The IRS has issued proposed regulations that will take effect on January 1, 2004 concerning the taxation of split-dollar life insurance arrangements. The proposed regulations, which are expected to be finalized sometime this year, significantly reduce the tax benefits of the so-called "equity split-dollar" life insurance arrangements.1 In a typical equity split-dollar arrangement, the employer pays the premiums on a life insurance policy issued to the employee. At the employee's retirement or death (or earlier termination of employment), the employer's premium advances are reimbursed without interest from the policy's cash value or proceeds. The balance of the death benefit or cash value belongs to the policy's owner (typically, the employee, or often an insurance trust established by the employee; these plans are often referred to as "collateral assignment" split-dollar plans).2 The employer's reimbursement right is secured by a collateral assignment filed with the insurance carrier.
New Tax Consequences
Under prior law, upon termination of an equity split-dollar arrangement (which, for example, could happen upon an insured employee's retirement, or upon the employee's death), there was no income tax consequence to the employee (or the policy owner if, for example, the policy was owned by the employee's insurance trust). Under the new regulations, the policy equity will be treated by the IRS as taxable compensation to the employee when "transferred" to him or her upon termination (except if termination is due to death), unless the premium payments paid by the employer are treated as a series of loans by the employer to the employee. If the employee elects (other than under the safe harbor described below) to treat the premium payments paid by the employer as a series of loans, all of the premiums paid on behalf of the employee (including all premiums paid before January 1, 2004) will be included in the loan balance. Furthermore, market-rate interest will be imputed on all premium payments, including those for previous years.
If the insurance policy is owned by an irrevocable insurance trust created by the employee,3 there are also gift tax consequences at the time of the termination of the split-dollar arrangement during the employee's lifetime. The policy equity (i.e., the difference between the policy's cash value and the employer's reimbursement right, assuming the employer has paid all of the premiums) will be treated as a taxable gift by the employee to the trust. Furthermore, if the trust is a generation-skipping trust, the termination will consume additional generation-skipping transfer tax ("GST") exemption, and if exemption is not available to shelter the additional gift, may cause a part of the trust not to be exempt from GST tax.
Safe Harbors Available to Pre-January 28, 2002 Equity Split-Dollar Arrangements
The proposed regulations do, however, include two safe harbor provisions available for equity split-dollar arrangements entered into before January 28, 2002. The safe harbors, which must be acted on before January 1, 2004, include:
1. Termination Prior to January 1, 2004: If the equity split-dollar arrangement is terminated before January 1, 2004, by repayment of all of the premium advances (i.e., a "roll-out"), the insured will not be taxed on the net increases in the policy. You should do a rollout now if the cash value of the policy is sufficient to cover the cost of repaying all advanced premiums and the cost of keeping the policy in force going forward.
2. Election to Treat Premiums As Loans: If, before January 1, 2004, you elect to treat your equity split-dollar arrangement as a series of loans, you can continue with the plan, and still avoid being taxed on the net increases in the policy upon terminating the arrangement at a later time. This safe harbor requires that all pre-2004 premium payments be treated as loans (although interest does not retroactively accrue on these prior payments as it otherwise would after January 1, 2004), and that subsequent premium payments be treated as additional loans. Moreover, there will not be any annual term ("P.S. 58") cost to report on the employee's income tax return. You might consider converting to a loan arrangement if the policy does not have sufficient cash value to pay off prior premium advances and to sustain the policy going forward after such repayment. If, under the terms of the plan, it is more advantageous that the current arrangement remains in place until death (e.g., due to poor health of the insured), it may be advisable to keep the current existing split-dollar plan in place. Each plan must be examined with current illustrations to evaluate what steps should be taken
It is also important to note that under the Sarbanes-Oxley Act of 2002, public corporations are generally prohibited from making loans to their executive officers and directors. This Act may well apply to public corporations paying premiums under split-dollar insurance arrangements with executive officers and directors.
If you are a party to a split-dollar arrangement, it is imperative that you review your plan and consider adopting the safe harbors prior to January 1, 2004. We are concerned that many split-dollar participants are not sufficiently aware of these time limits and will lose the benefit of the safe harbors as a result. If the plans are not dealt with prior to January 1, 2004, the negative tax consequences may be quite significant.
In addition, if the plans are converted to loan arrangements under the split-dollar rules, then they will certainly operate differently than originally planned; clients need to be aware of and, at times, plan to deal with these changes. For example, consider a situation where an employee has transferred his or her interest in an insurance policy subject to a split-dollar arrangement to a generation-skipping trust and does not adopt either of the safe harbors discussed above. If the split-dollar arrangement terminates prior to death--which is the contemplated plan under most split-dollar arrangements--the equity in the policy payable to the owner at that time will be subject to income tax, could generate as much as a 49% gift tax, and could generate as much as an additional 49% GST tax.
While many of these unfavorable tax consequences can be avoided if the split-dollar arrangement is kept in place until the employee's death, it will generally not be advisable to keep these arrangements for life, since the employee, in all events, must recognize taxable income (and have an imputed gift) in each year the split-dollar arrangement is in place (even if new premiums are not paid), based on the P.S. 58 table life insurance term rates.4 Those rates may become prohibitively expensive if the employee lives to an age even close to a normal life expectancy. In contrast, if either of the safe harbors is adopted prior to January 1, 2004, many of these consequences can be avoided. However, it is imperative that clients understand how the plan will operate if converted to a loan arrangement. Clients should meet with their insurance advisors, estate attorneys and, perhaps, accountants to review the status of each split-dollar plan and to agree upon a plan for dealing with the law changes.
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1. The proposed regulations have relatively little effect, however, on non-equity split-dollar life insurance arrangements; e.g., an employee only receives term life insurance coverage rather than an interest in the policy's equity.
2. While most split-dollar arrangements are between employers and employees, they may also occur outside of the employment context between two individuals. Parallel tax consequences apply to those arrangements. Additionally, in certain split-dollar arrangements, the insurance policy is owned by the employee rather than the employer (called an "endorsement split-dollar plan").
3. For estate planning purposes, the policy may actually be owned by an irrevocable insurance trust created by the employee for the benefit of the employee's spouse and/or children.
4. The IRS put in place a new P.S. 58 table which has been revised to reflect current mortality rates.
