies to the Revocable Trust as collateral.
4. The Insurance Trust agreed to pay the Revocable Trust a “Receivable” that was based on a complicated formula involving the total amount of premiums paid for the policies ($6.5 million),  the current cash surrender values of the policies upon the death of the last surviving insured, and the cash surrender values of the policies on the date that they were terminated.

Very importantly, only the Insurance Trust owned the policies. And, only the Insurance Trust had the right to terminate the arrangements.

The decedent reported the money given by the Revocable Trust to purchase the policies as taxable gifts that were equal to the economic benefit transferred from the Revocable Trust to the Insurance Trust. The decedent died shortly after this plan was put in place.

The decedent’s estate tax return reported the value of the split-dollar receivable (about $2.3 million) owned by the Revocable Trust. However, the IRS argued that the gross estate should include the cash surrender value of the policies, or nearly $6.2 million.

Tax Court Sides with Estate

The Tax Court agreed with the estate that Reg. §1.61-22 controlled the gift tax consequences of the split-dollar transaction. However, the regulations are generally silent on the estate tax consequences of split-dollar life insurance. 

Instead, Code Sec. 2042 generally controls the inclusion of life insurance policies in a decedent’s gross estate. Code Sec. 2042 did not apply here because the split-dollar policies insured the lives of the decedent’s daughter and son-in-law, and not the decedent.

Insurance Receivable Was Includible in the Estate

So the Tax Court turned to Code Secs. 2036 and 2038 to determine what rights the estate, through the Revocable Trust, had transferred and what rights it had retained. These statutes govern transfers with retained life estates and revocable transfers, respectively.

In this analysis, the decedent transferred cash when she sent money to the Insurance Trust to pay for the policies. In exchange, she received the split-dollar life insurance Receivable, which gave her the right to the greater of the amount loaned or the cash-surrender values of the policies. 

Here, only the Insurance Trust had the right to terminate the policies. And the decedent had no right to change, amend or modify the irrevocable Insurance Trust. As a result, the cash-surrender values of the life insurance policies were not includible in the decedent's gross estate. 

Instead, the property includible in the decedent's estate was the split-dollar life insurance Receivable, over which the decedent had unrestricted control. The value of the Receivable was stipulated by the parties as being just under $2.3 million.

According to the Tax Court, the key to the estate’s victory was that the decedent did not own the policies and had no rights to amend or revoke the Insurance Trust.

Court Could Not Address the Real Problem?

The Tax Court did not seem altogether happy with its decision and noted that the real problem may have been the decedent’s gift tax valuation of her gift to the Insurance Trust. The gift tax issue, however, was not part of this estate tax issue.

The problem there was caused by the valuation rule in the regulations which, according to the Tax Court, was not compelled by the Code. A solution was up to the regulation writers, not the courts.