he tax treatment of split-dollar insurance plans continues to evolve. Previously, companies used split-dollar life insurance to help employees defer taxation on the yearly accumulation of the policy’s cash surrender value as well as to provide a significant death benefit. Then, in revenue notice 2001-10 the IRS said any enrichment employers give employees using split-dollar insurance plans generally is taxable. Now, the IRS has issued revenue notices 2002-8 and 2002-59, as well as proposed regulations, which together make many of the benefits of split-dollar a thing of the past. Here’s how the changes affect clients with split-dollar insurance plans and what CPAs can do about them.
IRC sections 1271 to 1275 and 7872 would treat premiums the employer pays as a series of interest-free loans to the employee.
Otherwise, the IRS would consider the economic benefits of the policy (including any share of cash values when an employee receives them) to be transfers to that employee under IRC sections 61 and 83. The employee would value the economic benefit using the appropriate tables and rates explained below.
Under notice 2002-8 timing is critical when the employee computes insurance protection values using section 61. The key date for CPAs to remember is January 28, 2002. Plans entered into before this date must use table 2001, which is part of revenue notice 2001-10, to determine the value of life insurance protection the employer provides under the plan. (Table 2001 is the commonly accepted authority for valuing policies. It superseded the old PS 58 rates as of January 1, 2002.) Plans also can use the more favorable insurance company one-year term rates to determine the value of life insurance protection.
A plan entered into after January 28, 2002, can use the insurer’s published premium rates until January 1, 2004. Thereafter, for an employee to use these rates, the insurer must make them known to all persons who apply for term coverage and must use those rates when selling such coverage. That means the subsequent rates will be higher than those companies now are quoting.
Timing also is critical to how the IRS will tax policy cash values transferred to employees. Participants in split-dollar arrangements entered into before January 28, 2002, can terminate or convert such plans to loans by January 1, 2004, with no tax liability to the individual taxpayer under the safe harbor in notice 2002-8.
THE END OF REVERSE SPLIT-DOLLAR
Notice 2002-59 prohibits reverse
split-dollar plans from using either table 2001 or the
insurer’s alternative premium rates to value current life
insurance protection. Since these are the only two
authoritative ways of doing so, there is no method a reverse
split-dollar plan can use to safely compute a policy’s
economic value for tax purposes. Because the notice does not
offer an alternative, it essentially eliminates reverse
split-dollar plans as a means of transferring wealth.
Effective date. The proposed regulations apply only to transactions a taxpayer enters into after they become final. The IRS will treat material modifications of plans existing before that date as new plans subject to the final regulations.
Value of equity. The taxpayer’s interest in the policy’s cash surrender value and all other benefits under a split-dollar plan are included in gross income currently.
Value of economic benefit. Footnote 1 to the preamble allows taxpayers to use the higher PS 58 valuation rates for a regular split-dollar plan. It specifically forbids use of these higher rates in reverse split-dollar plans. Neither of these rules benefits the taxpayer.
Split-dollar defined . For the first time, the proposed regulations broadly define split-dollar as an arrangement between an owner and nonowner of a life insurance policy where one party pays all or part of the premiums and the other party may recover all or part of those premiums—with the recovery secured by a life insurance policy.
Tax treatment. There are generally two systems for taxing split-dollar benefits: The economic benefit system (endorsement) and the loan system (collateral assignment). Employment-related or donor/donee nonequity split-dollar arrangements fall under the former, which requires the benefits be taxed to the individual currently. A loan arrangement exists when the policy’s nonowner makes partial premium payments to the owner that a reasonable person would expect to be repaid from the policy’s death benefit. If the loan is non-interest-bearing and at a below-market rate, then forgone interest is taxable to the borrower.
HOW SARBANES-OXLEY APPLIES
Meet with each client who has a split-dollar or reverse split-dollar plan in place.
Review each plan separately in light of the timing issues proposed in notice 2002-8 for benefit valuation and prohibition of reverse split-dollar plans as targeted by notice 2002-59.
Unwind those split-dollar arrangements that no longer accomplish their goals. Among the possible solutions: Change the split-dollar to an endorsement plan where the employer is the policy owner to prevent a personal loan to an officer or director. Terminate those split-dollar arrangements where the cash value exceeds the employer’s premium payments. Consider converting future premium payments to loans. Terminate all reverse split-dollar plans.
Listen to the client’s goals, note how they’ve evolved and use the recent rule changes as an opportunity to fine-tune his or her investment and insurance program.
NEIL ALEXANDER, CFP, is founder and president of Alexander Capital Consulting LLC in Los Angeles. His e-mail address is firstname.lastname@example.org . LAWRENCE BRODY, JD, is an attorney and partner at Bryan Cave LLP in St. Louis where his practice focuses on split-dollar insurance. His e-mail address is email@example.com .