IRS Review of Split-Dollar Life Insurance
January 2001
On January 9, 2001, the IRS issued general guidance regarding split-dollar life insurance arrangements (SDAs) for the first time in over three decades. SDAs are a popular way for employers to provide permanent life insurance, supplemental retirement income and estate tax planning opportunities for their employees. Notice 2001-10 proposes to change longstanding tax practices governing the income taxation of SDAs. It is unclear what changes will be adopted in final form. Only interim guidance has been provided for now. Both new and existing SDAs are subject to the interim guidance - Notice 2001-10 does not provide any permanent grandfather exception. The remainder of this "On The Subject" describes SDAs, their uses, prior IRS ruling positions on SDAs, the proposed changes under the Notice and their practical implications for clients.
What is Split-Dollar Life Insurance?
An SDA is a financing technique by which two parties - often an employer and an employee - agree to share obligations and benefits under a permanent life insurance policy. Premiums, death benefits, policy cash value and dividends may be split under the SDA. Either the employer (the endorsement method) or the employee (the collateral assignment method) may own legal title to the policy covered under an SDA.
Traditional Types of SDA
An SDA may split policy obligations and benefits in a variety of ways. The three most common SDAs are Classic SDA, Equity SDA, and Reverse SDA.
Classic SDA
Classic SDA generally requires the employer to pay for a portion of the premium equal to the increase in policy cash value. The employer, in return for paying premiums, retains a right to receive an amount equal to the policy's cash value during the employee's lifetime and at death from policy death proceeds. The employee is then responsible to pay the remaining premium cost, which decreases as the employee grows older and the cash surrender value increases. The employer may provide a bonus to the employee to finance the employee's share of the premium cost. This form of SDA, while prevalent in the 1960s, is used less frequently today.
Equity SDA
Equity SDA, the prevailing form of split-dollar insurance used today, is a variation on Classic SDA. Equity SDA operates in a manner similar to Classic SDA except that the employer's interest in cash value is limited to its premium payments. Death benefits and cash value exceeding premium payments are allocated to the employee. The employee's "equity" under this type of arrangement is the permanent cash value allocated to the employee under the SDA. It is not uncommon for cash values, particularly with modern variable life insurance policies, to exceed premiums in a relatively short period of time, thereby providing a valuable benefit to the employee. It is for this reason that employers often use Equity SDA to provide a source of funds that can be accessed by the employee for retirement benefits.
Reverse SDA
Reverse SDA, as its name implies, reverses the roles of the employer and the employee in a Classic SDA. The employee retains rights to all of the policy's cash value, and the employer pays for its death benefit coverage under a predetermined cost table. In effect, the employer is "renting" death benefit coverage from the employee. The cost table may be either an IRS published table or the insurance company's published annual term rates. The intended advantage of Reverse SDA is that employer payments indirectly will help facilitate accumulations of cash value for the employee's benefit.
Longstanding IRS Split-Dollar Guidance
Revenue Ruling 64-328 addresses the federal income tax treatment of SDAs. The excess of the value of each year's current death benefit protection over the premium paid that year by the employee under a Classic SDA for an employee's benefit is a taxable economic benefit. The employee's share of death benefit protection is equal to the policy proceeds payable on death less the amount to be reimbursed to the employer. This ruling did not indicate that an SDA resulted in any other taxable benefits for the employee. The IRS ruled two years later that dividends and "other benefits," including the cash value attributable to paid up additions, would be taxable currently as well. No published ruling, however, specifically distinguished between Equity SDA and Classic SDA. Although the IRS could have analyzed the arrangement as an interest-free loan from the employer to the employee, it did not do so, perhaps because the law at the time did not allow the IRS to impute income from interest-free loans.
The IRS provided two methods to determine the value of the current death benefit protection to the employee in Revenue Ruling 64-328. First, taxable income could be reported using an IRS table, commonly called "P.S. 58 rates." The IRS developed these rates using mortality tables from the 1940s. Alternatively, an employer could determine the employee's taxable income using term rates published by the insurer for individual one-year term life insurance standard risks.
Alternative term rates have often allowed employees to acquire permanent life insurance at a very low cost. These rates often represent a small percentage - in some cases less than one percent - of the total premium cost for permanent life insurance during a given year. By using SDAs with the alternative term rates, the employer can pay all or a substantial part of the premium cost at little tax cost to the employee while recovering its entire capital outlay upon termination of the SDA.
