Case in Review: Cahill and Changes in the Family Estate Planning Landscape

The Tax Court has recently issued an opinion addressing several significant estate planning issues. In Estate of Cahill, T.C. Memo 2018-84, the Tax Court reviewed an inter-generational split-dollar arrangement under IRC §§2036, 2038, and 2703 (among other provisions). While this case may not break new ground in those areas, it shows the trend of the Tax Court to be more aggressive in its acceptance of those provisions to minimize the benefits of certain estate planning techniques.

Facts

The Split-Dollar Life Insurance Transaction and the Two Trusts

At issue in Cahill was a split-dollar arrangement involving two trusts, the “Survivor’s Trust” and the “MB Trust.” The Richard F. Cahill Survivor’s Trust (the “Survivor’s Trust”) was a revocable trust created by Richard Cahill. At all relevant times, Richard’s son, Patrick, was trustee of the Survivor’s Trust. The Morrison Brown Trust (the “MB Trust”) was an irrevocable trust created by Patrick as Richard’s attorney-in-fact on September 9, 2010. William, Patrick’s cousin and business partner, was trustee of the MB Trust. Throughout all times relevant to the litigation, Patrick was Richard’s attorney-in-fact.

Sometime after September 9, 2010, the MB Trust acquired three whole life insurance policies, one on Patrick’s life and two on the life of Patrick’s wife, Shannon. To fund lump-sum premiums on these policies, the MB Trust entered into split-dollar agreements with the Survivor’s Trust under which the Survivor’s Trust advanced $10 million to the MB Trust. These split-dollar agreements were entered into between the Survivor’s Trust and the MB Trust while Richard was 90 years old and lacked capacity. Patrick executed the split-dollar agreements as trustee of the Survivor’s Trust. William signed on behalf of the MB Trust. The Survivor’s Trust took a $10 million, interest only, 5-year loan to fund this advance.

Each split-dollar agreement could be terminated during the insured’s lifetime by written agreement between the Survivor’s Trust and the MB Trust. At termination, the MB Trust could opt to retain the policy. In such a case the MB Trust was required to pay the Survivor’s Trust the greater of1:

  1. premiums paid with respect to the policy; or
  2. the policy’s cash surrender value.

If the MB Trust did not retain the policy, the policy would be tendered to the Survivor Trust’s lender with the Survivor’s Trust retaining any excess cash surrender value above the amount due on the loan.

The Court referred to these rights as the “termination rights.”

Under the terms of the split-dollar agreements, upon the death of the insured, the Survivor’s Trust would receive a portion of the death benefit equal to the greater of:

  1. any remaining balance on the loan relating to the policy;
  2. the total premiums paid by the Survivor’s Trust with respect to the policy; or
  3. the cash surrender value of the policy immediately before the insured’s death.

The Court referred to these rights as the “death benefit rights.”

The Valuation and Mr. Cahill’s Estate Tax Return

Richard Cahill died on December 12, 2011. On his date of death, the aggregate cash surrender value of the policies equaled $9,611,624. Richard’s estate tax return reported a value of Richard’s rights in the split-dollar agreements of $183,700, less than 2% of the original $10 million advance. The estate’s theory regarding its valuation was that the estate’s interest was limited to a right to payments at the insured’s death because the MB Trust essentially would never agree to a termination of the split-dollar agreement. Given the ages of the insureds, Patrick and Shannon, the present value of the estate’s right based on the current cash surrender value of the policies would equal $183,700. The IRS issued a Notice of Deficiency adjusting the value to $9,611,624, the cash surrender value on Richard’s date of death.

After filing a Petition with the Tax Court, Richard’s estate filed a Motion for Partial Summary Judgment regarding certain issues, including the application of IRC §§2036, 2038, and 2703. The IRS did not file any cross-motion seeking summary judgment in its favor.

Analysis

 IRC §§2036(a)(2) and 2038(a)(1)

The Court first addressed IRC §§2036(a)(2) and 2038(a)(1). §2036(a)(2) includes property in a decedent’s taxable estate if: (1) the decedent made a lifetime transfer of property; (2) the transfer was not a bona fide sale for full and adequate consideration; and (3) the decedent retained the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. §2038(a)(1) includes property in a decedent’s taxable estate if: (1) the decedent made a lifetime transfer of property; (2) the transfer was not a bona fide sale for full and adequate consideration; and (3) the decedent retained the power, alone or in conjunction with any person, to alter, amend, revoke, or terminate, the transferee’s enjoyment of the transferred property.

There clearly was a lifetime transfer of $10 million. The Court, citing to the recent Powell 2 opinion, held that the termination rights held by the Richard Cahill at his death amounted to a right to both designate the persons who would possess or enjoy the transferred property and alter, amend, revoke, or terminate the transfer. Therefore, the sole issue for the Court to decide came to whether the “bona fide sale for full and adequate consideration” exception was satisfied. Regarding whether the sale was bona fide, the Court found there were several fact questions such as whether the transfer had a legitimate business purpose. Regardless, the Court was clear that there could not be “full and adequate consideration.” The reason is that the question of whether a transfer is for full and adequate consideration is one of value; “i.e., did what decedent transferred roughly equal the value of what he received in return?”3The Court cited to the estate’s own position that the value of what was transferred equaled $183,700 on Richard’s date of death. Given that 98% reduction in value from the $10 million transferred, there could not be “full and adequate consideration.” The Court disagreed with the estate’s arguments regarding application of the gift tax as mitigating this issue.

