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Split Decisions on Split Dollar
Mixed News in the IRS Proposals on Split-Dollar Insurance Arrangements
need a $10-million life insurance policy. You have the wherewithal to finance a portion of my insurance premiums. The cash value of the policy or the insurance proceeds can be used to pay you back.
It sounds simple enough-two parties joining forces in a fair arrangement that is mutually beneficial. But some important questions are hanging out there unresolved. Who is entitled to the cash value of the policy and/or the value of insurance proceeds in excess of the premiums? How will the respective parties be taxed? The IRS has now provided a preview of how these issues will be handled. Let's examine the split-dollar mechanism and the impact of the latest IRS position.
The Other Shoe
....thud. The long-awaited other shoe of split-dollar guidance appears to have finally arrived. As a matter of fact, it has been about 35 years since Revenue Rulings have shaped this area.1 Splitting up the dollars that are used to purchase life insurance premiums isn't a new concept, but in recent years, this arrangement has grown in popularity. Every variation of the idea has been attempted (with varying degrees of success). As practitioners have pushed the envelope further to maximize advantages of the arrangement, observers warned that sooner or later there would be a crack-down. Earlier this year, fears of intervention were realized when the IRS clarified its previous rulings and provided additional guidance with regard to split-dollar arrangements for the first time in 35 years. But the news in Notice 2001-10 is not entirely bad for split-dollar enthusiasts.
There are two primary areas that were addressed by the IRS in Notice 2001-10. First, regarding the tax treatment of equity split-dollar arrangements, is the issue of taxing the increased cash value or equity that the employee (or other insured party) will benefit from. The second issue is how to calculate the value of the term portion of the life insurance policy. The new guidelines restrict, but do not eliminate, the value of split-dollar arrangements.
The Split-Dollar Technique
One does not go out and purchase a type of life insurance called a "split-dollar" policy. Rather, the insurance itself can be whole life, universal life, or variable. However, it must be a permanent policy as opposed to term insurance, which is not suitable because it does not provide a final cash value or equity. A survivorship policy, i.e., one that pays benefits upon the death of the second of two individuals, is useful in reducing the amount of premiums.
In most split-dollar arrangements, the employee purchases the life insurance directly and is considered the owner of the policy. The employee then makes a collateral assignment of the policy to the corporation in return for the corporation's paying most of the premiums on the policy. In this manner, the corporation can lay out the funds to purchase the insurance policy and yet be fully confident that it will be repaid because it holds the policy itself as collateral. Thus, at the death of the employee, before any life insurance proceeds are paid to the employee, the corporation would be entitled to be compensated for the premiums that it had paid.
An alternative approach commences with a purchase of life insurance by the employer. The employer can then collect an amount equal to the premiums it pays using the policy's cash value and/or death benefits as necessary. The employer can then endorse all other interests in the policy to the employee. As compared with the collateral assignment approach, the endorsement method allows the corporation to have greater control over the policy. This would be appropriate where the insurance is being used to fund a future need such as a stock redemption buyout.
The cash value of the policy that exceeds the economic value of the premiums is considered the "equity" of the policy, hence the term "equity split dollar." The alternatives outlined above anticipate the equity's ultimately residing with the employee.
Example: Employee obtains a $5-million universal life insurance policy for which the annual premiums are $50,000. After 10 years, assume the cash value of the policy will generate enough income to finance all future premiums. If the employer funds all the premiums, it will be compensated for its $500,000 of out-of-pocket costs from the $5 million of life insurance proceeds. That will leave $4.5 million of cash value or equity for the employee.
It is also possible to design the arrangement so that the employer ends up with the cash value of the policy, in which case it is referred to as "reverse equity split dollar" arrangement. Unlike qualified retirement plans that must comply with nondiscrimination and top-heavy rules, split-dollar life insurance arrangements can be used selectively to recruit or retain a particular employee.
Who Uses Split-Dollar Plans?
The "split" in dollars reflects the method of funding the purchase of the insurance. Rather than have the insured purchase a policy by paying all the premiums directly, all or part of the premiums are paid by another entity, such as an employer. This is a useful approach where large amounts of insurance are contemplated, such as a $10-million policy that is associated with a businessowner's estate. Such a policy may provide liquidity so that business assets won't have to be sold to pay estate tax. Insurance assets might be associated with a stock redemption by the business. A policy this large would entail very large premiums which may not be suitable for the insured to bear directly.
