The tax treatment of a split-dollar arrangement depends on when the arrangement is first entered into. Generally, for split-dollar arrangements entered into after September 17, 2003, the taxation of the arrangement is governed by the Final Split-Dollar Regulations that were issued in 2003. Split-dollar arrangements entered into before September 18, 2003, are generally governed by revenue rulings and other guidance issued by the IRS between 1964 and the issuance of the final regulations.
Treatment under Final Split-Dollar Regulations
For split-dollar arrangements entered into or materially modified after September 17, 2003, the tax treatment will be under one of two mutually exclusive regimes: the economic benefit regime—the arrangement will be treated as the life insurance policy owner providing economic benefits to the non-owner, or the loan regime—the arrangement will be treated as the non-owner making loans to the owner. According to the final regulations, a split-dollar arrangement is one between a policy owner and a nonowner where:
- Either party pays all or part of the premiums, with at least one paying party entitled to recover the premiums. Recovery is secured by the policy proceeds.
- The arrangement is in connection with the performance of services, the employer or service recipient pays all or part of the premiums and the employee or service provider has the right to name the beneficiary or has an interest in the policy cash value.
- The arrangement is between a corporation and a shareholder, the corporation pays all or part of the premiums and the shareholder has the right to designate the beneficiary or has a share in the policy cash value.
Economic Benefit Regime Treatment
If the split dollar arrangement is not treated as a loan, the contract’s owner is treated as providing economic benefits to the non-owner. Economic benefit treatment will generally occur in either a non-equity collateral assignment arrangement or an endorsement arrangement. The person named on the policy as the owner is generally considered the owner of the policy.
A non-owner is generally any person (other than the owner) having an interest in the policy (except for a life insurance company acting only as the issuer of the policy). However, a special rule regarding who is treated as the owner applies to certain arrangements:
- an employer or service recipient is treated as the owner of a life insurance contract under a split-dollar life insurance arrangement entered into in connection with the performance of services if, at all times, the only economic benefit provided under the arrangement is current life insurance protection (i.e., the employer is treated as the owner of a nonequity collateral assignment arrangement involving an employee); and
- a donor is treated as the owner of a life insurance contract under a split-dollar life insurance arrangement that is entered into between a donor and a donee (for example, a life insurance trust) if, at all times, the only economic benefit that will be provided under the arrangement is current life insurance protection (i.e., the premium payer is treated as the owner of a private nonequity collateral assignment arrangement).
The non-owner (and the owner for gift and employment tax purposes) must take into account the full value of the economic benefits provided to the non-owner by the owner, reduced by any consideration paid by the non-owner. Depending on the relationship between the owner and the non-owner, the economic benefits may consist of compensation income, a dividend, a gift, or some other transfer under the tax code.
The value of the economic benefits is equal to:
- the cost of life insurance protection provided to the non-owner;
- the amount of cash value the non-owner has current access to (to the extent that amounts were not taken into account in previous years); and
- the value of other benefits provided to the non-owner.
The cost of life insurance protection will be determined by a life insurance premium factor put out by the IRS. Presumably, Table 2001 will be used until the IRS issues another table.
Under the economic benefit regime, the non-owner will not receive any investment in the contract with respect to a life insurance policy subject to a split dollar arrangement. Thus, the arrangement provides death benefits only to the non-owner. Premiums paid by the owner will be included in the owner’s investment in the contract. Also, any amount the non-owner pays toward a policy will be included in the income of the owner and increase the owner’s investment in the contract (i.e., contributory arrangements have income tax consequences to the deemed owner of the contract).
Death benefits paid to a beneficiary (other than the owner of the policy) by reason of the death of an insured will be excluded from income to the extent that the amount of the death benefit is allocable to current life insurance protection provided to the non-owner, the cost of which was paid by the non-owner or the benefit of which the non-owner took into account for income tax purposes.
Upon the transfer of the policy to a non-owner, the non-owner is considered to receive generally the cash value of the policy and the value of all other rights in the policy, minus any amounts paid for the policy and any benefits that were previously included in the non-owner’s income. However, amounts that were previously included in income due to the value of current life insurance protection provided to the non-owner may not be used to reduce the amount the non-owner is considered to receive upon roll-out. Thus, the taxation on the value of current life insurance protection will not provide the non-owner with any basis in the policy, while taxation for a previous increase in cash value will add basis for the non-owner.
Loan Regime Treatment
If the arrangement is not an economic benefit arrangement, that is if the owner is not the premium payer, then it is a split-dollar loan arrangement. A split-dollar loan will be found in the following four situations:
- where an owner and non-owner are treated, respectively, as borrower and lender;
- premium payments are made directly or indirectly by the non-owner (lender);
- it appears to be a loan under Federal tax law or a reasonable person would expect repayment in full; and
- repayment is secured by the policy’s death benefit or cash value or both.
