Treasury Addresses Split Dollar and Current Issues

he rosy glow of sunset was supposed to adorn the long gentle transition to the repeal of the estate tax. The calming effect of higher exemptions and lower tax rates was supposed to send the taxing authority and the taxed nodding off to sleep. Instead, the instincts of the hunter and the hunted have persisted. If anything, the level of contention has increased. Entering the final quarter of 2002, we find the Treasury and the IRS taking a proactive stance on several important issues.

Most significantly, less than three weeks after an article in The New York Times reported on an abusive estate tax technique, the Treasury rolled out Notice 2002-59 and closed a sophisticated loophole that many of the wealthiest families in America were counting on.

In addition, the IRS was able to amend its claims in Estate of Strangi and sustain its fight against certain aspects of family limited partnerships (FLPs). Let's examine these latest split-dollar and FLP developments along with the other areas affected by recent Treasury action:

"Competent Authority" and tax treaties

Regulations on practice before the IRS

Application of partial payments

Limited tax levies during negotiations

Suddenly, Split Dollar

The IRS has not responded very promptly to concerns about split-dollar arrangements in general. In fact, it took about 35 years in between a 1966 Revenue Ruling and the Notice issued by the Service during 2001. But just recently, the Treasury issued Notice 2002-59 "to stop the spread of an abusive tax avoidance transaction using split-dollar life insurance."

Why split dollar, why now? For thirty-five years, the tax community never concerned itself with lengthy discussions of split-dollar insurance.¹ Split-dollar arrangements existed, to be sure, but they arose primarily in the context of the employer/employee relationship. Two key rulings from 1964 and 1966 answered any questions that arose and whatever answers weren't clear were just left off to the side like sleeping dogs which are better left undisturbed.²

But along the way, a tax loophole…or what looked like a loophole, was detected. Based on information reported by The New York Times, a turning point may have come in 1996 when Jonathan Blattmachr and Michael Brown obtained an IRS ruling that appeared to enable them to develop a new tax avoidance variation-family reverse split-dollar life insurance.

By 2001, split dollar arrangements had become too high profile, too widespread, and too abusive to be ignored. How abusive? The article appearing on the front page of The New York Times on Sunday, July 28, 2002 and subsequent articles, have revealed a problem that far exceeded what anyone had imagined. In this distorted world, wealthy individuals pay $100,000 or more for an attorney's opinion letter on split-dollar tactics. Individuals pay $32 million, up front, for insurance policies that will ultimately pay out $127 million.

About 1,600 public companies pay premiums on split-dollar policies for executives. These arrangements may end up being treated as interest-free loans as a result of the Corporate Responsibility Act, which Congress passed in July, 2002.

Some insurance policies have had first-year premiums as high as $40 million. Insurance companies, which can normally collect commissions of up to 200% of a first-year premium appear to only charge about 11% on these mega policies-but even that "discounted" rate has left small insurance firms awash in commissions. One firm acknowledged $20 million of commissions on such policies.

Split Dollar Magic

The secret mechanism behind the split dollar concept is the discrepancy between what an insurance company can charge for the same insurance policy.

For instance, one might pay $550,000 for a policy, essentially paying all the premiums up front, or $50,000, the premium charged by the company for the current year's term only. This is significant because the payment of insurance premiums is treated as a taxable gift to the beneficiary of the life insurance policy. Another permissible approach to valuation of the current year's insurance involved using tables referred to as "the P.S. 58 rates."

In theory, one could value the taxable gift at $50,000 instead of $550,000 using the P.S. 58 rates or the insurer's lowest published rate. At a top gift tax rate of 50 percent, that would mean the difference of $25,000 of tax instead of $275,000. By placing the insurance in a trust naming the insured's spouse as the beneficiary for life, even the limited amount of transfer tax could be avoided.

Once one accepts the premise that this technique is valid, the next step is to supersize the policies and the tax savings. Thus, from policies with a payout of $1 million or $5 million, we soon see the $25 million $50 million and even the $127 million reported by The New York Times.

