IRS Reversed course on insurance policies for the wealthy to avoid estate tax

According to reports in the Ny Times, the IRS in 1996 permitted a elderly wealthy person to purchase a large insurance policy in order to avoid estate taxes, because the insured could count as a gift a much lower insurance premium rate. I.R.S. Loophole Allows Wealthy to Avoid Taxes However just a year later the IRS reversed course and said it would disallow sizeable premiums that were desinged to aovid estate and give taxes by David Cay Johnston In recent months some of the wealthiest older Americans have been buying huge life insurance policies on themselves. Curiously, these people have shopped not for the cheapest rates but for the highest rates they can find. In some cases, they delightedly pay 10 times the lowest rates for that insurance. Why would anyone willingly pay so much? Taxes. Through a technique invented by a lawyer in New York and a chemical engineer in California, each dollar spent on this insurance can typically eliminate $9 in taxes. Spend $10 million on this insurance, avoid $90 million or more in income, gift, generation-skipping and estate taxes. "I'm not saying this is the best thing since sliced bread, but it's really good for pushing wealth forward tax free," said Jonathan G. Blattmachr, the New York lawyer who heads the estate tax department at Milbank, Tweed, Hadley & McCloy and who explained the plan in a half-dozen interviews. The technique is legal, blessed by the I.R.S. in 1996. But some leading tax lawyers, as well as some accountants and insurance agents, say it shouldn't be. They say it effectively disguises a gift to one's heirs that should be taxed like any other gift. They also say it is but one example of how a tax exemption on life insurance that was approved by Congress in 1913 to help widows and orphans has been stretched to benefit the very richest Americans. Several thousand of these jumbo policies have been sold, according to agents who sell them, all under confidentiality agreements with the buyers and their advisors. One member of the Rockefeller family took out a policy, according to people who have seen documents in the deal. The several billion dollars of this insurance already sold, much of it in the last 18 months, means that tens of billions of taxes will not flow into federal and state government coffers in the coming decade or so. In recent months, policies with first-year premiums alone of $4.4 million, $10 million, $15 million, $25 million, $32 million and $40 million have been sold by New York Life Insurance, Massachusetts Mutual Life Insurance and other underwriters, according to insurance agents, accountants and tax lawyers who have worked on these deals. The agents selling the policies find them hard to resist — they can earn millions of dollars for selling just one such policy. The technique works this way. An older person — typically someone who does not expect to live long and who has at least $10 million and usually much more — wants to avoid estate taxes, which are 50 percent with such fortunes. Under tax law, money from a life insurance policy goes at death to heirs tax free. The premium paid on that life insurance is considered a gift to those heirs. Any annual premium that exceeds $11,000 is therefore subject to the gift tax of 50 percent. Only the wealthiest Americans pay such large premiums and are subject to this tax. The new technique sidesteps the gift tax in a two-step process. First, the person who is buying the policy reports on his tax return only a small part of what he really paid in premiums. Wouldn't the I.R.S. say that is cheating? No. It's perfectly legal. The reason is that insurance companies offer many different rates for the same policy. And the buyer is allowed to declare on his tax return the insurance company's lowest premium for that amount of insurance, even if that person could never qualify for that rate because of his age and health, and even if no one has actually ever been sold a policy at that rate. A low premium means a low gift tax. But in fact the buyer has really paid the very highest premium offered by that insurer for that amount of insurance. The insurer then invests the difference between the highest premium and the lowest premium. That investment grows tax free, paying for future premiums on the policy. At death, the entire face value of the policy is paid tax free to heirs. In an example cited by one agent, a customer paid a $550,000 premium for the first year alone, the highest price offered by the insurance company, for a policy that was also offered at $50,000, the lowest price. So $550,000 can be passed on to heirs tax free. Yet the gift tax is only $25,000 — 50 percent of the lowest premium, instead of $275,000, which is 50 percent of the highest premium. The I.R.S. would not comment officially. But an I.R.S. official who specializes in insurance matters said he had not heard that so many people were