Making Sense of Split-Dollar Plans.

A new tax directive is causing life insurers to look for alternatives to split-dollar plans.

Spilt-dollar life insurance plans aren't as attractive as they used to be. In January, the Internal Revenue Service issued a notice that effectively--though not officially--took away many of their tax benefits. Since then, some members of the life insurance industry have been exploring alternatives, including a sharedownership approach that can provide economic or planning advantages over split-dollar variations.

Split-dollar life insurance allows two parties--usually an employer and an employee--to share the costs and benefits of a life insurance policy. Employers typically use it to provide additional tax-advantaged benefits to valued employees, outside normal pensions and tax-qualified plans.

IRS Notice 2001-10 redefined the taxation of split-dollar plans, making them less tax-efficient and more costly. The notice provides "interim guidance" pending public hearings and implementation, but it is a strong indication that the IRS intends to issue a public ruling promulgating regulations. It also indicates the IRS' strong disagreement with the previously widespread view that equity split-dollar plans could provide significant, tax-free benefits for employees.

The notice did not directly affect traditional split-dollar plans, according to attorneys John Terakedis and Fred Fisher of the law firm Schottenstein, Zox and Dunn in Columbus, Ohio. In traditional plans, one party owns all of the cash value, while the other owns the true insurance, which is the excess of the death benefit over the cash value. The trouble with traditional split-dollar plans is that the cost of the true insurance can become too expensive as the insured becomes old, they said.

In equity split-dollar plans, an employer typically funds a policy for an employee, but retains an interest in the policy equal to the premiums it has paid. The employer usually recovers those premiums when the policy is terminated--usually without interest. That money comes from either the cash value or, if the employee dies, the death benefit. The employee's beneficiaries keep the rest. Under the IRS ruling, employees now must pay tax on the gains in the policy, either annually on the imputed gains, or all at once on the actual gains--upon either termination of the split-dollar arrangement, such as when the employee leaves the company or upon the employee's death.

Even under the IRS notice, the excess of the death benefit over the cash value in an equity split-dollar plan is income tax-free. For example, if the employer paid $100 in premiums, and if the cash value were $250 and the death benefit were $1,000, the employer would recover the $100 tax-free, the estate of the deceased employee would be liable for tax on $150, and the employee's beneficiary would receive the remaining $750 tax-free, Fisher said.

Since the IRS redefined the taxation of split-dollar plans, Hartford Life Insurance Co. has been actively promoting shared ownership of life insurance as an alternative strategy that still offers tax advantages. In a shared-ownership plan, two parties pay the premiums and own separate parts of the policy. The IRS notice has significantly damaged the viability of split-dollar plans, especially equity split-dollar plans, for many estate- and retirement-planning needs, said David Potter, a Hartford spokesman. Others in the life industry say split-dollar arrangements are still attractive, even though premiums are higher.

"This has created a lot of confusion, not to mention angst, among financial advisers," Potter said. "Life insurers have gotten besieged with phone calls from financial advisers as to what other life insurance planning techniques are available to replace split dollar to solve clients' estate- and retirement-planning needs."

Terakedis and Fisher said shared ownership differs from traditional split dollar, because it allows a residual owner--the one that owns the true insurance--also to own a portion of the policy's cash value. This allows the residual owner to save funds inside the policy on an income tax-deferred basis to meet the increasing annual term costs that will be incurred in later years of the policy. With proper planning, the residual owner's costs can be leveled out over the years or even eliminated.

Shared ownership differs from equity split-dollar plans, because both owners are charged for their shares of the policy's costs on an "arm's length" basis. Because neither owner subsidizes the other, none of the imputed transfers that the IRS notice says are taxable in equity split-dollar plans are present in shared ownership.

Another significant difference is that Hartford's shared-ownership plan is based on the principles of fundamental property law and contract law, while split-dollar is based on IRS rulings, said Mary Young, manager of program marketing.

Young said that under the new notice on split-dollar plans, the IRS has alerted the insurance industry that it may consider the employer to have made either an interest-free loan to the employee or to have provided compensation. The shared-ownership plan, in which the employee and employer buy separate parts of the policy, works because courts have ruled that life insurance policies are property.

