IRS again revises split-dollar insurance rules.

On Jan. 3, 2002, the IRS revised the treatment of split-dollar life insurance arrangements, by revoking Notice 2001-10 and replacing it with Notice 2002-8. Notice 2001-10 clarified prior rulings on taxation of split-dollar arrangements, provided taxpayers with interim guidance pending publication of further guidance and requested taxpayer and practitioner comments. The notice expressed the Service's concern with the growth of "equity split-dollar" arrangements, under which an employee can derive valuable economic benefits beyond the current life insurance protection addressed in Rev. Rul. 64-328.

Notice 2002-8 attempts to reach a compromise between taxation of existing split-dollar plans and future plans. The Service seems open to suggestions from the industry on the rates used to value life insurance protection under future split-dollar arrangements. The IRS is accepting comments until April 28, 2002. Although it provides interim guidance on the valuation of life insurance protection, it requests specific comments on appropriate rates for valuing current life insurance protection and on standards for use of an insurer's published premium rates for valuing current life insurance protection.

Split-dollar and Equity Split-dollar Arrangements

Split-dollar plans have long been used to fund a variety of permanent life insurance needs, including buy-sell agreements, fringe benefit plans and estate liquidity needs. Rev. Rul. 64-328 has been the cornerstone for the tax treatment of split-dollar arrangements, and has provided the "traditional" compensation method used for split-dollar arrangements.

Equity split-dollar refers to a particular kind of split-dollar plan, in which an employer has the right to receive only its premium advances when the split-dollar agreement terminates or the employee dies. Endorsement arrangements exist when the employer owns the policy. When the employee or a third party owns the policy, the arrangement is known as a collateral assignment. Both of these arrangements can involve equity plans. As a practical matter, equity split-dollar issues typically arise only under the collateral-assignment method.

The "equity" in equity split-dollar refers to the "crossover" point, when the policy begins to accumulate cash value in excess of the amount the employer is entitled to recover. The critical questions are who owns this equity and when or how it is taxed.

Until Notice 2001-10, the Service had not released a public ruling that addressed the income tax treatment of equity split-dollar arrangements. In Rev. Rul. 64-328, it held that an employee had to recognize as income each year the value of life insurance protection he received. This value is known as the "economic benefit." Rev. Rul. 64-328 revoked Rev. Rul. 55-713, which treated the split-dollar arrangement as a secured loan from an employer to an employee. It retained the P.S. 58 tables, which are based on mortality tables originally published in 1946.

As a result of suggestions the insurance industry made on valuation, in Rev. Rul. 66-110, the IRS allowed a taxpayer to calculate "economic benefit" based on the insurance carrier's alternative term rates instead of on the standard P.S. 58 rates.

In addition, the Service issued Letter Rulings 7916029 and 8310027, which involved endorsement split-dollar plans. In the rulings, the IRS held that the employee was taxable on the cash surrender value less the employee's contributions, in the year the employer transferred the policy to the employee.

Letter Ruling (TAM) 9604001 held that when a policy reached the crossover point and the cash surrender value exceeded the employer's premium advances, the insured had to include in income both the economic benefit and the annual buildup in the cash surrender value in excess of the amount repayable to the corporation. Because an irrevocable life insurance trust owned the policy, the IRS concluded that the insured made a deemed gift to the trust each year of the full amount included in his income.

Anticipated Comprehensive Guidance on the Tax Treatment of Split-dollar Insurance Arrangements

In some respects, the basic structure outlined by Notice 2001-10 will remain intact under the proposed regulations. Specifically, an employment-related split-dollar arrangement will be treated either as one in which an economic benefit is provided to the employee (with any policy equity being treated as a transfer subject to Sec. 83) or as a series of loans, subject to either Secs. 1271-1275 (the original issue discount (OLD) rules) or Sec. 7872, which (for a compensation-related below-market loan) is deemed an interest payment by the employee to the employer, funded by deemed compensation paid by the employer to the employee.

Important distinctions exist, however, between treatment under Notice 2001-10 and the expected proposed regulations. The expected regulations will mandate two mutually exclusive regimes, depending on ownership of the policy--either the endorsement arrangement or the collateral-assignment arrangement.

