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.
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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. |
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PRACTICAL
TIPS TO REMEMBER
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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.
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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 . |