Over the last several weeks, I have written a series of articles focusing on the planning utility and financial and tax leverage of the Loan Regime Method of Split Dollar™ life insurance. I have highlighted the timeliness of this planning technique considering the current low interest rate environment. The long-term applicable federal rate (AFR) for August 2020 is 1.12 percent. I have shown how corporate or individually owned policies can be converted into the Loan Regime Method of Split Dollar™. I have also shown how Collateral Assignment Split Dollar Arrangements using the Economic Benefit Regime can be " switched" into the Loan Regime Method of Split Dollar™. In these articles, I have loosely referenced in some planning examples the use of the Leveraged Split dollar™ (LSD™ Rollout) technique to terminate the Split Dollar Arrangement. This article will focus on the LSD™ Rollout Method.
At the same time, I have taken you down memory lane providing you with my own unique version of the Wonder Years (Estilo Panameño) as a result of growing up in the Panama Canal Zone. It was an "outside looking in" American childhood experience with many of the vestiges of growing up in America but situated in the tropics. I always liked Joe Cocker and recently renewed my enthusiasm after viewing his documentary on Netflix, as the best white soul singer in Rock and Roll history. When Ray Charles says that you have " Soul," you have soul! Joe Cocker’s signature album was called Mad Dogs and Englishmen.
Our " Wonder Years," always include stories about our pets. While I did have a neighbor that had an ocelot and a sloth, most of us in the Canal Zone grew up with dogs and cats. My family had two dogs - Snoopy, a mutt and Fritz, a German Short-Haired Pointer. Fritz always enjoyed special status with my German father (of blessed memory) because he was German. My father could always, speak to Fritz in German. It was their thing! He survived the death penalty with no penalty after devouring my Dad's order of German sausages from Usinger's in Milwaukee, on the day that they arrived. Snoopy would not have enjoyed the same result. Snoopy used to run the streets of our neighborhood with her pal, a black lab named Mingo.
The tropics are no friend to Man's best friend. Fritz met his end way too soon after being bitten by a poisonous snake in the field by our house. A virus several years later would kill most of the pets in the Canal Zone. My brother and I cried like we had never cried before! My mother said that my father also cried like a child when he heard the news about Fritz from the neighbor who found him. The Wonder Years!
Overview of the Leveraged Split Dollar™ Rollout
The Leveraged Split Dollar™ Rollout is a method to terminate an existing Loan Regime Split Dollar™ Arrangement at a significant discount. In the loan regime, the business as the lender receives a restricted collateral assignment interest in the life insurance policy's cash value and death benefit equal to the value of the loan plus any accrued interest. The collateral assignment interest is restricted until the earlier of the insured's death, termination of the Split Dollar Arrangement or surrender of the underlying policy. The value of the collateral assignment note is discounted due to this restriction.
At some point, the policyholder decides to terminate the Split Dollar Arrangement by purchasing the lender’s restricted collateral assignment interest in the policy. A valuation specialist value the note receivable for valuation purchases. Due to the restriction, the receivable is likely to be discounted. Following the purchase of the Split Dollar receivable from the lender, the Split Dollar Agreement is terminated. The policyholder uses a tax-free policy loan or withdrawal to purchase the note from the lender.
A decent amount has been written about Intergenerational Split Dollar life insurance following recent Tax Court litigation in the Cahill, Morrisette, and Cahill cases using Collateral Assignment Non-Equity Split Dollar and the Economic Benefit Method. These arrangements were private Split Dollar Arrangements typically designed to transfer large amounts of value from the taxpayer’s estate at large discounts. I am personally aware of exceptionally large transactions having taken place at obscene (in a good way!) discounts. Supreme Court Justice Potter Stewart in determining a threshold test for obscenity is famously known to have said, “ I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description ["hard-core pornography"], and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.”
In Cahill, the taxpayer claimed a 98 percent discount. Come on! How could anyone think that this level of discount wouldn't be challenged on principle alone? These cases were ultimately about valuation issues versus whether the arrangements were valid Split Dollar Arrangements. The Court in each case ruled that the arrangements were valid Split Dollar Arrangements. None of these arrangements used the Loan Regime Method of Split Dollar™.
The use of the Loan Regime Method of Split Dollar in a business context is significantly different than the transactions in recent tax court cases involving Intergenerational Split Dollar. First, the use of restricted collateral assignment in the context of business-sponsored Split Dollar has existed for over fifty years. In the early days, planners did not realize the valuation planning opportunities created by the restriction. Valuation in tax planning became much more mainstream in the decade of the 1980’s and 1990’s.
Second, the audit exposure in Intergenerational Split Dollar using private Split Dollar in large estates was almost 100 percent. The audit rate for regular corporations and LLCs that sponsor Split Dollar Arrangements is negligible at best (between 0.2-0.5 percent). Third, business Split Dollar has enjoyed significant non-business purposes ranging from employee benefit planning to business succession planning, et al unlike the Intergenerational Split Dollar transaction. The IRS has seen and ruled favorably on the use of restricted collateral assignments for controlling shareholders for at least five decades for these non-tax driven purposes. Lastly, the Tax Court cases almost exclusively used the Economic Benefit Method of Split Dollar instead of the Loan Regime.
Bottom Line – Loan Regime Method of Split Dollar™ arrangements using the Leveraged Split Dollar™ Rollout provides an exciting method in the low interest rate environment to build and transfer wealth with significant financial and tax leverage.