The advantage of the split-dollar approach is evident wherever two entities have a financial relationship and one of the entities has funds while the other entity needs life insurance coverage. In addition to the employment context, split-dollar arrangements can also be used by a corporation to benefit a major shareholder, by a trustee for the benefit of beneficiary, or just by one individual for the benefit of another, i.e., "private split dollar." Although Notice 2001-10 is directly concerned with those arrangements involving employers and employees, it states that the same principles generally apply to the Federal tax treatment of split-dollar arrangement in other contexts, i.e., "private split dollar."
Tax Consequences: Over time, the cash value of a life insurance policy, i.e., the amount the policy could be "cashed in" for prior to the insured's death, continues to rise without being subject to current taxation. If in fact the policy is cashed in, the proceeds would be subject to income tax. If the insured dies, the funds paid as a death benefit would not be subject to tax.
The "economic value" being received by the employee is the cost of the premiums that the employer paid on his or her behalf. Actually, the value is only a portion of the cost of the premiums because the employer retains an interest in the policy, so the premiums are partially for the employer's benefit as well. The value is further reduced because the annual economic benefit is based on the cost of term life insurance for that year. The employee gets a great bargain in this transaction because the income tax is based on relatively small premiums while the ultimate death benefit is much larger.
If the employee pays a portion of the premium that is equal to the economic value being received, the net taxable benefit is offset. However, if the employee is paying ever larger premiums as the value of the term component increases each year, it may be advisable to have a "rollout," i.e., a split-dollar agreement that terminates the plan at a specific time. The employee then can withdraw cash from the policy, pay the cost of premiums paid by the employer, and take full ownership of the policy.
Charitable Split Dollar
Another variation involves a gift by a donor to a charitable organization, which in turn purchases a life insurance policy that is held by a charitable trust. The death benefit is split between the charity and the donor's heirs. In theory, the donor is able to deduct the cost of purchasing the life insurance death benefit.
However, a warning against the charitable reverse split-dollar (CRSD) plan was issued by the Board of Directors of the National Council on Planned Giving in 1998. The Board concluded that the CRSD approach is risky because it "may expose donors to adverse income tax and transfer tax consequences" and "may endanger the tax-exempt status of charities that participate."
The conflict with regard to the charitable application of split dollar arises because the charity won't receive all the benefits and, as a step transaction, the gift may not qualify for a charitable deduction. In addition, attention is focused on this conflict because the charitable trust must report the economic value of any benefit received by the donor, and that category would presumably include the donor's heirs under §170(f)(8)1.
These issues led the IRS to issue a warning that this type of charitable split-dollar arrangements will not qualify for charitable deductions and, in fact, may subject participants to penalties.2 And, to end all arguments, the Tax Relief Extension Act of 1999, which President Clinton signed on December 17, 1999, not only precludes a charitable deduction for split-dollar arrangements but imposes an excise tax on charities engaging in such deals.
Impact of Notice 2001-10
Regarding the tax treatment of equity split-dollar arrangements, the bottom line is that if the cash value of life insurance benefits the employee to the extent it exceeds the value of premiums contributed by the employer, then a taxable transfer has taken place. That tax may be imposed under §83 as property transferred from an employer to an employee, or under §7872 as a loan or series of loans to which the imputed interest rules apply.
A series of six rules are set forth in the notice for determining which approach is applicable. For example, the IRS will honor the parties' characterization of the arrangement, but only if it is followed consistently.3 Note also that, pending further notice, the IRS will not treat the employer as having transferred part of the cash surrender value to employees under §83 solely because the interest or other earning credited to the cash surrender value of the contract cause it to exceed the amounts the employer is entitled to.
New Rates: A second area addressed by Notice 2001-10 involves the valuation of the life insurance coverage for one term. Previously, such an interest was valued using P.S. 58 rates or whatever the insurance company's lower term rates were, but as explained by Notice 2001-10: "The P.S. 58 rates set forth in Rev. Rul. 55- 747, which are based on mortality tables originally published in 1946, no longer bear an appropriate relationship to the fair market value of current life insurance protection."
