Split-Dollar Life Insurance Alert!

by Brian T. Whitlock, J.D., LL.M., CPA, Member, AICPA Tax Division's Trust, Estate, and Gift Tax Technical Resource Panel, and Howard Vogel, J.D., CPA, both of Blackman Kallick Bartelstein, LLP, Chicago, IL
 

Split-dollar life insurance arrangements have been excellent vehicles for small and large corporations. Small corporations have frequently paid a portion of the premiums for shareholders and, thus, helped them to leverage gifts. Large corporations have used split-dollar arrangements to provide key employees with nonqualified deferred compensation benefits in excess of the qualified plan limits.

Two major changesone legislative and the other regulatorypropose to change the use of split-dollar arrangements. First, under Section 402 of the Sarbanes-Oxley Act of 2002 (SOA), public companies are prohibited from making (directly or indirectly) extensions of credit in the form of personal loans to their officers and directors. This will likely eliminate the use of split-dollar life insurance arrangements for such companies key employees.

Second, proposed regulations (REG-164754-01) govern the future Federal income, employment and gift tax implications of split-dollar arrangements. The proposed regulations reverse over 35 years of tax history; however, unlike the SOA, the IRS will allow small businesses to continue to use all split-dollar arrangements. Although caution is warranted, the proposed regulations also allow existing split-dollar plans to make an election that could save future taxes. Tax advisers should review client split-dollar arrangements to determine if their clients could benefit by making the election before 2004.

Background

A split-dollar insurance arrangement is defined by Prop. Regs. Sec. 1.61-22(b)(1) as any arrangement (not part of a Sec. 79 group term life insurance plan) 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 typical split-dollar arrangement occurs between an employer and an employee. The most common type is collateral-assignment split dollar, in which the insured (or an irrevocable trust for his or her familys benefit) owns the policy, while the insureds employer pays some or all of the premiums. On the insureds death, the employer is repaid its premiums; the beneficiary receives the balance of the proceeds. Under current law, the insured employee is only taxed annually on the one-year term value of the life insurance (the lower of the Table 2001 cost or the insurers term rate). (For a general discussion, see English, Tax Clinic, IRS Again Revises Split-Dollar Insurance Rates, TTA, April 2002.)

The Rollout

The split-dollar arrangement is basically a financing plan for the purchase of life insurance, and usually contains an exit strategy (i.e., at some point, the insured will take over the policy and pay off the party that has advanced the premiums). The event that transfers the policy to the insured is a rollout. Currently, there are no tax consequences when the insured takes over the policy, if the premiums are repaid to the employer. If the policy is transferred to the insured without a premium repayment, he or she will recognize income equal to the premiums paid (without interest). In either event, no income is recognized currently on the cash value of the policy in excess of the premiums paid, if the rollout occurs before 2004.

Income Tax Changes

Beginning in 2004, if a split-dollar arrangement continues in its present form, the income tax consequences of a rollout could become severe. Although the IRS has not taken an official position on this issue for split-dollar arrangements entered into before final regulations are issued, the insured could be taxed on the policys excess cash-surrender value, which could be substantial. (The proposed regulations do not alter the taxation of premiums that are not reimbursed.)

The Election

The IRS is allowing taxpayers to change the future tax exposure of the cash-surrender value in excess of premiums, if they terminate the split-dollar arrangement before 2004 or treat the premiums paid as a loan to the insured. If the insured either terminates the arrangement or converts to this loan regime before 2004 and reports loan interest annually starting in 2004 (as opposed to reporting the term premium), he or she will not be taxed on the policys cash-surrender value on a rollout.

Example: X Corp. owns two $1 million split-dollar policies, covering employees A and B. In 2003, the policy on A is converted to a loan regime. In 2004, A and B are each age 50; the applicable Federal rate is 4%. In January 2005, each policy is rolled out; each employee repays the premiums to X. The premiums paid on each policy were $80,000 as of 2004 and the rollout date. Each policys cash-surrender value is $200,000.

The tax consequences are as follows: In 2004, A reports $3,200 of interest income ($80,000 4%); B reports $9,022, based on the P.S. 58 tables. In 2005, A reports zero income on the rollout; B takes the risk that the IRS may include $120,000 in his gross income (the cash value in excess of the premiums repaid).

All Aboard?

The SOAs full effect will not be known for many years. Nonetheless, commentators speculate that the loan restrictions on public companies will prohibit such companies from entering into (or continuing) split-dollar arrangements with directors and high-level officers.

The proposed regulations will continue; final regulations are not expected until later this fall, leaving taxpayers a very small window of opportunity to elect to convert to the loan regime. Prudent tax advisers should notify clients to review their split-dollar arrangement policies, request an in-force ledger from their insurance carriers showing the cash value relative to the premiums paid, measure their risks and explore their choices. The best time to roll out a policy may be right now. Tax advisers are warnedthe train will leave the station on Dec. 31, 2003.