SPLIT DOLLAR LIFE INSURANCE - CLIENT ENGAGEMENTS

Introduction

Split dollar life insurance is a method of funding cash value life insurance policies, where two different entities or people share in the cost and benefits of the insurance policy. This article will discuss six different client engagements relating to split dollar life insurance plans.

1. Setting up a split dollar life insurance plan for a client

(a) What is the engagement?
This engagement involves approaching existing or new clients and recommending the creation of a split dollar life insurance plan to fund a cash value insurance policy.

(b) Which clients?
Clients who have substantial estates and a need for liquidity to fund estate taxes. The ideal client has a large amount of illiquid assets, such as a business interest, real estate, or artwork, and a relatively small amount of liquid assets available to fund the estate taxes. Secondly, the client has an active business (corporation or partnership or LLC) which has sufficient cash flow to fund significant insurance premium payments.

(c) Benefits and Risks
The benefit of a split dollar life insurance arrangement, when used to fund estate taxes, is the reduction in the amount of the premium payment that is regarded as a gift. When clients purchase life insurance for estate tax purposes, they usually have the policy owned by an irrevocable life insurance trust for their children. The parents usually make gifts to the trust or the children to fund the premium payments. The advantage of a split dollar life insurance arrangement is that only a portion of the premium payment is treated as a gift. The split dollar arrangement is created between the employer funding entity (corporation or partnership) and the irrevocable insurance trust which owns the policy. Each year the corporation pays the entire premium payment less the PS 58 amount (actually, the lesser of the PS 58 or the alternative term insurance rate offered by the insurance company). The irrevocable trust pays the PS 58 amount or the alternative term insurance rate. The corporation's contribution is usually 80% or more of the total premium payment. The corporation's contribution is not treated as a gift; rather, it is treated as an investment in the policy which will be recovered when the split dollar agreement is terminated. The trust contributes the PS 58 amount which is funded by gifts from the parents. Thus, only the PS 58 portion of the premium payment is treated as a gift each year.

Example: John and Mary are employees of ABC Corporation. They're advised to purchase $10,000,000 of second-to-die life insurance to help fund estate taxes. The policy will be owned by an irrevocable insurance trust. The trust and ABC, Inc. enter into a split dollar agreement to fund the insurance policy. The annual premium payment for the policy is $76,000. The PS 58 amount in the first year of the policy is $1,519. The corporation contributes $74,681 ($76,000 minus $1,519). The trust contributes $1,519 which is funded by a gift from John and Mary. Thus, only $1,519 of the total premium payment is treated as a gift. This frees up the client's annual gift exclusions and the unified credit amount for other gifts.

The downside to a split dollar arrangement is that a portion of the death benefit will have to be returned to the corporation at the death of the insured. This means that a portion of the death benefit is potentially includible in the insured's estate depending upon the ownership interest the insured has in the corporation. In the above example, let us assume that John and Mary died and, at the second death, the total investment made by the corporation is 10 premium payments, that is $746,810. At the second death, $10,000,000 of insurance proceeds will be received by the trust and $746,810 of that amount will have to be returned to the corporation to reimburse it for its investment. The balance, $9,253,190, will be retained by the trust as estate tax exempt insurance proceeds. Thus a portion of the insurance proceeds is potentially includible in the estate of the second spouse to die depending upon that spouse's interest in the corporation at the time of death.

The other two risks or concerns that one has to be concerned with in creating a split dollar plan are the possible adverse tax consequences of an equity split dollar arrangement and the possible estate tax inclusion of insurance proceeds when the insured shareholder is a controlling shareholder in the corporation. (Both of these issues are discussed below).

(d) References
The most important ruling governing the taxation of split dollar is Revenue Ruling 64-328. Revenue Ruling 66-110 elaborates on the use of the PS 58 rate or the alternative term insurance rate in calculating the economic benefit of the employee.

