Estate Planning Review, Vol. 29, No. 6, June 19, 2003

Life Insurance Planning

News on Split Dollar and Other Insurance Topics

Following up on proposed regulations issued in July, 2002 (REG-164754-01), the IRS has answered at least one question left unanswered by the earlier proposals. The latest proposed regulations, issued May 8, 2003, concern the valuation of the economic benefits provided under certain types of split-dollar life insurance arrangements. To help our readers understand the implications of the new proposed regulations, as well as other news on the insurance front, we present the following interview with Lee Slavutin, MD, CLU. Dr. Slavutin is a principal of Stern Slavutin-2 Inc., an insurance and estate planning firm in New York City, and is a member of the CCH Financial and Estate Planning Advisory Board.

CCH: With so many different IRS pronouncements on the topic of split-dollar life insurance in recent years, it is sometimes difficult to know the status of the rules. Having said that, could you briefly explain where we are in terms of what the IRS has and has not said about split-dollar life insurance arrangements?

Dr. Slavutin: Although there may have been some confusion about this issue, the latest set of regulations represent a supplement to the July 2002 proposed regulations. They are not final regulations. I think it is important to reiterate the point that we have not yet seen final regulations on any of the guidance having to do with split-dollar arrangements. This is significant because it means that, unless a taxpayer elects to have the regulations apply at an earlier date, or a material modification of an existing arrangement occurs in the future, these regulations will only apply to split-dollar arrangements (SDAs) established after the final regulations are published. It is expected that final regulations will be adopted perhaps late this year or early in 2004.

Accordingly, this also means that Notice 2002-8 LK:NON: RULINK NOTICE2002-8 , IRB 2002-4, 398, remains our primary guidance for existing and pre-final regulation split-dollar arrangements. Therefore, there is still time for certain of our clients to take advantage of the potential relief that the transitional rules contained in Notice 2002-8 provide. This transitional rule provides that a split-dollar arrangement entered into prior to January 28, 2002, can be terminated without having to recognize any income from the equity build up in cash value if (1) the arrangement is terminated before January 1, 2004 or (2) the arrangement is (a) converted to a loan before January 1, 2004, (b) is treated as a loan going forward, and (c) all previous payments are treated as loans. Generally, this is an important consideration for clients whose split-dollar arrangements have been in existence for some time and have built up a considerable amount of equity.

Similarly, the issue of what constitutes a “material modification” is important because we do not want our clients to lose any of the tax benefits provided for existing arrangements under Notice 2002-8. For example, with respect to split-dollar arrangements entered into prior to January 28, 2002, taxpayers can continue to use the lower insurance company term rates to value the economic benefits, rather than Table 2001. The basic message is not to do anything to change an existing splitdollar arrangement that could be construed as a material modification. At this point we do not have a clear definition of what a material modification is. It could involve a change to the policy, replacement of a policy, a Code Sec. 1035 LK:NON: FIN-IRC S1035 exchange, a reduction in the death benefit on an existing policy, etc. —we just do not know. Thus, it is imperative to be very cautious in this regard.

2003 Supplemental Proposed Regulations

CCH: Could you place the new proposed regulations in perspective as to how they relate to the 2002 proposals?

Dr. Slavutin: Although the 2002 proposed regulations left a number of questions unanswered, the 2003 supplemental proposed regulations attempt to answer at least one of those questions. Specifically, the supplemental proposed regulations (Prop.Reg. §1.61-22(d)(3) LK:NON: FNHLINK S1.61-22(D)(3) ) deal with the valuation of the equity in an equity endorsement split-dollar life insurance arrangement. Before proceeding, it might be beneficial to define exactly what we mean by “equity” and “endorsement split dollar.”

The two basic forms of split-dollar arrangements are characterized as follows: (1) the employee or a trust for the employee's family owns the policy (usually referred to prior to the 2002 proposed regulations as “collateral assignment split dollar”) or (2) the employer owns the policy (endorsement split dollar).