Young said the law in all 50 states supports the notion that life insurance is a property that can be contractually co-owned, much as real estate. As long as the life insurance shared-ownership arrangement is fair and undertaken by reasonable adults not under any duress, the sharing of premium is unaffected by anything the government has stipulated about split-dollar plans, Young said. "Our position is that if someone thinks the IRS closed the door on split dollar, shared ownership will open the window," she added. "It would be really tough for the IRS to close the window, since shared ownership is based on property law and contract law 101. Congress would have to change decades of property law and contract law."

The shared-ownership plan has been around for several years, but it has not been widely used and is often over-looked, said Young. "Folks will be interested in blowing the dust off," she said. "We're seeing renewed interest."

Financial planner Mark W. Hackmeier, owner of Houston-based Mark W. Hackmeier & Associates, started to seriously write shared-ownership plans about four years ago and now spends 90% of his time marketing them. He currently writes about $1 million in premium a year.

"I had been writing split-dollar for probably 25 years, but I became concerned in 1996, when the IRS issued its TAM," he said. TAM stands for tax advisory memorandum, which is less important than an IRS notice. "It meant split-dollar was on the IRS' radar screen." When Hackmeier writes split-dollar plans now, he also has clients sign a disclaimer saying he had informed them of the shared-ownership alternative.

Access to Cash Value

Shared-ownership plans can avoid the income-tax traps outlined in the IRS notice. Another major allure of shared-ownership is that the insured's spouse can have access to the cash value even though the death benefit is placed outside the estate of both spouses, said Terakedis and Fisher.

Terakedis and Fisher said they are aware of only a few shared-ownership plans jointly held by an employer and employee. Most are privately owned to help accumulate cash values. But they said employers and employees may move away from equity split-dollar plans as shared-ownership plans become a more attractive alternative.

Life insurance has been used as a savings vehicle for most of the past century, Hackmeier said. When there is only one owner, however, he or she has access to cash values only by retaining ownership. If he or she places the policy into an irrevocable trust, the death benefit goes outside the estate and the owner gives up ownership of the policy and access to the cash.

Terakedis and Fisher were motivated five years ago by clients who wanted maximum flexibility with access to cash values and death benefits excluded from the estate. "Our initial efforts predated all of the private split-dollar rulings," Terakedis said. "We thought then and now that our shared-ownership concept addressed any concerns the IRS might have. We avoided equity split-dollar by creating two owners for the policy and making sure that neither owner subsidized the other. We have both owners paying on a current basis for the respective interests in the policy."

Columbus, Ohio-based R/S Management Services Inc., a client of Terakedis' and Fisher's law firm, developed the administrative software needed to track the shared-ownership plan. Terakedis and Fisher then contacted Hartford Life to gauge the insurer's interest in a marketing relationship with R/S. Curious about the idea, Hartford asked a Washington law firm to scrutinize it to see if it had any holes. That firm tweaked the plan slightly but declared it sound. Hartford then entered into an administrative services agreement with R/S.

The software system is important particularly in shared-ownership plans, because it tracks the two owners' relative interest in the policy's cash values, both in absolute terms and in comparison to the policy illustration prepared by the insurance agent. "In a down market, it lets you know how far you are falling behind," Fisher said. "Every year, it tells owners where they are in comparison to the illustrated plan."

As the insured grows older, the death benefit becomes more expensive. "Early in the life of the policy, it's advantageous for the owner of the death benefit to pay more into the policy's cash value to build up a fund to pay future costs of the death benefit," Terakedis said. "But at no time do we let one owner subsidize the other's account. It's important to know where each owner stands."

Tracking every cost of the policy is easier to do when using what Terakedis calls "the open architecture" of a variable life policy. "This feature and the investment aspect of variable life were keys to why shared ownership made sense at the time we were developing it and why it still does," he said.

Other brokers have felt the impact of the IRS notice. "There is a scare out there, and we're looking at alternatives," said Tom Lobaugh, a Chicago-based senior vice president in the employee-benefits department of Willis Inc., a worldwide broker and advisory firm. "The major corporations are aware of what's going on, and there's more caution since the 1996TAM."