(e) How to initiate the engagement
Contact those clients with significant illiquid assets and an active operating business and discuss with them the tax leverage available when using a split dollar insurance arrangement. Use an example similar to the one described above to illustrate how the gift tax component can be greatly reduced, to 10% or less of the premium payment.

Sample letter:

Dear Jack,

We have previously discussed the need for liquidity to fund the estate taxes that will be owed by your estate. This is particularity important for you because of the substantial value of your business and because of your desire to maintain the business for your son and not have it liquidated. There is an insurance arrangement, called Split Dollar, which will allow you to greatly increase the tax leverage which is available with insurance products. I'd like to discuss this with you in the next week or two and also have Mary (Jack's insurance agent) with us at the meeting. I will call you next week to arrange a convenient time for us to get together.

Yours truly,

Harry Lawyer

2. Split Dollar Life Insurance Audit

(a) What is the engagement?
This engagement is a review of a split dollar life insurance arrangement for any client that has one. It involves a review of all the agreements and an examination of the PS 58 or alternative term rates used to report the economic benefit. There are three key elements that must be reviewed:

1. Is there a properly executed split dollar insurance agreement?
2. Is there a properly executed collateral assignment agreement?
3. Are the alternative term insurance rates used by the client to report the economic benefit in compliance with the rules set forth by the IRS. In particular, the alternative term insurance rate must be a rate charged by the insurer for individual one year term life insurance available to all standard risks, the rates must be published by the insurance company, and the rates must be issued by the same insurance company that issued the policy used in the split dollar arrangement. For example, term rates available only to preferred risk nonsmokers cannot be used as a substitute for the PS 58 rate because they are not available to all standard risks; term insurance rates issued by a subsidiary of an insurance company cannot be used for split dollar arrangements where the policy was issued by the parent insurance company; and term insurance rates for policies which are not available for sale to standard risks cannot be used to measure the economic benefit.

(b) Which clients?
Any client with a split dollar insurance arrangement should be audited to ensure proper compliance.

(c) Benefits and Risks
The benefit for the clients is that a properly documented split dollar insurance arrangement will withstand audit by the IRS. In one case, the client supposedly had a split dollar arrangement but the agreement was not properly executed and the premium payments were characterized as income from the corporation to the shareholder (in a properly documented arrangement, only the PS 58 amount, not the entire premium , is characterized as income).

(d) Reference
See Karl S. Goos vs. Commissioner, Tax Court Memorandum decision 1991-146, April 2, 1991 for an example of an arrangement which was not properly documented.

(e) How to initiate the engagement
Approach all clients with existing split dollar arrangements and emphasize the importance of proper documentation to avoid adverse tax consequences.

Sample letter:

Dear Helen,

You created a split dollar arrangement to fund a significant life insurance policy five years ago. It is time for us to review the arrangement and make sure it is operating in proper compliance with IRS guidelines. The benefit of doing this is that, in the event of an IRS audit, we will avoid any adverse tax consequences. I will call you and Ron (Helen's insurance agent) to arrange a meeting next week to review the documents.

Yours truly,

Sam Attorney

3. Equity Split Dollar Review

(a) What is the engagement?
This engagement is a review of clients with equity split dollar arrangements to determine if there is any equity and what to do if there is. Equity split dollar is an arrangement where the employer is entitled to receive its total premium investment when the split dollar agreement terminates. Any buildup of cash value in the insurance policy in excess of the employer's premium contribution is not returned to the employer but is retained by the policy owner (usually the employee or the insurance trust). The excess of cash value accumulation over the total premium investment by the employer is called Equity. In 1996, the IRS issued a technical advice memorandum (96-04-001) which stated that the policy's equity is currently taxable as income, and, when the policy is owned by a third party, it is also taxable as a gift from the employee to the third party owner. The technical advice memorandum is a private ruling which applies only to the particular taxpayer who was audited. In addition, many practitioners believe that the ruling did not adequately address the fundamental rule of insurance policy taxation (Code Section 72), which states that a policy's cash value is not taxable until the policy is surrendered. It is the author's understanding that the IRS currently has a number of technical advice memorandum and private letter ruling requests regarding equity split dollar taxation. It is quite possible that the IRS will formalize its decision on equity split dollar and publish a revenue ruling in the next year or so. However, we do not have any definite indications as to what will happen at this point in time.