In an endorsement split-dollar arrangement, the employer owner endorses a portion of the death benefit, usually most of the death benefit, to a beneficiary named by the employee. The employer will retain its right to receive a portion of the death benefit. In an endorsement equity split-dollar arrangement the employer's interest in the death benefit is equal to the lesser of the cash value of the life insurance or the premiums paid. For example, a corporation owns a $1 million life insurance policy on an employee's life pursuant to a split-dollar arrangement. The arrangement is terminated at a time when the corporation has paid an aggregate of $100,000 in premiums and the policy has a cash value of $300,000. Under these circumstances, the corporation would receive $100,000 and the employee would receive the equity, i.e., $200,000. Equity is the amount of cash value in the policy less the cumulative employer premium investment. In “equity split dollar,” the equity is “owned” by the employee or a trust for the benefit of the employee's family, and can be accessed by the employee or the trust.

Under the 2002 proposed regulations, if the policy is owned by the employee (collateral assignment variety), the arrangement would be treated as a loan under Code Sec. 7872 LK:NON: FIN-IRC S7872 with the possible application of the original issue discount rules of Code Secs. 1271 LK:NON: FIN-IRC S1271 through 1275 LK:NON: FIN-IRC S1275 On the other hand, in the case of an endorsement type arrangement, in which the employer owns the policy, the arrangement is treated as conveying an economic benefit to the employee. Under this rationale, one must determine the value of the term insurance component as well as the value of any other benefits deemed to be provided under Code Sec. 61 LK:NON: FIN-IRC S61 It is this economic benefit present in the endorsement type arrangement that is the subject of the new supplemental proposed regulations.

An Example

CCH: Could you provide us with an illustration of how the supplemental proposed regulations would work?

Dr. Slavutin: I would suggest that we do this by taking a close look at the Examples provided in the proposed regulation itself (Prop. Reg. §1.61-22(d)(3)(G) LK:NON: FNHLINK S1.61-22 , Examples 1 and 2). In Example 1, an employer and an employee enter into an equity endorsement split-dollar life insurance arrangement. Under this arrangement, the employer pays all of the premiums on the life insurance contract until the termination of the arrangement or the employee's death. The arrangement also provides that upon the happening of either of these events, the employer is entitled to receive the lesser of the aggregate premiums paid or the policy cash value of the contract, while the employee is entitled to receive any remaining amounts. In addition, under the terms of the arrangement and applicable state law, the policy cash value is fully accessible by the employer and the employer's creditors, however, the employee has the right to borrow or withdraw that portion of the policy cash value in excess of the amount payable to the employer upon termination of the arrangement or the employee's death.

In this SDA, the employer purchases a life insurance contract with constant death benefit protection of $1,500,000. As of December 31 of Year One, the policy cash value equals $55,000 and the employer has paid $60,000 of premiums on the life insurance contract. As of December 31 of Year Two, the policy cash value equals $140,000 and the employer has paid aggregate premiums of $120,000. Finally, as of December 31 of Year Three, the policy cash value equals $240,000 and the employer has paid $180,000 of premiums on the life insurance contract.

Under the terms of the arrangement, the employer paid all of the premiums on the life insurance and the employee had the right to borrow or withdraw the portion of the policy cash value in excess of the amount payable to employer. Under a theory akin to that of constructive receipt in the deferred compensation area, the IRS considers that the employee had current access to this excess portion. Accordingly, Example 1 states that the employee must include in income all of the economic benefits under the arrangement, that being the cost of current life insurance provided to the employee and the amount of cash value that he or she had current access to. This theory is somewhat controversial in that it goes against one of the basic tenets of the taxation of life insurance (ordinarily, the owner of a whole life insurance policy is not taxed on the built-in gain in a policy, unless he cancels the policy and cashes it in). If you recall, this was the theory first advanced in Technical Advice Memorandum 9604001 LK:NON: LTRLINK LTR9604001 , which was the progenitor to what would become a whole new wave of IRS pronouncements on split-dollar arrangements.

