IRS Cracks Down on Abusive Split-Dollar Life Insurance Scheme
August 2002
On July 28, 2002, the New York Times reported that a legal technique, which the article said was blessed by the IRS, existed to avoid gift and estate taxes by using high current life insurance rates. The technique often involves having a wealthy individual obtain, through a split-dollar arrangement, current life insurance protection from a family trust that holds a permanent life insurance policy. The amount paid by the individual annually for the current life insurance protection is based on a rate that is significantly higher than the actual cost of providing such protection within the policy. The intended result from having the individual acquire the current life insurance protection at a high rate from the family trust — in some cases ten or more times greater than the rate for comparable term coverage available from other carriers — is to accumulate cash surrender value in the trust for the benefit of another person without paying any gift tax. Similar arrangements in the employment context — often referred to as "reverse split-dollar" — have also been used by some employers in an attempt to accumulate policy cash surrender value for an employee’s benefit without any income tax. As we reported to you in our most recent On The Subject . . . Tax Rules Proposed for Split-Dollar Life Insurance (July 2002), these transactions are suspect particularly in light of recent proposed regulations.
The U.S. Department of Treasury and the Internal Revenue Service have now issued Notice 2002-59 in response to the tax scheme reported by the New York Times and its purported favorable tax results. As we anticipated, both agencies take the position that existing guidance and tax law principles do not sanction the use of inflated life insurance rates to transfer cash surrender value and other permanent policy benefits to a third party without tax consequences. Regardless of what rate is used under these schemes to value current life insurance benefits, we understand the IRS will review the facts and circumstances on a case-by-case basis to determine if policy benefits are being provided or transferred without proper reporting of tax liability. In addition to not allowing reliance on current life insurance rates for purposes of valuing policy benefits other than the current life insurance protection, the Notice also clarifies that insurance rates higher than those published by the IRS in Table 2001 cannot be used to value the current life insurance protection. The government’s position in Notice 2002-59 is effective for all periods before its publication and applies to split-dollar arrangements now in force in all contexts. It appears that the Internal Revenue Service will pursue taxpayers who have established arrangements like those described in the New York Times article.
Please note that the Notice does not impact traditional split-dollar life insurance arrangements and the transitional tax planning opportunities available under Notice 2002-8. (See our prior On The Subject . . . IRS Changes Course On Split-Dollar Life Insurance And Offers Transitional Tax Planning Opportunities evaluating tax strategies available under Notice 2002-8, January 2002).
