Estate of Becker: Self-Funding Life Settlement Transaction Avoids Estate Tax on Insured
The life settlement market has become so successful that longevity is now a recognized asset class among institutional, as well as individual, investors. Market acceptance, however, has not stopped investors from developing innovative structures to provide them with exposure to longevity-linked returns. In Estate of Becker v. Comm’r,1 the Tax Court considered whether a unique life settlement transaction, which funded itself for 30 months, had adverse estate tax consequences. The case, however, is equally interesting for the plan to provide exposure to the longevity of the insured.
In order to appreciate the structuring of the life settlement transaction in Estate of Becker, it’s important to understand the steps the parties took to ensure that the beneficiary of the life insurance policy had an “insurable interest.” The IRS challenged the transaction on the ground that the beneficiaries of the policies lacked an insurable interest. In addition, in many states, the payment of the life insurance proceeds to the investor is voidable by the insurer when the beneficiary of the life insurance policy lacks an insurable interest in the insured2. We’ll start by exploring this limitation.
I. The Insurable Interest Limitation
Code § 7702(a) defines a life insurance contract as “any contract which is a life insurance contract under the applicable law.”3 Foremost among the legal requirements for a contract to be treated as insurance is that the owner of the contract have an insurable interest in the life referenced in the contract. In Dow Chem. Co. v. United States,4 the IRS challenged a corporate-owned life insurance (COLI) plan as not qualifying as “life insurance” under Code § 7702 for the reason that the policy owner (Dow) did not have an insurable interest in the lives of all of the 4,051 employees insured under the plan.5 The IRS looked to Michigan law to determine whether the employer had an insurable interest. The Court noted that the Michigan Supreme Court has held that a life insurance policy naming as a beneficiary one who has no insurable interest in the life of the insured was a wagering contract, contrary to public policy and void.6 Accordingly, the court held that the presence of an insurable interest is a necessary component of a life insurance contract valid under state law and, therefore, Code § 7702(a) as well.
In H.R. Rep. No. 105-220, the Conference Report to Accompany H.R. 2014, the Taxpayer Relief Act of 1997 (P.L. 105-34), Congress stated that the favorable tax treatment provided by the Code for life insurance is available only if the policyholder has an insurable interest in the insured when the contract is issued and if the life insurance contract meets certain requirements designed to limit the investment character of the contract. In TAM 9812005, the IRS further stressed the importance of an insurable interest before a contract will be treated as life insurance for federal income tax purposes:
For purposes of discussing the issues raised by the [IRS] Field [office] and the Taxpayer, this memorandum has assumed arguendo the existence of an insurable interest to support the COLI contracts. If Taxpayer did not have an insurable interest in the employees covered by the COLI program when the contracts were issued under the law of State K, the contracts insuring those lives would not be life insurance under applicable law and would fail to qualify as life insurance under section 7702.
In Ducros v. Commissioner,7 the court stated that the question of whether a contract of insurance was a valid one is to be determined by the law of the place where the contract was made. Under the law of Ohio (the relevant state in that case), an individual taking out insurance on his own life has a right to designate anyone he chooses as his beneficiary, irrespective of whether such beneficiary has an insurable interest in his life. Accordingly, the contract considered in that case qualified as insurance as it was initially procured by the insured himself.
II. The Transactions in Estate of Becker
In Estate of Becker, the insured (Dr. Becker) created an irrevocable life insurance trust for the benefit of his wife and children. The trust was designed to ensure that Dr. Becker himself did not possess any incidents of ownership of the trust or its assets. Accordingly, the trust was designed to not be part of the insured’s taxable estate when the Dr. Becker died.
An insurance broker (Steinfelder) obtained two insurance policies on the life of Dr. Becker for the trust. Steinfelder earned commissions equal to thirty month’s premiums on the policies. The insurer paid commissions to Steinfelder of $1 million on one policy and $700,000 on the other policy.
Steinfelder then made a loan to Dr. Becker in an amount equal to the commissions that he earned from the insurer. Dr. Becker then lent the same amounts to the trust. The trust used the loan to pay the initial 30 months of premiums on the policies. Although this cash flow suggests that the policies were funded without a net cash outlay, Steinfelder borrowed the amount loaned to Dr. Becker from a third party. This third-party loan was repaid two months later when the insurer paid the commission to Steinfelder.
