Can be an effective method of attracting and retaining valuable key employees.
Final regulations on split-dollar life insurance arrangements were issued by the Treasury Department and IRS on September 17, 2003. These regulations govern the income, gift and employment taxation of (1) split-dollar arrangements entered into on and after September 18, 2003, and (2) pre-existing arrangements that are "materially modified" on and after that date. The taxation of split-dollar arrangements entered into on or before September 17, 2003 is governed by IRS Notice 2002-8 (unless they are materially modified after that date).
Click here to jump ahead to a discussion of IRS Notice 2002-8.
Click here to jump ahead to a discussion of the final Treasury regulations.
A split-dollar arrangement is a method of purchasing life insurance in which the premium payments and policy benefits are disproportionately divided between two parties, often a business and an employee or a shareholder, but sometimes also two individuals or an individual and a trust. The premium payments and policy benefits are split between the parties in a manner specified in a split-dollar agreement.
Split dollar is a method of buying life insurance, not a reason for buying it. A need for life insurance should always exist before a split-dollar arrangement is considered.
In a business setting, it may be the employer's need to provide a valuable fringe benefit to a key employee, or to attract a new employee into the business. For the employee, the split-dollar arrangement may provide life insurance protection for survivors at a lower current out-of-pocket cost than personally purchased life insurance.
Can be an effective method of attracting and retaining valuable key employees.
The employer may have access to the policy's cash value. (Cash values are a feature of permanent life insurance only. Withdrawals and loans will affect policy values and death benefits, and may have tax consequences.)
The employer can be highly selective regarding which employees are covered.
The arrangement needs no IRS pre-approval.
Split dollar can provide needed personal life insurance protection at a reduced current out-of-pocket cost.
Split dollar can be combined with a cross-purchase buy-sell agreement to even out the current premium cost in the case of a wide age variance.
Split-dollar life insurance arrangements entered into on and after September 18, 2003 are subject to final federal tax regulations that are generally less favorable than the prior tax treatment, particularly in the case of equity split-dollar arrangements (defined later).
Employers and employees who want a more predictable tax environment may want to consider executive bonus life insurance arrangements as a possible alternative to split dollar.
Graphic: How Split-Dollar Arrangements Funded with Life Insurance Work
If an employer does not have a group term life insurance plan, or wishes to provide coverage for one or more select individuals over and above a basic group life plan, split dollar can be used to provide the protection.
A split-dollar arrangement also can be used to help provide estate liquidity for an employee's estate, and the policy ownership can usually be set up so that the federal estate tax is avoided (which is usually not possible with nonqualified deferred compensation), although there may be some gift tax cost.
A corporation may wish to assist its shareholders in establishing an insured cross-purchase buyout agreement by contributing to the premium cost of the policy. If the corporation is in a lower tax bracket than the shareholder, the corporation may be able to pay the (nondeductible) split-dollar premiums more economically than the shareholder can.
The Sarbanes-Oxley Act of 2002 "SOX", enacted in response to highly publicized corporate accounting scandals, raises a concern over the suitability of split-dollar arrangements for certain executives in public corporations. This legislation generally prohibits "extensions of credit" from public corporations to "executive officers." In plain English, it is a federal crime for a publicly traded company, directly or indirectly, to enter into a loan arrangement with certain directors and officers. The statute refers to a publicly-traded company as an "issuer".
Section 402 of SOX provides, in relevant part: It shall be unlawful for any issuer (as defined in §2 of the Sarbanes-Oxley Act of 2002), directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer. An extension of credit maintained by the issuer on the date of enactment of this subsection shall not be subject to the provisions of this subsection, provided that there is no material modification to any term of any such extension of credit or any renewal of any such extension of credit on or after the date of enactment.
If a split-dollar arrangement is deemed to be a loan for federal tax purposes, and is taxed under the loan regime (discussed later), will it also be treated as a prohibited "extension of credit" for federal securities law purposes? The answer is unclear under the language of the law as it was enacted.
Some insurance companies fear that the law may be interpreted broadly to mean that even arrangements taxed under the economic benefit regime (discussed later) are subject to the Sarbanes-Oxley loan prohibition. In other words, how the arrangement is viewed for tax law purposes may have no bearing on how it is viewed for securities law purposes.
In T.D. 9092 (the final tax regulations), the Treasury Department and IRS explicitly state that "interpretation and administration of Sarbanes-Oxley fall within the jurisdiction of the Securities and Exchange Commission." Congress has been urged to create a statutory exception for split-dollar arrangements but has declined to do so.
The following generalizations can be made regarding the potential applicability of SOX §402 to split-dollar life insurance arrangements:
The arrangements least likely to be treated as a loan under SOX §402 are nonequity endorsement split-dollar arrangements.
Based on an analysis of non-SOX banking laws applicable to split-dollar arrangements, there is a reasonable basis for arguing that an equity endorsement arrangement should not be treated as an extension of credit under SOX §402.
Unless and until the Securities and Exchange Commission issues a blanket exception for split-dollar arrangements from coverage under SOX §402, it seems likely that SOX would apply to all collateral assignment arrangements.
Even though SOX §402 would likely be treated as applying to collateral assignment arrangements, it is possible to argue that a nonequity collateral assignment arrangement should not be treated as an extension of credit under SOX §402 because no equity is being transferred to the executive.
Unless and until this issue is favorably resolved, the safe course would be to use extreme caution and follow the guidance of the client's counsel with respect to (1) whether to install new split-dollar arrangements covering an executive officer of a public corporation, (2) whether to make further premium advances under existing split-dollar arrangements involving executive officers of public corporations, and (3) any current developments that may affect the applicability of split dollar to public corporation executives.
Executive bonus life insurance arrangements, in which W-2 compensation rather than a loan is involved, may be an alternative for public corporations until this issue is resolved.
Caution: Under the final Treasury regulations issued in Sept. 2003, the formal ownership of a life insurance policy used to fund a split-dollar arrangement is the primary determinant of the federal tax consequences that result from the arrangement.
The Pension Protection Act of 2006 added income inclusion rules and exceptions with regard to employer-owned life insurance. Click here for a EOLI discussion.
Under the endorsement method, the employer owns the policy, and an agreement spells out the employee's rights. Typically, the agreement will give the employee the right to name a personal beneficiary for the employee's share of the death proceeds as prescribed in the split-dollar agreement between the parties.
In the collateral assignment method, the employee (or a third party such as an ILIT) owns the policy and names a personal beneficiary, but assigns policy benefits to the employer as collateral for the employer's premium advances under the arrangement. A third party, often the employee's irrevocable life insurance trust or an adult child, also may be the policy owner. This "third party collateral assignment method" is often used for estate tax planning purposes, as discussed later.
Equity split dollar is an arrangement in which the employer's share of the cash value and death benefit is limited to its aggregate net premiums paid. Any cash value in excess of the employer's aggregate net premiums inures to the benefit of the employee. Thus, the employee gradually builds up an "equity" interest in the cash value as well as having current life insurance protection.
Equity split-dollar arrangements were the primary impetus behind the series of IRS actions that culminated with the issuance of final Treasury regulations on split-dollar arrangements (September 2003), which are covered later in this section.
A split-dollar rollout occurs when the arrangement is terminated and the employer is repaid for its aggregate premium advances under the arrangement. A rollout often occurs at the employee's retirement. After the rollout, the employee may use dividends (when applicable) and paid-up additions to offset any further premium payments.
The original or classic split-dollar arrangement is not used now, but is important in understanding the origin and evolution of the split-dollar concept. Under the classic arrangement, the employer's share of the premiums equals the annual increase in the cash value of the policy. The employee pays the balance of the premium.