Endorsement Split-dollar

In endorsement split-dollar arrangements, an employer is the policy's formal legal owner. The regulations should provide that the benefits provided to the employee (i.e., death-benefit protection and other economic benefits) will be taxed to him. A later transfer of the life insurance policy to the employee will be taxed under Sec. 83. This is the "traditional" compensation method.

The notice explicitly rejected the concept first announced in TAM 9604001 (and suggested in Notice 2001-10) that the Service would currently tax any increase in the cash-surrender value of a life insurance policy that exceeded the employer's interest in the policy while the split-dollar arrangement was in force. The notice specifically states:

The proposed regulations will not treat an employer as having made a transfer of a portion of the cash surrender value of a life insurance contract to an employee for purposes of section 83 solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the employer.

This statement seems to suggest that it is possible for the employer's interest in the policy cash values to be less than the entire cash value. However, the question of the tax treatment of equity at termination or reclassification is not stated (and most likely will be subject to debate and analysis). At this point, the conservative interpretation is that equity will be a taxable transfer to the policy owner because, by comparison, the provision's safe harbor of equity from taxation at termination or reclassification appear limited to policies issued prior to Jan. 28, 2002.

Collateral-assignment Split-dollar

In collateral-assignment split-dollar arrangements, the employee owns the policy. The proposed regulations are expected to provide that if the employee is obligated to repay the employer (either out of policy proceeds or otherwise), the premiums paid by the employer would be treated as a series of loans subject to either the below-market loan rules or the OID rules. If the employee is not obligated to repay the employer's premiums, such premiums would be treated as taxable compensation when paid by the employer.

For arrangements entered into after Jan. 27, 2002 but before issuance of final guidance, the parties can treat the arrangement as either a loan or as "traditional" compensation split-dollar. A current split-dollar arrangement may be reclassified as a loan, as long as all premium payments from the inception of the arrangement (minus any repayment) are treated as loans. By providing only these possibilities, the notice seems to foreclose the possibility of establishing a collateral-assignment split-dollar arrangement after the effective date of the final regulations. If this interpretation were correct, all forms of split-dollar (independent of form of ownership) would begin to resemble endorsement split-dollar arrangements. Consequently, cash value should continue to accumulate without taxation until it is somehow transferred to the employee at termination of the arrangement.

The intentional elimination of the use of collateral-assignment split-dollar by the IRS could have negative consequences for estate planning. By requiring the use of endorsement split-dollar, the Service would potentially be subjecting every trust- (or other third-party) owned split-dollar arrangement to estate tax for the first three years of the arrangement under Sec. 2035. Use of endorsement split-dollar may also complicate a later rollout to an irrevocane trust, triggering a potential transfer for value or application of Sec. 2035.

An open question (which may be addressed when the proposed regulations are released) is the extent to which the parties can enter into a quasi-joint purchase arrangement, under which the employee owns cash value proportionate to his share of premium payments.

Other Issues

The same principles are expected to govern the Federal tax treatment of split-dollar life insurance arrangements in other contexts, including those that provide benefits in gift and corporation-shareholder contexts.

The proposed regulations addressing the Federal tax treatment of split-dollar life insurance arrangements would only apply to arrangements entered into after the date of publication of final regulations.

Notice 2002-8 announces the Service's intention to issue proposed regulations that would not be effective until the date that final regulations are published. Until the IRS issues final regulations, split-dollar arrangements will continue to be taxed in accordance with existing revenue rulings.

The Service will not challenge reasonable efforts to comply with the requirements governing loan transactions. The final regulations will be effective only for arrangements entered into after the publication date of the final regulations and will not be enforced retroactively.

Loan treatment may be advantageous in some situations. One of the benefits of split-dollar treatment as a below-market loan under Sec. 7872 is that the employee will not have additional compensation income for the value of the economic benefit from life insurance protection. Additionally, the policy's cash-surrender value will not represent property transferred to the employee.