exploiting this loophole. He could not say whether the issue would be re-examined. The deal gets better because of a second step. Even that $25,000 tax can be avoided by shifting the gift-tax obligation to the spouse through a trust. In 1982, Congress made all transfers between spouses tax free, so the gift tax disappears. If the policy holder continues to pay huge premiums year after year, he can pass along much or all of his fortune tax free if he lives long enough. Michael D. Brown of Spectrum Consulting in Irvine, Calif., said, many clients in their 50's and 60's, working with other agents, are now trying to do just that. By far the biggest deals have been made by two insurance agents who work together, Mr. Brown, a former chemical engineer, and Louis P. Kreisberg of the Executive Compensation Group in Manhattan. The technique was devised in 1995 by Mr. Blattmachr and Mr. Brown. Mr. Blattmachr has since expanded his idea and other estate tax lawyers have copied his methods. "In 1995 I was told that this was the stupidest idea ever by a guy who is now collecting millions in commissions from selling" such insurance, Mr. Blattmachr said. Among his peers Mr. Blattmachr is renowned for his creativity in finding ways to pass down fortunes without paying taxes and without breaking the law. He is a busy man. Recently he set off to counsel clients in eight cities over three days — a trip made possible by a client who provided him with a private jet. Afterward he spent the weekend fishing with his brother, Douglas, whose company, Alaska Trust, helps wealthy Americans set up perpetual trusts, some of them using Mr. Blattmachr's insurance plan. One buyer of an insurance plan like Mr. Blattmachr's paid $32 million in the first year for a policy that will pay $127 million tax free to the grandchildren, according to a lawyer who worked on the deal and spoke on condition of not being identified. No gift taxes were paid. Sales of such insurance soared after the Internal Revenue Service announced 18 months ago that it was considering restrictions on similar techniques, which are known as split-dollar plans. In Alaska, premiums for such insurance totaled just $1.1 million in 1999, but ballooned to more than $80 million last year, state records show. This month, when the I.R.S. issued its proposed restrictions, it did nothing to stop Mr. Blattmachr's plan. Indeed, the proposed I.R.S. rules can be read as strengthening the validity of his plan, Mr. Blattmachr and some other estate tax lawyers say. Mr. Brown said that in some cases, when the policy holder dies quickly, both the government and the heirs come out winners, at the expense of the insurance company. "This is a good deal because both the government and the heirs get 90 percent of what they could have gotten," he said. He added: "We think it is good policy to allow this because it discourages games like renouncing your citizenship or investing offshore." But many estate tax lawyers and insurance experts think that because Mr. Blattmachr's plan is similar to the plans the I.R.S. moved to stop on July 3, it should be ended as well. While the I.R.S. in 1996 approved the outlines of the Blattmachr plan, these opponents argue that the plan as sold by agents like Mr. Brown and Mr. Kreisberg stretches that ruling so far that it no longer provides protection in an I.R.S. audit. Some of them say it is the huge fees involved that are blinding their competitors to aspects of the Blattmachr plan that make it vulnerable to being banned as an abusive tax shelter. Commissions for the insurance agents run between 70 percent and 200 percent of the first-year premium when it is $1 million or so, while on the jumbo policies commissions are typically 9 percent to 11 percent, or up to $4.4 million on a policy with a $40 million first-year premium, Mr. Kreisberg said. He acknowledged that many peers in the estate tax world say that he earned $100 million in gross commissions last year, but said, "I wish it were half that." Mr. Kreisberg did not dispute a statement by someone with knowledge of payment records that his small firm's commissions this year have already reached $20 million. Lawyers who opine on the validity of the deals can also earn big fees. Mr. Blattmachr gets $100,000 for his basic opinion letter and is reported to have charged as much as $250,000. Sanford J. Schlesinger of the law firm Kaye Scholer said he passed up a chance to collect a six-figure fee for advising on one of these deals because he thinks the deals should not pass muster with the I.R.S. "My mother taught me that if something seems too good to be true, it isn't true," he said. Other leading estate tax lawyers, as well as some accountants and insurance agents, say Mr. Blattmachr's insurance technique should fail because it is wholly outside the intent of Congress in giving tax breaks for life insurance, the I.R.S. ruling on the plan notwithstanding. "If the I.R.S. understood this they