In the May 13, 2021, decision in the Estate of Clara M. Morrissette, the U.S. Tax Court (T.C. Memo 2021-60) struck down the Section 2036, 2038, and 2703 arguments put forth by the IRS pertaining to split-dollar receivables; however, Judge Joseph Robert Goeke made significant adjustments to the value of the receivables.
The IRS issued a $39.4 million deficiency with respect to the estate of Clara M. Morrissette, increasing the fair market values of rights associated with various split-dollar life insurance arrangements from $7.5 million to $32.1 million. Along with the increase, the IRS also determined an underpayment penalty of 40% for gross valuation misstatement under Section 6662(b)(5). The primary issue of the case revolved around whether Sections 2036 or 2038 applied to recapture various transfers of premiums made as part of the split-dollar agreements, as well as the application of Section 2703 to disregard certain rights – in this case, the right to terminate the split-dollar agreements.
In addition to the legal issues surrounding Sections 2036, 2038 and 2703, the primary valuation issue was the determination of the fair market value of the split-dollar arrangement receivables focusing on the appropriate discount rate, as well as the appropriate time horizon used in the discounted cash flow model.
In general, Sections 2036 and 2038 apply if:
The exception to Sections 2036 and 2038 is met if the transfer is a bona fide sale for an adequate and full consideration. The court held that that the transfers met the bona fide sale exceptions of both sections, as there was an arm’s-length bargained-for exchange for each split-dollar agreement, and there was a legitimate non-tax purpose to protect the underlying business to stay in the family. Furthermore, the court ruled that the special valuation rules of Section 2703(a) would not require the disregarding of the restriction of termination of the agreement. The court found the agreement to be a bona fide business arrangement and not a device to transfer property to members of the decedent’s family for less-than-adequate and full consideration.
Upon ruling on the legal issues, the court next turned its attention to the valuation matters and the determination of the fair market values of the split-dollar receivables. One observation is that over 100 pages of a 120-page opinion tackled the legal issues, while the valuation issues were discussed in only 10 pages of the opinion. In those 10 pages, the court analyzed the two most relevant drivers in the value of a split-dollar receivable, namely the appropriate discount rate applied to the cash flows and the repayment schedule.
The IRS expert used returns on corporate bonds and company specific debt to conclude at discount rates of approximately 9.3% and 6.9%. Alternatively, the taxpayer’s expert concluded at a rate of 15% using primarily life settlement data. Concluding that the life settlement data lacked the required details, the court stated:
“On their face, life settlements are an appealing source to determine the discount rate because the return depends on the performance of a life insurance policy … The differences between the life settlements and the split-dollar agreements make the comparison unreliable especially in the light of the lack of transparency associated with the life settlement yields.”
The final question with regard to the valuation, was the time frame of the cash flows. The IRS argued that the family intended to terminate the split-dollar arrangement after the passing of Clara Morrissette, while the taxpayer argued that there was no pre-arranged plan for termination and that the policy would be held until the eventual passing of the insured. Given the judge’s feeling that the taxpayer was standing on both sides of the transaction, the judge ruled using approximately a four-year time frame for termination of the split-dollar arrangements. This resulted in an approximate discount to face of 8%.
The most telling narrative may be found in the penalties discussion of this case. Despite the narrative detailed in the case that the IRS agent initially did not pursue penalties because of the various legal issues involved and the reliance on a credible appraiser, the judge clearly expressed his discontent in stating:
“The taxpayer’s opined value was not reasonable, and the brothers should have known that. The brothers had the trust pay $30 million and turned it into $7.5 million for estate tax purposes. They should have known that the claimed value was unreasonable and not supported by the facts … The petitioner did not rely on it in good faith … The estate is liable for the 40% penalty for gross valuation misstatement of the split-dollar rights.”
The obvious lesson in this case is that the legal planning and structuring has to be done with extreme sensitivity toward correct execution and having a non-tax business purpose. As the court pointed out, tax benefits are certainly permissible, but the transaction cannot be purely tax-driven. From a valuation perspective, we find it interesting that almost the entire valuation difference came down to the assumption of a drastically reduced payoff period – a valuation difference that could not be anticipated between the hypothetical willing buyers and willing sellers that constitutes the default provision of fair market value.