Wealthy taxpayers who want to avoid paying exorbitantly high estate taxes of up to 50% have taken solace in recent years with a tax scheme that enabled them to purchase certain life insurance policies which get passed on to heirs tax free. Those days are over.

The way the scheme worked, up until last Saturday's Treasury Department notice (Notice 2002-59), a taxpayer would purchase a life insurance policy for a high price, when the actual value of the policy is significantly lower. The taxpayer would report the lower price on a gift tax return. The difference between the actual cost of the policy and the value of the policy would be invested, tax free, and used to pay the premiums for the remaining life of the taxpayer. Since life insurance proceeds are not taxed, when the taxpayer dies, the entire value of the policy gets passed over to the beneficiary or beneficiaries, tax free.

"The Notice makes clear that using any scheme to understate the value of benefits for income or gift tax purposes won't be respected," said Pamela F. Olson, acting assistant Secretary of the Treasury for Tax Policy.

Some taxpayers have invested as much as $40 million for such policies. The New York Times last week (U.S. Bans a Scheme to Avoid Estate Tax, August 17, 2002), described a typical policy that might cost $550,000 but be worth $50,000. The taxpayer reports $50,000 as a gift and the $500,000 passes out of tax range. In a second layer of the tax avoidance scheme, the taxpayer can gift the policy to his or her spouse, and since gifts to spouses are not subject to gift tax, the entire transaction becomes tax free.

The technique was devised in 1996 by a New York lawyer, Jonathan G. Blattmachr, and a California-based chemical engineer, Michael Brown. The two received a ruling from the Internal Revenue Service allowing what was at that time called "family reverse split-dollar" life insurance. The Treasury Department now claims that Mr. Blattmachr, who has been advising clients on this technique since 1996, went far beyond the intent of the ruling.