Although the parties’ documentation was imperfect, it appeared that Dr. Becker satisfied his loan to Steinfelder by transferring the obligation of the trust to Steinfelder.
Steinfelder then transferred the trust’s promissory notes to his wholly-owned limited liability company (ALD). ALD transferred the trust’s obligations to another LLC named JTR. The opinion is silent on the terms of this transfer and who owned JTR.
At this time (approximately two months after the policies were originated), the trust entered into an agreement with LT Funding LLC (LT Funding). The opinion is silent as to who owned LT Funding, although it is clear that neither Dr. Becker nor his family had an ownership interest in LT Funding. Under this agreement (the “LTF Agreement”), the trust agreed to pay 75% of the death benefits under the policies to LT Funding. In exchange for this promise, LT Funding agreed to pay all future premiums due on the policies. The trust also agreed to pay a 6% yield on all advances that LT Funding made to pay premiums. The LTF Agreement had a senior right of payment over the trust’s obligation to pay JTR.
Less than two years after these arrangements were put into place, Dr. Becker died in an automobile accident. The insurer paid the full death benefits on the policies to the trust. The trust, LT Funding and JTR became embroiled in a dispute as how the death benefits should be split. It appears from the opinion that JTR received nothing and LT Funding received $9 million in a negotiated settlement.
III. Taxation of the Death Benefits Received by LT Funding
An issue relevant to the life settlement industry but not addressed by the opinion in Estate of Becker is whether the death benefits received by LT Funding are tax-exempt under Section 101(a) of the Internal Revenue Code of 1986, as amended (the “Code”). It appears that the amounts paid to LT Funding could be disqualified as death benefits by reason of the transfer for value rules. In any event, the death benefits are likely taxable to LT Funding under the split-dollar regulations.
A. The Transfer for Value Rules
Death Benefits paid on a life insurance contract generally are excluded from the recipient’s gross income if paid by reason of the insured’s death. Code § 101(a)(1). Notwithstanding the general rule of Code § 101(a)(1), Code § 101(a)(2) generally provides that in the case of a transfer for valuable consideration, by assignment or otherwise, of an “interest in a life insurance contract,” the amount excluded from gross income by the transferee does not exceed the value of such consideration, any premiums paid, and other amounts subsequently paid by the transferee.8 Treasury Regulation § 1.101-1(e)(1) defines an interest in a life insurance contract as:
The interest held by any person that has taken title to or possession of the life insurance contract, in whole or in part, for state law purposes . . . and the interest held by any person that has an enforceable right to receive all or part of the proceeds of a life insurance contract.
Parenthetical omitted.
A transfer of an interest in a life insurance contract means:
The transfer of any interest in the life insurance contract, including any transfer of title to, possession of, or legal or beneficial ownership of the life insurance contract itself. The creation of an enforceable right to receive all or part of the proceeds of a life insurance contract constitutes the transfer of an interest in the life insurance contract.9
If a person transfers less than all of their interest, the transferor remains entitled to the Code § 101(a) exclusion for the ratably retained interest.10 A bona fide purchase of a policy is considered a transfer for valuable consideration.11 The consideration given, however, does not need to be in the form of cash or other property with a readily ascertainable value.12 It is a well-established principle that where an insurance policy is acquired for stock, the transfer is for “a valuable consideration.”13
Although LT Funding did not pay any consideration for its 75% (plus 6%) interest in the death benefits under the policies, it seems likely that its agreement to pay future premiums on the policies could be treated as “valuable consideration” paid to the trust for the right to receive such death benefits. Under Monroe,14 and PLR 7734048, transfers of the right to receive death benefits are made for valuable consideration even if the consideration is not a current cash payment. Furthermore, the rights obtained by LT Funding lack any indication of being a gift.
B. The Split Dollar Regulations
The sharing of death benefits between the trust and LT funding raises the issue as to which party or both should be treated as the owner of the policies for federal income tax purposes. It is likely that under the “split-dollar life insurance arrangement” regulations (the “Split-Dollar Regulations”), the trust should be treated as the sole owner of the Policies. This result would prevent LT Funding from treating its share of the death benefits as excludible from income under Code § 101(a).
