Split Dollar Insurance Rules Have Changed: A Deadline Looms
November 2003
Important News
Rules for the taxation of split dollar life insurance arrangements have changed. If you are currently involved in a split dollar arrangement, December 31, 2003 could be a very important deadline for you. If you act before year end, you may be able to avoid the income taxation of any existing equity in a life insurance policy subject to a split dollar arrangement.
Typical Arrangement
Split dollar is an arrangement under which one party (generally the employer or corporation) assists the other party (generally the employee or shareholder) in purchasing and paying for a life insurance policy on the employee or shareholder’s life, while enabling him or her to retain a portion of the life insurance protection. This arrangement is often, but not always, set forth in a written agreement between the two parties.
Equity Plans
Split dollar plans are either “equity” plans or “non-equity” plans. In a typical “equity” split dollar plan, the employer advances premiums for a policy owned by the employee or an irrevocable insurance trust established by the employee. The employee (or trust) has an obligation to reimburse the employer for these premium advances, and this obligation is often secured by means of a collateral assignment of the policy from the employee (or trust) to the employer. In an equity split dollar arrangement, this reimbursement obligation is limited to the lesser of (i) the aggregate payments made by the employer, or (ii) the policy cash value. On termination of the arrangement, the excess of cash value over the premium paid (the equity) belongs to the employee (or trust).
New Rules to Govern
The rules governing the taxation of split dollar arrangements have not been significantly altered for decades. In recent years, however, the IRS has expressed a strong disdain for equity split dollar insurance plans. Now, as a result of IRS Notice 2002-8 (issued in January of 2002) and the Final Regulations (issued September 11, 2003), the treatment of split dollar plans has been drastically changed. Not surprisingly, these changes are not favorable to the insured employee. Under these new rules, split dollar plans have been segregated into three distinct time frames: (i) “Old Plans” which are those created prior to January 28, 2002 (and not materially modified), (ii) “Interim Plans” which are those created after January 28, 2002, but prior to September 17, 2003 (and not materially modified), and (iii) “New Plans” which are those created after September 17, 2003. Subject to some very limited grand fathering rules (discussed below), IRS Notice 2002-8 and the Final Regulations now require the taxation of the policy equity.
Two New Regimes for New Plans
The Final Regulations create two mutually exclusive regimes for the tax treatment of New Plans and materially modified Old or Interim Plans based solely on ownership of the underlying insurance policy subject to the split dollar arrangement. If the employer or corporation is the owner of the policy, then the “Economic Benefit” Regime is applicable. If the employer or corporation is not the owner of the policy, then the “Loan” Regime will govern the treatment of the split dollar arrangement.
Economic Benefit Regime
Under the Economic Benefit Regime, the employee (who is the non-owner of the policy) is taxed on the value of the “current life insurance protection” or the “annual economic benefit” provided by the employer. This taxation of the annual economic benefit has been the state of the law for decades, however, the Final Regulations have changed how this annual economic benefit is to be calculated. As you might guess, this change is not necessarily favorable to the employee. Under the old rules, the annual economic benefit was calculated by reference to the PS 58 Table or, if lower, the insurance carrier’s “published, standard risk, one year term rate.” Under the Final Regulations, these alternate term rates are no longer available.
Perhaps the most significant change under the Economic Benefit Regime is the taxation of policy equity on an annual basis. Under the Final Regulations, the employee will be taxed on the annual increase in policy equity if the employee has “current access” to the equity. Current access includes, but is not limited to, the ability of the employee to borrow or withdraw from the policy or effect a policy surrender. These new rules apply to arrangements put in place on or after September 17, 2003.
Loan Regime
Under the Loan Regime, the employer or corporation’s premium advances will be treated as a series of loans to the employee. If the loan arrangement does not provide for “adequate interest,” then the arrangement will be taxed as a below market loan to the employee. Under the below market loan rules, the employer or corporation is deemed to have paid the employee an amount equal to the “foregone interest” and the employee is deemed to have repaid a like amount to the employer as interest. From the employee’s perspective, the amount of the foregone interest taxable as compensation will likely be significantly greater than the amount the employee would have previously recognized as income under the old split dollar rules.
And Now the Good News – Limited Grandfathering Still Available
Despite the fact that equity split dollar plans appear to have been restricted on a going-forward basis, there still is a chance to protect the equity in any Old Plans if certain actions are taken by December 31, 2003. IRS Notice 2002-8 provides certain safe harbors to Old Plans. If an Old Plan is either rolled-out (terminated) or converted to a loan by the end of this year, the pre January 1, 2004 equity will not be taxed. This will be extremely important for existing split dollar plans with substantial equity.
Your Plan Must Be Reviewed Now!
First, you need to determine how these new rules impact your existing split dollar arrangement. Then, if applicable, in order to determine accurately the degree of policy equity that exists and therefore the wisdom of taking any actions, you will need to get the financial details of the policy from the insurer. Because the December 31, 2003, safe harbor deadline is fast approaching, you need to consult with your tax and legal advisors to review the relevant documentation and reach an informed decision.