Practitioners have also relied on Revenue Ruling 64-328 in developing Equity SDAs as an alternative or supplement to non-qualified deferred compensation plans. Cash value inside a permanent life insurance policy grows on a tax deferred basis. As noted above, only the value of the current death benefit protection - and not cash values - was treated as an economic benefit under the Classic SDA considered in Revenue Ruling 64-328. Relying on this ruling, Equity SDAs have been used to generate cash rich policies from which the employee could withdraw or borrow amounts against to supplement retirement income. This technique has become particularly popular with Section 501(c)(3) organizations, which are not allowed to defer compensation on a tax-deferred basis for their executives unless the benefits are subject to a substantial risk of forfeiture.
In 1996, the IRS issued a Technical Advice Memorandum (TAM) providing for immediate taxation of the employee's "equity" in the policy as soon as cash value exceeded the employer's premium recovery amount. The TAM, while applicable to only one taxpayer not precedent in other cases, caused considerable concern that the IRS was changing its historical view of SDAs. Industry groups submitted extensive legal briefs arguing that the TAM was wrong under current law and that any change should be made only on a prospective basis by formal statute or published ruling.
IRS Notice 2001-10
Notice 2001-10 addresses three important issues affecting SDAs: the proper income taxation for Equity SDAs, P.S. 58 rates and alternative term rates.
Equity SDAs
The IRS has narrowed the scope of Revenue Ruling 64-328 to apply only to Classic SDAs. This interpretation represents the IRS' apparent position that an employee receives economic benefits from Equity SDAs in excess of current term life insurance coverage. The Notice states that "it is necessary to account for the employee's rights in cash surrender value under an equity split-dollar arrangement in a manner consistent with the substance of the parties' contractual positions." Actual policy ownership is irrelevant according to the Notice.
The Notice offers three approaches for taxing Equity SDAs in lieu of Revenue Ruling 64-328. One approach treats the employer as the policyowner consistent with the substance of the arrangement. The employee would then be subject to income tax on the cash value transferred by the employer to the employee. If the cash value transferred to the employee is subject to a substantial vesting condition, taxation will be deferred until the restriction lapses. As under current rules, the employee would also be taxed on the current life insurance protection and any dividend payments allocated solely to the employee. The Notice, however, provides little guidance regarding when the "substance" of the arrangement supports this approach and what events qualify as a transfer of cash value.
A second approach is to treat the arrangement as involving a below-market interest-free loan under Section 7872 of the Internal Revenue Code. Treating premium payments as interest-free loans will be appropriate when the substance of the arrangement is such that the employee is the owner of the policy. This occurs when the employer has "a reasonable and bona fide expectation of repayment [of its premium payments]." Section 7872, when applicable, would treat the unstated interest on each loan (i.e., premium payment) as compensation income to the employee (offset by interest income). Presumably, taxable employers would be entitled to a deduction for the deemed compensation payment to the employee. A benefit from loan treatment is that the employee would not be taxable on the current term life insurance coverage or cash value provided to the employee under the Equity SDA.
A third approach is to tax the employee on the entire premium payment when made. There would be no premium split, no imputed compensation income and no equity taxation under this approach. Immediate taxation of the entire premium payment appears limited to situations in which there is no bona fide intent for the employer to retain any interest in the policy. An example may be when the employer makes an absolute commitment to paying a bonus equal to the employer's premium payments on termination of the SDA.
P.S. 58 Rates
The IRS has replaced the P.S. 58 rates with a new standardized set of insurance rates. This is not a surprise as the P.S. 58 rates were based on mortality tables from the 1940s and were unrealistically high. The IRS reasonably determined that the P.S. 58 rates overstated the value of current term life insurance protection. Effective beginning in 2002, IRS Table 2001 must be used instead of the P.S. 58 rates to report the value of current death benefit coverage. The rates under IRS Table 2001 are materially lower than the P.S. 58 rates at all ages. Employers, under a limited exception, may nevertheless continue to use P.S. 58 tables for SDAs and tax-qualified retirement plans until the end of 2001.
This change and related provisions of the Notice cast considerable doubt on the viability of Reverse SDAs. The Notice indicates that using a P.S. 58 rate for a Reverse SDA "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." The Notice further warns that "[n]o published guidance has authorized reliance on the P.S. 58 rates for this purpose." While the impact of these comments on existing Reverse SDAs is unclear, these comments and withdrawal of the P.S. 58 rates certainly reduce the attractiveness of these arrangements in the future.
Alternative Term Rates
The IRS has questioned whether alternative term rates developed by insurers under current rules reflect an appropriate measure of the economic benefit under an SDA. The Notice states that alternative term rates "may not realistically be available for all standard risks who apply for term insurance." It appears in some cases that alternative term rates have been based on contracts filed with the state insurance commissioner that have never been sold to the public. Even assuming that alternative term rates reflecting economic realities are used to report income, the IRS is considering whether life insurance protection provided to different taxpayers should be valued differently depending upon which insurer has issued the SDA policy.
