Using Loan Method Split Dollar in the After Life!

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. It was a rigorous summer. Reveille every morning was at 0430 hours and Taps was at 2100 (9:00) hours. My highlight of the summer was falling into an eight-foot large ditch full of rocks headfirst at night in the rain. 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 out several teeth out.

Every night we had a movie that we could watch. Normally, I am not 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. The movie’s plot deals with a fantasy afterlife where mistakes in life are made and worthy characters get do-overs. It is a timeless story about love, redemption, football, and shady business deals. In Post-Mortem Split Dollar, taxpayers have an opportunity to utilize a Split Dollar technique to transfer wealth more efficiently in a Dynasty Trust.

This article focuses on the ability to use Split Dollar, a technique normally used in inter vivos planning rather than post-mortem planning. The article focuses on the idea that a inter vivos planning technique can also be used 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.

Non-Grantor Trusts

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 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 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.

Split Dollar Life Insurance in the After Life

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.

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. The Postmortem Split Dollar technique in the article envisions a Loan Method Split Dollar arrangement between the Marital/QTIP Trust and a Dynasty Trust which is designed to perpetuate wealth for multiple generations within a family. Additionally, the Marital Trust creates a new investment limited liability company (LLC) as the sponsor and lender to the Dynasty Trust.

The Loan Method uses the Collateral Assignment Method of Split Dollar. In the Collateral Assignment Method, the Trust (in our case) is the applicant, owner, and beneficiary of the policy. The Marital Trust makes a one-time loan using the long term applicable federal rate which is 1.12% in October 2020. This rate is fixed for the term of the loan. The loan proceeds of the Marital Trust are used to pay premiums on a Non-Mec basis to preserve tax-favored treatment on loans and withdrawals from the policy for Dynasty Trust beneficiaries. The LLC within the Marital Trust retains an interest in the policy’s cash value and death benefit equal to the value of the loan plus any accrued interest. The Dynasty Trust collaterally assigns an interest in the policy to Marital Trust LLC for its contributions and interest in the policy.