I spent the summer of 1980 before entering my sophomore (Yearling) year at West Point at Camp Buckner which is about eight miles from the main base. This summer is dedicated to military training – field artillery, armor, and infantry. The highlight of the summer was falling into a large ditch of rocks headfirst. Somehow, I was not knocked unconscious and managed to crawl out and walk about 200 meters to the infirmary. The first question was, “Were you drunk,” and not “Are you OK.” Fortunately, I did not receive a concussion or fractured skull but did manage to knock a number of teeth out. That summer reveille was at 0430 hours. TAPs was at 2100 hours (9:00 PM). Every night we had a movie that we could watch.
I am not normally a fan of dramatic “soapy” love stories but somehow the film Heaven Can Wait featuring Warren Beatty and Julie Christie managed to hook me. I am not certain why, but it did. This article focuses on the ability to use Split Dollar a technique normally thought of for inter vivos planning rather than post-mortem planning. This article focuses on the idea that a planning technique can also be extremely powerful in post-mortem planning using assets from a marital trust or QTIP Trust to sponsor a Split Dollar life insurance arrangement with a Dynasty Trust to transfer wealth in a manner that functions in some manner as an effective estate freeze technique.
Marital Trusts and Credit Shelter Trusts are typically taxed as Non-Grantor Trusts for income tax purposes. Investment in alternative strategies such as hedge funds and fund-of-funds has become very mainstream in asset allocation in order to provide non-correlated investment returns. The trade off in the pursuit of these investment objectives is short term capital gain taxation taxed at ordinary rates. For the New Yorker or Californian, this means Marital Trusts and Credit Shelter Trusts could be taxed at rates as high 55-57 percent.
Trusts that are not taxed as Grantor Trusts are taxed as separate taxable entities. Unfortunately, it takes very little investment income to push a Non-Grantor Trust into the top marginal tax bracket- $12, 950. A Non-Grantor Trust is a trust that does not fall within any of the provisions of IRC Sec 671-679. Unfortunately, the Non-Grantor is taxed in the same manner as a high net worth taxpayer in the top marginal tax bracket.
The unlimited marital deduction allows a married couple to defer the payment of federal estate taxes until the death of the surviving spouse. Depending the length of the over-life, i.e. the time between the death of the first spouse and the surviving spouse substantial appreciation in Marital Trust assets can take resulting in a much larger estate tax bill at the death of the second spouse. Adding further insult, the marital trusts are taxed as non-grantor trusts.
I have written at nauseam as some readers might comment about the planning benefits of Split Dollar life insurance and particularly the Loan Method of Split Dollar life insurance in the current low interest rate environment. The long term applicable federal rate in October 2020 is 1.12 percent. Split Dollar life is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, Split Dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives.
Split Dollar can also be used in a non-corporate setting and is referred to as a Private Split Dollar. However, in this case, the Martial or QTIP Trust will establish an investment LLC within the marital trust to sponsor the Split Dollar agreement rather than the trustee of the marital trust. In the post-mortem Split Dollar arrangement, the Marital Trust LLC, will sponsor the Split Dollar arrangement. The trustee of a Dynasty Trust will be the applicant, owner and beneficiary of a life insurance policy possibly insuring the live of members of the second or third generation family members. The LLC will be a one-time fixed loan at the long-term AFR (1.12%) for the term of the loan.
The trustee of the Dynasty Trust will collaterally assign an interest in the policy cash value and death benefit to the Marital Trust LLC equal to the amount of the loan plus any accrued interest. The Dynasty Trust during the term of the Split Dollar arrangement will own the excess cash value and death benefit. excess death benefit is paid to the ILIT during the course of the arrangement. The proposed insured(s) are the children and/or their spouses. A Private Split Dollar arrangement can be formed between the Marital Trust and a Dynasty Trust established at the children or grandchildren's generation.
Restricted collateral assignment is the classical form of Split Dollar arrangement utilized by the majority shareholder of a closely held business. Under restricted collateral assignment Split Dollar, a restriction is added to the Split Dollar agreement which “restricts” the company’s access in the policy under the Split Dollar arrangement (greater of cash value or premium). The “restriction” limits the Marital Trust LLC’s access until the earlier of the death of the insured, termination of the Split Dollar agreement, or surrender of the policy.
The policy should be funded on a non-MEC basis to preserve the trustee's ability to take tax-free loans and withdrawals from the policy. The trustee of the Dynasty Trust can decide in conjunction with the Manager and Trustee of the Marital Trust to terminate the Split Dollar arrangement. The Leveraged Split Dollar Rollout™ creates a vehicle for termination on a heavily discounted basis. The net result of the termination is a tax-free transfer of the Marital Trust assets on a heavily discounted basis (65-90%), which reduces the amount of estate taxation at the death of the surviving spouse. The policy within the Dynasty Trust accumulates on a tax-free basis with a death benefit that will be income and estate tax-free as well as GSTT exempt.
The post-mortem Split Dollar plan is a post-mortem planning strategy that reduces the level of taxation on the death of the surviving spouse while migrating assets in a very tax efficient manner to a Dynasty Trust. Using the Loan Method of Split Dollar at the current long term AFR, the assets in the Marital Trust are effectively frozen. Marital Trust assets are repositioned in a life insurance policy within the Dynasty Trust accumulating on a tax-free basis available for tax-free loans and withdrawals. The Leveraged Split Dollar Rollout™ provides a mechanism to "strip" Marital Trust assets in a heavily discounted manner resulting in a lower taxable estate upon the death of the surviving spouse.