Under the classic arrangement, if the employee dies while the arrangement is in effect, the employer will receive that part of the total death benefit equal to the aggregate net premiums it has paid, or the cash value, as prescribed in the split-dollar agreement. If the employer's recovery is limited to net premiums paid, the cost to the employer is the loss of the use of the premium dollars while the arrangement was in effect.
In an employer-pay-all arrangement, the employer advances the entire premium.
The sharing of the death benefit under this arrangement can be designed so that the employer recovers its entire investment (net premiums paid) or the cash value of the policy at the time of the employee's death, as prescribed in the split-dollar agreement. The balance of the proceeds is payable to the employee's beneficiary.
Final Treasury regulations on the federal income, employment, self-employment and gift taxation of split-dollar life insurance arrangements were issued by the Treasury Department and IRS in September 2003. These regulations were prospective only, meaning, they generally only affect future split-dollar life insurance arrangements established after the effective date of the final regulations (with an important exception).
The final regulations govern the taxation of (1) new split-dollar arrangements entered into on and after September 18, 2003, and (2) pre-existing arrangements that are "materially modified" on or after that date. The taxation of split-dollar arrangements entered into on or before September 17, 2003 is governed by IRS Notice 2002-8 (unless they are materially modified after that date). Treasury and IRS have provided guidance on certain modifications that will not be deemed "material" (discussed later).
Taxpayers could elect to rely on the proposed regulations (July 2002 and May 2003) for a split-dollar arrangement entered into before the final regulations took effect, provided all parties were consistent in their treatment of the arrangement.
Participants in equity split-dollar arrangements that were entered into before January 28, 2002, had through December 31, 2003, to (1) roll out the policy and terminate the arrangement, or (2) convert the arrangement retroactively to an interest-free loan that accounts for all employer payments, and thereby avoid taxation of the equity portion upon subsequent rollout. After December 31, 2003, a participant's receipt of the equity portion is a taxable event, even for an arrangement in effect on January 28, 2002.
Clients should be encouraged to seek the advice of tax counsel with respect to both existing split-dollar arrangements and new split-dollar proposals.
Important point to remember: The guidance provided in IRS Notice 2002-8, NOT the split-dollar final regulations issued in September 2003, generally govern the taxation of split-dollar arrangements entered into on or before September 17, 2003 (unless the parties elected to rely on the prior proposed regulations).
In January 2002, the IRS issued Notice 2002-8 [2002-1 C.B. 398], revoking IRS Notice 2001-10, which had been issued only a year earlier to provide interim guidance on the taxation of split dollar. In addition to presaging the proposed regulations that would be issued a few months later, Notice 2002-8 provided temporary guidance regarding the valuation of current life insurance protection provided under split-dollar arrangements. It also provided grandfather/safe-harbor rules for split-dollar arrangements entered into (1) prior to Jan. 28, 2002, and (2) after Jan. 28, 2002 but before the effective date of final regulations.
Valuing Current Life Insurance Protection: Pending the publication of further guidance, the IRS issued temporary guidance in Notice 2002-8 on valuing the current life insurance protection provided in a split-dollar life insurance arrangement.
The former P.S. 58 rates generally have been replaced by the Table 2001 rates. However, a split-dollar arrangement between employer and employee, entered into before Jan. 28, 2002, in which the split-dollar agreement specifically provides that the P.S. 58 rates will be used to determine the taxable value of current life insurance protection provided to the employee, may continue to utilize this approach to measure the value of the current life insurance protection for the duration of the arrangement.
Since reverse split-dollar arrangements typically provide life insurance protection to the employer, such arrangements entered into prior to January 28, 2002, will not be able to use P.S. 58 rates to measure economic benefit costs. The proposed regulations issued in July 2002 explicitly stated that "Taxpayers may not use the P.S. 58 rates for 'reverse' split dollar life insurance arrangements or for split dollar life insurance arrangements outside of the compensatory context" (footnote 1 to preamble). Since private or family split-dollar arrangements are "outside of the compensatory context," P.S. 58 rates may not be used for them either.
For arrangements entered into before the effective date of future guidance on valuation of the economic benefit, taxpayers may use the rates in Table 2001 to measure the value of current life insurance protection provided on a single life in a split-dollar arrangement. Taxpayers must make "appropriate adjustments" in the Table 2001 rates for policies covering more than one life.
For arrangements entered into before the effective date of future guidance, taxpayers may continue to determine the value of current life insurance protection by using the insurer's lower published premium rates (in lieu of the Table 2001 rates) that are available to all standard risks for initial-issue, one-year term life insurance. However, for arrangements entered into after January 28, 2002, and before the effective date of future guidance, an insurer's published YRT rates will not, after December 31, 2003, be deemed available to all standard risks who apply for term insurance unless—
the insurer generally makes the availability of such rates known to persons who apply for term insurance coverage from the insurer, and
the insurer regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurer's normal distribution channels.
To summarize: Under Notice 2002-8, for split-dollar arrangements entered into—
before January 28, 2002, P.S. 58 rates can continue to be used in a compensatory context if specifically required by the terms of the split-dollar agreement.
before the effective date of future guidance, Table 2001 rates may be used.
before January 28, 2002, the insurer's published one-year term insurance rates may be used if lower than Table 2001 rates.
after January 28, 2002 and before the effective date of future guidance, the insurer's lower published one-year term rates may be used; but in order to use such rates after December 31, 2003, the insurer must (i) make the availability of such rates known, and (ii) regularly sell term insurance policies at such rates.
The AALU issued a pertinent caution:
"The fact that these standards are not applicable to pre-January 28, 2002, arrangements does not on its face signify a Revenue Service retreat from its practice in some situations of challenging whether this issuer's published premium rates are available to all standard risks (e.g., are non-smoker rates available to all standard risks?)." [AALU Bulletin 02-1, January 7, 2002]
Table 2001 Rates: The Table 2001 rates are substantially lower than the P.S. 58 rates and include rates below age 25 and above age 70.
Click here to display the Table 2001 rates.
Grandfather/Safe Harbor Rules: In Notice 2002-8, the IRS provided a set of grandfather or "safe harbor" rules for split-dollar arrangements entered into before the effective date of final regulations.
Safe Harbor Rule No. 1: For split-dollar arrangements entered into before Sept. 18, 2003, in which the current life insurance protection is treated as a taxable economic benefit, the IRS will not treat the arrangement as having been terminated for so long as the parties continue to treat and report the value of the current life insurance protection as a taxable economic benefit to the employee (or other benefited person). "This treatment will be accepted," says the Notice, "without regard to the level of the remaining economic interest that the sponsor has in the life insurance contract." Could IRC §61 tax treatment continue, then, even after the employer (or other sponsor) has been repaid for its premium advances?
Safe Harbor Rule No. 2: For split-dollar arrangements entered into before the effective date of final regulations, the parties may treat premiums and other payments by the employer (or other sponsor) as loans. When this is done, the IRS will not challenge "reasonable efforts" to comply with the OID requirements of IRC §§1271-1275 and the imputed interest requirements of IRC §7872. All payments by the employer (or other sponsor) from the inception of the arrangement, reduced by any repayments, before the first taxable year in which such payments are treated as loans for federal tax purposes must be treated as loans entered into at the beginning of that first year in which such payments are treated as loans.
Safe Harbor Rule No. 3: For split-dollar arrangements entered into before Jan. 28, 2002, in which an employer (or other sponsor) has made premium or other payments under the arrangement, and has received or is entitled to receive full repayment of all of its payments, the IRS will not assert that there has been an IRC §83 taxable transfer to the employee if the arrangement is terminated (rolled out) before January 1, 2004.
