Once a great idea reaches the tipping point, there are two possible outcomes with potentially negative effects.
First, profits decrease significantly as competition drives down the exclusivity premium paid by early adopters. Second, the strategy has a much higher chance of becoming public knowledge and being scrutinized by government regulators. So, here’s the question: has private split-dollar reached the point of “competitive syndrome”?
With the current regulatory environment becoming increasingly challenging for financial advisors to navigate, it is our responsibility as advisors to fully understand and explain the risks, tax consequences and potential litigation costs prior to recommending such strategies to clients.
The competitive syndrome
The competitive syndrome describes a plan that becomes too aggressive, putting the client at risk for an IRS challenge. It starts with a great sales idea developed by an intrepid innovator. The innovator engages a knowledgeable attorney, who researches the idea to make sure of the legal footing. The attorney often provides an opinion letter, although this is more difficult now, under Circular 230.
As the concept spreads, the idea gathers steam and permutations are added, making the next generation “better.” Many times “better” can mean it appears better because it has a more aggressive tax position. A similar example of plan designs leapfrogging each other to be “better” is the recent IRS aggressive 412(i) plans, overfunded with life insurance. Advisors recommending such strategies should be cautioned, as the IRS can take a wide-sweeping approach to fix a nuance or problem it doesn’t like or dissolve a plan perceived to have been derived from ill intent. The resulting effects are felt by clients, insurance carriers and advisors.
The hybrid strategy
After decades of no action, the IRS finally issued new regulations in 2003 for split-dollar life insurance arrangements. The general reaction by most agents was to pull back, stop using collateral assignment split-dollar or rely on the traditional endorsement method, which was left unscathed. Since then, agents found the new split-dollar regulations provided many plan design opportunities. Out of this creative flurry emerged the discounted private split-dollar (DPSD) strategy.
The DPSD plan takes advantage of an obscure section of the new regulations that refers to “hybrids.” There are two basic types of split-dollar. One is the economic benefit regime, where the owner of the policy endorses the net death benefit to another person or trust. The other is the loan regime, where one person lends money to another person or trust (who is the owner of the policy) to pay the premiums.
The hybrid is a loan regime taxed as an economic benefit regime. This type of strategy is determined by the arrangement. For example, if the arrangement is a loan to an irrevocable life insurance trust (ILIT) and the agreement assigns to the lender the greater of the premiums paid or the cash value of the policy, the ILIT has no value other than the net death benefits. The regulations state where the policy owner’s only value is the death benefit, the arrangement will be taxed under the economic benefit regime — a hybrid. The ILIT owns the policy and borrowed the premiums, which gave the lender the right to recover 100% of the cash values. This leaves the ILIT with just the net death benefit. Because the arrangement is a hybrid, there is no interest due on the loan. In lieu of interest, the “cost” to the ILIT is the term rate (economic benefit) on the net death benefit, or the ILIT can elect to pay the tax on the term rate.
The value rests in how the arrangement of the private split-dollar plan is structured and valued. Consider the following hypothetical situation. If Dad (G1) enters into a private split-dollar loan arrangement with an ILIT, where the insured are his kids (G2) or grandkids (G3), the terms of the note are zero-interest loans, and it’s payable only at the death of the insured (which is 30 or more years out), then what is the discounted market value of the note?
Historically, appraisers have issued valuations indicating the fair market value of this type of note as 5% to 10% of its face amount. Yet, the market value of a $1 million note might only be $50,000 to $100,000. That being said, G1 has potentially reduced his estate tax liability by the discount of the note. In addition, if G1 gifts the note to the ILIT at his death, he has transferred 90% to 95% of the $1 million to his G3 without estate or gift taxes. Many knowledgeable attorneys think this type of arrangement has a strong tax position with little downside because the taxpayer has nothing to lose by arguing the value of the note at the death of G1. As is the case with any complex tax strategy, there is a risk the IRS will not agree with the legal opinions of competent tax counsel. So, clients and their advisors must determine whether they’re comfortable with the merits of this solution.
The competitive syndrome at work
Let’s look at just one way advisors may attempt to make this plan even more aggressive by accelerating the gift of the note. The first step of the arrangement happens after three or four years. A new irrevocable trust is set up for the benefit of G2 and G3. Then G1 gifts the note to the new trust, relying on an appraisal stating the value is 5% of the face value of the note.
The second step happens when the cash values are equal to the total premiums paid. The trustee of the ILIT will now surrender the life insurance policy and transfer the cash to a new trust to terminate the split-dollar arrangement. Without consideration of time or value of money, G1 has now transferred $1 million to G2 and G3 for a gift value of $50,000. The total cost is about two or three cents on the dollar, and by using a properly designed trust, G1 doesn’t give up control.
Why could this arrangement be considered very aggressive or risky even though every step has legal authority? Tax practitioners point to the legal arguments the IRS typically uses, called substance-over-form, step transactions and self-dealing. The tax court will consider all of the facts, including how G1 established or approved the terms of the arrangement and set up the two trusts and how G1 selected the trustee, made the loan and gifted the note to his heirs at a 95% discount. Additionally, the court will examine how the trustee of the ILIT, who is arguably acting on behalf of G1, will agree to surrender the policies and pay off the note, killing the very benefit the ILIT was supposedly established to provide. The IRS would most likely argue the only real reason for the plan was tax avoidance.
Without having full disclosure of the potential pitfalls of implanting such strategies, high net-worth families may well decide the risk is worth the reward. The downside could be significant if the IRS assesses G1 as it did 412(i) plans, 419 plans, retired life reserve plans and other tax shelter programs.
All professional advisors owe a fiduciary obligation to their clients to protect them from their own emotional decisions. Be careful if you offered an opportunity to market programs where the rewards are tied to aggressive tax reduction strategies. Such strategies are ill-advised, and as a trusted, responsible advisor, you should consider alternative solutions to better serve your clients’ best interests.