Estate planning is a complex undertaking, especially with the looming reduction in the applicable federal etate and gift tax exemption amount set for 2026. As wealthy individuals contemplate the potential impact on their estates and the challenges posed by trust illiquidity, a strategy gaining significant attention is the use of intergenerational split-dollar arrangements. This technique provides a unique approach to address liquidity concerns while optimizing the benefits of life insurance within the confines of changing tax laws.
Understanding Split-Dollar Arrangements
Before diving into the specifics of intergenerational split-dollar planning, it's essential to grasp the fundamentals of split-dollar arrangements. Split-dollar is a financial arrangement where the proceeds or cash value of a life insurance contract are shared or divided by the parties to the arrangement, primarily upon the insured's death.
In some cases, it can also involve splitting the cost of premiums needed to sustain the life insurance policy. When this arrangement involves family members, it is often referred to as private split-dollar.
In the context of estate planning, split-dollar arrangements are commonly used in conjunction with Irrevocable Life Insurance Trusts (ILITs). These trusts own the life insurance policies and the premiums are typically paid by the settlor of the trust or a proxy acting on their behalf.
Court Decisions and Types of Split-Dollar Arrangements
Recent court decisions shed light on the complexities and nuances of split-dollar arrangements. In the successful case of Estate of Marion Levine v. Commissioner, the U.S. Tax Court issued an important ruling on split-dollar planning. However, it's important to note that not all split-dollar cases have ended favorably, as evidenced by previous decisions like Estate of Cahill v. Commissioner and Estate of Morrissette v. Commissioner.
Two primary types of split-dollar arrangements are recognized by the Tax Code:
Economic Benefit Regime: Under this type of arrangement, the ILIT typically pays the term cost of the life insurance while another party, such as a family member or a family trust, covers the remaining portion of the annual policy premium. All the aforementioned U.S. Tax Court decisions dealt with this type of split-dollar arrangement.
Loan Regime: This type of arrangement often occurs between an employee and their employer. Here, the employee borrows funds from the employer to pay insurance premiums and the employee pledges the insurance policy as collateral security for the loan. Imputed interest income on the loan is taxable to the employee. If the employer forgives the loan upon the employee's death, the outstanding loan balance becomes taxable to the employee or their estate.
Estate Planning Objectives of a Split-Dollar Arrangement
Split-dollar arrangements have garnered attention from estate planners due to their potential benefits:
Purchase More Life Insurance: Split-dollar arrangements allow the funding of life insurance premiums from sources outside of the ILIT, reducing the donor's required current gifts to the ILIT. This enables the ILIT to acquire the desired amount of life insurance, especially when significant gifts would otherwise exceed annual exclusions or applicable exemption amounts. In cases where loans are involved, the gift tax implications of traditional ILIT funding sources can be avoided.
Avoid Estate Taxes: Ownership of the life insurance policy by the ILIT ensures that the settlor-insured does not retain any "incidence of ownership" over the policy. Consequently, the life insurance proceeds are excluded from the settlor-insured's taxable estate. This is particularly effective in intergenerational split-dollar planning, where the settlor is not the insured. For instance, in Levine, Mrs. Levine's children were the insured individuals, and the ILIT owned the policies from the outset, eliminating any incidence of ownership for Mrs. Levine.
Valuation Discounts: Intergenerational split-dollar arrangements often involve sizable advances or loans from the funding individual to acquire the life insurance policy. These advances can be valued at a substantial discount from their face value when the lender's estate assesses their worth. This discounting, supported by a discounted cash flow analysis, considers factors such as the insured child's life expectancy and the cash value of the policy.
Intergenerational Split-Dollar Arrangements
Intergenerational split-dollar planning is a specialized form of split-dollar arrangement tailored to unique circumstances. Several key characteristics typically define these arrangements:
Age and Life Expectancy: The funding individual in intergenerational split-dollar plans is often older, typically above 70 years old, with a relatively short life expectancy.
Borrowing: In some cases, the funding individual may borrow funds to finance the life insurance policy, especially if their personal financial resources are insufficient.
Premium Payment: Intergenerational split-dollar plans often involve a single premium payment or premiums paid over a relatively short period, such as three to five years.
Insured Individual: The insured individual under the life insurance policy is typically an adult child of the funding individual, typically aged between 30 and 60 years. The younger the insured, the greater the discount on the related loan note.
Timely Passing: In these arrangements, the funding individual tends to pass away within 10 years after establishing the split-dollar arrangement. The lender's estate then values the unpaid advance or loan at a significant discount, accounting for various factors like the insured child's life expectancy and policy values.
Observation on Tax Code IRC 2703(a)
An intriguing argument raised in the Levine case pertains to IRC §2703(a), a frequently overlooked Tax Code provision. This section disregards, for valuing property, certain options, agreements, or rights that allow property to be acquired at a price below its fair market value. The IRS argued that Mrs. Levine placed a restriction on her ability to control the $6.5 million she advanced through the split-dollar arrangement, triggering IRC §2703(a). The Tax Court, however, agreed with the estate's interpretation that IRC §2703(a) applies only to property owned by the decedent at the time of death, not property disposed of earlier or property, such as life insurance policies, that the decedent never owned.
IGSD May be an Option
As the potential reduction in the federal gift and estate tax applicable exemption amount to approximately $7.0 million per person in 2026 approaches, estate planning strategies are evolving to address concerns of trust illiquidity. Intergenerational split-dollar arrangements offer a valuable solution and a roadmap for navigating these challenges effectively.
The Levine case provides a convincing example of how intergenerational split-dollar planning can be structured to maximize benefits while minimizing estate tax exposure. This innovative approach can assist in securing a legacy while optimizing the use of life insurance. However, it's crucial to work closely with experienced estate planning professionals to tailor these arrangements to individual circumstances, ensuring compliance with ever-evolving tax laws and regulations.
At Life Insurance Strategies Group, LLC, we do not sell life insurance. We help our affluent individual and institutional clients make decisions regarding life insurance involving complex situations.