This essentially gave the parties to existing split-dollar arrangements a grace period (through December 31, 2003) to decide whether to terminate, modify or continue the arrangement as originally instituted. Thus, an equity split-dollar arrangement entered into prior to January 28, 2002, could have been rolled out to the employee on or before December 31, 2003 without triggering an IRC §83 tax to the employee on the equity. The employee had to, of course, reimburse the employer's aggregate premium payments or be subject to tax on un-reimbursed amounts.
Safe Harbor Rule No. 4: For split-dollar arrangements entered into before January 28, 2002, in which an employer (or other sponsor) has made premium or other payments under the arrangement, and has received or is entitled to receive full repayment of all of its payments, the IRS will not assert that there has been an IRC §83 taxable transfer to the employee (or other benefited person) if, for all periods beginning on or after January 1, 2004, all payments by the employer (or other sponsor) from the inception of the arrangement, reduced by any repayments to the employer, are treated as loans for federal tax purposes. The parties must report the tax treatment in a manner that is consistent with loan treatment, including IRC §§1271-1275 and 7872. Any such payments by the employer (or other sponsor) before the first taxable year (beginning January 1, 2004 in most cases) "in which such payments are treated as loans for Federal tax purposes must be treated as loans entered into at the beginning of that first year in which such payments are treated as loans."
The IRS indicated that, except for the portion of Notice 2002-8 dealing with the valuation of current life insurance protection, "no inference should be drawn from this notice regarding the appropriate Federal income, employment, and gift tax treatment of split-dollar life insurance arrangements entered into before the date of publication of final regulations. However, taxpayers may rely on this notice (including a reasonable application of the rules to be proposed . . .) or Notice 2001-10 for split-dollar life insurance arrangements entered into before the date of publication of final regulations."
The final Treasury regulations provide guidance on the taxation of split-dollar arrangements for purposes of the federal income, employment, self-employment and gift taxes for arrangements entered into on and after September 18, 2003. Generally, the final regulations follow the tax scheme laid out in the proposed regulations (July 2002) and the supplemental proposed regulations (May 2003), with some modifications and additions.
Definition of Split-Dollar Life Insurance Arrangement: The final regulations generally define a split-dollar life insurance arrangement as any arrangement between an owner of a life insurance contract and a non-owner of the contract under which either party to the arrangement pays all or part of the premiums, and one of the parties paying the premiums is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums, and such recovery is to be made from, or is secured by, the proceeds of the contract. The definition does not cover the purchase of a life insurance contract in which the only parties to the arrangement are the policy owner and the life insurance company acting only in its capacity as issuer of the contract.
Definition of Non-equity Arrangement: Under a non-equity split-dollar life insurance arrangement, one party typically provides the other party with current life insurance protection but not any interest in the policy's cash value.
Definition of Equity Arrangement: Under an equity split-dollar life insurance arrangement, one party to the arrangement typically receives an interest in the policy cash value (or equity) of the life insurance contract disproportionate to that party's share of policy premiums. That party also typically receives the benefit of current life insurance protection under the arrangement.
Special Rules: The final regulations retain the special rules from the 2002 proposed regulations that treat certain arrangements entered into either in connection with the performance of services, or between a corporation and another person in that person's capacity as a shareholder in the corporation, as split-dollar life insurance arrangements, regardless of whether the arrangements otherwise satisfy the general definition of a split-dollar life insurance arrangement. Neither the general rule nor the special rule covers key person life insurance arrangements under which a company purchases a life insurance contract to insure the life of a key employee or shareholder, but retains all the rights and benefits of the contract, including the rights to all death benefits and cash value.
Caution: The IRS and Treasury have expressed concern that certain arrangements may be inappropriately structured in an attempt to avoid the application of these regulations; for example, by using separate life insurance contracts that are, in substance, one life insurance contract. The IRS indicates that it will use existing regulatory authority to challenge such transactions.
Owners and Non-owners: The final regulations generally retain the rules in the July 2002 proposed regulations for determining the owner and the non-owner of the life insurance contract. Thus, the owner generally is the person named as the policy owner. If two or more persons are designated as the policy owners, the first-named person generally is treated as the owner of the entire contract. Treasury and IRS rejected the argument of some commentators on the proposed regulations that determining tax ownership based on whom the parties name as the policy owner represents a departure from general tax principles (i.e., the substance-over-form doctrine). In the view of Treasury and IRS, the final rule provides a clear, objective standard so that both taxpayers and the IRS can readily determine which tax regime applies under the final regulations.
Exception for Undivided Interests: If two or more persons are named as policy owners of a life insurance contract and each person has, at all times, all the incidents of ownership with respect to an undivided interest in the contract, those persons are treated as owners of separate contracts for purposes of the final regulations (although not for purposes of IRC §7702 and other rules for the taxation of life insurance contracts). An undivided interest in a life insurance contract consists of an identical fractional or percentage interest or share in each right, benefit, and obligation with respect to the contract.
The IRS will consider all of the facts and circumstances of an arrangement to determine whether the parties have appropriately characterized the arrangement as one involving undivided interests and, therefore, not subject to the split-dollar final regulations.
Ownership Attribution Rules: The final regulations provide ownership attribution rules for compensatory split-dollar life insurance arrangements. Under these rules, the employer or service recipient will be treated as the owner of the life insurance contract if the contract is owned by a member of the employer's controlled group [determined under the rules of IRC §414(b) and (c)], a trust described in IRC §402(b) (and sometimes referred to as a "secular trust"), a grantor trust treated as owned by the employer (including a rabbi trust), or a welfare benefit fund [within the meaning of IRC §419(e)(1)].
Two Mutually Exclusive Tax Regimes: The final regulations retain the approach of two mutually exclusive regimes, an "economic benefit regime" and a "loan regime," for determining the tax treatment of split-dollar life insurance arrangements. A split-dollar arrangement must be fully and consistently accounted for by both parties under one of the alternative tax regimes.
As under the 2002 proposed regulations, ownership of the life insurance contract generally determines which regime applies. Despite criticism from commentators on the 2002 and 2003 proposed regulations, the IRS and Treasury concluded that the two-regime approach, based on policy ownership, properly accounts for the division of costs and benefits in a split-dollar life insurance arrangement.
Some commentators on the proposed regulations suggested that taxpayers be permitted to elect which regime would apply to their split-dollar life insurance arrangements (as was the case under the now-revoked Notice 2001-10). However, in the view of the IRS and the Treasury, taxpayers effectively have the ability to elect which regime will apply by designating one party or the other as the owner of the life insurance contract.
Special Rule: If the only economic benefit enjoyed by the employee (or donee) is current life insurance protection, the employer (or donor) is deemed to be the owner of the policy for tax purposes. Apparently, then, a non-equity split-dollar arrangement in an employment or gift context will always be taxed under the economic benefit regime, regardless of actual policy ownership.
Caution: If the party advancing premiums is not entitled to recover those premiums under the terms of the arrangement, general tax principles will apply to the premium payments rather than one of the split-dollar tax regimes.
Taxation under the Economic Benefit Regime [Reg. §1.61-22(d)-(g)]: The final regulations retain the basic rules for taxation under the economic benefit regime that had been set forth in the 2002 and 2003 proposed regulations. Thus, the final regulations provide that, for these arrangements, the owner of the life insurance contract is treated as providing economic benefits to the non-owner of the contract, and those economic benefits must be accounted for fully and consistently by both the owner and the non-owner. The value of the economic benefits, reduced by any consideration paid by the non-owner to the owner, is treated as provided from the owner to the non-owner.
