Tax Rules Proposed for Split-Dollar Life Insurance Arrangements
July 2002
On July 3, 2002, the Internal Revenue Service proposed extensive regulations concerning split-dollar life insurance arrangements (SDAs). The proposed regulations in many respects are consistent with Notice 2002-8, which announced that new rules would be established for equity split-dollar life insurance arrangements or Equity SDAs. An Equity SDA is an SDA that allocates cash value in excess of premium payments to an employee. At the same time, the proposed regulations provide some significant new rules for all SDAs. If finalized, the proposed regulations will likely increase the tax costs associated with offering Equity SDAs in the future.
Parties to existing SDAs should consider what changes, if any, are appropriate in light of the proposed tax rules. It is important to understand that the split-dollar proposed regulations are only effective for SDAs entered into on or after the effective date for final regulations. Favorable safe harbor and transition rules remain available under Notice 2002-8 to parties to an SDA entered into before the date of final regulations. Our prior discussions regarding split-dollar life insurance and Notice 2002-8 are posted at www.mwe.com/news/ots0102b-2.htm. (Click here^)
We will be evaluating the new proposed tax regime and its application to SDAs in the coming months. The proposed regulations raise new questions and leave others unanswered. We offer at this time a brief summary of the framework under the proposed regulations and some initial observations.
Executive Summary of Key Provisions
The proposed regulations provide comprehensive rules for taxing Equity SDAs under two separate tax regimes based on ownership of the life insurance policy. If the owner of the policy subject to the Equity SDA is the employer under the so-called "endorsement method," the employer will be treated as providing economic benefits to the non-owner employee. The economic benefit regime requires that the employee be taxed on the value of the current life insurance protection provided to the employee under an Equity SDA as well as all other economic benefits and rights provided to the extent not paid for the employee. If the owner of the policy subject to the Equity SDA is the employee under the so-called "collateral assignment method," the non-owner employer will be treated as making a series of loans in the form of policy premiums to the employee-owner. If the loans do not provide adequate stated interest, the owner-employee will be deemed to have imputed compensation income.
The proposed regulations clarify the tax rules applicable to non-equity split-dollar arrangements. A non-Equity SDA is an SDA in which the only economic benefits provided to the employee are the current value of life insurance protection plus paid up additions. Some had feared that the loan regime would apply to non-Equity SDAs in which the employee owns the policy based on Notice 2002-8. The proposed regulations provide that only the economic benefit regime applies to non-Equity SDAs regardless of who owns the split-dollar policy.
The proposed regulations also extend these rules to SDAs involving parties other than an employer and an employee. A so-called "private split-dollar arrangement" may exist between a donor and a donee. Amounts deemed transferred from a donor to a donee under an SDA will be treated as gifts. Similarly, an SDA may exist between a corporation and a shareholder and amounts that are deemed to be transferred to a shareholder under these rules will be treated as dividends.
Initial Observations
Economic Benefit Regime Unattractive for Equity SDAs
The proposed regulations, if finalized in their current form, appear to reduce dramatically the attractiveness of structuring Equity SDAs under the endorsement method. The IRS is now proposing that any benefit provided by the owner (employer) of a policy to a non-owner (employee) under an Equity SDA, including rights to cash surrender value in excess of premium payments, is a current taxable economic benefit. This is a significant change from the rule provided under Notice 2002-8, in which no policy equity would be taxable under the economic benefit regime until termination of the Equity SDA. The proposed regulations do, however, reserve a section for valuing these economic benefits, and the IRS specifically requests comments on methods to tax policy equity before termination of an Equity SDA. Other proposed adverse rules include no basis to the non-owner for contributions towards the purchase of the policy (although gains on transferring the policy are reduced for some payments); taxable income to the policy owner equal to the contributions received from the non-owner; no deduction to the owner (employer) for current life insurance protection provided to the non-owner (employee); and an increase in the fair market value of the policy upon transfer to the non-owner to include "all other rights under the contract" in addition to policy cash surrender value.
Using the Loan Regime Requires Careful Tax Planning in Advance
Loans that do not bear an adequate rate of interest may be subject to different tax rules under the loan regime depending upon the terms of the SDAs. If a premium payment under an Equity SDA is treated as a "demand loan," the amount of foregone interest for the year is treated as transferred annually from the non-owner to the owner. In contrast, if a premium payment under an Equity SDA is treated as a "term loan," then the difference between the premium payment and the present value of the non-owner’s right to recover the premium payment¾ referred to under tax rules as "original issue discount" or OID¾ is treated as an amount transferred from the lender (non-owner) to the borrower (owner) immediately. The OID is also taxable to the lender under normal tax rules.
Tax consequences associated with term loan treatment usually will be unacceptable. With a term longer than 10 years using current interest rates, over half of the premium payment will be treated as an amount transferred from the non-owner to the owner. Fortunately, the proposed regulations provide a few special rules to avoid acceleration of the taxable benefit under term loans. For example, if a loan is repayable on the death of the owner or conditioned on the future performance of substantial services, the amount deemed transferred from the non-owner to the owner can be measured annually similar to a demand loan.
Beware of Private Split-Dollar Arrangements Based on P.S. 58 Rates
Some firms have aggressively marketed arrangements in which an individual will "lease" current life insurance protection from a split-dollar policy held by an irrevocable life insurance trust (ILIT). The amount paid by the individual to lease this coverage is computed using so-called P.S. 58 rates, which are based on mortality experience from the 1940s. It is our experience that these rates dramatically overstate the price of the insurance coverage. As a result, the "lease" payments by the individual will result in policy cash value accumulation for the ILIT’s benefit. These arrangements promise tremendous cash value accumulation with little or no gift tax cost to the individual. The preamble to the proposed regulations specifically notes that P.S. 58 rates cannot be used in this type of private split-dollar life insurance arrangement.
Parties Can Continue to Use Existing Rules for Valuing Current Life Insurance Protection - At Least for Now
The proposed regulations do not provide new rules for valuing current life insurance protection under split-dollar arrangements that are not treated as loans. Notice 2002-8 provides that parties may continue to rely on insurance company rates allowed under current rules to report taxable income resulting from split-dollar arrangements "pending future guidance." It is unclear when "future guidance" will be forthcoming from the IRS. It does appear that the IRS is working on developing a unified table to report the value of current life insurance protection for arrangements on a prospective basis that will result in taxable income substantially higher than under current alternative term rules.
Evaluate Existing or Planned Equity SDAs Before the Final Regulations
As noted above, the proposed regulations will only be effective when and if they are finalized, which is unlikely to occur before the end of 2002. This means that parties can continue to rely on the safe harbors and transition rules set forth in Notice 2002-8 for arrangements established before the date on which the IRS issues final regulations. Some of these rules, as outlined in our prior On the Subject…, provide valuable planning opportunities in the right situations. For example, Equity SDAs that are not structured as loans can defer tax on policy equity until termination of the arrangement or, in some cases, permanently avoid tax on policy equity. In addition, parties should consider at this time any planned changes to existing split-dollar life insurance arrangements. If a split-dollar agreement is "materially modified" after the IRS issues the final regulations, the amended arrangement will be treated as if it is a new split-dollar arrangement. The proposed regulations leave open, for additional comment, the definition of "materially modified."
We will continue to monitor closely further developments regarding split-dollar life insurance arrangements as the IRS receives comments from taxpayers.