If the split-dollar arrangement is treated as a loan, the owner is considered the borrower, and the non-owner is considered the lender. For example, in a split-dollar loan arrangement between an employer and employee, the lender would be employer and the borrower the employee. If the split-dollar loan is a below market loan, then interest will be imputed at the Applicable Federal Rate (AFR), with the owner and the non-owner of the policy considered to transfer imputed amounts to each other. Each payment under the split-dollar arrangement will be treated as a separate loan.
The employer is considered to transfer the imputed interest to the employee. This amount is considered taxable compensation, and generally will be deductible to the employer (however, no deduction will be allowed in a corporation-shareholder arrangement). The employee is then treated as paying the imputed interest back to the employer, which will be taxable income to the employer. This imputed interest payment by the employee will generally be considered personal interest and therefore not deductible.
The calculation of the amount of imputed interest differs depending on the type of below market loan involved. A below market loan is either a demand loan or a term loan. A demand loan is a loan that is payable in full upon the demand of the lender. A split-dollar demand loan is tested each calendar year for sufficient interest. The AFR rate used for demand loans is the blended annual rate. All other below market loans are term loans. (A term loan is where repayment is fixed at some point in the future). A split-dollar term loan is tested on the date the loan is made for sufficient interest. The AFR rate for term loans depends upon the length of the term loan:
- the short-term rate is used for loans that mature in three years or less;
- the mid-term rate is used for loans that mature in more than three years, but not more than nine years;
- the long-term rate is used for loans that mature in more than nine years.
Generally, a split-dollar term loan will cause more interest to be imputed in the early years of the arrangement, with the amount of imputed interest decreasing each year. In a split-dollar demand loan, the imputed interest will be smaller in the early years of the arrangement, but will increase each year the arrangement is in place.
Effective Date of Regulations
These regulations apply to split-dollar arrangements entered into after September 17, 2003, and arrangements entered into on or before September 17, 2003, that are materially modified after September 17, 2003. The final regulations provide a non-exclusive list of changes that will not be considered material modifications. This list includes:
- a change solely in premium payment method (for example, from monthly to quarterly);
- a change solely of beneficiary, unless the beneficiary is a party to the arrangement;
- a change solely in the interest rate payable on a policy loan;
- a change solely necessary to preserve the status of the life insurance contract under Code section 7702;
- a change solely to the ministerial provisions of the life insurance contract (such as a change in the address to send premiums); and
- a change made solely under the terms of the split dollar agreement (other than the life insurance contract) if the change:
- is dictated by the arrangement;
- is nondiscretionary to the parties; and
- was made under a binding commitment in effect on or before September 17, 2003.
Notably, an exchange of policies under Code section 1035 is not on the list of nonmaterial modifications, even though the authors are aware that comments were submitted to the IRS prior to the issuance of the final split-dollar regulations requesting that 1035 exchanges not be considered a material modification.
The final regulations also contain rules on when a split-dollar arrangement is considered to be entered into. A split-dollar arrangement is entered into on the latest of the following dates:
- the date the life insurance contract is issued;
- the effective date of the life insurance contract under the arrangement;
- the date the first premium on the life insurance contract is paid;
- the date the parties to the arrangement enter into an agreement with regard to the policy; or
- the date on which the arrangement satisfies the definition of a split-dollar life insurance arrangement.
The only arrangements excluded from the definition of split-dollar are group term life insurance plans under Code section 79 (other than those providing permanent protection to the employee), the purchase of life insurance between the policy owner and the life insurance company issuing the policy, and key person insurance where the corporation owns all of the rights in the policy. In addition, any plan under which there is no expectation of reimbursing the party advancing the premiums is not a split-dollar plan. In such situations, the premium payments will be treated as taxable income, a dividend, or a gift, depending on the relationship between the parties.
Split-Dollar Prior to Regulations
Split-dollar arrangements that were entered into before September 18, 2003, are governed by various rulings and other guidance that have been issued by the IRS between 1964 and the issuance of final regulations on split-dollar arrangements in 2003. This guidance includes Notice 2002-8,16 which provides transition rules for arrangements not subject to the split-dollar regulations and is primarily focused on equity collateral assignment arrangements. However, no inference is to be drawn from Notice 2002-8, or the proposed or final regulations regarding the appropriate tax treatment of split-dollar arrangements entered into before September 18, 2003.
