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TO: All Professional Tax Personnel NTA-512
FROM: Lee Slavutin, MD, CLU DATE: October 21, 2003

RE: Split-Dollar Life Insurance—The Final Chapter

Background

After issuing a series of notices and proposed regulations over the last few years, the IRS has at long last issued the final split-dollar life insurance regulations. These regulations aren’t any great surprise. They pretty much follow the proposed regulations, generally increasing the amount employees must include in income during the term of a split-dollar arrangement, especially for equity arrangements. Fortunately, only post-9/17/03 arrangements are subject to these new rules. For pre-9/18/03 arrangements, the kinder, gentler guidance provided by Notice 2002-8 should be followed.

We’ll only briefly describe the final regulations here. (Frankly, we doubt you’ll use them much, as they pretty much put an end to all but the simpler nonequity-type split-dollar plans.) Instead, we thought it’d be more helpful to stand back and take a look at where we stand with various split-dollar arrangements now that all the dust has settled. As summarized in Appendix 1, the taxation of these arrangements depends on when they were entered into. Also, there’s a window of opportunity between now and the end of 2003 for some pre-1/28/02 arrangements to lock-in substantial tax savings.

Note: The final regulations specifically apply to all types of split-dollar arrangements (e.g., employment or private arrangements). However, this discussion focuses on arrangements between employers and employees.

What is a Split-dollar Life Insurance Arrangement?

The term split-dollar life insurance refers to an arrangement in which two parties (in this article, an employer and employee) split the cost and the benefits of a whole life or other cash-value life insurance policy.
Split-dollar plans typically are structured as follows:

1. Collateral Assignment Arrangements. The employee (or an irrevocable life insurance trust) owns the policy, but the employer pays most of the premium or “loans” this amount to the employee (or trust) who is then responsible for paying the entire premium. The employer receives a security interest in the policy as collateral for making the premium payments or “loan,” which are repaid at the employee’s death (or the arrangement’s termination). In an equity arrangement, the employer is entitled to receive only its accumulated premiums. Any cash surrender value (CSV) in excess of this amount (i.e., equity) is provided to the employee. In a nonequity arrangement, the employer receives the larger of its accumulated premiums or the CSV. In other words, all the employee receives under a nonequity arrangement is the term-life coverage.

2. Endorsement Arrangements. The employer owns and pays the premiums on a policy insuring the employee’s life and endorses the death benefit in excess of the CSV to the employee’s beneficiary. These are usually nonequity plans used to provide executives death benefits while they’re employed and deferred compensation arrangements when they retire.

The Final Regulations Apply to Post-9/17/03 Arrangements

The final regulations apply to arrangements entered into (or materially modified) after 9/17/03 (post-9/17/03 arrangements). Here, parties to a split-dollar arrangement are taxed under one of two mutually exclusive regimes, neither of which is particularly attractive with regards to equity plans:

1. Economic Benefit Regime. This regime applies to all nonequity split-dollar arrangements (i.e., where the employee does not share in the policy’s CSV). It also applies to equity arrangements (i.e., where the employee shares in the policy’s CSV), if the employer owns the policy (i.e., the endorsement method is used). Under the economic benefit regime, the employee must include in gross income each year (a) the value of the term-life component of the policy less any amount paid by the employee, plus (b) the value of any CSV provided to the employee during the taxable year (IRC Sec. 61). Finally, if the policy is transferred to the employee, any CSV in excess of the amount payable to the employer plus amounts previously included in the employee’s income will be taxed under IRC Sec. 83. (The factors for valuing the term-life component have not yet been provided. Presumably, they’ll be similar to the rates provided in the IRS Table 2001.)

2. Loan Regime. The loan regime method applies to equity arrangements where the employee owns the policy (i.e., the collateral assignment method is used). Under the loan regime, the premiums paid by the employer are treated as a series of loans from the employer to the employee if the employee has an obligation to repay the employer. Such loans are subject to the below-market loan rules. (The $10,000
   de minimis exception doesn’t apply here. Thus, the below market loan rules apply even to de minimis premium loans.) If the employee isn’t obligated to repay the employer’s premium payments, such amounts are treated as compensation income to the employee at the time the premiums are paid by the employer.

Warning: Although not entirely clear, it appears that public companies would be prohibited from entering into equity collateral assignment split-dollar arrangements with directors and executive officers, as they are prohibited under Sarbanes-Oxley from making personal loans to such individuals.

Bottom Line: Equity split-dollar arrangements can no longer be used to provide tax-free income to executives—that pretty much puts an end to new equity arrangements after 9/17/03. Nonequity arrangements, however, may continue to be a viable way to provide pure term insurance to executives, depending on the rates contained in the new yet-to-be issued term-life tables. Thus, split-dollar arrangements may not be altogether a thing of the past.

