or more than four decades, split-dollar plans have been a popular way to fund employee insurance benefits, deferred compensation, business succession and family wealth transfer. Earlier this year, however, the IRS issued notice 2001-10. It indicates the IRS and the Treasury Department are reviewing the federal income tax treatment of split-dollar arrangements. The notice also “clarifies” prior IRS rulings and provides taxpayers with “interim” guidance they can follow until further guidance is published. These are the first changes to the split-dollar rules in 25 years and they will have a significant impact on how clients use this technique.
DEFINITION AND USES
Split dollar is not an insurance policy. Rather, it is a plan for funding the purchase of life insurance. Under a split-dollar plan, two parties share insurance premium payments, death benefits and cash surrender values. While the parties often are an employer and selected employees, two private individuals may also enter into a split-dollar plan.
Before the January IRS notice, a split-dollar life insurance plan deferred taxation to the employee on the yearly accumulation of cash surrender value. In addition, taxes on any gain over basis were not due until the policy terminated. With its new pronouncement, the IRS and Treasury Department say any enrichment an employer gives an employee using split-dollar insurance is generally taxable. This means CPAs who previously helped clients establish tax-favored split-dollar plans may now find the party is over.
THE PROPOSED CHANGES
The IRS-recommended rule changes focus on the five features that once made split-dollar plans so attractive:
Below-market-rate loans. When the employee is the beneficial owner of the policy from the beginning, it’s reasonably likely the employer will be repaid its premiums from the death benefits. Under these circumstances, the notice treats employer premium payments as below-market-rate loans that must carry imputed interest to the employee.
Taxable cash value. As the policy cash value under an equity split-dollar plan builds, the employee’s equity in the annual increment would be taxable under IRC Sec. 83. (See www.neildocs.comdocsIRSAnnouncement.pdf for more information.)
Taxable equity transfer. The IRS will consider equity build-up in split dollar plans to be taxable income each year.
Term coverage. If an employee does not choose loan treatment, he or she must report compensation income from the term insurance coverage (reduced by the employee’s premium payments, if any).
Table changes. Beginning on January 1, 2002, table 2001, Reportable Economic Benefit, ( www.neildocs.comdocsTable2001.PDF ), replaces the old PS 58 table the parties used to determine the economic benefit of life insurance protection under split-dollar contracts. While the rates in table 2001 are lower than in PS 58, they are still higher than most alternative carrier rates. Under the new guidelines, insurance company alternative rates will increase after December 31, 2003.
One thing is certain: Employees whose wealth increases as a result of payments made from their employer’s pocket under new split-dollar arrangements may now find the transaction taxed as a loan, a gift or as an IRC section 83 transfer. The fate of existing split-dollar plans is less certain, pending IRS guidance expected later this year. Proper documentation for all split-dollar plans is now more important than ever to ensure the tax authorities treat them the way the taxpayer intends. Equally crucial are the cash flow records for payment of the term policy benefit. These payments can flow between the employer and the insurance company as well as from the employee to the employer or directly to the insurance company.
Don, age 45, is a key executive at privately held Hammock Enterprises, an outdoor furniture manufacturer. Part of Don’s compensation is a $1 million life insurance policy paid for using a split-dollar plan. Annual premiums began at $7,733 of which Hammock paid $7,167 and Don $566. Hammock was to be repaid its portion of the premiums from any death benefits, with the remainder going to Don’s beneficiary. As owner of the policy, Don had designated his wife as beneficiary. If either party terminated the policy before Don’s death, the remaining cash value, less the total premium payments Hammock advanced, would go to Don.
Before notice 2001-10, Don received substantial tax-free economic benefits from Hammock’s largess. He was not taxed on Hammock’s premium payments. Nor was he taxed on the policy’s annual cash value build-up. Don, and many executives like him, got what amounted to a free ride. As currently proposed, the IRS changes will tax Don on each of these economic benefits.
Solution. Don’s CPA can recommend several alternatives if the proposed changes are not altered by subsequent guidance:
1. Terminate the plan and seek alternative solutions to provide a similar benefit.
2. Revise the existing plan by examining Don’s and Hammock’s circumstances to determine the merits of:
Treating the premiums Hammock pays as a below-market-rate loan to Don that generates imputed interest income to him.
Substituting another employer investment that results in no reportable employee benefits or income.
Having Don report current taxable income under sections 83 or 61 (or both).
3. Amend the plan document and collateral assignment to properly reflect the employer’s intent. It remains unclear whether the IRS will grandfather existing plans. If it does not, Don and Hammock can presumably cancel the plan and policy, create a new plan and purchase another policy conforming to the new rules.
4. If Don and his employer want the split-dollar plan to be treated as a loan, it must meet these tests:
The plan must consistently and exactly follow the written plan document from the time the agreement takes effect.
The parties must account for all of the plan’s economic benefits, including items such as imputed interest on Hammock’s premium payments, table 2001 reportable economic benefits depending on the policy terms and—very important—Don must actually pay his share of the annual premium cash payment.
If Don and his employer follow these steps, it appears the one remaining economic benefit will be a change in the cost of term insurance, as it appears in table 2001.
WHAT TO DO NOW
The interim IRS guidance requires practitioners to examine clients’ split-dollar plans to determine if there is a better way to accomplish the same mission. We advise CPA firms to compile a list of clients that have split-dollar plans. This includes clients with
Existing plans that have been in place five years or longer.
Undocumented or improperly documented plans.
Plans whose provisions (such as faithful premium payment by employees) have not been consistently followed.
CPAs should advise these clients of the IRS notice and compute the tax effects to them under the interim rules. Then the CPA and client can sit down and decide what changes, if any, should be made to the split-dollar plan to minimize the effect of the new rules. CPAs should also keep an eye out for any final guidance the IRS may issue as a result of the comments it received on notice 2001-10.
Neil Alexander, CFP, is founder and president of Alexander Capital Consulting, LLC, in Los Angeles. His e-mail address is firstname.lastname@example.org .