Loans must be properly structured. If the loan is to be repaid on or before a certain date (term loan), the interest rate would be determined when the loan commences, and the rate is fixed for the duration of the loan term. Recent applicable Federal rates have been low and may provide a planning opportunity. However, the employee would be taxed on the present value of the interest due over the term loan at the transaction's commencement. A loan that does not have a certain term or repayment date is a demand loan, as the employer may demand repayment at any time. The interest rate is a short-term floating rate, redetermined annually using a blended rate provided by the IRS. Depending on whether interest rates rise or fall, this may have a dramatic impact on the income or gift issues related to the employee.

Valuation of Life Insurance Protection

The notice provides interim guidance on the valuation of life insurance protection, "pending the consideration of comments and publication of further guidance."

The P.S. 58 rate table remains revoked, as provided in Notice 2001-10. However, for split-dollar arrangements entered into before Jan. 28, 2002, an employer and an employee can continue to use the P.S. 58 rates (provided for in their agreement) to determine the value of current life insurance protection provided to the employee.

The concession that allows the continued use of the P.S. 58 rates does not appear to apply to a reverse split-dollar arrangement. The notice specifically states that the P.S. 58 rates can be used to "determine the value of current life insurance protection provided to employees...." Omitting the word "employer" seems to preclude the use of the P.S. 58 rates to value the employer's share of the premium under reverse split-dollar plans.

Conceivably, in some arrangements, the employer can require the employee to pay some portion of the annual premium that the parties mutually agreed on. However, if the employee's contribution were less than the required economic benefit, the employee would have taxable income under Rev. Rul 64-328. The complexity of these arrangements is likely to need judicial interpretation.

For arrangements entered into before the effective date of future guidance, taxpayers may use the Table 2001 rates originally published in Notice 2001-10. According to the notice, taxpayers should make appropriate adjustments to these, premium rates if the life insurance protection covers more than one life. The notice does not specify how to compute the appropriate economic-benefit values for survivorship life policies. Industry sources have reported that the Service has no objection to the application of the formula approved in the "Greenberg to Greenberg" letter to the Table 2001 rates.

For arrangements entered into prior to Jan. 28, 2002 taxpayers may continue to use an insurer's lower published premium rates, available to all standard risks for initial issue one-year term insurance, to determine the value of current life insurance protection.

For arrangements entered into after Jan. 27, 2002, but before the effective date of future guidance, taxpayers may continue to use an insurer's alternative term rate for tax years 2002 and 2003. However, for periods after 2003, the IRS will not consider an insurer's published premium rates to be available to all standard risks that apply for term insurance unless the insurer (1) generally makes the availability of such rates known to persons who apply for term insurance coverage from the insurer and (2) regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurer's normal distribution channels.

This position is much more generous for the continued use of an insurer's alternative term rate than the position in Notice 2001-10. Notice 2001-10 provided no grandfathering from the new rate requirement.

Safe Harbors for Arrangements Entered into before the Final Regulations' Publication Date

The notice provides limited safe harbors for existing equity split-dollar plans. By satisfying the requirements of these safe harbors, participants can avoid taxation on a life insurance policy's equity. The notice does not grant a general grandfathering of existing equity split-dollar plans. Unless the safe harbors are followed, the parties are not assured of avoiding taxation on the equity at time of a rollout or a termination (see Exhibit).

For split-dollar arrangements entered into before Jan. 28, 2002, the IRS would not assert that a taxable transfer of property has been made to the employee on termination of these arrangements if the arrangement (1) is terminated before 2004 or (2) continues after 2003, the parties treat all payments by the employer from inception of the arrangement as a loan from the employer to the employee and the tax treatment of such arrangement going forward is reported consistent with loan arrangements governed by applicable Code sections. These safe-harbor provisions give the parties the opportunity to assess their arrangement prior to 2004 and potentially avoid taxation under Sec. 83 on the equity portion of the policy's cash value.