The Split-Dollar Regulations provide an extensive set of rules for arrangements, known as “split-dollar life insurance arrangements,” by which two or more persons (the policy “owner” and one or more “non-owners”) join in purchasing life insurance and agree to allocate policy costs (i.e., premiums) and benefits between them and/or their beneficiaries.15 In general, under a “split dollar arrangement,” the party treated as the “owner” of the policy will be treated as the owner for all US federal income tax purposes.16 The “non-owner” must include in income currently the full value of all economic benefits provided to the non-owner, reduced by the consideration paid directly or indirectly by the non-owner to the owner for those economic benefits.17
The ”owner” of the policy in a Split-Dollar Arrangement is the person named as the policy owner of such contract.18 If, however, two or more owners are designated, each such person is treated as the owner of a separate policy. Since the policies only named the trust as the owner of the policies, and the trust had the exclusive ability to control the policies, the owner of the policies under the Split-Dollar Regulations should be the trust.
Under the Split-Dollar Regulations, a non-owner is “any person (other than the [“owner”]) that has any direct or indirect interest in such contract (but not including a life insurance company acting only in its capacity as the issuer of a life insurance contract).”19 LT Funding is not the “owner” of the Policy, as defined above, but was entitled to a portion of the death benefits. Because LT Funding is a person (other than the owner of the Policy) that has an interest in the Policy (but is not a life insurance company acting only in its capacity as the Policy issuer), LT Funding should be a “non-owner” under the Policy for purposes of the Split-Dollar Regulations.
IV. The Estate Tax Issue in Estate of Becker
The IRS asserted that the value of Dr. Becker’s estate should include the death benefits paid on the insurance policies, even though Dr. Becker did not retain any incidents of ownership over the trust or the policies themselves. The IRS asserted that Dr. Becker (and therefore, his estate) was the only party to the transactions described above that had insurable interest in Dr. Becker’s life. Accordingly, the IRS asserted that the estate was the owner of the policies.
The court, after a short recitation of relevant state law, concluded that the trust had an insurable interest in Dr. Becker’s life. This conclusion seems incontrovertible given the beneficiaries of the trust were Dr. Becker’s wife and children. The IRS, however, did not stop here. It asserted, using a doctrine more at home in the realm of corporate mergers and acquisitions than estate planning, that the “step transaction” doctrine should be applied to hold that LT Funding was the beneficiary of the policies to the extent of the 75% interest in death benefits and that LT Funding did not possess an insurable interest in Dr. Becker’s life.
The IRS and courts occasionally use the judicially created step transaction doctrine to collapse a series of formally segregated steps into a single transaction or to reorder the steps in a manner that results in a different tax treatment than the treatment that would otherwise follow from the form of the transaction.20 In certain instances, Treasury Regulations, either explicitly or implicitly, invoke this doctrine. 21
Under the binding commitment test, a series of formally separate transactions will be stepped together if, at the time the first step is taken, there is a binding commitment to take the later steps.22 The court refused to apply the binding commitment test because the steps took place so closely in time. It noted that the binding commitment test is reserved to link steps that take place years apart.
The court refused to apply the “end result” version of the step transaction doctrine because this version of the doctrine collapses steps between the contracting parties. In the case of the policies held by the trust, the IRS sought to collapse steps between the trust and LT Funding. The end result version of step transaction doctrine could have applied to transactions between the trust and the insurer, not a financing transaction ancillary to the issuance of the policies.
Last, the court considered whether the acquisition of the policies by the trust was so interdependent with the LTF Agreement so as to render the trust’s acquisition of the policies “fruitless” without the LTF Agreement. This version of the step transaction doctrine is referred to as the “interdependence test.” The court held the combined facts that the policies were funded upfront for 30 months and Dr. Becker could have funded more money into the trust if the trust needed cash, proved that the trust’s acquisition of the policies made economic sense even if the LTF Agreement was ignored. Accordingly, the court refused to apply this version of the step transaction doctrine.
*Mark Leeds ((212) 506-2499; mleeds@mayerbrown.com) is a tax partner in the New York office of Mayer Brown. Mark regularly provides legal services to participants in the life settlement markets. His practice is focused on the tax consequences of a variety of capital markets, hedge fund, banking and insurance products and strategies, including over-the-counter derivative transactions, swaps, tax-exempt derivatives and strategies for efficient utilization of tax attributes—such as net operating losses. Mark regularly works on innovative insurance products and structures.