The IRS will allow employers to report current life insurance coverage using alternative term rates going forward under certain circumstances. The Notice provides that employers may continue to use alternative term rates under existing rules for policies issued on or before March 1, 2001 until the end of 2003. Thereafter, alternative term rates must meet the following additional requirements: (i) the insurer must generally make the rates known to persons who apply for the term coverage, (ii) the insurer must regularly sells term insurance at those rates, and (iii) the insurer cannot more commonly sell term insurance at higher rates to individuals who are standard risks. These changes are intended to ensure that "real rates" are used to report income. The Notice also provides that the IRS reserves the right to deny the use of alternative term rates for all other policies issued after the later of December 31, 2003 or December of the year in which further guidance is provided. This reservation appears consistent with the IRS' stated desire for uniform rates and suggests that alternative term rates will not be allowed for new policies indefinitely.
Interim Rules Pending Final Guidance
The IRS will allow parties to treat Equity SDAs as subject to either Section 83 (regarding taxable transfers of property) or Section 7872 (regarding taxable interest-free loans) pending the issuance of further guidance. The selection of tax treatment by the parties will be recognized so long as "(i) such characterization is not clearly inconsistent with the substance of the arrangement, (ii) such characterization has been consistently followed by the parties from the inception of the arrangement and (iii) the parties fully account for all economic benefits conferred on the employee in a manner consistent with that arrangement." If the parties do not qualify for loan treatment under this rule, the default treatment for the Equity SDA will be taxation under Section 83. We offer the following observations regarding the interim rules.
Loan Treatment
Few, if any, existing Equity SDAs have been treated as taxable interest-free loans under Section 7872. As noted above, loan treatment under the interim rules going forward is only available for Equity SDAs that have been consistently treated as loans from their inception. Consequently, loan treatment will be unavailable for most Equity SDAs under the literal terms of the consistency provision without terminating and restarting the entire arrangement. We understand that the IRS is reconsidering this point and may allow taxpayers to amend their tax returns for prior years to reflect loan treatment and qualify for loan treatment under the interim rules.
Section 83 Treatment
Section 83 is the default treatment for Equity SDAs that don't qualify as Section 7872 loans under the interim rules. It appears, at least for now, that the IRS has provided a moratorium on subjecting cash value increments in Equity SDAs to current tax under Section 83 pending the publication of additional guidance. The Notice provides in this regard that an employer will not be treated as transferring cash value to the employee "solely because interest or earnings" credited to cash value cause the cash value to exceed the premium payments reimbursable to the employer. Cash value should not exceed premium payments when disregarding "interest or other earnings" in the normal course. However, this provision will not protect an employee who actually accesses cash value before termination of the SDA or who acquires cash value on termination of the SDA.
Thus, the Notice falls short of providing permanent grandfather protection for cash value accumulations. The Notice provides that any taxation solely because of interest or earnings credits will "apply prospectively," suggesting future action by the IRS on this issue. What prospective treatment means in this case is unclear. This protection may mean that Section 83 will apply to (i) all cash value in an Equity SDA at the time of the future guidance, or (ii) only to cash value that accrues in the policy after the effective date of future guidance. It seems unlikely that the IRS would apply Section 83 taxation only to future Equity SDAs.
There may be some advantage to having employees contribute now towards premium costs if Section 83 applies to an Equity SDA. An employee will not be subject to tax on term life protection to the extent that such coverage is allocable to premium payments made by the employee. Likewise, it will be difficult for the IRS to tax policy equity that is attributable to premium payments made by the employee. This strategy may work particularly well if these contributions are made during the early years of the policy when the employer is younger and term protection is less expensive.
Next Steps
The Notice is the first step in what is likely to be a significant period of regulatory review and public comment. The IRS has requested comments on the tax treatment of SDAs and is likely to receive numerous responses from several trade associations and employers. We understand that leaders in the insurance industry have already met with high level officials in the Department of Treasury regarding the Notice.
McDermott, Will & Emery's Estate Planning, Employee Benefits and Tax Departments have been tracking these issues for years. We have consistently advised clients and friends of the firm regarding both the technical and practical considerations regarding SDAs, including providing information on potential government challenges. Given the potential threat to Equity SDAs, corporate employers should consider steps to protest against the Notice, either singly or as part of a broader coalition. For example, employers with existing Equity SDAs might urge more comprehensive grandfathering.