It is prudent to review existing split dollar plans for clients, particularly those arrangements that are least 4 or 5 years old, where there is a real possibility that the cash value build up is in excess of the employer premium contribution, and a question of equity taxation might exist. These clients should be informed of the existence of the TAM and the risk of equity taxation should be explained. Many practitioners would advocate that nothing be done in terms of reporting equity tax at this point in time. There is certainly substantial authority under Code section 72 to say that the cash value of an insurance policy, whether it is part of a split dollar arrangement or not, should not be taxed until the policy is surrendered. There is also a possibility that amending an existing split dollar arrangement (to switch it from an equity plan to a non-equity plan) might cause the loss of grandfathering status if the IRS chooses to grandfather an existing agreement in the future.

(b) Which clients?
Clients with split dollar arrangements that have been in existence for at least 4 or 5 years should be reviewed to determine if there is equity and to advise the clients about possible equity taxation.

(c) Benefits and Risks
Review of an equity split dollar arrangement should include some plan for an exit strategy if, in fact, the IRS formalizes its position and decides that equity should be taxed currently. For example, the client might be encouraged to make gifts in excess of the PS 58 amount to the insurance trust, which owns the policy. The gifts could accumulate in the trust and be used as a source of funds to repay the corporation if the split dollar agreement has to be terminated at some point in the future. Another possible plan for an exit strategy from the split dollar agreement, is to create a grantor retained annuity trust and make the insurance trust the remainder beneficiary of the GRAT. This would provide the insurance trust with the source of funds to repay the corporation and terminate the split dollar agreement, if necessary, in the future.

The risk of continuing an equity split dollar arrangement and not reporting the income is that the IRS might audit the plan and insist that equity be reported for each of the open years as income and a gift. The gift tax statute of limitations may be open for more than 3 years if no gift tax return is filed and there has not been proper disclosure of the arrangement.

(d) References
The only ruling on equity taxation for collateral assignment split dollar arrangements is TAM 9604001. A comprehensive discussion of split dollar insurance and the TAM can be found in "Split-Dollar Primer" published by the Association for Advanced Life Underwriting [1922 F Street NW, Washington DC 20006-4390, Telephone number (202) 331-6081, fax number (202) 331-2164, Web site: www. Agents-online.com].

(e) How to initiate the Client engagement
Contact all clients with split dollar arrangements that have been existence for 4 or more years.

Sample letter:

Dear Henry,

In 1996, the IRS issued a private ruling which raises the possibility of certain adverse consequences for split dollar arrangements. The ruling only applies to the individual tax-payer who was examined at that time by the IRS. Nevertheless, it would be prudent for us to review your split dollar plan to see what we need to do in light of this ruling. I will contact you and Paul (Henry's insurance agent) next week to arrangement a time to discuss this with you.

Yours truly,

Sam CPA

4. S Corporation Split Dollar

(a) What is the engagement?
This engagement involves the review of split dollar arrangements in which the insured individual is a shareholder in an S corporation. In a number of private letter rulings the IRS has raised an important tax issue involving these split dollar plans. If the S corporation pays the entire premium for a split dollar insurance policy, and the insured shareholder does not contribute any portion of the premium, then the PS 58 amount (or the alternative term insurance rate) will be imputed as income to the shareholder. The IRS has suggested that the imputed income might be treated as a dividend to the shareholder and, if the other shareholders do not receive a comparable dividend, then that dividend could create a second class of stock and terminate the S corporation election. To avoid this undesirable consequence, the insured shareholder in an S corporation split dollar agreement should always contribute the PS 58 amount toward the premium payment, rather than having it imputed to him as income.

(b) Which clients?
Any S corporation client with a split dollar arrangement should be reviewed to avoid the above-described tax problem.