It becomes very clear that these transactions were no longer about a company fronting insurance premiums for an employee and then getting paid back. This approach to split dollar was to exploit a loophole for purposes of tax avoidance.³

Closing A Split-Dollar Loophole

In 2001, after the IRS announced plans to examine and possibly restrict the use of split-dollar plans, wealthy individuals scurried to get their split dollar policies in place before it was too late. In Alaska, premiums for this type of insurance totaled $1.1 million in 1999 but increased to $80 million last year.

Confronted by The New York Times article, the IRS could no longer ignore the fact that thousands of such wealthy individuals were paying little or no transfer tax on such insurance maneuvers, and a huge stream of tax revenue was being diverted. The Treasury may have established a new speed record for fashioning an immediate response.

The bottom line is that the most abusive of the split dollar arrangements were never valid in the first place. The IRS had broken its 35-year silence in 2001 with Notice 2002-10 to prevent the use of P.S. 58 rates because taxpayers were using those rates to understate the economic benefits provided under split-dollar arrangements. A new table was provided on an interim basis. In July, 2002, the Treasury returned to the split-dollar topic with Notice 2002-8 and proposed regulations on the valuation of split-dollar insurance interests.

Organizers of split-dollar plans apparently felt Notice 2001-10 not only didn't affect them adversely, they actually felt it strengthened their position in some ways. The Treasury responded with Notice 2002-59, which establishes emphatically that there was no legitimate loophole that was ever open in the first place:

"[The] Treasury and the Service understand that, under certain split-dollar life insurance arrangements (some of which are referred to as `reverse' split-dollar), one party holding a right to current life insurance protection uses inappropriately high current term insurance rates, prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The use of such techniques by any party to understate the value of these other policy benefits distorts the income, employment, or gift tax consequences of the arrangement and does not conform to , and is not permitted by, any published guidance."

Practical Impact

It is estimated that thousands of clients from the wealthiest tier of society have engaged in this tax reduction technique. Their needless expenditures on high premiums that now will fail to produce major tax savings will mean years of litigation with promoters of the technique, tax advisors, and the IRS. Insurance agents who sold the mega-policies may avoid being dragged into such litigation unless they offered tax advice.

A Broader Mandate: There may be a much larger impact that flows from this IRS initiative and threatens all split-dollar arrangements and other life insurance techniques. The IRS has stated that it would disregard valuations involving disparate valuations of the premiums for life insurance to manufacture an advantage for income tax or transfer tax purposes.

Cautious observers of the IRS know that a crackdown on a particular abusive technique can quickly become an IRS attack on an entire class of techniques. For instance, several years ago, in the name of restricting abusive trusts, the income tax rates on individual personal trusts were condensed and remain highly burdensome even for a small personal trust.

Strangi Days

A few observers have also warned that maximizing the use of family limited partnerships (FLPs) may result in estate tax savings that are ultimately found to be too good to be true. One of the key victories taxpayers have enjoyed during a succession of legal victories over the past two years was, Estate of Strangi, 115 TC 478.⁴

In Strangi, $10 million of assets was exchanged for a 99% interest in an FLP just two months prior to the taxpayer's death, yet the FLP was upheld for having enough economic substance, Section 2703 was found to be inapplicable, the formation of the FLP did not constitute a taxable gift, and the FLP qualified for a 31% valuation discount-effectively transforming $10 million into $6.9 million for estate tax purposes.

But there are now signs that the IRS has not thrown in the towel. The United States Court of Appeals for the Fifth Circuit has permitted the IRS to amend its claim and argue that assets transferred to the FLP were includible in the decedent's gross estate under Section 2036. Procedurally, it is a minor issue-a motion to amend the claim was made 52 days prior to trial, there was no indication by the Tax Court that such an amendment would unduly burden the parties or delay the proceedings, so it was an abuse of discretion not to permit the claim to be amended.

Substantively and symbolically, this is no minor issue. It is a sign of the Service's continued interest in policing exploitation of FLPs. In remanding, the Fifth Circuit also upheld the business purposes in forming the FLP, so the new consideration of the Sec. 2036 argument is only a second bite at the valuation portion of the decision. Estate of Strangi, Court of Appeals, 5th Cir., USTC 2002-2, No. 01-60538 (June, 2002).