In a typical employment context, the economic benefit regime generally will govern the taxation of endorsement method arrangements in which the employer owns the policy and the employee's rights are spelled out in an endorsement to the policy.
The tax consequences of the provision of economic benefits will depend on the relationship between the owner and the non-owner. Thus, the provision of the benefit may constitute a payment of compensation, a dividend distribution under IRC §301, a capital contribution, a gift, or a transfer having a some other tax character. The economic benefit must be taken into account by the non-owner based on its tax character.
Non-Equity Split-Dollar Life Insurance Arrangements: Under the final regulations, the tax treatment of a non-equity split-dollar arrangement generally follows the tax treatment of a non-equity split-dollar arrangement under Rev. Rul. 64-328 [1964-2 C.B. 11] and its progeny. The proposed regulations had required that the average death benefit for the taxable year be used to compute current life insurance protection. The final regulations provide instead that
subject to an anti-abuse rule intended to discourage manipulation of the policy cash value to understate the economic benefitcurrent life insurance protection is determined on the last day of the non-owner's taxable year unless the parties agree to use the policy anniversary date. Taxpayers may change the valuation date with the consent of the IRS.
Thus, in the case of non-equity arrangements taxed under the economic benefit regime, the owner is deemed to provide current life insurance protection to the other party equal to the excess of the death benefit (including paid-up additions), determined on the valuation date just described, over (1) the amount payable to the owner at the insured's death, plus (2) the amount of any policy loan outstanding. Pending further guidance, the taxable cost of the current life insurance protection on an annual basis is the amount of the annual coverage times the Table 2001 factor (until Table 2001 is superseded by later IRS guidance) or other rates permitted under Notice 2002-8, reduced by any premiums paid by the insured.
Special rules: The final regulations retain the special rule for non-equity split-dollar life insurance arrangements. Under this special rule, non-equity arrangements entered into in a compensatory context or a gift context are subject to the economic benefit regime. The final regulations provide rules for determining the tax treatment of the arrangement if the parties subsequently modify the arrangement so that it is no longer a non-equity arrangement. If, immediately after the modification, the employer, service recipient, or donor is the owner of the life insurance contract (determined without regard to the special rule for non-equity arrangements), the employer, service recipient, or donor continues to be treated as the owner of the life insurance contract (such that the normal rules of the economic benefit regime for equity split-dollar life insurance arrangements will apply). If, immediately after the modification, the employer, service recipient, or donor is not the owner, the employer, service recipient, or donor is treated as having made a transfer of the contract to the employee, service provider, or donee as of the date of the modification. For purposes of these rules, the replacement of a non-equity arrangement with a successor equity arrangement will be treated as a modification of the non-equity arrangement.
The final regulations add another special rule regarding the transfer of a life insurance contract under a split-dollar life insurance arrangement from an owner to a non-owner when payments under the arrangement had been treated, prior to transfer, as split-dollar loans under Reg. §1.7872-15. Under this rule, the economic benefit regime applies to the split-dollar life insurance arrangement from the date of the transfer and the payments made (both before and after the transfer) are not treated as split-dollar loans on or after the date of the transfer. The transferor of the life insurance contract must fully take into account all economic benefits provided under the split-dollar life insurance arrangement.
Equity Split-Dollar Life Insurance Arrangements: The final regulations generally retain the rules set out in the 2002 and 2003 proposed regulations for the taxation of equity split-dollar life insurance arrangements. The owner and the non-owner must fully and consistently account for any right in, or benefit of, a life insurance contract provided to the non-owner under an equity split-dollar life insurance arrangement. Therefore, the value of the economic benefits provided by the owner to the non-owner for a taxable year equals:
the cost of any current life insurance protection provided to the non-owner;
the amount of policy cash value to which the non-owner has current access (to the extent that such amount was not actually taken into account for a prior taxable year); and
the value of any other economic benefits provided to the non-owner (to the extent not actually taken into account for a prior taxable year).
The final regulations provide that the non-owner has current access to any portion of the policy cash value to which the non-owner has a current or future right, and that is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner's general creditors. The IRS and Treasury intend that ''access'' be construed broadly to include any direct or indirect right under the arrangement allowing the non-owner to obtain, use, or realize potential economic value from the policy cash value.
Policy cash value is inaccessible to the owner if the owner does not have the full rights to policy cash value normally held by an owner of a life insurance contract. Policy cash value is inaccessible to the owner's general creditors if, under the terms of the split-dollar life insurance arrangement or by operation of law or any contractual undertaking, the creditors cannot, for any reason, effectively reach the policy cash value in the event of the owner's insolvency.
Commentators on the proposed regulations argued that IRC §72(e) specifically provides for tax-free inside build-up under a life insurance contract, precluding any taxation of policy cash value to the non-owner prior to a "realization event" (such as rollout of the policy). In the Treasury and IRS view, the tax-deferred inside build-up provided by IRC §72(e) properly applies only to the taxpayer that owns the life insurance contract. If the owner of the contract provides any of the rights or benefits under the contract to another taxpayer, such provision of rights and benefits is subject to tax under the rules that otherwise follow from the relationship between the parties.
This result applies whenever an employer that owns a life insurance contract compensates an employee by giving the employee rights to the policy cash value. In that case, the employer, as the owner of the contract, enjoys tax-deferred inside build-up under IRC §72(e), but the employee has gross income under IRC §61(a)(1) equal to the value of the economic benefit attributable to the employee's rights to the cash value.
Other commentators on the proposed regulations argued that the tax should be imposed on a transfer of property in connection with the performance of services under IRC §83 rather than as an economic benefit under IRC §61. In other words, the employee's current access to policy cash value would give rise to transfers of property with respect to portions of the life insurance contract. Under an IRC §83 approach, inside build-up on amounts already taxed to the non-owner would be tax-free to the non-owner under IRC §72(e). Under the May 2003 proposed regulations critiqued by the commentators, the subsequent inside build-up is tax-deferred to the owner but not to the non-owner. Treasury and the IRS rejected the IRC §83 approach in the final regulations.
The final regulations clarify that the non-owner has current access to policy cash value only if, under the arrangement, the non-owner has a current or future right to policy cash value. The non-owner will not have any such right in a true non-equity arrangement. If the non-owner does have such a right, any restriction on the owner's creditors to reach policy cash value, whether established by contract or by local law, results in an economic benefit to the non-owner.
In certain cases, a separate tax rule may require the non-owner to include an amount in gross income under an equity split-dollar life insurance arrangement at a time earlier than would be required under the split-dollar regulations.
Investment in the Contract: The final regulations retain the rule of the 2002 proposed regulations that the non-owner has no investment in the contract under IRC §72(e) prior to a transfer of the contract. The final regulations also retain the rule that any amount paid by the non-owner to the owner for any economic benefit is included in the owner's gross income.
In the Treasury and IRS view, because only the owner of a life insurance contract can have an investment in that contract, a non-owner employee cannot have basis in the contract for any of the costs of current life insurance protection. In addition, such costs should not be included in the non-owner's basis or investment in the contract if and when the non-owner becomes the owner of the contract because those payments were made for annual life insurance protection, which protection was exhausted prior to the non-owner's acquisition of the contract. Similarly, the fact that the split-dollar life insurance arrangement may require the non-owner to reimburse the owner for the cost of the death benefit protection provided to the non-owner does not mean that such payment is not income to the owner. In the Treasury/IRS view, the owner is "renting out" part of the benefit of the life insurance contract to the non-owner for consideration, and such consideration constitutes income to the owner.