Notice 2002-8 Continues to Govern Pre-9/18/03 Arrangements

Fortunately, the final regulations don’t apply to pre-9/18/03 arrangements (as long as the arrangement isn’t materially modified after 9/17/03—more on this later). For these arrangements, the kinder and gentler rules of Notice 2002-8 can be used. Under these rules, the parties to the agreement can treat the value of the current life insurance protection as an economic benefit provided to the employee, or they can treat the premium payments advanced by the employer as loans.

Loan Treatment. If the arrangement is treated as a loan, the below-market loan rules of IRC Sec. 7872 apply. The IRS will not challenge reasonable efforts to apply these rules. Loan treatment won’t usually be the chosen arrangement as it’ll usually result in the executive having to recognize more income than if economic benefit treatment is used. However, you might want to convert certain pre-1/28/02 equity arrangements that have previously been accounted for using the economic benefit method to the loans, as doing so by 1/1/04 will prevent taxation of the CSV provided to the executive when the arrangement terminates. We’ll have more on this later.

Warning: Sarbanes-Oxley prohibits public companies from making personal loans to directors and executive officers. Although not entirely clear, it appears that public companies would be prohibited from treating split-dollar arrangements with such individuals as loans.

Economic Benefit Treatment. Here, the value of the current term-life insurance protection provided to the employee (net of any employee payments) is included in the employee’s income each year. Also, any portion of the policy’s CSV provided to the employee is taxed when it’s made available to the employee. (As explained later, under Notice 2002-8, this generally won’t happen until the arrangement or policy terminates.)

The current term-life insurance protection is valued using the IRS Table 2001 premium rates or, if lower, the insurer’s published premium rate that is available to all standard risks for initial issue one-year term insurance. (However, after 2003, most post-1/28/02 split-dollar life arrangements won’t be able to use the insurer’s lower rate because few will meet the more stringent rules applicable after 2003. Therefore, beginning in 2004, most post-1/28/02 plans will have to use Table 2001 rates instead of the lower insurer rates to value term insurance.)

In addition to including the value of the term insurance in income each year, any CSV provided to the employee must be included in the employee’s income when it’s made available to the employee. Fortunately, an employee won’t be considered as having received (and, thus, having to include in income) a portion of a policy’s CSV until the split-dollar arrangement or policy is terminated. Furthermore, if a pre-1/28/02 arrangement is terminated by 12/31/03 or treated as a loan by 1/1/04, the employee won’t be considered as having received a portion of a policy’s CSV even when the split-dollar arrangement is terminated (as long as the policy is still in force).

Some Pre-1/28/02 Equity Arrangements Come out Way Ahead by being Terminated by 12/31/03

Pre-1/28/02 arrangements that will benefit most from being terminated by 12/31/03 are equity arrangements with mature policies (generally ones that have been outstanding for at least 10 years) that have built up enough equity to pay back the company loan and keep the policy going. Recommending that a client terminate such an arrangement by 12/31/03 will undoubtedly make you your client’s favorite person when he or she sees the huge amount of taxes it saves.

Warning: This special rule applies to terminating the arrangement, not the policy. If the policy is terminated when the arrangement is terminated, any excess CSV is recognized as ordinary income—just as it would be in any other circumstance.

Example 1: Terminating a pre-1/28/02 split-dollar arrangement.

In 1980, Wolf, Inc. and its owner/CEO, Red, entered into a split-dollar agreement to purchase a
$10 million whole-life policy to be owned by Red. Red was 30 and the annual premium was $88,150. At Red’s death or the policy’s earlier cancellation, Wolf, Inc. will receive the lesser of the company’s cumulative premium advances (currently $1.69 million) or the policy’s CSV. The policy’s current CSV is $3.65 million and it earns about 6.8% or $247,000 per year, which is more than enough to cover it’s annual $88,150 premium.

If Red pays back Wolf, Inc.’s loan by withdrawing and/or borrowing $1.69 million from the policy’s $3.65 million CSV, the 6.8% earnings on the remaining $1.96 million CSV should continue to cover the policy’s annual $88,150 premium. Thus, Red would be well advised to terminate this arrangement (but not the policy) before 2004. If he does so, his $1.96 million share of the CSV won’t be included in his income when the arrangement terminates. Furthermore, it will never be subject to income tax if the policy is kept in force until his death. That ought to make Red a happy camper!

If Red doesn’t terminate the arrangement before 2004, the value of policy’s current term insurance will continue to be included in his income each year and, more importantly, the policy’s CSV in excess of the $1.69 million payable to Wolf, Inc., will be taxable when the arrangement is eventually terminated. Yikes—Red won’t be happy about that!

Recommendation: We highly recommend that you get busy right away identifying older split-dollar arrangements while there’s still enough time to meet the 12/31/03 termination date. Some of your clients may stand to gain (or lose) big by meeting (or missing) the deadline. Furthermore, the final regulations make it clear that this deadline won’t be extended.