According to Example 1, in Year One, the economic benefit is composed of $0 of policy cash value (because the cash value did not exceed the amount payable to the employer in Year One) and the cost of $1,445,000 ($1,500,000 face value minus $55,000) of current life insurance protection. For Year Two, the economic benefit includes $20,000 of policy cash value ($140,000 policy cash value as of December 31 of Year Two, minus $120,000 payable to the employer). In addition, the employee received current life insurance protection of $1,360,000 ($1,500,000 minus the sum of $120,000 payable to the employer and the $20,000 of policy cash value). Thus, the employee includes in gross income for Year Two, the sum of $20,000 of policy cash value plus the cost of $1,360,000 of current life insurance protection. For Year Three, the cash value provided to the employee is $40,000 ($240,000 policy cash value determined as of December 31 of Year Three, minus the sum of $180,000 payable to the employer and $20,000 of aggregate policy cash value that was already included in gross income for Year Two). For Year Three, the current life insurance protection provided to the employee is $1,260,000 [$1,500,000 minus the sum of $180,000 payable to the employer and $60,000 of aggregate policy cash value ($20,000 for Year 2 and $40,000 in Year Three that the employee includes in gross income)]. Accordingly, for Year Three, the employer includes in gross income the sum of $40,000 of policy cash value and the cost of $1,260,000 of current life insurance protection.

Example 2 makes several changes to the facts provided in Example 1. Specifically, the employee cannot directly or indirectly access any portion of the policy cash value. However, the terms of the arrangement or applicable state law provide that the policy cash value in excess of the amount payable to the employer upon termination of the arrangement or the employee's death is not accessible to the employer's general creditors. For the latter reason, the employee is still considered to have current access to this excess portion of the cash value. Therefore, the employee includes in gross income the value of all economic benefits flowing from the arrangement and the results for Years One through Three are exactly the same as in Example 1.

CCH: How would you summarize the supplemental proposed regulations?

Dr. Slavutin: The bottom line is that under the new regulations, employees would be required to include in income each year not only the value of the insurance protection provided under a split-dollar arrangement, but also the cash value benefit accessible by the employee. However, that said, I cannot emphasize enough that these rules apply only to endorsement equity split-dollar arrangements established after the final regulations are published. They do not apply to endorsement split-dollar arrangements entered into before the effective date of final regulations. Nor do they apply to collateral assignment split-dollar arrangements, even those established after the final regulations are published, because those arrangements will be treated as loans. Similarly, the supplemental proposed regulations do not apply to endorsement nonequity split-dollar arrangements —those in which the employer is entitled to the greater of the cash value or premiums paid upon termination. In the latter case, because the employer is entitled to any excess cash value, the only tax concern for the employee involves the taxation of the value of the life insurance protection.

CCH: With respect to your last point, how is the value of the insurance protection determined? Does one use the life insurance company tables, Table 2001, or some other table?

Dr. Slavutin: This is an issue that was not addressed in the supplemental proposed regulations. Thus, at least for the moment, we have to rely on Notice 2002-8. Pursuant to that ruling, for 2003, it is still acceptable to use the insurance company term rates to value the life insurance portion of the benefit. In 2004, assuming the final regulations have not yet been published and if the plan were established prior to January 28, 2002, the insurance company term rates can still be used. However, for plans established after January 28, 2002, one must use Table 2001 or an insurance company table based on policies that are actually being sold to the public.

Sarbanes Oxley and Split Dollar

CCH: Do you know of any other news concerning the topic of split-dollar insurance that subscribers should be made aware?