If the arrangement was entered into prior to Jan. 28, 2002, but the parties did not change the tax treatment of their collateral-assignment split-dollar arrangement after Jan. 1, 2004, the safe-harbor rules would not apply. In addition, the Service will not treat the split-dollar arrangement as terminated (and thus will not assert that there was a property transfer taxable under Sec. 83), for as long as the parties continue to report the value of the life insurance as an economic benefit to the employee. The notice does not mandate that the tax treatment of a collateral assignment split-dollar plan be changed to a loan method after Jan. 1, 2004, but that the IRS will not tax any equity under the plan if the parties satisfy the safe-harbor requirements. Thus, the parties can continue the tax treatment under the collateral-assignment split-dollar arrangement (taxing the economic benefit) past the safe-harbor date. However, a risk exists thai the IRS will contend that a taxable transfer of the equity occurred at time of rollout.

This "arrangements entered into" language contains substantial ambiguity. The notice does not address what is actually required to "enter into" an arrangement, nor does it address whether any change to the arrangement or the policy could affect the ability to hold the date of the arrangement. Undoubtedly the Service will issue additional guidance on what constitutes a substantial modification to pre-existing arrangements. Because the agreement controls the parties' contractual arrangement, a reasonable position is that the arrangement is "entered into" on the date the split-dollar agreement is signed by the parties and then funded with a life insurance policy within a reasonable time thereafter. The IRS would have to issue additional guidance if a policy is exchanged but the agreement remains the same.

Exhibit: Chart of Notice 2002-8

                               Economic benefit value

Arrangements     1) P.S. 58 costs or
entered into     2) Insurer's alternative-term rates (i.e., lower
before              initial issue one-year term rate available to all
Jan. 28, 2002       standard risks offered by insurer).

Arrangements     1) Table 2001 rates or
entered into     2) Insurer's alternative term rates until 2004. After
on or after         2003, insurer's alternative-term rates used must
Jan. 28, 2002       also be made available to all persons who apply for
but before          term insurance with the insurer and be regularly
issuance of         sold through the insurer's normal distribution
final guidance      channels.

Arrangements     1) Anticipating expected proposed regulations.
entered into     2) Will depend on whether endorsement split-dollar or
after issuance      collateral-assignment split-dollar.
of final
guidance         Endorsement split-dollar   Collateral-assignment
                                            split-dollar

                 1) Table 2001 or           1) Economic-benefit concept
                 2) Insurer's                  not applicable. Employer
                    alternative-term           premiums are loans.
                    rate, but based on      2) Unclear issues:
                    new criteria or         a) Use of collateral-
                 3) Subject to additional      assignment split-dollar
                    guidance. Areas still      on a "traditional" basis
                    under study.               when employee owns cash
                                               value or
                                            b) Use of collateral-
                                               assignment split-dollar
                                               with cash-value split
                                               proportionate to the
                                               parties' premium
                                               payments.

Termination of   1) Value of untaxed        1) Value of transferred
arrangement         equity.                    employer interest.
(rollout)

                    Taxation of equity split-dollar arrangements

Arrangements     1) Taxed under existing revenue rulings.
entered into     2) Several safe harbors when equity arrangement is
before              terminated prior to 2004 or reclassified as a Sec.
Jan. 28, 2002       7872-compliant loan after 2003, with all premiums
                    from the inception of the arrangement representing
                    the initial borrowed amount.

Arrangements     1) Equity is not taxable as it accrues.
entered into     2) Probable taxation of equity at the termination or
on or after         reclassification of the split-dollar arrangement if
Jan. 28, 2002       equity is transferred. Reclassification must be to
but before          a Sec. 7872-compliant loan, with all premiums from
issuance of         the inception of the arrangement representing the
final guidance      initial borrowed amount.

Arrangements     1) Anticipating expected proposed regulations.
entered into     2) Will depend on whether endorsement split-dollar or
after issuance      collateral-assignment split-dollar.
of final         3) Any transfer of cash value in endorsement
guidance            split-dollar will be taxable.

                 Endorsement split-dollar   Collateral-assignment
                                            split-dollar

                 1) Employee will be        1) Employer premiums are
                    taxed on economic          taxable compensation.
                    benefit.

Termination of   1) Transfer of policy to   1) Any transfer of
arrangement         employee is taxable        employer's interest in
(rollout)           under Sec. 83.             policy to employee is
                                               taxable compensation.

FROM ALAN J. ENGLISH, CPA, PHOENIX, AZ