would say that it relies on a disguised gift — and if you have to pay gift taxes, then Jonathan's insurance deal does not work," said an estate partner at a tax firm in New York, who like others, said they could not be identified because they have signed confidentiality agreements that are part of all such insurance deals. Another legal expert said paying 10 times too much for insurance in a plan like this reminds him of a matriarch selling the family business to her granddaughter for $10 million when it was actually worth 10 times that amount. "The I.R.S. wouldn't let a family get away with selling the business for a dime on the dollar," this lawyer said, "and they should not allow it to work in reverse through insurance." Wealthy Family Sues Famous Lawyer Over Tax Plan By Wendy Davis, Trusts & Estates contributing writer Online Exclusive, Jul 8 2003 New York real estate magnate Charles B. Benenson and his wife file suit accusing noted trusts and estates lawyer Jonathan Blattmachr of breach of contract and conflict of interest. At core, but not part of the complaint, is the reverse split dollar arrangement—a tax loophole that the IRS recently warned it will not allow Print-friendly format E-mail this information High-profile trusts and estates lawyer Jonathan Blattmachr is famous for his clever use of trusts, family limited partnerships and sophisticated insurance plans to reduce inheritance and gift taxes. But last summer a particular insurance tactic that he had employed caught the attention of the U.S. Treasury and Internal Revenue Service after it was detailed in a front-page article in The New York Times decrying the lucrative loophole for the ultra-rich. Now, a family that bought the same type of policy made notorious by the Times—and the subject of an official notice from the Service—is suing Blattmachr and his law firm, Milbank, Tweed, Hadley & McCloy LLP. The family, Charles B. Benenson, of Benenson Realty Company, his wife Jane and his son (Jane's stepson) William, claims that the plan they bought is not the one his family expected. In Los Angeles this June, the Benensons filed suit for breach of contract, malpractice and other charges. Specifically, the Benensons claim that the insurance policy, which is supposed to pay $48.5 million in death benefits, is underfunded by about $1.5 million and might lapse within the next decade. The family blames Blattmachr, a New York-based partner at Milbank, as well as husband-and-wife insurance agents Louis and Amie Kreisberg; insurance agent Michael Brown; and the insurance companies that sold the policy. These firms include: Spectrum Consulting L.P. (also called Spectrum Financial Network Insurance and Investments, L.L.C.), where Brown is a managing partner and member; Executive Compensation Group, where Louis Kreisberg is an officer; CM Life Insurance Company, a subsidiary of Massachusetts Mutual Financial Group; and Massachusetts Mutual Financial Group. The Benensons also allege that Blattmachr, who introduced them to the Kreisbergs and the other players in the deal, did not "fully disclose" that he also represented the other parties at the time of the introduction. (Louis Kreisberg is on the editorial board of Trusts & Estates magazine; Blattmachr is a contributor to the magazine.) A spokesman for Milbank, who asked not to be identified, says: "Milbank's only client in the matter…was the Benensons, and they were faithfully served." Calling the suit "baseless" and "meritless," the firm spokesman said that the lawyers "intend to defend ourselves vigorously and we fully expect to prevail." "Milbank and Mr. Blattmachr practice law," added the spokesman. "The Benensons are complaining about the insurance product that they acquired. Neither Milbank nor Mr. Blattmachr had anything to do with the client's choice of insurance products." Kreisberg says that the lawsuit is frivolous and he fully intends to defend against it. Brown and Mass Mutual declined to comment. The Benensons are asking for the approximately $1.5 million they say it will take to fund the plan, a refund of the fees and commissions they paid to Blattmachr and the insurance agents, and punitive damages. Milbank Tweed's fee, according to the complaint, was $970,000; that included the work done on the deal and a tax opinion letter. Commissions to the insurance agents and broker, according to the suit, ran to more than $4.4 million. The Benensons also agreed to keep the details of the deal confidential, says one of their current lawyers, Virginia Miller of Anderson Kill & Olick PC, the law firm where former New York City mayor Rudolph Giuliani once worked. IRS Warning The Benensons' policy, a family reverse split dollar arrangement, became a popular estate planning strategy among the very wealthy from 2000 to 2002. Armed with a 1996 IRS ruling, Blattmachr and others presented such plans as a way of passing family wealth to heirs without estate tax and with greatly reduced gift taxes