Dr. Slavutin: The accounting and corporate reform legislation commonly known as the Sarbanes-Oxley Act of 2002 (P.L. 107-204) continues to be a major concern for those who are now involved in public company split-dollar insurance arrangements. Among its conflict-of-interest provisions, the Act prohibits public companies from entering into loans with certain executives and officers (Act Sec. 402(a)). Although that portion of the Act deals specifically with the Securities and Exchange Act of 1934, the potential implications for split-dollar arrangements, particularly collateral assignment split-dollar plans, are unclear at the moment. Insurance industry representatives had requested that language be added in Conference clarifying that (1) the provision was not intended to apply to split-dollar arrangements, (2) the provision is prospective, and (3) it applies only to public companies. Although the latter two points were clarified favorably, language specifically stating that the provision was not intended to apply to split-dollar arrangements was not included in the final bill.

It is possible that the SEC may treat collateral assignment split-dollar plans as loans as the IRS regulations would. If that is the case, premium payments, even those made pursuant to existing split-dollar plans, may be treated as new loans which are prohibited. The insurance industry has been trying to get some guidance from the SEC on this question, but at least so far, the SEC has not seen this problem as a high priority.

CCH: While waiting for this issue to be resolved, what advice would you give to anyone faced with the potentially negative ramifications of Sarbanes-Oxley?

Dr. Slavutin: There are two basic courses of action. The first would be to advise public companies to suspend payments under split-dollar plans for the benefit of executives or directors. In the interim, the policy's cash value could serve as a source of premium payments or the employee could pay the premium. The second possible course of action would be to switch to an endorsement split-dollar arrangement. Of course, when accomplishing such a switch, one must be mindful of the “transfer-for-value” rule. However, Code Sec. 101(a)(2) LK:NON: FIN-IRC S101(A)(2) , does provide an exception to the transfer-for-value rule for a transfer to a corporation in which the insured is a shareholder or officer.

It is also important to note that certain split-dollar arrangements should not be affected by Sarbanes-Oxley. For example, it does not affect an arrangement between a publicly traded company and an employee who is not an executive or officer. Similarly, an endorsement split-dollar arrangement even with an executive or officer should be safe because such an arrangement would be not be ordinarily be construed as a loan.

Other Insurance News

CCH: Any additional news about insurance generally that we should be aware of?

Dr. Slavutin: Recently, the IRS has been quite active in attacking what it considers to be abusive insurance programs, such as offshore insurance companies created to shelter investment income (Notice 2003-34, IRB 2003-23, 990) or welfare benefit plans established to avoid the limitations under Code Sec. 419A LK:NON: FIN-IRC S419A (Notice 2003-24, IRB 2003-18, 853, involving sham collective bargaining agreements). In this regard, it is important to note the tougher rules with regard to the disclosure of “listed” transactions that are considered tax shelters (Reg. §1.6011-4 LK:NON: FNHLINK S1.6011-4 and Notice 2001-51, 2001-2 CB 190). Failure to disclose a listed transaction can result in severe penalties.

Another area of concern for the IRS involves abusive Code Sec. 412(i) LK:NON: FIN-IRC S412(I) plans. This section of the Code involves a fully insured defined benefit pension plan —a plan that is otherwise perfectly legitimate. However, there are at least two variations of such plans to which the IRS is opposed. The first variation involves a violation of the incidental benefit limitations. Insurance provided under such plans is supposed to be only an incidental benefit because the main rationale for the plan is retirement funding not insurance protection. Consequently, the IRS may disqualify plans that attempt to exceed the limitations allowed under the incidental benefit rules. Another variation involves the purchase of an insurance policy by the plan, and several years later, the sale of the policy to the participant or to a life insurance trust for a very low value. Thus, taking advantage of a low cash surrender value and effectively shifting value from the plan to an outside structure at a very low tax cost.

CCH: Do you see any legislative action with respect to life insurance that would be of concern?

Dr. Slavutin: The recently passed Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27) does not contain anything specifically targeting life insurance. However, there are several legislative proposals that have been introduced, that may yet find their way into another bill. For example, the Senate version of the Act contained a number of amendments that were later dropped including those dealing with corporate owned life insurance and certain deferred compensation arrangements.