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IRS Changes Course On Split-Dollar Life Insurance And Offers Transitional Tax Planning Opportunities

On January 3, 2002, the Internal Revenue Service revoked its controversial split-dollar life insurance guidance from last year (Notice 2001-10) and committed to provide comprehensive regulatory guidance regarding the tax treatment of split-dollar arrangements (SDAs). Notice 2002-8 outlines rules that are expected to be included in proposed regulations and provides interim guidance for SDAs that may be relied upon as safe harbors. Our January 2001 On The Subject… provides an extensive discussion and analysis of split-dollar life insurance, its uses and Notice 2001-10.

Existing Arrangements and Interim Guidance

Notice 2002-8 provides interim guidance for employers and individuals who have SDAs. Unique planning opportunities may be available for SDAs that are entered into before the IRS issues final regulations, which are anticipated in early 2004. Special tax treatment is provided for SDAs established before January 28, 2002. In addition, amendments to existing SDAs may be required. Some of the more significant changes under Notice 2002-8 that impact planning for existing SDAs and SDAs entered into before issuance of final regulations are described below.

No Income Tax on Termination of Existing Equity SDAs Before 2004

The IRS has indicated that proposed regulations will provide for income tax on policy cash surrender value (CSV) that an employee is entitled to retain upon termination of an Equity SDA. (An SDA that limits an employer’s interest in a policy to its premium payments and allocates remaining CSV to an employee is referred to as an "Equity SDA".) However, an Equity SDA entered into before January 28, 2002, may be terminated at any time before January 1, 2004, without resulting in a taxable transfer of the life insurance policy’s CSV to the employee. The employer must receive or be entitled to receive full repayment of its share of the premiums as part of the termination to qualify for this special one-time opportunity.

This is an important transitional relief. These rules effectively allow excess CSV accumulated under pre-January 28, 2002, Equity SDAs before January 1, 2004, to be tax deferred until the employee makes policy withdrawals. The excess CSV as of January 1, 2004, may also be enjoyed on a tax-free basis if it is used to defray future premium payments or provide additional death benefit coverage.

No Income Tax on Increases in CSV During Term of an Equity SDA

Increases in CSV during the term of an Equity SDA will not be subject to current income tax. This position applies in the interim (i.e., is applicable to Equity SDAs entered into before the publication of final regulations) and is expected to be provided in proposed regulations. It overrules the IRS’s position in a 1996 Technical Assistance Memorandum (TAM) in which incremental CSV increases were determined to be taxable transfers to the covered employee. It appears unlikely that the IRS will revert to its original position in the 1996 TAM.

Value of Current Life Insurance Protection May Be Used to Report Taxable Economic Benefit from an Equity SDA

Employers can continue to report current life insurance protection provided under Equity SDAs entered into before the publication date for final regulations as the employee’s primary taxable economic benefit during the term of the arrangement. Parties must report other incidental economic benefits (such as dividends allocated to an employee) under existing IRS standards. The IRS will treat an Equity SDA as continuing in effect so long as the employer has a remaining economic interest in the life insurance policies subject to the arrangement. Implicit in this position, however, is that the IRS will likely assert that there is a taxable transfer of the underlying policies to the employee when the employer no longer has a remaining economic interest in the arrangement (except for special pre-2004 terminations described above).

IRS Provides Flexibility for Measuring Value of Current Life Insurance Protection

The IRS, while undecided on the methods and rules for measuring current life insurance protection under SDAs, has provided the following alternatives for valuing such protection:

• SDAs entered into on or before January 28, 2002 may continue to use indefinitely either P.S. 58 rates, or, if lower, insurer rates allowed under pre-Notice 2002-8 standards.

• All SDAs not described in the previous bullet point entered into before the effective date of future guidance may use insurer rates as well, subject to special distribution and sales requirements for term rates after December 31, 2003.

• All SDAs entered into before the effective date of future guidance may use the Table 2001 rates as provided in Notice 2001-10. Notice 2002-8 sanctions "appropriate adjustments" to this table when reporting economic benefits under "second to die" survivorship policies.

