Business Succession Planning and Life Insurance

Steve Leimberg's Estate Planning Email Newsletter - Archive Message #584

Date:	16-Sep-03 11:13 PM
From:	Steve Leimberg's Estate Planning Newsletter
Subject:	Split-Dollar - Ten Things To Do

Today is the last day before the new split-dollar regulations take affect. (If you missed LISI's special split-dollar reports last week, log into LISI at http://www.leimbergservices.com
Once logged in, click on the Estate Planning Newsletter tab on the far left. Drop down to commentaries 580 , 581 , and 582).

These new rules apply – only to split-dollar life insurance arrangements entered into AFTER today, September 17, 2003 and…

Define split-dollar life insurance,
Set rules for the taxation of economic benefits provided under a split-dollar life insurance arrangement,
Provide rules for the taxation of amounts received under a life insurance contract that is part of a split-dollar life insurance arrangement,
Lay out the additional tax consequences of a split-dollar life insurance arrangement, including the treatment of death benefit proceeds.
Tell us the tax implications of a transfer of a life insurance contract (or an undivided interest in the contract) that is part of a split-dollar life insurance arrangement.
Remind us that, if the transaction does not involve either split-dollar loans or economic benefits, then general income tax, employment tax, self-employment tax, and gift tax principles apply – based on the relationships of the parties. In other words, if the final regs don't apply, general tax principles do.

LISI is blessed with a number of members who are superb life insurance advisors. Lee Slavutin is among the best of the best of that list. Dr Slavutin, Chairman of Stern Slavutin-2 Inc., an insurance planning firm in New York, is the author of over 90 articles on insurance and estate planning topics for CCH, WG&L, PPC, and the New York Law Journal - and is the author of "Guide to Life Insurance Strategies" published by PPC.

Here's Lee's most helpful…

10 Things to Do Now That the Split Dollar Regs. Are Out

1. Review Notice 2002-8. This will provide guidance for split dollar arrangements established before September 18, 2003. The Notice provides guidance on valuing the insurance protection in split dollar arrangements (SDAs) in Section III, and the tax treatment of equity SDAs in Section IV. The proposed regulations issued in July 2002, in its “Background and Explanation of Provisions,” and Revenue Ruling 2003-105 re-affirm the importance of Notice 2002-8. Remember all SDAs established prior to the final regulations will be governed by Notice 2002-8 – unless they are materially modified after September 17th, 2003.

2. As a practical matter, it may not be worth spending any time studying the final regulations unless you are contemplating establishing a new SDA after September 17, 2003 or materially modifying an old SDA after September 17, 2003.

3. Identify all of your clients that have SDAs (if you have not already done so). Notify them in writing of the change in the rules governing the taxation of SDAs and that you will contact them about the need to make changes, if any. Clients with SDAs will fall into three major groups:

(1) private company collateral assignment SDA,
(2) private company endorsement SDA and
(3) public company SDA.

4. Identify clients with private company collateral assignment split dollar plans and large amounts of equity. “Equity” is defined as the excess, if any, of policy cash value over the amount owed to the employer. These clients need to be evaluated IMMEDIATELY. They may realize huge tax benefits by utilizing one of the two transition rules in Notice 2002-8 (Section IV, Paragraph 4).

They can terminate the SDA or convert to a loan BEFORE January 1, 2004 and NOT have to recognize income and gifts on the accumulated equity. BUT these options EXPIRE on December 31, 2003. You can be a hero if you advise the clients now, or possibly guilty of malpractice if you don’t. The evaluation of these opportunities takes time. You need to review the split dollar agreements, the life insurance policies, and updated in-force insurance illustrations. You and the client will need several weeks to do this. Do not wait until November or December to start this process.

5. Identify clients with private company collateral assignment SDAs and modest or no equity. These clients will constitute the largest group, especially if the SDA is less than 10 years old and has not had enough time to accumulate significant equity. An exception to this 10-year rule is a split dollar policy funded heavily in the early years; for example a “single premium” whole life policy.