Deciding Whether to Treat Pre-1/28/02 Arrangements as Loans

Pre-1/28/02 arrangements that haven’t built up enough equity by 12/31/03 to pay back the company loan and keep the policy going will need to be continued. The employee’s tax treatment of such an arrangement depends on whether, as of 1/1/04, the client elects to treat arrangement (including all employer payments from inception of the arrangement reduced by any repayments to the employer) as a loan. If so, it’ll be taxed under the below market loan rules and any CSV provided to the employee won’t be taxed when the arrangement terminates. If not, the economic benefit treatment applies. In this case, the value of the current term-life insurance protection (net of any employee payments) is included in the employee’s income each year and any CSV provided to the employee will be subject to tax if the arrangement terminates after 1/1/04 and before the employee’s death.

Bottom Line: Employers will need to decide by 1/1/04 if they want to use the loan or economic benefit treatment for continuing pre-1/28/02 arrangements. For equity plans, this will not be an easy question to answer. Even with today’s low interest rates, the income required to be recognized annually under the loan method is likely to be higher than under the economic benefit method where the low insurance company term rates can be used. Accordingly, it’ll likely come down to deciding whether it’s better to (1) recognize more income each year so as not to pay any tax on the CSV provided to the employee when the arrangement terminates, or (2) recognize less annual income, but pay tax on the CSV provided to employee when the arrangement terminates. For nonequity plan, the answer is easy. As the executive won’t be receiving any CSV, economic benefit treatment usually will be the way to go.

Example 2: Deciding what to do with a pre-1/28/02 equity arrangement that can’t be terminated.

In Example 1, assume instead Red started the arrangement in 1990, that he was 30 at that time, and has been accounting for the arrangement using the economic benefit method. Also, at the end of 2003, the cumulative premiums paid by Wolf were $1.11 million and the policy’s CSV was $1.36 million. In this case, terminating the arrangement isn’t feasible, as Red would have to use $1.11 million of the policy’s CSV to pay back Wolf, which wouldn’t leave enough to pay the $88,150 annual premium (the earnings on the remaining CSV of $250,000 at 6.8% would only be about $17,000 a year). In fact, Red figures he’ll need to keep the arrangement going for another 10 years before he’ll be able to payoff the loan and have enough CSV remaining to continue paying the $88,150 annual premiums. Therefore, Wolfe and Red need to decide by 1/1/04 whether to treat the arrangement as a loan or economic benefit. They base this decision on the following information for the next five years.

The next five years will continue along the same lines with the insurance company term rate being about $70,000 less each year than interest under the loan method. Also, by 2014, the CSV will exceed Wolf’s cumulative premium payments by about $2.2 million.

If they treat the arrangement as an economic benefit, Red will recognize less income while the arrangement is in effect. (For example, in 2004, he’ll recognize $59,700 of income under the loan method, but only $3,994 under the economic benefit method.) However, if he rolls out the arrangement in 2014, under the economic benefit method, he’ll be taxed on the CSV he receives (around
$2.2 million). This amount isn’t taxable under the loan method (if elected by 1/1/04) as long as the policy remains in force.

If Red is pretty sure he’ll want to roll the policy out in 2014 (or earlier), he may be better off using the loan treatment as the $2.2 million income he’ll have to otherwise recognize in 2014, will outweigh the additional $690,150 [($70,000 × 5) + $340,150] he’ll have to recognize from 2004–2014. However, if Red expects to continue the arrangement beyond 2014, he may well decide it’s better to keep his current income down by continuing to use the economic benefit treatment. However, he’ll also want to come up with an exit strategy for the eventual rollout of the arrangement.

Making Sure Notice 2002-8 Continues to Apply to Pre-9/18/03 Arrangements

The regulations state that a pre-9/18/03 arrangement that is materially modified after 9/17/03 will be treated as a new arrangement (and, thus, will become subject to the regulations). Clearly, this is not a good thing, especially for equity plans. Unfortunately, the regulations give little guidance on what types of changes can be made without “materially modifying” the arrangement, other than obviously minor changes such as a change solely in the mode of premium payment or in the interest rate charged on policy loans—duh! What if you want to change a policy that’s not performing well or you want to increase or decrease the policy amount? Are these material modifications? Who knows—personally we wouldn’t risk it unless the change makes sense, even if it causes the arrangement to be subject to the new regulations.

Conclusion

Split-dollar plans aren’t as good a deal as they used to be (especially equity plans). Nevertheless, they continue to be viable benefit plans when given the right circumstances. You won’t likely see many new equity split-dollar plans, but we expect other arrangements to stick around. Also, pre-9/18/03 equity plans will continue to enjoy tax benefits as long as the arrangement is continued and not materially altered. Finally, pre-1/28/02 split-dollar arrangements need to be identified and reviewed before the end of 2003. Substantial tax savings may be realized by terminating some of these arrangements by 12/31/03. For other pre-1/28/02 arrangements, you need to determine if the client is better off using the loan or economic benefit method. If the loan method is desired, it must be put in place by 1/1/04.

References:

Notice 2002-8, 2002-4 IRB 398.

Regs. 1.61-2, 1.61-22, 1.83-1, 1.83-3, 1.83-6, 1.301-1, 1.7872-15.

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Appendix 1

Action Plans for Split-dollar Life Insurance Arrangements