(c) Benefits and Risks
The obvious benefit to the client is preservation of the S corporation election.

(d) References
See private letter rulings 93 18 007, 93 31 009, 96 51 017, and 97 09027.

(e) How to initiate the client engagement
Speak to all S corporation clients with split dollar arrangements

Sample letter:

Dear Susan,

It is important that you contribute a small portion of the premium payment under the split dollar arrangement that is currently funded by your S corporation. If the corporation pays the entire premium, then this might have adverse tax consequences. I will call you next week to discuss this further and make any necessary corrections.

Yours truly,

Jack Smith, Esq.

5. Controlling Shareholder Split Dollar

(a) What is the engagement?
This engagement involves the review of any split dollar agreement in which the insured individual is a controlling shareholder of the corporation. If the split dollar life insurance policy is owned by an irrevocable trust and it is intended the insurance proceeds be excluded from the insured's estate, then certain provisions may be needed in the split dollar agreement. If the corporation has an incident of ownership in the policy, then that incident of ownership will be imputed to the insured and will cause estate tax inclusion of the proceeds. The IRS issued a private letter ruling (9511046) which provides very clear guidelines for drafting an agreement in this situation. The guidelines are as follows:

1. The corporation must pay the entire premium,
2. The corporation cannot unilaterally terminate the agreement,
3. The corporation has a very restricted right, namely the right to be repaid its investment in the policy and nothing else.

The rationale for these provisions is described in the private letter ruling. If the corporation is not required to pay the entire premium and could demand that the trust pay a portion of the premium this may result in an incident of ownership. If the trust has no assets other than the insurance policy, then the corporation's demand for a portion of the premium payment is equivalent to indirect access to the policy's cash value, the only asset of the insurance trust. Similarly, if the corporation could unilaterally terminate the agreement and demand repayment of its investment in the policy, and the trust has no asset other than the policy's cash value, then, the corporation's demand is equivalent to access to the policy's cash value, which results in an incident of ownership.

(b) Which clients?
Any client where the split dollar arrangement involves an insured controlling shareholder needs to be examined. The agreement should be reviewed and compared with the provisions in private letter ruling 9511046. If the agreement does not follow the provisions of the letter ruling than it should be amended to make any necessary changes.

(c) Benefits and Risks
The obvious benefit of a properly drafted agreement is that the insurance proceeds will escape estate tax inclusion. If the agreement is not properly drafted and has to be amended, there may be a 3 year rule on the possible estate tax inclusion of the insurance proceeds: that is, if the insured were to die within 3 years of the amendment, the IRS might still be able to invoke estate tax inclusion of the insurance proceeds.

(d) References
Regulation 20.2042-1(c)(6); Estate of Milton L. Levy, v. Commissioner of Internal Revenue, 70 TC 873, September 7, 1978; Revenue Ruling 76-274, Revenue Ruling 79-129, Revenue Ruling 82-145, Letter Ruling 9348009, Letter Ruling 9511046.

(e) How to initiate the engagement
Any client who is a controlling shareholder and who has a split dollar arrangement should be contacted.

Sample letter:

Dear Milton,

The IRS has recently published several rulings with guidelines for the exclusion of split dollar insurance policies from estate taxation. I think it would be prudent to review your split dollar insurance agreement to make sure it is in compliance with the IRS provisions. Fortunately, we can always amend the split dollar agreement, if necessary, to avoid any adverse tax consequences. I look forward to speaking you next week so that we can discuss this further.

Yours truly,

Philip Smith, Esq.

6. Private Split Dollar

(a) What is the engagement?
This engagement involves approaching certain clients to discuss the possibility of creating a private split dollar arrangement.