Taxation of Amounts Received under the Life Insurance Contract: The final regulations retain the rule in the 2002 proposed regulations that any amount received under the life insurance contract (other than an amount received by reason of death) and provided, directly or indirectly, to the non-owner is treated as though paid by the insurance company to the owner and then paid by the owner to the non-owner. This rule applies to certain policy loans (referred to in the regulations as "specified policy loans").
Thus, any amounts the non-owner receives under the contract (e.g., dividends, policy loans, partial surrender proceeds) are deemed to have been paid first to the owner, and then to the non-owner. Such amounts will be taxed to the owner under the IRC §72 annuity rules; i.e., federal income tax-free until basis has been fully recovered. The non-owner generally will report amounts received as compensation, gift, or dividend, depending on the relationship between the parties. An employee, for example, would have compensation income upon the receipt of a policy loan, unlike the usual treatment of a policy loan to the policy owner.
Death Benefit Exclusion: The final regulations retain the rule that the IRC §101(a) death benefit exclusion applies to exclude death benefit proceeds paid to a beneficiary (other than the owner of the life insurance policy) from the gross income of the beneficiary only to the extent such amount is allocable to current life insurance protection provided to the non-owner under the split-dollar life insurance arrangement, the cost of which was paid by the non-owner, or the value of which the non-owner actually took into account as an economic benefit provided by the owner to the non-owner.
Commentators on the proposed regulations objected, arguing that the IRC §101(a) exclusion extends to the entire amount of death benefit proceeds paid on the death of the insured. The IRS and Treasury disagreed on the theory that to the extent the non-owner has neither paid for nor taken into account the current life insurance protection, the proceeds paid to the estate or designated beneficiary of the non-owner is a separate transfer of cash that is not shielded from tax by the IRC §101(a) exclusion. Instead, the death proceeds are deemed payable to the owner, and are excluded from the owner's income by reason of the IRC §101(a) exclusion, and then paid by the owner to the non-owner's beneficiary (whether or not paid to the beneficiary directly by the insurance company) in a transfer to be taken into account under the split-dollar regulations.
The tax character of death benefit proceeds transferred or deemed to be transferred by the owner to the non-owner is determined by the relationship between the owner and the non-owner.
Transfer of Life Insurance Contract to the Non-owner: The final regulations follow the 2002 proposed regulations in determining the tax treatment of a transfer of the life insurance contract from the owner to the non-owner. A transfer of a life insurance contract (or an undivided interest therein) underlying a split-dollar life insurance arrangement occurs on the date that the non-owner becomes the owner of the entire contract (or an undivided interest therein). Unless and until ownership of the contract is formally changed, the owner will continue to be treated as the owner for all federal tax purposes.
The fair market value of an undivided interest must be the proportionate share of the fair market value of the entire contract without regard to any discounts or other arrangements between the parties.
After a transfer of an entire life insurance contract, the transferee generally becomes the owner for federal income, employment, and gift tax purposes, including for purposes of the split-dollar regulations. Thus, if the transferor pays premiums after the transfer, the payment of those premiums may be includible in the transferee's gross income if the payments are not split-dollar loans under Reg. §1.7872-15. Alternatively, the arrangement will be subject to the loan regime if the payments constitute split-dollar loans under Reg. §1.7872-15.
Taxation under the Loan Regime [Reg. §1.7872-15]: The final regulations generally adopt the rules of the July 2002 proposed regulations for the loan regime. Under the loan regime of Reg. §1.7872-15, a payment made pursuant to a split-dollar life insurance arrangement is a split-dollar loan and the owner and non-owner are treated, respectively, as borrower and lender if:
the payment is made either directly or indirectly by the non-owner to the owner;
the payment is a loan under general principles of federal tax law or, if not a loan under general principles of federal tax law, a reasonable person would expect the payment to be repaid in full to the non-owner (whether with or without interest); and
the repayment is to be made from, or is secured by, either the policy's death benefit proceeds or its cash surrender value, or both.
Thus, under the loan regime, the non-owner of the life insurance policy (lender) is treated as making loans of all or part of the premiums to the policy owner (borrower). The loan regime applies to a typical equity collateral assignment arrangement in which the employee owns the policy and uses it as collateral for the employer's advance of premium payments. The loan regime does NOT apply to a non-equity collateral assignment split dollar arrangement involving employment or a gift, where the employer or donor is treated as the owner and the economic benefit regime applies. For example, non-equity private split-dollar (which involves gifts) would not be subject to the loan regime.
During the earlier years in which a split-dollar life insurance arrangement is in effect, policy surrender and load charges may significantly reduce the policy's cash surrender value, resulting in under-collateralization of a non-owner's right to be repaid its premium payments. Nevertheless, so long as a reasonable person would expect the payment to be repaid in full, the payment is treated as a split-dollar loan under Reg. §1.7872-15, rather than as a transfer under Reg. §1.61-22(b)(5), on the date the payment is made.
Below-Market Loans: The loan regime seeks to account for the benefits provided by the lender to the borrower when the loans are below-market. Each payment under a covered split-dollar arrangement is treated as a separate loan for federal tax purposes.
If a split-dollar loan does not provide for sufficient interest, the loan is a below-market split-dollar loan subject to the imputed interest rules of IRC §7872 and Reg. §1.7872-15. If the split-dollar loan does provide for sufficient interest, then, except as provided in Reg. §1.7872-15, the loan is subject to the general rules for debt instruments (including the original-issue-discount or OID rules).
If a split-dollar loan is a below-market loan, then, in general, the loan is recharacterized as a loan with interest at the "applicable federal rate" (AFR), coupled with an imputed transfer by the lender to the borrower. The timing, amount, and characterization of the imputed transfers between the lender and borrower of the loan will depend upon whether the loan is a demand loan or a term loan, and the relationship between the lender and the borrower. For example, the imputed transfer generally would be characterized as compensation if the lender is the borrower's employer.
If a split-dollar loan is repayable on demand, the short-term applicable federal rate applies in calculating the imputed interest. Since this rate changes monthly, the calculation normally would have to be made monthly. But tax law permits taxpayers to use a blended annual rate when a demand loan has a fixed principal that is outstanding for an entire calendar year [IRC §7872(e)(2); see also Rev. Rul. 86-17, 1986-1 CB 377]. The IRS releases the blended annual rate in a revenue ruling issued in July of each year. The blended annual rates for recent years appear below:
|
Year |
Rate |
|
2011 |
0.40% |
|
2012 |
0.22 |
|
2013 |
0.22 |
|
2014 |
0.28 |
|
2015 |
0.45 |
Special Rules for Certain Term Loans: Special rules are provided for split-dollar term loans payable upon the death of an individual, certain split-dollar term loans that are conditioned on the future performance of substantial services by an individual, and gift split-dollar term loans. Under the loan regime, these are treated as split-dollar term loans for purposes of determining whether the loan provides for sufficient interest. However, if the loan does not provide for sufficient interest when the loan is made, the forgone interest is determined on the loan annually similarly to a split-dollar demand loan.
The rate used to determine the amount of forgone interest each year is the AFR based on the term of the loan, determined on the date the split-dollar loan is made. The rate is not re-determined annually.
Split-dollar Loans with Stated Interest that is Subsequently Waived, Canceled or Forgiven: If a split-dollar loan provides for stated interest that is subsequently waived, canceled or forgiven, appropriate adjustments must be made by the parties to reflect the difference between the interest payable at the stated rate and the interest actually paid by the borrower at that time. Further, if stated interest is subsequently waived, canceled or forgiven, an amount is treated as re-transferred from the lender to the borrower.