Other Treasury Issues

Tax Treaties; Competent Authority: Tax treaties generally provide that taxpayers who feel they are being taxed unfairly (inconsistently with treaty provisions) by the United States and/or a treaty country (i.e., a foreign nation) may request assistance from the U.S. Competent Authority. Simplified procedures are available where the proposed adjustment does not exceed $200,000 ($1 million in the case of a partnership or corporation). Rev. Proc. 2002-52.

Practice Before the IRS: Final regulations on practice before the IRS have been revised to require professionals to (1) furnish information concerning the identity of individuals the practitioner reasonably believes has possession of documents requested by the IRS; (2) advise a client of the consequences of any noncompliance, error, or omission under the Code and regulations; and (3) return, upon a client's request, the records of the client that are necessary for the client to comply with his or her federal tax obligations. A censure may be imposed on any practitioner who does not follow these procedures. Treasury Decision 9011 (July, 2002).

Partial Payments: Procedures for applying partial tax payments have been restated by the IRS. A taxpayer's written instructions to the IRS can determine how a partial payment is applied to taxes, penalties and interest. In the absence of instruction, the IRS acts in its own best interest, applying payment to each successive period of time, in descending order and based on a priority order of tax, penalties and then interest. Rev. Proc. 2002-26.

Limits on Tax Levies During Negotiations: The IRS has proposed regulations based on amendment of Code Sec. 6331 by the IRS Restructuring and Reform Act of 1998. The proposed changes would restrict the use of tax levies while offers to compromise or offers for installment agreements are pending. However, the restrictions will not apply if the IRS determines that the offers are being made solely as a delaying tactic or if the collection of the tax is in jeopardy. NPRM REG-104762-00.

Technical References

¹ Between Rev. Rul. 66-110 in 1966 and Rev. Rul. 2001-10 in 2001, thirty-five years elapsed without the IRS addressing split dollar issues.

² Rev. Rul. 64-328, 1964-2 C.B. 11 held that that "P.S. 58" table of rates for one-year premiums may be used to determine the value of the current life insurance protection provided to an employee under a split-dollar life insurance arrangement. Rev. Rul. 66-110, 1966-1 C.B. 12 also allowed an insurer's published premium rates for one-year term insurance to be used to measure the value of the current life insurance protection so long as those rates are available for initial issue insurance.

³ "Split Decisions on Split Dollar", The Estate Analyst (May, 2001).

⁴ "How NOT to FLP", The Estate Analyst (July, 2002); "An Achilles heel for FLPs?", The Estate Analyst (Oct., 2001).

Closing Comment:

It's Just Not Fair! They may have looked like the classic farming couple, standing with a pitchfork in, American Gothic, a 1930 painting by Grant Wood,* but Earl and Mildred Koester, a modest farm couple from Minnesota, have left us with a lesson about the American tax system.

Mildred Koester died in 1988 with an estate of $201,000 that she left to her husband. Earl Koester died in 1996 with an estate worth $1 million and an estate tax liability of $109,000. That liability could have been avoided with better estate tax planning since, based on the estate tax rules in effect at the time, a married couple could have transferred up to $1.2 million of assets free of transfer tax.

The Koesters could have avoided the tax, but didn't. Who, if not themselves, is to blame? The estate argued that considering the complexity of the estate tax system, the Koester's, having limited education, were disadvantaged and denied equal protection under the law, a violation of the Constitution. (Mrs. Koester had graduated high school. Mr. Koester had completed eighth grade.)

The Tax Court was not swayed by these arguments. The Koesters were free to obtain any legal or tax advice they wanted and arrange their own affairs as they saw fit. Moreover, the Koesters had, in fact, hired an attorney who assisted them in drafting their wills.

The estate also argued that the Koester's lack of higher education made it impossible for them to hire a competent attorney. This, of course, would mean that anyone short of a college education would be vulnerable not only to complex tax codes and attorneys who look smarter than they actually are, but to all the challenges of a modern world where there are sophisticated choices and unscrupulous people.

The lesson taxpayers may learn from this is that grown ups have to live with their own choices, including their choice of attorneys and their tax decisions. Be advised, it's called "life" and it's not always fair. Carry a pitchfork. Estate of Koester v. Comm'r., T.C. Memo. 2002-82.

* The "couple" in American Gothic are intended to be a farmer and his spinster daughter. The artist used his sister and the family dentist as models.

© R. Moshman 2002