IRC §2703

Next, the Court reviewed application of §§2703(a)(1) and (2). The IRS argued that, as an alternative to the application of §§2036(a)(2) and 2038(a)(1), the MB Trust’s ability to veto termination of the split-dollar agreements should be disregarded under §2703. §2703(a)(1) applies to disregard, for purposes of valuation, “any option, agreement, or other right to acquire or use the property at a price less than” fair market value. §2703(a)(1) applies to disregard, for purposes of valuation, “any restriction on the right to sell or use such property.” An exception to §2703(a) applies if the arrangement: (1) is a bona fide business arrangement; (2) is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and (3) terms are comparable to similar arrangements entered into by persons in arms’ length transactions.4

The Court was not willing to accept the estate’s argument that §2703(a) does not apply to the split-dollar arrangements. The estate contended that the split-dollar agreements were more like promissory notes or partnership interests than property as contemplated by §2703(a) such as options, buy-sell arrangements, or other restraints on alienation. However, the estate cited to no authority for this proposition. The Court gave a number of reasons why it felt the analogies are not applicable. Aside from those items, the Court held that §2703(a)(1) applied due to the fact that the MB Trust was granted the rights under the split-dollar agreements at a price less than the full fair market value of what was transferred. Again, the Court cited to the estate’s valuation noting that the MB Trust obtained the use of $10 million in exchange for what the estate argues to be valued at $183,700 to the Survivor’s Trust. Under §2703(a)(2), the Court held that “it is clear that … the split-dollar agreements, and specifically the MB Trust’s ability to prevent termination” restricted Richard’s rights to use his termination rights and withdraw his investments. As such, §§2703(a)(1) applies. However, the Court left for trial whether the §2703(b) exception may apply.

Treas Reg. §1.61-22

Beyond these arguments, the estate raised certain arguments regarding application of Treas. Reg. §1.61-22 to the proposed adjustment. Specifically, those regulations apply to determine the gift tax value of rights under similar split-dollar arrangements (economic benefit regime). While those regulations apply for gift tax purposes, the do not refer to the estate tax. Although the estate argued that consistency principals should apply, the Court did not agree.

In the end, the Court denied all of the estate’s requests for summary judgment. Although the Court used language in its opinion seeming to come to a final conclusion on a number of issues, it is important to note that the IRS did not file a cross-motion for summary judgment. Therefore, the Court’s opinion does not necessarily dispose of those issues. While it may be unlikely for the Court to render a different opinion after trial, failure of the IRS to have the matters disposed of through a cross-motion leaves certain issues open which the Court seemed to feel resolved.

Conclusion

Although Cahill, from a procedural standpoint, only denies the estate partial summary judgment on the issues discussed above, there are a handful of important take-aways from Cahill:

  1. although some planners felt the Powell decision was a “bad facts” opinion which would not garner broad application, the Tax Court has cited it here (which also may be considered a “bad facts” case given the timing of the transactions, Patrick’s role on multiple sides of the transaction, and the 98% discount asserted);
  2. the Court extended its finding beyond §2036 to §2038. That is not particularly surprising, given the statutory language is the same, but shows that the Court may not feel compelled to limit application of Powell;
  3. certain planners have believed that the consent of an adverse party may serve as an exception to the application of §2036(a)(2)5. Combined with Powell, this opinion indicates that the Tax Court sees no such exception; and
  4. the Court is applying §2036(a) outside of the family entity context to other types of arrangements. While the statute may not be so limited, its application has largely involved family limited partnerships and similar entities.

The effect of this ruling is that planners will need to be vigilant in structuring all types of family arrangements, not just family limited partnerships. Considering this ruling and Powell, it is increasingly important not to allow the senior generation to hold any vote with respect to distributions, liquidations, or other aspects relating to enjoyment of property, even of that vote is held in as a minority vote or otherwise requires the consent of an adverse party. Current arrangements likely need to be reviewed for restructuring to avoid these issues as well.

In addition to applying the logic of this case to several different family arrangements, this case may signal the end to family split-dollar arrangements. Outside of the family context, such arrangements may remain valuable planning opportunities. However, given the Court’s analysis, it remains to be seen how useful family split-dollar arrangements will be.

It appears the Court’s position under §2703 may be more aggressive than its other positions. However, if it believes §2703(a) applies, it may be difficult for the estate to prove application of the §2703(b) exception. If that is the case, and the logic of Cahill is applied more broadly, then valuation of interests in any number of family arrangements, including family limited partnerships, may be required to be no less than liquidation value. This outcome may be unlikely but has been suggested by some well-respected planners.

Planners can be expected to eagerly await the final outcome of Cahill. The issues left open by the Court, and, in fact due to the particular procedural context of this ruling, whether the Court alters its opinion since the IRS did not seek summary judgment, may be important in structuring any number of planning techniques such as family limited partnerships, split-dollar agreements, and other intra-family contractual arrangements.

Footnotes

  1. Worth noting in the termination and death benefit rights is that upon first blush it seems that the repayment terms are inconsistent with the type of transaction entered into because a higher value could be paid to the Survivor’s Trust based on the formulas being a “greater of” calculation. As such, the author reminds the reader that the split-dollar arrangement and the loan was interest-only which helps reconcile the structure of the repayment terms and the rights under the split-dollar arrangements.
  2. Estate of Powell v. Commissioner, 148 T.C. 18 (2017). In Powell, the full Tax Court essentially held that the power of a limited partner to participate in a vote regarding liquidation (which, in Powell, was essentially a veto power) caused estate tax inclusion due to the “alone or in conjunction with any person” provision of §2036(a)(2), notwithstanding the fiduciary duties applicable to the decedent’s actions.
  3. Citing Estate of Hurford v. Commissioner, T.C. Memo 2008-287.
  4. IRC §2703(b).
  5. But note Treas. Reg. §20.2036-1(b)(3)(i) and §20.2038-1(a) as well as Helvering v. City Bank Farmers Trust Co., 296 U.S. 85 (1935).