on the premiums. "I'm not saying this is the best thing since sliced bread, but it's really good for pushing wealth forward tax-free," Blattmachr said, according to The New York Times article last July. The Times story noted that insurance companies had sold thousands of these policies, adding up to billions of dollars of insurance, the bulk of it issued since early 2001. Shortly after publication of the newspaper article, the Treasury Department and IRS issued a notice refuting Blattmachr's interpretation of the gift tax required on premium payments. Before that notice, purchasers of these plans believed that they did not have to pay gift taxes on the entire amount of the premium price, but instead could value the premiums based either on government tables or the insurance company’s published rates (usually lower than the amount actually paid.) The August Notice, 2002-59, changed that. It said that the donor could no longer use the government’s premium rates or lower insurance company rates if the donor, or donor’s estate, has the right to the insurance. The August notice was accompanied by a press release stating that the IRS would not respect reverse split dollar arrangements "where the parties attempt to avoid taxes by using inappropriately high current term insurance rates, prepayment of premiums or other techniques to understate the value of taxable policy benefits." The warning was loud and clear. Soon afterward, wealthy families stopped purchasing these types of plans, say insurance lawyers. But what about those families like the Benensons that already had such plans in their estates? Estate planning experts note that it is too soon for such plans to have been audited by the IRS. For now, the Benensons are not complaining in their lawsuit about the tax consequences of the plan. But the suit, filed just before the statute of limitations for a possible complaint ran out, could be amended later. The family’s lawyers say that the Times article helped spur the lawsuit in that it contributed to their disillusionment with Blattmachr and the insurance agents. "The itch that they had was scratched by The New York Times and then drew blood," says their attorney Eugene Anderson, name partner of Anderson Kill. Allegations The Benenson family alleges that Blattmachr approached them in early 2000 with a life insurance plan that he proposed would be a perfect fit for the family. Blattmachr, who had represented the family for several years, according to the Benensons' current lawyers, allegedly presented the policy as an estate-planning tool that would result in lower taxes while taking account of the Benensons cash flow needs. In 1986, New York real estate magnate Charles B. Benenson was listed in the Forbes 400 with a net worth estimated at more than $200 million. Benenson, a Yale grad, had built his father’s Bronx apartment house business into a realty empire, investing with several other New York City builders, including Lawrence Tisch and Harry Helmsley. The plan Blattmachr allegedly approved involved purchasing a $60 million life insurance policy on his wife Jane, who was 81 years old in the summer of 2000, when the deal was signed. In a complex sequence of events, the family is said to have used the Alaska Trust Company, run by Blattmachr's brother, Douglas, to create a trust to buy the insurance policy. Other parties Benenson claims were involved in the transaction include the Kreisbergs, Michael Brown and companies headed by them, with Massachusetts Mutual Financial Group the ultimate insurer. According to the complaint, the Benensons were supposed to pay about $23.5 million in premiums during the first three years of the policy, but also get back about $3.7 million in a partial surrender. Meanwhile, the policy proceeds were to decrease from $60 million in the first year to $48.5 million in year four, after which the plan was to pay $48.5 million regardless of when Jane died. To make matters even more complicated, the policy was backdated to June of 1999, when Jane was still 80 because Mass Mutual does not issue this type of policy on people older than 80. The family's current lawyers say the backdating, while perfectly legal in itself, ended up causing the confusion that led to the problems. The Benensons thought they were agreeing to pay about $10.96 million in premiums in the first year, $7.2 million in the second year and $5.6 million in the third year. The family also expected to withdraw approximately $3.7 million in the second year. But what the family says it did not realize was that the schedule of payments and withdrawals also was backdated one year. According to the Benensons, this meant that they were supposed to pay around $18 million, then receive $3.7 million back shortly upon signing the contract. Instead, they only paid around $10.9 million and never withdrew the $3.7 million. The Benensons claim they did not know anything was amiss until June of 2001, when the Kreisbergs