Under the new approach, Table 2001 based on current mortality date and fair market values is provided. In general, the use of Table 2001 rather than P.S. 58 will reduce the taxable income to employees. P.S. 58 rates still can be used to taxable years ending on or before December 31, 2001. An insurer's lower published premium rates may still be used as an alternative to the Table 2001 rates if conditions are met:
The insurer must make all term insurance applicants aware of the lower rates.
The insurer must regularly sell such insurance through normal distribution channels.
The insurer can't, as a general practice, sell term insurance at higher rates to those applicants considered standard risks.
The alternative insurer rates may face a sunset of the later of December 31, 2003, or December 31 of the year that further guidance is published.
It may be concluded that conventional split-dollar arrangements are more attractive thanks to Table 2001. Equity split-dollar arrangements remain valuable.4
Reverse Equity Split Dollar
Up to this point, we have addressed equity split-dollar arrangements where the employee has derived an additional economic benefit from an employer's contributions toward the purchase of life insurance. But it is also possible to have a reverse situation, where the employer is entitled to the equity of the life insurance policy, i.e., the cash surrender value and benefits in excess of the aggregate of premium payments paid by the employer.
With regard to reverse equity split-dollar arrangements, it may appear attractive to utilize the higher P.S. 58 rates rather than the alternative insurance company rates or the new Table 2001 rates. However, in this context, the use of P.S. 58 rates may overstate the value of benefits allocated to the employer and cause the employee's premiums to have less value than the benefits received by the employee.
Under Part III, Subpart B of Notice 2001-10, the IRS specifically questions the use of P.S. 58 rates on reverse split-dollar arrangements as well as the insurers' published term rates. It concludes that "to ease administrative burdens, minimize disputes, and provide grater assurance that similarly situated taxpayers are treated the same ***the value of current life insurance protection provided under split- dollar arrangements and qualified retirement plans [should] be determined under one or more premium rate tables prescribed for those purposes."
Proceeding With Caution
The apparent risks in using split-dollar arrangements has been known to financial planners for many years. The IRS basically showed its hand in 1996 when it said the annual increase in cash value of a split-dollar policy was subject to income and gift tax.5 Those concerns have now been confirmed by Notice-2001-10. But the arrival of new guidelines has to be taken in proper perspective.
The new rules do not cause existing split-dollar plans to pay an immediate tax or be reformed as of yet, but there is that potential unless the IRS includes a grandfathering provision in the final version of any guidelines.
In general, employees using split-dollar plans will benefit by using Table 2001, but equity split dollar arrangements will be more complex and may cause the employee to realize more income in some cases. And how private split dollar arrangements fare under the final rules remains to be seen.6
Technical References
1 Revenue Rulings 64-328 and 66-110 date from 1964 and 1966, respectively. In Rev. Rul. 64-328, life insurance was purchased using contributions from an employer and employee who were co-owners of the policy. The employer paid the amount equal to the increase in the policy's cash surrender value. Thus, the only economic benefit inuring to the employee was the value of the insurance protection attributable to the portion of the contract's death benefit payable to the employee's beneficiary. Rev. Rul. 66-110 addressed dividends, which were also includible in the employee's gross income. These principles were later amplified in Rev. Rul. 78-420 and Rev. Rul. 79-50. None of the published rulings dealt with equity split dollar, such as where the employer's interest in the insurance is limited to the total of premium payments, leaving the built-up equity in the policy to the employee. This is an extra economic benefit that the employee enjoys that goes beyond what Rev. Rul. 64-328 contemplated.
2Notice 99-36.
3"The IRS will generally accept the parties' characterization of the employer's payments under a split-dollar arrangement, provided that (i) such characterization is not clearly inconsistent with the substance of the arrangement, (ii) such characterization has been consistently followed by the parties from the inception of the arrangement, and (iii) the parties fully account for all economic benefits conferred on the employee in a manner consistent with that characterization." Notice 2001-10.
4Zaritsky and Leimberg, Notice 2001-10 will have dramatic effects on split- dollar arrangements, 28 EP 3, p. 99 (March, 2001).
5In 1996, TAM 9604001 indicated that equity accumulating under a split-dollar arrangement would be currently taxable to the employee as income under §83-a position that foreshadowed the IRS position in Notice 2001-10.
6The final rules may take the form of a Revenue Ruling or a new regulation. Public comments were solicited through April 30, 2001.
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© 2001 R. Moshman
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