INCOME ON SURRENDER OF LIFE INSURANCE POLICY

Taxpayers often borrow funds from their life insurance policies. If the loans are not repaid, the insurance company may apply the cash surrender value of the policy to the loan balance (including accrued interest on the loans) when the total loan balance gets close to or exceeds the cash surrender value. This is often done in conjunction with a cancellation of the policy at that time. To the extent that the policy loan exceeds the owner’s “investment in the contract,” the owner will have to recognize income at that time.

This is what happened to Carolyn McGowen, and she had to recognize over $565,000 in income when her loan balance of over $1.065 million on a variable life policy exceeded the cash surrender value of the policy, prompting the carrier to cancel the policy and apply the cash surrender value to the loan balance.

Carolyn did not dispute that she had income from the surrender of the policy. She instead claimed that the income was “income from discharge of indebtedness,” and that she could then apply a special exclusion for income from discharge of indebtedness that was otherwise available to her under Code Section 108.

The Tax Court reviewed the situation and noted that the policy loan was in fact a genuine loan (which is how Carolyn was able to receive the loan advances without them being income to her at that time).  However, the Court noted that “income from discharge of indebtedness” occurs when the “debtor is no longer legally required to satisfy his debt either in part or in full.” This did not occur when the policy was cancelled – instead, the loan was actually paid in full through credit of the policy cash surrender value to the loan balance. Carolyn’s income was not from discharge of indebtedness, but arose directly under Code Section 72(e). Section 72(e) treats distributions from insurance policies to owners as income to the extent that the distributions exceed the investment in the contract. Thus, Code Section 108 (and its exceptions to income from discharge of indebtedness) could not be used by Mrs. McGowen.

Bill S. McGowen, et ux., TC Memo 2009-285

ARE DOMESTIC ASSET PROTECTION TRUSTS READY FOR PRIME TIME?

In theory, it should be possible to use a properly structured domestic asset protection trust (DAPT) to receive assets from a settlor and have the assets protected from the settlor’s creditors, while also having completed gift treatment and no estate tax inclusion for the settlor, even though the settlor remains a discretionary beneficiary of the trust.

In non-DAPT jurisdictions, creditors of a settlor can typically reach the assets of a trust the settlor funds even if the settlor’s interest is wholly discretionary. This results in an incomplete gift. In a DAPT jurisdiction such as Nevada or Alaska, however, the assets are protected from the settlor’s creditors (subject to exceptions that vary from state to state). Thus, it has been argued that at the settlor’s death the assets of the trust are not included in the settlor’s estate and thus avoid estate tax. The settlor gets the best of many worlds – the assets grow outside of his taxable estate, the assets are protected from his creditors, and in a pinch the trustee can still apply trust assets for his or her benefit.

In Private Letter Ruling 200944002, the IRS gave much welcome recognition to this result. Based on this recognition, tax advisors are more likely now to proceed with this type of planning.

The lynchpin of this planning is that the local DAPT law of the state provides substantial limits on creditors of the settlor reaching the trust assets. This creditor protection is fairly likely to be respected by courts when the settlor is a resident of the state with DAPT law, and the trust is settled in that state with assets situated in that state. That is all well and good for settlors who reside in such states, but what if the settlor resides outside of such a state? Can the settlor establish a trust in a DAPT jurisdiction and still obtain these tax results?

The private letter ruling does not answer this question, since it involved a settlor who resides in the applicable DAPT jurisdiction. Presently, the law is unsettled as to the effectiveness of the creditor protection as to settlors residing outside of the DAPT state, including possible challenges to the application of such protection due to the Constitution’s Full Faith & Credit Clause. Therefore, while the private letter ruling does provide more authority for a favorable result, there is still a great deal of uncertainty in regard to the results for settlors residing outside the DAPT jurisdiction.

FAMILY PARTNERSHIP HOLDING ONLY DELL STOCK SUBJECTED TO LIMITS ON VALUATION DISCOUNTS

A recent case family limited partnership case involved a partnership whose principal asset was publicly traded shares of stock of Dell. The highly liquid nature of those assets was used by the IRS and the reviewing courts to limit the amount of applicable discounts that were sought based on transfer restrictions in the partnership agreement and for lack of marketability.

In regard to transfer restrictions that were in the partnership agreement, the IRS claimed that these restrictions could not be used to reduce the value of gifted limited partnership interests pursuant to Section 2703(a)(2). Section 2703(a)(2) provides that “any restriction on the right to sell or use [the subject] property” are disregarded, unless the safe harbor requirements of Section 2703(b) are met. One of these safe harbor requirements is Section 2703(b)(1) which requires that the restriction “is a bona fide business arrangement.” The IRS argued that since the partnership owned only liquid shares of Dell, there was no “business” and thus no “bona fide business arrangement” under 2703(b). The Tax Court and the 8th Circuit Court of Appeals agreed. While the appeals court noted that at times shares of stock in a partnership can be a “business” for this purpose, such as where the stock is closely held and the arrangement is to maintain close control, this arrangement did not allow for a finding of a business. The courts found that the primary purposes of the arrangements were to protect the recipients of the gifts from dissipating the assets and to teach the children how to handle their money and did not relate to a business arrangement.

The second principal issue in the case related to the liquid nature of the Dell stock and the lack of marketability discount for the limited partnership interests. The IRS’ appraiser made an interesting argument that the fact that all the partners could agree to terminate the partnership, and that the partnership asset was a highly liquid asset, combined to put a limit on the lack of marketability discount since at some level of discounting the parties could find a mutual basis upon which it made sense to instead liquidate the partnership. This seems a little odd under the willing buyer – willing seller standard since who is to say when and why the other partners would consent to such a liquidation (that is, why it would ever be in their interests to consent to the liquidation), but both the Tax Court and the appellate court bought into the argument and thus limited the lack of marketability discount based on this theory.

HOLMAN v. COMM., 105 AFTR 2d 2010-XXXX, (CA8), 04/07/2010