allegedly asked for an additional $577,616. Relations between the Benensons and the defendants soon unraveled. Who Understood What? One of the steps the Benensons took was to hire Richard Harris, a New Jersey insurance agent, as a consultant. "From a life insurance point of view, in terms of all the twists and turns, this is rocket science," says Harris of the intricate deal. He alleges that the family never received all of the materials they were entitled to. Without that paperwork, he says, there is no way the Benensons could have fully understood the policy they had purchased. Harris also concludes that if the family now takes out the $3.7 million, the policy will be left underfunded and will lapse within the next 10 years, before Jane's 93rd birthday. These numbers are somewhat inexact, says Harris. Benenson attorney Virginia Miller calculates that the policy would lapse even earlier, before Jane's 91st birthday. Regardless, Harris and Miller both say that it is their understanding that the family did not realize they had to pay two years' worth of premiums upon signing. Had this been clearer, the family might not have done the deal. "If they thought they had to put up $18 million up front instead of $11 million up front, they might not have gone ahead with transaction," says Harris. This is also where Blattmachr's representation of both the insurance agents and Benensons becomes problematic, say the Benensons' lawyers. As the agents' commission was dependent on the deal going through, they had a motive to see it close. That motive, they allege, created a potential conflict of interest that was not "fully disclosed" as early as it could have been. Miller says that Blattmachr did disclose the potential conflict of interest before the family signed the deal. But, she says, the Benensons did not agree in writing to waive the potential conflict of interest, as is required by legal ethics rules in California—where the lawsuit was filed and where William Benenson, trustee of the insurance trust, lives. Miller also claims that the Benensons did not fully understand the ramifications of the potential conflict. Yet another allegation in the complaint is that Blattmachr did not disclose his relationship with the Alaska Trust Company, whose president and CEO is Jonathan's brother, Douglas Blattmachr. Even so, courts looking at the Benenson situation might not view the potential conflict as problematic, say legal ethics experts. Malpractice claims frequently contain allegations that an attorney did not disclose a conflict of interest, says legal ethics scholar John Leubsdorf, a professor at Rutgers School of Law, Newark. But, adds Leubsdorf, disgruntled clients can't prove malpractice simply because there is a conflict of interest. There also has to be a problem with the legal services received and, if the lawyer provided good representation, the conflict will not in itself be grounds for a lawsuit. The Benensons' complaint lists a variety of other matters about which they contend they were misled. For example, the Benensons believed the agents' compensation would be about $2 million to $2.5 million, but now say that the agents and their broker together received more than $4.4 million. The legal complaint does not provide an explanation for the Benensons' mistaken belief about the fees, but Harris claims that the amount was too deeply buried in the fine print. Another, related allegation is that no one discussed with the Benensons the possibility of funding the deal with private placement life insurance. Harris says that commissions are usually much lower with private placement life insurance because they are separately negotiated. "Generally, when those things become negotiated," says Harris, "the numbers are hugely different." He estimates that the commission only would have been $600,000 with private placement. An Industry Watches For all of the allegations in the complaint, the one claim that is missing—an accusation that Blattmachr gave bad tax advice—is what industry observers are most interested in seeing litigated. Even in the pre-August 2002 heyday of the family reverse split dollar plan, tax and insurance experts were divided about whether it was a legitimate way of lessening taxes. Some think that Blattmachr might yet prevail should the IRS fight the tax breaks in court. But others remark that these types of aggressive tax-lessening policies were always a train wreck waiting to happen. "Highly paid people tempt clients with ways to circumvent the intent of the tax laws," says Joseph Belth, a professor emeritus of insurance at Indiana University. But, he says, purchasers of these aggressive policies frequently don't realize the ramifications of their plans. "In most policies issued for non-traditional products, there's a great deal of risk on the policy-holder," says Belth. "The whole nature of the risks assumed by a policy-holder are not made completely clear at the time of sale."