he flurry of IRS and Treasury Department activity focusing on split-dollar insurance arrangements came to a close when the Treasury issued final regulations for all such arrangements entered into or “materially modified” after September 17, 2003. Notwithstanding voluminous taxpayer and practitioner comments, these regulations offer few changes from the July 2002 and May 2003 proposed ones on this popular executive benefit. All new and materially modified split-dollar arrangements will follow either the economic benefit or the loan regime (explained below). Rejecting criticism of this rigid system and the suggestion that taxpayers be permitted to elect which regime applies, the Treasury held firm to a bright-line mandatory rule based on policy ownership. Consequently, CPAs will find a handful of complex definitions will determine the treatment of all future private-company split-dollar arrangements. PUBLIC-COMPANY PLANS
In its explanation the Treasury Department expressly declined to address the issue of whether the Sarbanes-Oxley Act of 2002 applies to split-dollar arrangements, noting that the interpretation and administration of the act fall within SEC jurisdiction. As a result of the uncertainty CPAs should advise public companies to discontinue payments under split-dollar arrangements for directors and officers until the SEC addresses the issue, if ever. THE FINAL REGULATIONS
The final rules apply only to split-dollar arrangements entered into or materially modified after September 17, 2003. Although the regulations don’t define material modification , they include a nonexclusive list of safe harbors. For example, changes in the mode of premium payment, policy-loan interest rates or beneficiary choices (provided the beneficiary is not a party to the arrangement) are not material under Treasury regulations section 1.61-22(j)(2). Notably, IRC section 1035 like-kind exchanges did not make the safe harbor list. If the examples are any indication, the only sure bet is to assume any change with economic significance will be a material modification governed by the final regulations. Pre-September 17, 2003, arrangements. IRS notice 2002-8 continues to govern these plans. (Except as provided in the notice, the IRS declared obsolete the rulings practitioners previously relied on—revenue rulings 79-50, 78-420, 66-110 and 64-328). Notice 2002-8 divides pre-September 17 arrangements into two categories: those created before and after January 28, 2002. Pre-January 28 arrangements may continue to use the insurer’s lower published premium rates for income and gift tax purposes. Post-January 28, 2002, plans, however, may use these lower rates only if the insurer actually discloses them to policy applicants and regularly sells insurance using these rates—which is not likely to happen. Otherwise, CPAs must determine the income and gift tax consequences for post-January 28, 2002, arrangements using the much higher table 2001 rates (which were published in notice 2001-10). | | Split-Dollar Is… Split-dollar agreements are common between an employer and executive employee and concern the payment of premiums on policies insuring the employee’s life. Terms vary but typically the company agrees to pay all or most of the premiums and is repaid—without interest—from the death benefit following the insured’s death. Split-dollar arrangements have become very popular because of the unique tax advantages they offer the insured. The employee includes only the term insurance portion of the premium as income and has access to the policy cash value in excess of the premium refund due the employer without income tax consequences. | | The final regulations did not extend the December 31, 2003, sunset provision for the safe harbors under notice 2002-8 for pre-January 28, 2002, arrangements. That means the opportunity to terminate or convert these arrangements to loans without recognizing income expired on December 31, 2003. Subject to the premium rate rules described above, ongoing pre-September 17 arrangements arguably may operate as in the past, without participants recognizing as income the equity buildup within the policy in excess of the amount needed for premium reimbursement (“excess policy equity”). Notice 2002-8 contains no-inference language that may support such a strategy while the arrangement is in effect. It says, “No inference should be drawn from this notice regarding the appropriate federal income, employment and gift tax treatment of split-dollar insurance arrangements entered into before the date of publication of the final regulations.” The safest approach, however, is for CPAs to help clients develop an exit strategy they can implement before there is excess policy equity or before the insured’s age and premium rates make the income and gift tax consequences prohibitive.
New or modified split-dollar arrangements. The final regulations can produce punishing results for those who fail to analyze their applicability on a case-by-case basis before entering a new arrangement or modifying an existing one. Here are the questions CPAs should ask. Is it split-dollar? The definition under the final regulations is so broad that arrangements not previously considered split-dollar may well be swept within its scope. Consequently, practitioners must analyze all insurance-related transactions with a fresh eye to determine whether they fit within this expansive definition instead of relying on preregulation notions. According to the final regulations, a split-dollar arrangement is one between a policy owner and a nonowner—other than group term insurance plans—where 
Either party pays all or part of the premiums, with at least one paying party entitled to recover the premiums. Recovery is secured by the policy proceeds.
The arrangement is in connection with the performance of services, the employer or service recipient pays all or part of the premiums and the employee or service provider has the right to name the beneficiary or has an interest in the policy cash value.