1 T.C.Mem. 2024-89 (September 24, 2024)
2 Insurable interest is a matter of state law. State laws differ in defining insurable interest and in specifying the consequences of a lack of insurable interest. In many states, a policy is void ab initio if it lacks an insurable interest at inception. In other states, the policy is not void, but the estate of the insured can maintain an action to recover the death benefit from any person who receives same. And in a line of recent cases, the Delaware Supreme Court has combined the two theories to hold that a policy lacking an insurable interest at inception is void ab initio but the estate may still be entitled to the death benefit.
3 S. Prt. No. 98-169 Vol. I (P.L. 98-369) pp. I-572 (“A life insurance contract is defined as any contract, which is a life insurance contract under the applicable State or foreign law…”); House Conference Report Number 861, 98th Congress, 2d Session 1075 (1984), 1984-3 (volume 2) C.B. (same); Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Congress, 1st Session 646 (1984) (same); Wesley C. Wickum, et ux. v. Comm’r., T.C. Memo 1998-270. See PLR 200002030 (January 18, 2000); PLR 199921036 (June 1, 1999); PLR 9840040 (October 2, 1998). Written determinations, such as private rulings and technical advice, may not be cited as precedent that is binding on the Service. Section 6110(k)(3). Still, written determinations can and are often used to provide informal insight into the Service’s mind set regarding a particular issue. The persuasive reasoning contained in the determination may be considered by the courts in the absence of authority to the contrary. See Buckeye Power Inc. v. U.S., 79 A.F.T.R. 2d 97-2794 (Fed. Ct. Cl. 1997); AT&T Corp. & Subsidiaries v. U.S., 94 A.F.T.R. 2d 2004-6959 (Fed. Ct. Cl. 2004).
4 250 F. Supp. 2d 748, 821 (E.D. Mich. 2003) (reversed on other grounds)
5 The question of insurable interest usually arises in disputes between the insurer and policyholder over the validity of an obligation to pay an insurance benefit. See Hicks' Estate v. Cary, 332 Mich. 606, 52 N.W.2d 351 (1952) (insurable interest rule may not be interposed by the deceased's widow to invalidate the right of a corporation to the proceeds of a life insurance policy owned by the corporation which formerly employed the deceased).
6 See Mutual Benefit Ass'n v. Hoyt, 46 Mich. 473 , 9 N.W. 497 (1881).
7 272 F.2d 49, 51 (6th Cir. 1959)
8 Even if there is a transfer, the transfer for value rule will not apply if there is no consideration given in exchange for that transfer. Haverty Realty & Inv. Co. v. Comm’r, 3 T.C. 161 (1944).
10 Treas. Reg. § 1.101-1(b)(2)(ii); see also Maxson Hall v. Comm’r, 12 TC 419 (1949), acq. 1949-2 CB 2.
11 Rev. Rul. 2009-14, 2009-21 I.R.B. 1031.
12 Monroe v. Patterson, 197 F. Supp. 146 (ND Ala. 1961). See also PLR 7734048 (May 26, 1977).
13 See e.g., King Plow Co. v. Comm’r, 110 F.2d 649 (5th Cir. 1940); Stroud & Co. v. Comm’r, 45 B.T.A. 862 (1941); Lambeth v. Comm’r, 38 B.T.A. 351 (1938); Hacker v. Comm’r, 36 B.T.A. 659 (1937).
17 Treas. Reg. § 1.61-22(d)(1)
18 Treas. Reg. § 1.61-22(c)(1)
19 Treas. Reg. § 1.61-22(c)(2)(i)
20 See, e.g. Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938); Helvering v. New Haven & SSLRR, 121 F2d 985 (2d Cir. 1941); Warner Co. v. CIR, 26 BTA 1225 (1932); Manhattan Bldg. Co. v. CIR, 27 TC 1032 (1957); King Enters, Inc. v. US, 418 F2d 511 (Ct. Cl. 1969); Rev. Rul. 70-140, 1970-1 CB 73.
21 See, e.g., Treasury Regulations §§ 1.351-1(a)(3); Treas. Reg. § 1.708-1(d)(6).