Still a Good Deal

But split-dollar plans are still popular, Lobaugh said. "Split dollar has always been a great deal for the executive," said Lobaugh, who works as a broker. "Since January, it's still a good deal. The executive just doesn't get as much. Or someone else can still pay for the benefit by making up for what the executive owes the IRS. Premiums can be increased so there's more cash in the policy at rollout--when the split-dollar agreement is terminated--to cover the increased tax due."

For example, one of Lobaugh's clients, a German-owned company in the automotive industry with an American division, uses equity split-dollar plans to bring the benefits of eight American executives up to a par with those of German executives. Lobaugh said the current-year premium on the policies, issued by Pacific Life Insurance Co., was $396,309 before the IRS notice and $536,164 afterward, for the same level of benefits.

While that company had no reservations about the higher premium, Willis has developed a "financed insurance" alternative for clients, Lobaugh said. Under this arrangement, the client company pays premiums with loans from a finance company. The finance company actually makes the premium payments, while the client company pays only the interest on the loan. The effect is that the corporate client's annual outlay is substantially less.

Meanwhile, the corporate client invests the equivalent of the premiums in its own business, and the policy's cash surrender value or death benefit repays the loan in the future. Lobaugh said this is advantageous to the corporate client, because its return on equity is usually greater than the internal rate of return on the cash value of the insurance policy. "We started doing that because we heard there was a little bit of resistance out there" to split-dollar plans, he said.

Aon Consulting has not seen much of a groundswell of response to the IRS' January notice, said James L. Hess, the head of Aon's life insurance actuarial consulting in Somerset, N.J. Hess said industry associations representing companies and agents have been busy contacting the IRS, state legislators and members of Congress to influence some change, but they have not been successful. "I expect they will be successful in getting clarification," he said. "There are some questions about what the notice means. But I don't expect a change in direction."

Hess said he is not surprised that the industry continues to write split-dollar policies. He noted that the IRS "clearly tipped its hand" three or four years ago, but the industry made no substantial changes to what it was doing. "So I'm not surprised there's not much change in the industry as a result of this notice," he said. "The notice is probably viewed as something that hasn't happened yet. Later this year, there will probably be another notice that puts it into effect."

'Bonus' Approach

Aon Consulting has urged clients to take simpler approaches to split-dollar plans, but Hess said most insurance brokers would not agree to change "because, in my opinion, split dollar is so ingrained in them--it's the Cadillac approach to executive life insurance."

One simpler alternative is the "bonus" approach, in which the employee/insured purchases and owns the policy, and the employer pays the premium. The premium is treated as a cash bonus to the employee, and the employee is taxed each year. Another idea is for the employer to own the policy and the employee to name the beneficiaries. At some point, perhaps age 65, the company gives the policy to the employee. "That's a taxable event, but if the parties know that it's down the road, they can make preparations for that event," Hess said. "It can be financially far superior to set it up that way and pay that tax."

Shared-ownership plans are not yet widely used in business contexts, said Patrick Smith, Hartford Life's director of advanced marketing. He estimated that 90% of shared-ownership plans involve two spouses and an irrevocable life insurance trust. But he provided two examples of how shared ownership can work extremely well in a business situation: deferred-compensation plans and buy-sell plans.

Consider a deferred-compensation split-dollar plan, in which a company would buy and own a life policy on an employee and in the future would pay the policy's surplus cash value to the employee. If the employee died, it would pay the spouse a survivor benefit, but that benefit would be taxed as ordinary income. Under a shared-ownership deferred-compensation plan, the spouse would be the owner of the death benefit and would receive the death benefit free of income tax.

In traditional buy-sell plans covering, for example, two owners of a small business worth $1 million, each partner buys a policy on the life of the other for $500,000. If one dies, the survivor acquires the deceased's share of the business, paying the spouse the $500,000 death benefit. But Smith said that if one of the owners is significantly older or has health problems, the younger owner would be stuck paying much higher premiums. Applying shared-ownership to that case would allow the older, less-healthy owner to develop the cash-value side of the policy and use it as a source of supplemental retirement income, while the younger owner could own and finance the less-expensive death benefit part of the policy.

"Because they have many applications, we expect to do more with shared-ownership plans," Smith said.