(b) Which clients?
In general there are two groups of clients that might be suitable for a private split dollar arrangement. First, clients who have significant amounts of money accumulated in an old irrevocable trust. For example, clients with old GST exempts trust, may be good candidates for private split dollar arrangements. The client can create a new irrevocable insurance trust with a set of beneficiaries different from the GST trust, and use money in the GST trust to fund the insurance premium payments in the new trust through a private split dollar agreement between the trusts. Second, clients who want to create insurance trusts and exclude the insurance proceeds from their estates, but also want to have access to the policy's cash value may be candidates for private split dollar arrangements. In this second group, the insured individual's spouse can enter into a split dollar agreement with an insurance trust that owns the policy on the insured individual. The spouse can have access to the policy's cash value through loans and, ultimately, the policy's cash value will be included in that spouse's estate. However, the insurance component (that is, the proceeds in excess of the cash value) should remain outside the insured individual's estate because he or she has no incident of ownership in the policy (the spouse's economic interest in the policy is not imputed to the insured individual).

(c) Benefits and risks
The major benefits of a private split dollar arrangement are the reduction in the amount of the taxable gift (like corporate split dollar, the PS 58 component, not the entire premium, is regarded as a gift) and the possible access to the policy's cash value by the spouse of the insured.

Example #1:
Tamara is 60 years old and her family created an irrevocable GST exempt trust 30 years ago. The GST trust has millions of dollars in assets. Tamara and her children are beneficiaries of the GST trust but her husband is not. Tamara wants to establish an insurance trust for the benefit of her husband. She creates the trust and the trust then enters into a split dollar agreement with the GST trust. Under the split dollar agreement, the GST trust will fund the annual premium less the PS 58 cost. The insurance trust will pay the PS 58 cost, which will be gifted by Tamara to the insurance trust. Only the PS 58 portion of the premium will be a gift, the balance of the premium payment made by the GST trust will be treated as an investment in the policy not as a gift. In order to obtain this result, it is important that the GST trust is entitled to some return on its investment in excess of the principal contribution. Therefore, the GST trust should be entitled to receive either the cash value of the policy or the total premiums invested plus some applicable interest factor for a reasonable rate of return, when the split dollar agreement is terminated.

Example #2
Sam and Doris are married and want to create an irrevocable insurance trust for the benefit of their children. They also want to have access to the policy's cash value in case they need a supplemental source of income in their retirement years. Sam creates an irrevocable insurance trust and names his brother, Paul, as the trustee of the insurance trust. The insurance trust and Doris enter into a private split dollar agreement under which the trust will pay the PS 58 component of the premium and Doris will pay the balance of the premium each year. Doris will have access to the policy's cash value through policy loans during her lifetime. When the split dollar agreement terminates, Doris will be paid the greater of the policy's cash value or her premium investment. Doris's ability to access the policy's cash value will result in inclusion of the cash value in Doris's estate when she dies. However, Sam, the insured, has no direct access to the policy's cash value, and therefore has no incident of ownership in the policy. Therefore, the policy proceeds will not be included in Sam's estate at his death.

It is possible that the IRS might attempt to characterize private split dollar arrangements as interest-free loans. However, if the premium payor is entitled to some reasonable rate of return on the premiums invested in the policy, this risk should be minimized.

(d) References
See Private letter rulings 9636033 and 9745019

(e) How to initiate the engagement
Approach clients who meet one of the criteria described above.

Sample letter:

Dear Henry,

We have discussed the possibility of creating an insurance trust to provide estate tax-free proceeds to your children at your death. One of the concerns that you have had is the ability to access the policy's cash value during your lifetime. Although, you cannot do this directly it might be possible to create an arrangement where your wife, Susan, could have access to the policy's cash accumulation without causing unnecessary adverse tax consequences. I would like to discuss this concept with you and your insurance agent, Stanley, when we get together in two weeks for your estate plan review. I will call you next week to arrange a convenient time.

Yours truly,

Ivan Stern, Esq.

CONCLUSION

There are many different client situations where split dollar life insurance can provide significant tax benefits for clients who have liquidity needs. There are also many tax rules and pitfalls one has to be aware of when creating or reviewing split dollar arrangements. The six client arrangements described above will provide you with an opportunity to help your existing or new clients who want to do sophisticated estate planning.