Clients with modest or no equity will not find the two transition opportunities of Notice 2002-8 of great value. They can continue their SDAs and, if the SDAs were created before January 28, 2002, still use the insurance company term rates to value the insurance protection benefit, as long as those rates are available to all standard risks (Notice 2002-8, Section III, paragraph 3). Do these clients have to report any income and gift as equity develops and the SDA continues (i.e., the SDA is not terminated)?

Notice 2002-8 tells us that this growth of cash value does NOT constitute a transfer of property under Section 83 (Section IV, Paragraphs 1. and 2.), and the Notice does not say that this growth of cash value is taxable under Section 61. The Notice, however, does not explicitly say that Section 61 does not apply to the cash value growth. Most commentators have concluded that if the IRS regarded the cash value growth as taxable under Section 61 they would have had said so. Many of us will probably take the position that the equity is NOT currently taxable. On the other hand, the Notice implies that termination of an equity-SDA will result in income and a gift (if the policy is owned by a third party) unless the SDA is able to use one of the two transition rules of IV.4.

Separately, we will have to think about the long-term issue of increasing term costs and possible exit strategies. But here, we are not under the same time pressure of having to act before the end of the year.

6. Identify clients with private company endorsement SDAs. Most of these SDAs are non-equity plans and, therefore, the possibility of taxation on equity on termination is not an issue. These clients can continue to use insurance company term rates to value the insurance protection if the SDAs were established before January 28, 2002.

7. Stop premium payments on public company collateral assignment SDAs. What are your options?

Here are some ideas:

a. the employee pays the premium;
b. convert to an endorsement SDA, which should not be subject to the loan prohibition rule of Sarbanes Oxley;
c. sell the public company’s interest to a non-public entity (trust, partnership) that can pay the premiums and be careful to avoid the transfer for value rule.

Do not hold your breath waiting for the SEC to rule on this issue!

8. Start planning for increasing term costs if the SDA continues. Remember that the economic benefit rates will jump considerably when one spouse dies under a second-to-die policy.

Possible Solution: When the policy has developed a large amount of equity at some point in the future, pay back most but not all the employer obligation and convert the SDA to a loan. Example: in 2012, the policy has a death benefit of $3,000,000 and a cash value of $1,000,000, and the employer is owed $500,000. Take a policy loan of $450,000 and pay back the employer $450,000. The employer is now owed $50,000. Convert the SDA to a split dollar loan. Now the employee/trust has to pay interest on $50,000 rather than the term insurance cost on $$2,500,000 (total death benefit less employer obligation). Conversion of the SDA to a split dollar loan should not be treated as a termination of the SDA – at least this seems to be implied by IV.2 and IV.3 of the Notice.

9. Do not modify an existing SDA, unless you are using the transition rules of the Notice or you are forced to modify the SDA by the Sarbanes Oxley Act. The regulations give us a very limited list of "sure fire" nonmaterial modifications:

a change in the mode of premium payment;
a change in the beneficiary of the insurance policy;
a change in the interest rate payable on a policy loan;
a change required to preserve the status of the policy under section 7702;
a change in the ministerial provisions of the policy such as a change in the address for premium notices;
a non-discretionary change required by the split dollar agreement in effect on or before September 18, 2003;
a change in the owner of the policy as a result of a Section 318(a) transaction;
a court or state-ordered policy change resulting from insolvency of the insurer;
a change in the insurer resulting from an assumption reinsurance transaction.

Note that this safe harbor list does NOT include Section 1035 policy exchanges!

A material modification after September 17 forces the client into one of the two tax regimes of the regulations, forces taxation based on policy ownership, and eliminates the use of insurance company term rates after 2003, unless they meet new and more stringent standards.

10. Above all else, ACT NOW. There is no reason to wait any longer! The IRS has not changed any of the really important principles in the proposed regulations and has NOT EXTENDED the expiration date for the special transition rules of the Notice.

HOPE THIS HELPS YOU HELP OTHERS!

Lee Slavutin

Edited by Steve Leimberg

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