IRS Revising Rules for Split-Dollar Insurance

On Jan. 10, 2001, the IRS released Notice 2001-10, indicating that it is (1) reviewing the tax treatment of "split-dollar" life insurance arrangements, (2) "clarifying" prior rulings on split-dollar arrangements, (3) providing "interim guidance" and (4) requesting comments. The Service has definitely "fired a shot across the bow" of split-dollar arrangements.

The notice addresses "split-dollar arrangements between employers and employees," but then goes on to state that these principles "govern the Federal tax treatment of split-dollar arrangements in other contexts, including arrangements that provide compensation to non-employees and economic benefits to corporate shareholders and arrangements involving gifts." Additionally, even though this is an initial notice and the Service has requested comments, it provides interim guidance for all split-dollar arrangements. Commentators have already pointed out several ambiguities and issues that the IRS will need to resolve. However, in the meantime, this guidance should not be underestimated or ignored.

Basically, the notice provides a choice of using either a Sec. 7872 below-market-interest loan method or a Sec. 83 compensation method. Either way, the Service is requiring an em-ployer to account for any and all economic benefits conferred on an em-ployee.

The notice describes the tax treatment alternatives available under these two methods:

• Premiums that an employer pays must be structured as bona fide loans subject to Sec. 7872. This creates imputed income for an employee as compensation, but does not create income under Sec. 83 on the cash value shifted to (and not forfeitable) by the employee. Simply put, the employee would not recognize as annual income the economic benefit of the Table 2001 annual term rates. An inherent danger occurs when the employee does not repay the loan under its terms and therefore would have to recognize additional income.
• If a loan structure is not consistently followed or if a taxpayer chooses a nonloan structure, an employee must include the economic benefit in income and report that income under Sec. 83 on all employer-generated cash values that vest to the employee. The notice provides a new table replacing the P.S. 58 costs for computing this benefit.
• If an employer pays a premium without a reasonable expectation of receiving repayment, the entire premium would be treated as compensation to the employee.

The "Background" section of the notice discusses IRS attempts to define split-dollar arrangements. Basically, Rev. Rul. 64-328 has been the cornerstone for defining split-dollar arrangements. It held that an employee's gross income in any year includes the value of life insurance protection provided to him in that year, less any amount actually paid by the employee—the so-called "P.S. 58" costs. Rev. Rul. 64-328 revoked Rev. Rul. 55-713, which had treated the split-dollar arrangement as a secured loan from an employer to an employee, but retained the P.S. 58 rate tables from Rev. Rul. 55-713.

At the time Rev. Rul. 64-328 was issued, the increase in the sophistication of insurance products was not foreseen. The notice expresses the IRS's concerns with the growth of "equity split-dollar" arrangements under which an employee can derive valuable economic benefits beyond the current life insurance protection addressed in Rev. Rul. 64-328.

The notice also demonstrates the Service's concern that P.S. 58 costs (which are based on mortality tables originally published in 1946) no longer bear an appropriate relationship to current insurance protection. The IRS is particularly concerned with the use of P.S. 58 costs in "reverse split-dollar" arrangements, and states "[t]he use of P.S. 58 rates in this manner significantly overstates the value of the policy benefits allocated to the employer, such that the employee's share of the premiums is significantly lower than the employee's actual share of the policy benefits. No published guidance has authorized reliance on the P.S. 58 rates for this purpose." Many split-dollar arrangements use "insurer's published term rates," which are much lower than P.S. 58 tables and do not truly represent policies actually sold. Consequently, the notice provides a new table (Table 2001) as an interim substitute for the P.S. 58 rates.

For many in-force contracts, the Sec. 83 approach will apply, as few in-force split-dollar arrangements will meet the requirements of the below-market loan provision. For new split-dollar arrangements, taxpayers will need to evaluate and choose between the methods.

In addition to providing guidance on split-dollar arrangements, Notice 2001-10 may prove to be a foot in the door for the IRS to visit more sophisticated insurance/compensation products, especially those that use an "interpolated terminal reserve" calculation to purchase a policy from an employer, often for less than the accumulated cash value.

From Alan J. English, CPA, Phoenix, AZ