Below-Market Loan Treatment Available as an Alternative to Report Taxable Income from Equity SDAs

Parties may elect to treat premium payments under Equity SDAs issued before the date of final regulations as below-market loans regardless of actual ownership or the method used to establish the Equity SDA. In effect, the employee is deemed to be the economic owner of the policy, and the employer is treated as extending credit with each premium payment. Interest not charged by the employer on each premium payment is treated as compensation income to the employee. The employee, as policy owner, is not taxed on current life insurance protection provided under the arrangement.

Below-Market Loan Treatment May Present Tax-Savings Advantages

Below-market loan treatment for Equity SDAs may be more advantageous than reporting income based on current life insurance protection depending upon the employee’s age and planning objectives. Financial projections must be performed to determine which tax treatment is most appropriate for each situation.

May Reduce Annual Compensation Income

Interest rates are at historic low levels, which normally reduces the annual tax cost when using below-market loan treatment for Equity SDAs. Compensation income on premium payments under the below-market loan rules for Equity SDAs may be less than the annual amount for the current value of the life insurance protection, particularly in the case of older individuals. Planning opportunities may exist to lock in these rates for premium payments made by the employer under certain circumstances.

Avoids Income Tax on Termination of SDA

Under below-market loan treatment, the employee is not subject to income tax upon acquiring full economic ownership of a policy subject to an Equity SDA following its termination. Premium payments will be treated as paid by the employee, thereby resulting in basis for purposes of future policy withdrawals. In contrast, termination of an Equity SDA (other than a termination qualifying for special tax treatment as described above) not reported as a below-market loan is anticipated to result in taxable income equal to the employee’s residual policy CSV. In addition, it is unclear whether amounts paid by the employee toward current life insurance protection under such Equity SDAs will be treated as creating policy basis by the IRS.

Provide Relief for Equity SDAs Not Previously Reported as Below-Market Loans

Notice 2002-8 eliminates the consistency requirements under Notice 2001-10. Equity SDAs entered into before the date final regulations are issued may be treated as below-market loan arrangements even though they have not been treated as below-market loan arrangements from inception. Each employer premium payment made before the tax year that loan reporting is elected must be treated as an employer loan made at the beginning of the tax year in which such election is made. Equity SDAs entered before January 28, 2002, that are terminated before January 1, 2004, may also be converted into below-market loan arrangements without triggering income tax on the termination. In addition, the IRS will not challenge "reasonable efforts" by parties to report income under the below-market loan approach.

Notices 2002-8 and 2001-10 Represent Safe Harbors, Not Final Rules

Notice 2002-8 states that "no inference should be drawn from this notice" regarding the appropriate tax treatment for SDAs entered into before the final regulations become effective. Instead, taxpayers may rely on the principles described in Notices 2002-8 and 2001-10 for SDAs entered into before the date of publication of final regulations. These statements suggest that taxpayers may either rely on rules provided in the Notices as safe harbors or take an alternative position based on an interpretation of existing law.

New Arrangements and Proposed Regulations

Notice 2002-8 states that proposed regulations are expected to determine the applicable tax treatment of an Equity SDA depending upon whether the employer or the employee is designated owner of the policy. If the employer is the designated owner, then the employer would be treated as providing current life insurance protection during the term of the Equity SDA that will be treated as taxable compensation income to the employee. Further, a transfer of the policy by the employer to the employee would result in income tax on the policy’s CSV. If the employee is treated as the policy owner, then the premium payments made by the employer will treated as below-market loans under the Equity SDA if the employee is obligated to repay the employer. However, there will be no income tax on CSV increases inside the policy. Premium payments will be treated as compensation income if there is no obligation to repay. The IRS has requested comments on whether regulations should continue use of published term rates of insurers as an alternative to uniform tables.

Notice 2002-8 represents a significant step towards providing fair and practical rules for SDAs. The IRS has requested comments on Notice 2002-8 and the proposed regulations to be issued later this year. We will continue to monitor this situation closely and evaluate interim planning opportunities for clients.