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 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.
INTERIM GUIDANCE
Notice 2002-8 offers guidelines
to employers and employees until the IRS issues final
split-dollar regulations; the rules make two critical points
about the tax treatment:
 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superseded the old PS 58 rates as of January 1, 2002.)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
In notice 2002-59 the IRS
specifically targets these plans, where one party buys a
policy (usually a family member or employee) and then
“rents” the death benefits to another (a wealthier family
member or employer). With the rent payments typically
greatly exceeding the actual cost of the death benefit the
policy provides, this strategy transfers large amounts of
cash from one entity or individual to another with little or
no tax liability. 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.
The notice similarly provides no apparent remedy for
existing reverse split-dollar plans that now are out of
compliance with the law. The IRS will likely address the
disposition of these plans—one taxpayer at a time.
PROPOSED REGS
The
regulations the Treasury Department published in July 2002
apply to split-dollar policies and have a variety of
provisions. The more significant ones affecting the tax,
financial and estate-planning practices found at most CPA
firms include
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
A new set of accounting and
corporate governance reforms immediately took effect when
President Bush signed the Sarbanes-Oxley Act of 2002 into
law. Among them was section 402, which prohibits any
public reporting company from extending credit in
the form of a personal loan to any executive officer or
director. Privately held companies are exempt. Certain types
of split-dollar arrangements (especially collateral
assignments) implicitly create a personal lending
relationship between the two parties. This may run afoul of
the act, creating a felony punishable by jail time. Some
CPAs and attorneys are counseling their corporate and
personal clients to discontinue further premium payments on
public company split-dollar arrangements until they receive
clear official guidance. Meanwhile, the insurance industry
is seeking clarification of how Sarbanes-Oxley applies to
split-dollar plans.
PROACTIVE STEPS
These
changes in the tax law are an opportunity for CPAs to better
serve their clients. Here’s a checklist of some best
practices they can follow:
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.
WHAT’S NEXT?
Both
America’s economic difficulties and the abuses of some
corporations will continue to create a backlash of ever more
stringent rules on a wide variety of business activities.
Insurance practices are in the crosshairs of tax legislation
specifically designed to deal with some of the more gaping
loopholes. Given the importance of corporate governance
issues, directors and key executives will remain in the
spotlight. Investors will expect to see a change in
corporate culture to one that adheres to both the spirit and
the letter of the law instead of trying to find ways to keep
things running as before. CPAs must observe these changes
carefully and advise clients accordingly. NEIL
ALEXANDER, CFP, is founder and president of Alexander
Capital Consulting LLC in Los Angeles. His e-mail address is
nalex@alexcap.com
. 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 lbrody@bryancave.com
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