The arrangement is between a corporation and a shareholder, the corporation pays all or part of the premiums and the shareholder has the right to designate the beneficiary or has a share in the policy cash value. Which regime applies? In a nutshell the economic benefit regime governs the taxation of endorsement split-dollar plans where the policy owner (often the employer) pays the premium, thereby providing a benefit to the nonowner (often the employee). The loan regime governs collateral assignment arrangements, where the nonowner (the employer) pays the premium on a policy the insured or the insured’s donee owns.
What tax rules apply to the economic benefit regime? Depending on the relationship between the owner and nonowner, the economic benefit will be taxed as compensation, dividend, capital contribution or gift. The value of the economic benefit is income to the nonowner (employee or shareholder) for each tax year in an amount equal to the sum of the
Cost of the current life insurance protection provided to the nonowner.
Amount of policy cash value the nonowner has current access to (to the extent not accounted for in a prior tax year).
Value of any other economic benefit the nonowner receives. The cost of current life insurance protection is based on the life insurance premium factor “designated or printed in guidance published in the Internal Revenue Bulletin … .” The Treasury did not issue new guidance in conjunction with the final regulations. Therefore, it appears table 2001, published in notice 2001-10, will continue to apply until further Treasury guidance. A nonowner with a present or future right in the policy cash value has current access within the meaning of the regulations to the extent he or she can directly or indirectly tap the cash value, or the owner and the owner’s creditors can not access it. Clearly an employee will be deemed to have current access to excess policy equity: Given the definition’s breadth, it remains to be seen whether the scope of current access reaches beyond excess policy equity. In a change from the proposed regulations, the final regs say current life insurance protection and policy cash value are determined on the last day of the nonowner’s tax year unless the parties agree to use the policy anniversary date. In light of the foregoing rules nonowners under new or modified split-dollar arrangements in the economic benefit regime can expect to be taxed on life insurance costs based on rates significantly higher than current ones (until the government issues further guidance) and, for the first time, to be taxed on the excess policy equity.
What tax rules apply under the loan regime? The treatment of a split-dollar loan depends on
The relationship of the borrower and lender.
Whether the loan is a demand or term loan.
Whether the loan is below-market, as defined in IRC section 7872(c)(1). The borrower-lender relationship determines whether the loan is a gift, compensation-related or a corporation-shareholder loan (see Treasury regulations section 1.7872-15(e)(1)(i)). A loan is below market if it fails to provide for sufficient interest. Under the final regulations, a demand loan provides for sufficient interest if, in each calendar year, the interest rate, compounded annually, is no lower than the blended annual rate for the year (published in the July Internal Revenue Bulletin ). A term loan (including loans payable upon the insured’s death) provides for sufficient interest if the present value of all payments due exceed the amount of the loan, determined as of the loan date using the applicable federal rate (AFR) for that time. | If a split-dollar arrangement under the loan regime fails the test for sufficient interest or does not provide for interest, the premiums will be treated as a below-market loan. For tax purposes the forgone interest is a transfer from the lender to the borrower (as compensation, dividend or gift) and a retransfer of interest (generally not deductible) from the borrower to the lender. In new rules found in the final regulations, stated interest is disregarded if the lender pays it. Stated interest the lender waives or forgives is treated as paid by the lender and retransferred to the borrower. The retransferred amount then will be increased by a deferral charge, unless, in the usual case of a nonrecourse loan, the arrangement includes a written representation the loan will be repaid.
|  | PRACTICAL TIPS TO REMEMBER | 
Public companies should discontinue payments under split-dollar arrangements for directors and officers until such time as the SEC clarifies the applicability of Sarbanes-Oxley to the plans.
Because the final regulations did not extend the December 31, 2003, sunset date to convert or terminate pre-September 17, 2003, split-dollar arrangements without recognizing income, that option is no longer available.
CPAs should help clients develop an exit strategy they can implement before a split-dollar arrangement accumulates excess policy equity or before the insured’s age and premium rates make the income and gift tax consequences prohibitive. | | WHAT’S NEXT?
This brief summary provides CPAs with only a taste of the complexities they will encounter in wading through the final regulations. Nonetheless, split-dollar arrangements are not likely to go away completely. Therefore, it is essential that parties to split-dollar plans analyze them carefully using current insurance illustrations and immediately develop a plan for dealing with the future tax consequences. Failure to do so could mean many unpleasant surprises.
MARGARET GALLAGHER THOMPSON, JD, is chair of the estates and trusts practice group at Cozen O’Connor, a law firm in Philadelphia. Her e-mail address is mthompson@cozen.com . |