Value of Economic Benefit and Tax Implications
For collateral assignment and endorsement split-dollar arrangements, the party receiving the death benefit protection is taxed on the value of the Reportable Economic Benefit (REB) he or she receives from participating in the split-dollar arrangement (unless he or she pays a portion of the premium at least equal to this amount).17 The REB cost may be calculated by using government premium rates. For many years, P.S. 58 rates were used to calculate the value of the protection. However, the IRS revoked the use of P.S. 58 rates and provided new Table 2001 rates. P.S. 58 rates may generally be used prior to 2002; Table 2001 rates may generally be used starting in 2001. Notice 2002-8 does provide for some grandfathering of P.S. 58 rates. For split-dollar arrangements entered into before January 28, 2002, in which a contractual agreement between an employer and employee provides that P.S. 58 rates will be used to determine the value of current life insurance protection provided to the employee (or the employee and one or more additional persons), the employer and employee may continue to use P.S. 58 rates.
If the insurer publishes rates for individual, initial issue, one-year term policies (available to all standard risks), and these rates are lower than the P.S. 58 or Table 2001 rates (as applicable), these insurer rates may be substituted. Only standard rates may be substituted, not preferred rates (e.g., those offered to nonsmoking individuals). The substituted rate must be a rate charged for initial issue insurance and must be available to all standard risks.
For arrangements entered into before September 18, 2003, taxpayers may use the insurer’s lower published premium rates that are available to all standard risks for initial issue one-year term insurance. However, for arrangements entered into after January 28, 2002, and before September 18, 2003, for periods after December 31, 2003, an insurer’s rates may not be used unless: (1) the insurer generally makes the availability of the rates known to those who apply for term insurance coverage from the insurer; and (2) the insurer regularly sells term insurance at those rates to individuals who apply for term insurance coverage through the insurer’s normal distribution channels.
These more stringent requirements for an insurer’s alternative term rates were contained in Notice 2002-8. In the authors’ opinion it will be very difficult for an insurer’s alternative term rates to meet the regularly sold requirement. This is due to the fact that in order to make these rates less expensive than the currently available government table rates (i.e., the Table 2001 rates), insurer’s typically make their one-year term products noncommissionable and nonrenewable. This begs the question of how they can be regularly sold if few producers are interested in selling them (because they won’t be paid a commission) and few insureds are interested in buying them (because they have to undergo medical underwriting each year to requalify). For split-dollar arrangements entered into after January 28, 2002 (or materially modified after that date), before using an insurer’s alternative term rates to calculate the REB cost, it is strongly suggested that an inquiry be made as to how many of the one-year term policies the insurer has actually sold so that the client’s tax advisor can determine whether such rates qualify as regularly sold.
There are no rulings on the amount of economic benefit to be included when the employee has not had a full year’s benefit under a policy (e.g., the policy was purchased on September 1 for a calendar year employee). It would seem that the IRS would accept any reasonable attempt at allocating the cost in such a year. Also, there has been no formal guidance from the IRS as to which rates should be used to measure the economic benefit resulting from a split-dollar arrangement using a policy which insures more than one life. The IRS has said that taxpayers should make appropriate adjustments to premium rates if life insurance protection covers more than one life. Where the policy death benefit is payable at the second death, it is generally believed that following the first death, the Table 2001 or P.S. 58 rates for single lives should be used to measure the survivor’s economic benefit.
The REB cost, regardless of whether the government’s table rates or an insurer’s alternative term rates are used, get more expensive as the insured gets older, and may become prohibitively expensive once the insured lives past age seventy. Although the REB cost for second-to-die arrangements may be very inexpensive while both insureds are alive, even at older ages, upon the first death single life rates apply and the REB cost can skyrocket. As a result of the increasing REB cost, split-dollar arrangements tend to be good short- and mid-term plans, but not particularly attractive long-term plans. For this reason, an exit or rollout strategy is generally recommended prior to the point where the REB costs become too expensive from and income and/or gift tax standpoint (see discussion of rollout strategies in the Frequently Asked Questions below).
Private Split-Dollar Plans and Tax Implications
The use of private split-dollar life insurance has grown substantially as a result of favorable rulings. It appears that private non-equity collateral assignment split-dollar remains viable (as well a private loan arrangements), but the issues in the new Regulations related to the income-tax compensation measures (discussed above) should be applicable to the gift-tax treatment of private equity collateral assignment split-dollar. Thus, agreements entered into before January 28, 2002 would be unchanged. In fact, existing agreements using the P.S. 58 table rates could potentially be enhanced by switching to the Table 2001 rates. One advantage of private split-dollar is the smaller gift-tax cost associated with the transfer of the premium for the pure term insurance protection. The Table 2001 rates would create a lower gift-tax cost for entering into a split-dollar agreement with the insured’s irrevocable life insurance trust. In fact, survivorship (second-to-die) coverage would result in an extremely low Table 2001 rate.
