IRS attacks split-dollar life insurance.

Split-dollar life insurance techniques have become more and more prevalent in the executive compensation and general estate planning arenas over the last several years. As a result of this increased popularity, questions regarding the income and gift taxation of such techniques have arisen. The IRS has issued Letter Ruling (TAM) 9604001, which provides guidance on its position on certain split-dollar arrangements.

In the TAM, the taxpayer is chairman and chief executive officer of a holding company and owns 51% of that company. The holding company owns 98% of a subsidiary company. The subsidiary, two insurance companies and a trust entered into the following transaction: (1) Subsidiary paid X dollars to each of the two insurance companies for two paid-up $500,000 life insurance policies on the life of the taxpayer; (2) the insurance companies issued the life insurance policies to the trust as owners of the policies; (3) the trust entered into split-dollar agreements with Subsidiary; and (4) the trust assigned the policies to Subsidiary as collateral for the trust's obligation under the agreements to repay the X dollars in premiums paid to each insurance company.

Under the terms of the split-dollar arrangement, the trust continues as the owner of the policies and the designated beneficiary of the policy proceeds. The trustees retain all incidents of ownership in the policies. The subsidiary retains an unqualified right to receive a portion of the death benefits equal to the total amount of the premiums it paid. The agreements may be terminated for a number of reasons, including (a) Subsidiary's bankruptcy or liquidation; (b) termination of Taxpayer's employment; and (c) written notice by the trust or by Taxpayer. If there is a termination prior to Taxpayer's death, the trust must reimburse Subsidiary before the collateral will be returned to the trust. If the policies are canceled or surrendered, Subsidiary is to be reimbursed from the cash surrender proceeds. Under this arrangement, the cash surrender value is expected to exceed the amount of the premiums paid in year 4 of the policies.

The agreements among the trust and Subsidiary also provide that any dividends on the policies are applied to purchase paid-up additional insurance on Taxpayer's life. Additionally, the policy owners may borrow from the policies or pledge or assign them, but only to the extent that a policy's cash surrender value exceeds the amount of the premiums paid by Subsidiary.

Based on these facts, the Service concluded that the taxpayer must include in income, on an annual basis, as long as the arrangements are in effect, both the amount equal to the one-year term cost of declining life insurance and any cash surrender buildup in the policies that exceeds the amount that must be returned to Subsidiary when the arrangement is terminated.

The IRS relied on Rev. Ruls. 64-328 and 66-110 to reach the above conclusion. The Service analogized to the "collateral split-dollar arrangement" highlighted in Rev. Rul. 64-328, in which the employer paid the portion of the annual premiums to the extent of the increase in the cash surrender value, and the employee paid the balance. The employer was entitled to receive from the policy's proceeds an amount equal to the cash surrender value, or at least a sufficient part thereof to equal the funds it provided for premium payments.

Rev. Rul. 64-328 noted that the practical effect of this arrangement was that, while the employee pays a substantial part of the first premium, the employee's share of future premiums decreases rapidly. The ruling concluded that the amount to be included in income each year a split-dollar arrangement is in effect is the annual value of the benefit received by the employee under the arrangement, which is an amount equal to the one-year term cost of the declining life insurance protection to which the employee is entitled from year to year, less any portion provided by the employee.

Rev. Rul. 66-110 concluded that any benefit received from a split-dollar arrangement in addition to the current insurance protection outlined in Rev. Rul. 64-328 is also includible in the employee's gross income. According to Rev. Rul. 66-110, the additional benefit may be a policyholder dividend distributed directly to the employee or it may be paid in the form of additional one-year term insurance, or paid-up life insurance for a period of more than one year.

While the collateral split-dollar arrangement in Rev. Rul. 64-328 was different from that addressed in the TAM (paid annual premiums vs. a single premium), the IRS stated that the conclusion in Rev. Rul. 64-328 should apply because Taxpayer in the TAM is in the same position as the employee in the revenue ruling after the employer has paid the premiums on the policy for a period of three years. In the TAM, the only factual difference is that Subsidiary attained the fully paid-up status by making one premium payment. The Service found the difference to be insignificant.

As a result, the insurance protection provided to Taxpayer is includible in Taxpayer's gross income pursuant to Sec. 61 and Regs. Sec. 1.83-1 (a) (2). The cash surrender values in the policies are not currently taxable to Taxpayer under Sec. 83 because they remained subject to the claims of Subsidiary's general creditors, as well as the claims of Subsidiary as a creditor. Income will be reportable in later years under Sec. 83, to the extent the cash surrender value of the policies exceeds the premiums paid by Subsidiary, because this is the amount returnable to Subsidiary.

The IRS also concluded that Taxpayer made a taxable gift to the trust equal to the amount included in his income each year under the split-dollar arrangements. The Service relied on its analysis in Rev. Rul. 78-420, in which the split-dollar arrangement called for the employee's wife to be the policy's owner. The ruling concluded that the value of the life insurance protection provided by the employer included in the income of the taxpayer was deemed to be transferred to the wife for gift tax purposes. As a result, Taxpayer was deemed to have made a gift to the trust under the same analysis.

This TAM illustrates the willingness of the IRS to attack split-dollar plans in which the employee/insured will receive a benefit in excess of the amount required to be returned to the employer who paid premiums on the policy under a split-dollar collateral assignment arrangement. In light of the many varieties of split-dollar plans in existence, this ruling should be carefully reviewed and employees should be on the lookout for future IRS developments in this area.