The final regulations add new rules under which:
this re-transferred amount generally is increased by a deferral charge; and
a payment by the lender to the borrower that, in substance, is a waiver, cancellation or forgiveness is treated as a waiver, cancellation, or forgiveness for tax purposes.
Nondeductibility of Interest by Borrower: In general, interest on a split-dollar loan is not deductible by the borrower under IRC §§264 and 163(h).
Non-recourse Loans: If a payment on a split-dollar loan is non-recourse to the borrower and the loan does not otherwise provide for contingent payments, Reg. §1.7872-15 treats the loan as a split-dollar loan that provides for contingent payments unless the parties to the split-dollar life insurance arrangement provide a written representation [see Reg. §1.7872-15(d)(2)] with respect to the loan.
The final regulations eliminated the requirement in the proposed regulations that a non-recourse split-dollar loan provide for interest payable at a stated rate. However, the final regulations include a new rule [Reg. §1.7872-15(a)(4)] that disregards certain stated interest if such interest is to be paid directly or indirectly by the lender, or a person related to the lender.
If a split-dollar loan is non-recourse and the parties to the split-dollar life insurance arrangement had made the representation under Reg. §1.7872-15(d)(2), although adjustments are required to be made by the parties if the interest paid on the split-dollar loan is less than the interest payments required under the split-dollar loan if all payments were made, a deferral charge is not imposed.
Payment Ordering Rules: Payments made by a borrower to a lender pursuant to a split-dollar life insurance arrangement are applied in the following order: to accrued but unpaid interest (including any OID) on all outstanding split-dollar loans in the order the interest accrued; to principal on the outstanding split-dollar loans in the order in which the loans were made; to payments of amounts previously paid by the lender pursuant to the split-dollar life insurance arrangement that were not reasonably expected to be repaid; and to any other payment with respect to a split-dollar life insurance arrangement. Payments to which the payment ordering rule applies are limited to those that are made to or for the benefit of the lender [Reg. §1.7872-15(k)].
Special rules apply for split-dollar loans that provide for certain variable rates of interest; contingent interest payments; lender or borrower options; and below-market split-dollar loans with indirect participants.
Certain revenue rulings that have provided split-dollar guidance for taxpayers in the past have been declared obsolete by the IRS, with important limitations [Rev. Rul. 2003-105, 2003-40 I.R.B. 1].
The obsolete rulings are:
Rev. Rul. 64-328, 1964-2 C.B. 11;
Rev. Rul. 66-110, 1966-1 C.B. 12 (except as provided in Section III, paragraph 3 of Notice 2002-8, 2002-1 C.B. 398 and Notice 2002-59, 2002-36 I.R.B. 481);
Rev. Rul. 78-420, 1978-2 67; and
Rev. Rul. 79-50, 1979-1 C.B. 139.
In the case of any split-dollar life insurance arrangement entered into on or before September 17, 2003, taxpayers may continue to rely on these revenue rulings to the extent allowed by the grandfather/safe harbor provisions of Notice 2002-8, but only if the arrangement is not materially modified after September 17, 2003.
The final regulations provide a non-exclusive list of modifications to split-dollar arrangements that will not be deemed "material." Thus, these changes can be made without subjecting a pre-Sept. 18, 2003 arrangement to the final regulations:
A change solely in the mode of premium payment (e.g., from monthly to quarterly payments);
A change solely in the beneficiary of the life insurance contract, unless the beneficiary is a party to the arrangement;
A change solely in the interest rate payable under the life insurance contract on a policy loan;
A change solely necessary to preserve the tax status of the life insurance contract under IRC §7702;
A change solely to the ministerial provisions of the life insurance contract (e.g., a change in the address to send payment);
A change made solely under the terms of any agreement (other than the life insurance contract) that is a part of the split-dollar arrangement if the change is non-discretionary by the parties and is made pursuant to a binding commitment (whether set forth in the agreement or otherwise) in effect on or before Sept. 17, 2003;
A change solely in the owner of the life insurance contract as a result of a transaction to which IRC §381(a) applies (relating to corporate acquisitions) and in which substantially all of the former owner's assets are transferred to the new owner of the policy;
A change to the policy solely if such change is required by a court or a state insurance commissioner as a result of the insolvency of the insurance company that issued the policy; or
A change solely in the insurance company that administers the policy as a result of an assumption reinsurance transaction between the issuing insurance company and the new insurance company to which the owner and the non-owner were not a party.
In August 2002, the Treasury Department released Notice 2002-59 for the purpose of halting "an abusive tax avoidance transaction using split-dollar life insurance." Notice 2002-59 appears to be directed primarily at private split dollar and reverse split dollar, but it could potentially reach any split-dollar arrangement that, in the opinion of Treasury and IRS, seeks to avoid taxation by using (1) unjustifiably high term insurance rates to value current life insurance protection, (2) the prepayment of premiums, or (3) any other technique that is deemed to undervalue the true economic benefits of the arrangement for federal income tax, employment tax, or gift tax purposes.
Although P.S. 58 rates have seldom been used in compensatory split-dollar arrangements to value the current life insurance protection, they have frequently been used in reverse split-dollar and private split-dollar arrangements to magnify the portion of the premium paid by the employer or donor.
Consider a situation in which the donor pays the premiums on a policy that funds a private split-dollar arrangement between the donor and a trust. The beneficiaries of the trust are family members of the donor. Under the terms of the split-dollar agreement, the donor agrees to pay annually the greater of the P.S. 58 cost or the insurer's one-year term rate, and the donor enjoys the death benefit protection. Thus, the donor transfers annually to the trust more than the premium required to maintain the insurance policy, simply by paying P.S. 58 costs. Suppose further that the split-dollar agreement terminates after a few years, the donor's rights in the death benefit end, and the insurance protection passes to the trust beneficiaries. The arrangement served as a way to transfer wealth to the trust beneficiaries.
Notice 2002-59 says that this kind of technique is not permitted by any published guidance. A party to a split-dollar arrangement may use Table 2001 or the insurer's published term rates only for the purpose of valuing the current life insurance protection conferred by one party on another. If the trust (i.e., its beneficiaries) enjoyed the current life insurance protection in the preceding example, rather than the donor, Table 2001 rates or insurer term rates could have been used.
Internal Revenue Code Section 409A was added by the American Jobs Creation Act of 2004 and generally provides that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Section 409A is discussed at length under “Executive Compensation: Deferred Compensation Arrangements”. Click here to jump to that section.
The issue with respect to split-dollar arrangements was whether Section 409A would apply to them. Traditionally, split-dollar arrangements were not considered to be arrangements that deferred the receipt of compensation. The IRS provided clarification of the matter in its Notice 2007-34, which provides guidance regarding the application of IRC §409A to split-dollar life insurance arrangements. The balance of this section discusses Notice 2007-34.
Background: To the extent that certain types of split-dollar arrangements provide for the deferral of compensation within the meaning of IRC §409A, the requirements of IRC §409A would apply to them. However, death benefit-only arrangements and arrangements providing for short-term deferrals of compensation are not subject to IRC §409A. As a general rule, split-dollar arrangements subject to taxation under Treas. Regs. §1.61-22 (the "economic benefit regim") provide for a deferral of compensation that is subject to IRC §409A, while those arrangements subject to taxation under Treas. Regs. §1.7872-15 (the "loan regime") do not provide for a deferral of compensation and, thus, are not subject to IRC §409A.
Section 409A Grandfathered Amounts: IRC §409A is not effective with respect to amounts deferred in taxable years beginning before January 1, 2005, unless the plan under which the amount deferred was made is materially modified after October 3, 2004. IRC §409A is also not effective with respect to earnings on grandfathered benefits. If a split-dollar arrangement that is subject to taxation under Treas. Regs. §1.61-22 was implemented prior to January 1, 2005, the earnings on such arrangement prior to January 1, 2005 are grandfathered, while those accruing thereafter are subject to taxation under IRC §409A. Where benefits under a split-dollar life insurance arrangement have a component that is a §409A grandfathered benefit and a component that is a §409A non-grandfathered benefit, the calculation of the §409A grandfathered component of the benefit may be made under any reasonable method that allocates increases in policy cash value attributable to the §409A grandfathered benefit. For this purpose, a method will not be treated as reasonable if it allocates a disproportionate amount of policy costs and expenses to the §409A non-grandfathered component.
Split-Dollar Life Insurance Arrangements Subject to Treas. Regs. §1.61-22 ("Economic Benefit Regime"): This type of split-dollar arrangement generally provides for deferred compensation taxable under the §409A rules if, under the terms of the arrangement and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year of the service provider to compensation that, pursuant to the terms of the arrangement, is or may be includible in the income of the service provider in a later taxable year of the service provider. For this purpose, the right to compensation that is described in Treas. Regs. §1.61-22(d)(2)(i) and (3) as the cost of current life insurance protection is treated as provided under a death benefit plan and is not deferred compensation for purposes of §IRC §409A. Thus, a service provider (i.e., employee) will not be taxed under the §409A rules on the current cost of life insurance protection under the split-dollar arrangement. If, however, under the split-dollar arrangement and under the relevant facts and circumstances, the service provider has a legally binding right during the taxable year to economic benefits (e.g., policy cash values) to which the service provider has current access or that are payable in a later taxable year, the service provider will be subject to tax under the §409A rules.
Split-Dollar Life Insurance Arrangements Subject to Treas. Regs. §1.7872-15 ("Loan Regime"): These types of split-dollar arrangements generally will not give rise to deferrals of compensation subject to the §409A rules.
Grandfathered Split-Dollar Arrangements: A split-dollar life insurance arrangement that is not grandfathered under §409A, but that is grandfathered under Treas. Regs. §1.61-22 (i.e., not subject to the new split-dollar regulations unless materially modified), is subject to the §409A rules if, under the terms of the arrangement and the relevant facts and circumstances, the service provider (i.e., employee) has a legally binding right during a tax year to compensation that is payable to the service provider in a later tax year, such as upon termination of employment. However, if modifications are made to a split-dollar life insurance arrangement to bring it into compliance with the §409A rules or to avoid application of §409A, the IRS will not treat the modifications as being material for purposes of voiding the arrangement’s grandfathered status under Treas. Regs. §1.61-22. Notice 2007-34 provides an extensive list of changes that can be made without triggering a material modification for purposes of Treas. Regs. §1.61-22.
An imputed transfer under the split-dollar loan regime that is treated as an imputed transfer of compensation will have consequences under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA) if the adjustment represents wages to the borrower. In response to questions regarding the consequences of an imputed transfer for employment and self-employment tax purposes, the final Treasury regulations on split dollar clarified the regulations under IRC §§1402(a), 3121(a), 3231(e), and 3306(b) to refer to Reg. §1.7872-15 (the loan regime) as well as Reg. §1.61-22 (the economic benefit regime).
The final Treasury regulations apply for federal gift tax purposes, including private split-dollar life insurance arrangements.
Thus, if an irrevocable life insurance trust is the owner of the life insurance contract underlying the split-dollar life insurance arrangement, and a reasonable person would expect that the donor, or the donor's estate, will recover an amount equal to the donor's premium payments, those premium payments are treated as loans made by the donor to the trust and are subject to the loan regime. In such a case, payment of a premium by the donor is treated as a split-dollar loan to the trust in the amount of the premium payment. If the loan is repayable upon the death of the donor, the term of the loan is the donor's life expectancy determined under the appropriate table under Reg. §1.72-9 as of the date of the payment and the value of the gift is the amount of the premium payment less the present value (determined under IRC §7872 and Reg. §1.7872-15) of the donor's right to receive repayment.
If the donor is treated under Reg. §1.61-22(c) as the owner of the life insurance contract underlying the split-dollar life insurance arrangement, the donor is treated as making a gift to the trust. The value of the gift is the value of the economic benefits provided to the trust, less the amount of any premium paid by the trustee. For example, assume that under the terms of the split-dollar life insurance arrangement, on termination of the arrangement or the donor's death, the donor or donor's estate is entitled to receive an amount equal to the greater of the aggregate premiums paid by the donor or the cash surrender value of the contract. In this case, the donor makes a gift to the trust equal to the cost of the current life insurance protection provided to the trust, less any premium amount paid by the trustee. Thus, a payment by the donor will not constitute a gift if the trust pays the portion of the premium equal to the cost of the current life insurance protection and the donor pays the balance of the premium.
On the other hand, if the donor or the donor's estate is entitled to receive an amount equal to the lesser of the aggregate premiums paid by the donor, or the cash surrender value of the contract, the amount of the economic benefits provided to the trust by the donor equals the cost of any current life insurance protection provided to the trust, the amount of policy cash value to which the trust has current access (to the extent that such amount was not actually taken into account for a prior taxable year), and the value of any other economic benefits provided to the trust (to the extent not actually taken into account for a prior taxable year). The value of the donor's gift of economic benefits equals the value of those economic benefits provided to the trust for the year minus the amount of premiums paid by the trustee.
The final regulations treat the donor as the owner of a life insurance contract where the donee is named as the policy owner if, under the split-dollar life insurance arrangement, the only economic benefit provided to the donee by the donor under the arrangement is the value of current life insurance protection. Any amount paid by a donee, directly or indirectly, to the donor for such current life insurance protection would generally be included in the donor's gross income.
Where the donor is the owner of the life insurance contract that is part of the split-dollar life insurance arrangement, amounts received by the irrevocable insurance trust (either directly or indirectly) under the contract (e.g., as a policy owner dividend or proceeds of a specified policy loan) are treated as gifts by the donor to the irrevocable insurance trust as provided in Reg. §1.61-22(e). The donor must also treat as a gift to the trust the amount set forth in Reg. §1.61-22(g) upon the transfer of the life insurance contract (or undivided interest therein) from the donor to the trust.
The federal gift tax consequences of the transfer of an interest in a life insurance contract to a third party will continue to be determined under established gift tax principles, notwithstanding who is treated as the owner of the life insurance contract under the final regulations [see, e.g., Rev. Rul. 81-198, 1981-2 C.B. 188].
For federal estate tax purposes, regardless of who is treated as the owner of a life insurance contract under the final split-dollar regulations, the inclusion of the death proceeds of a split-dollar life insurance arrangement in a decedent's gross estate will continue to be determined under IRC §2042. Thus, the death proceeds will be included in the decedent's gross estate under IRC §2042(1) if receivable by the decedent's executor, or under IRC §2042(2) if the death proceeds are receivable by a beneficiary other than the decedent's estate, and the decedent possessed any incidents of ownership with respect to the policy.
In a split-dollar arrangement, death proceeds payable to the employee's personal beneficiary are generally includible in the employee's gross estate for federal estate tax purposes. Regardless of the nominal ownership of the policy, the employee usually has the right to designate the beneficiary of his or her portion of the death proceeds, and perhaps other incidents of ownership as well.
If the endorsement method was used for the split-dollar arrangement, the employee could rid himself of incidents of ownership by irrevocably assigning all policy rights to a third party. However, if the employee is a controlling (more than 50%) shareholder, this may not work. In this situation, the corporation's incidents of ownership in the policy will be attributed to the controlling shareholder [Reg. §20.2042-1(c) (6)]. So, even though the controlling shareholder-employee assigns all direct incidents of ownership, he or she is still treated as having indirect incidents of ownership.
Another risk is that an employee may die within three years of the assignment. The assignment of the policy rights would become a transfer within three years of death, bringing the death proceeds into the gross estate [IRC §2035(a)].
Of course, if the death proceeds are payable to the employee's surviving spouse, the marital deduction will shelter them from the federal estate tax. But there could be an estate tax problem at the spouse's later death.
The employee's direct incidents of ownership under the regular collateral assignment method cause the employee portion of the death proceeds to be includible in the gross estate.
If the employee's irrevocable trust or another third party is the policy owner, the employee will hold no direct incidents of ownership. However, the employer's security interest under the collateral assignment could be viewed by the IRS as creating indirect incidents of ownership for a controlling shareholder.
For this reason, a "restricted" or "limited" collateral assignment has been used to avoid attribution of the employer's incidents of ownership to a controlling shareholder. Here, the employer's rights as collateral assignee do not include the right to borrow the policy's cash value or any other right or power that would be deemed an incident of ownership potentially attributable to the employee.
It appears that the ownership attribution rules (discussed earlier) in the final regulations are used only to determine policy ownership for federal income tax purposes, and that incidents of ownership will continue to be the pertinent test for federal estate tax purposes.
In the final split-dollar regulations, the IRS and Treasury declined to address the extent to which a decedent's interest in a co-owned policy is included in that decedent's gross estate under IRC §2042. They indicated that the subject may be addressed in future guidance.
Split-dollar arrangements generally fall within the meaning of "welfare benefit plans" subject to ERISA. However, unfunded welfare benefit plans are exempt from the disclosure, participation, vesting, funding and plan termination insurance provisions of ERISA Title I. The Department of Labor takes the position that a plan is "unfunded" if the general creditors of the employer can reach the plan assets. Further, arrangements that cover only a select group of executives or other highly compensated employees, or that cover less than 100 participants, are generally exempt from ERISA's reporting and disclosure requirements. Even so, summary plan descriptions can be a valuable employee communication tool, and an employer may choose to provide them to split-dollar participants although the arrangement is exempt from ERISA Title I.
A split-dollar arrangement should have a named fiduciary, a method spelled out for funding and making payouts, and a claims procedure.
A federal law enacted in 1999 disallowed federal income tax deductions for contributions made to charity under "personal benefit contracts" in which there is a payment, or expectation of a payment, of premiums on any life insurance, endowment, or annuity contract that directly or indirectly benefits the donor, his family, or other related entities. This law was designed to eliminate so-called "charitable split dollar," and followed similar regulatory action by the IRS.
Under the typical charitable split-dollar arrangement, the taxpayer created an irrevocable life insurance trust that applied for a policy on the taxpayer's life. The trustee entered into a separate split-dollar agreement with a charity which specified the proportions in which the premiums and death proceeds would be shared. The trustee designated as beneficiaries of the policy both the charity and members of the taxpayer's family, as called for in the split-dollar agreement.
The donor gave cash or property to the charity each year with the understanding that the charity would use such assets to pay its share of the premiums. The advertised benefit of this arrangement—before the IRS and then Congress lowered the boom—was that the donor's annual transfers to charity were deductible as charitable contributions, even though the donor's family personally benefited.
The new law also imposes an excise tax on charities participating in such arrangements. The tax is levied in the amount of any premium payments; in other words, a 100% tax. Charities are required by the law to report annually all such payments.
Further, the IRS has indicated that a charity's federal income tax exemption could be jeopardized by participating in charitable split dollar since it is deemed to be providing a private benefit rather than carrying out its charitable purposes.
Revenue rulings marked with an asterisk (*) have been revoked except to the extent they provide guidance for split-dollar arrangements grandfathered under IRS Notice 2002-8.
Reg. §1.409A
IRC §§264(a)(1), 163(h)
IRC §101(a), 101(j), 6039I
Rev. Rul. 64-328, 1964-2 C.B. 11*
Reg. §1.61-22(d)-(g) (economic benefit regime)
Reg. §1.7872-15 (loan regime)
IRS Notice 2002-8, 2002-1 C.B. 398
Burnet v. Wells, 289 U.S. 670 (1933)
Sercl v. U.S., 82-2 USTC ¶9528 (8th Cir. 1982)
Genshaft v. Comm'r, 64 T.C. 282 (1975)
Johnson v. Comm'r, 74 T.C. 1316 (1980)
Bagley v. U.S., 30 AFTR2d ¶72-5054 (D.C. Minn. 1972)
Healey v. U.S., 843 F.Supp. 562 (D.C.S.D. 1994)
Rev. Rul. 64-328, 1964-2 C.B. 11*
Rev. Rul. 66-110, 1966-1 C.B. 12*
Rev. Rul. 67-154, 1967-1 C.B. 11
Rev. Rul. 78-420, 1978-2 C.B. 67*
Rev. Rul. 79-50, 1979-1 C.B. 138*
T.A.M. 9452004
T.A.M. 9604001
T.A.M. 9918060
Ltr. Rul. 8547006
Ltr. Rul. 7832012
IRC §72(e)
Reg. §1.72-11(c)
Reg. §1.61-22(d)-(g)
Reg. §1.7872-15
IRS Notice 2002-8, 2002-1 C.B. 398
Rev. Rul. 78-420, 1978-2 C.B. 67*
Rev. Rul. 81-198, 1981-2 C.B. 188
Ltr. Rul. 9636033
IRC §2042
Reg. §20-2042-1(c)(6) (controlling shareholder situation)
Estate of Milton Levy v. Comm'r, 70 T.C. 873 (1978)
Schwager v. Comm'r, 64 T.C. 781 (1975)
Estate of Alfred Dimen v. Comm'r, 72 T.C. 198 (1979)
Estate of Howard Carlstrom v. Comm'r, 76 T.C. 142 (1981), IRS acq. 1981-2 C.B. 1
Estate of James Tomerlin v. Comm'r, T.C. Memo 1986-147
Estate of Gordon Thompson v. Comm'r, T.C. Memo 1981-200
Rev. Rul. 76-274, 1976-2 C.B. 278
Rev. Rul. 79-429, 1979-2 C.B. 321
Rev. Rul. 79-129, 1979-1 C.B. 306
Rev. Rul. 82-145, 1982-2 C.B. 213
Ltr. Rul. 9026041
Ltr. Rul. 9348009
Ltr. Rul. 9511046
Ltr. Rul. 9636033
Ltr. Rul. 7916029
Ltr. Rul. 8310027
Reg. §1.61-22(d)-(g)
Reg. §1.7872-15
IRS Notice 2002-8, 2002-1 C.B. 398
Reg. §1.61-22(d)-(g)
Reg. §1.7872-15
Ltr. Rul. 9636033
Ltr. Rul. 9745019
Ltr. Rul. 200910002
Copyright 
2016, Pentera Group, Inc., 921 East 86th Street, Suite 100, Indianapolis, Indiana 46240. All rights reserved.
This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any of its licensees or their distributees intend to, or are engaged in, rendering legal, accounting, or tax advice. If legal or tax advice or other expert assistance is required, the services of a competent professional should be sought.
While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use of or reliance upon this service.
Click here for additional information on undivided interests.