Estate and Gift Tax Issues and Tax Implications
Many split-dollar arrangements were entered into with the goal of avoiding inclusion of the proceeds in the insured’s gross estate while at the same time limiting the gift tax consequences of the premium payments to just the REB cost. Under this type of arrangement, the insured’s Irrevocable Life Insurance Trust (ILIT) is the policy owner and a collateral-assignment agreement is formed with the insured’s employer (or the insured, in the case of private split-dollar). If it is an employer pay all (i.e., a noncontributory arrangement), the REB cost is taxable to the employee under the economic-benefit theory. In addition, the REB cost is also treated as gifts by the employee to the trust. Plans entered into prior to January 28, 2002 are grandfathered with respect to the measure of the economic benefit. However, plans entered into after that date would be subject to treatment under Table 2001 rates and the new restrictions with respect to the insurer’s standard term rates. This should not be a significant problem since lower economic-benefit rates result in a smaller income- and gift-tax cost. Again, pre-January 28, 2002 plans using P.S. 58 rates may consider the benefits of shifting to Table 2001 rates.
Loan arrangements (i.e., Loan Regime Split-Dollar) can also be used to accomplish the same estate planning goals. With a loan arrangement that involves an employer and the employee’s ILIT, assuming that the employer pays the entire premium and isn’t paid the loan interest by the trust, the loan interest would be income taxable to the employee and would also be treated as a gift from the employee to the ILIT. In the case of a private loan arrangement, there should be no income tax consequences, but the loan interest if imputed would be treated as a gift.
Some critical issues are presented for the split-dollar and loan arrangements entered into with an insured’s ILIT:
- First, with equity split-dollar agreements if there is a lifetime rollout the equity may create not just adverse income tax issues, but also adverse gift tax issues.
- Second, with both equity and non-equity collateral assignment split-dollar and loan arrangements that involve the insured’s employer or the insured having a collateral interest in the policy to secure the premium payer’s interest in the policy, such collateral interest can cause estate inclusion of the policy in the insured’s estate. In order to avoid this, a restricted collateral assignment should be used whenever the insured is a controlling owner of the employer or is directly the collateral assignee pursuant to a private split-dollar arrangement. A restricted collateral assignment avoids the collateral assignee having incidents of ownership in the policy by limiting the rights of the collateral assignee to being repaid its interest in the event the arrangement is terminated or upon the death of the insured(s). Thus, the collateral assignee would have no right to access the policy cash value.
- Third, demand loan arrangements should be avoided where the arrangement is between the insured or a business controlled by the insured and the insured’s ILIT. Using a demand loan in either of these situations could cause inclusion of the policy in the insured’s estate. This is due to the fact that the right to call the loan could be considered tantamount to the right to force a withdrawal or loan from the policy, which would constitute an incident of ownership in the policy.
Use of Whole Life Dividends and Tax Implications
Generally, dividends paid under participating life insurance contracts are income-tax free because they are considered a return of the policy owner’s capital due to favorable mortality, interest, and loading experience.
But in a split-dollar arrangement, dividends paid to the insured more closely resemble a transfer of capital from the employer to the employee and may be added to any other taxable economic benefit provided by the policy. Generally, the results are as follows:
- If the employee receives the policy dividend in cash, the employee must report ordinary income in that amount and the employer will receive no deduction.
- If the dividend is paid in cash to the employer, the employee has no taxable income and the employer has no taxable income (until amounts received tax-free from the contract exceed the employer’s premiums).
- If the dividend is used to reduce the employee’s share of the premiums, the employee will have taxable income and the employer will receive no deduction.
- If the dividend is used to reduce the employer’s share of the premiums, the employee will have no taxable income and the employer will have no taxable income.
- If the dividend is left on deposit at interest for the employee’s account, both the dividend and the interest on it are taxable income to the employee. The employer receives no deduction.
- If the dividend is left on deposit at interest in the employer’s account, the employee has no taxable income. The dividend is a nontaxable return of capital but any interest is taxable to the employer.
- If the employee owns and controls any paid-up additions (i.e., both the cash value and death benefits), the dividend is taxable to the employee and no deduction is allowable to the employer.
- Where the employer owns and controls the cash value of any paid-up additions but any death benefit in excess of the cash value is controlled by the employee, the employee is charged with the cost of insurance protection from the net amount at risk in the dividends. The employer receives no deduction.
- If the dividend is used to purchase one-year term insurance under the so-called fifth dividend option and the death benefit is payable to the employee, the full amount of the dividend is taxable as ordinary income to the employee. The employer receives no deduction.
- If the dividend is used to purchase one-year term insurance under the so-called fifth dividend option and the death benefit is payable to the employer, the employee receives no taxable income and the employer receives no deduction.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM