Notice 2002-8: IRS overhauls split dollar.

On January 3, 2002, the Internal Revenue Service issued Notice 2002 8, 2002-4 I.R.B. 398, ("the notice"), which represents the most significant development in the taxation of split dollar life insurance plans since 1964.

In the notice the IRS addresses two key issues that have been the subject of several controversial IRS pronouncements on split dollar plans in recent years: 1) the tax treatment of the employee's interest in the policy cash value in so-called "equity" split dollar plans; and 2) the standards used to determine the insurance company term rates that may be used to measure the value of current life insurance protection. The IRS also announces a fundamental change in the taxation of split dollar plans by prescribing two alternative theoretical approaches. The new rules are presented in the context of employment-related split dollar plans. However, the notice states that the same principles are expected to govern split dollar plans in other contexts, including gift and corporation-shareholder contexts.

Background

Beginning in 1964 with Rev. Rul. 64-328, 1964-2 C.B. 11, the IRS has treated split dollar life insurance as an employee benefit plan in which the employer's premium investment in the policy provides current life insurance protection for the employee. The annual economic benefit of the life insurance protection, measured by one-year term insurance rates, is includible in the employee's gross income to the extent that it exceeds the employee's contribution to the plan. To measure the benefit, the parties may choose between so-called "P.S.58" one-year term rates supplied by the government, or the insurer's term rates, if lower. However, the insurer's rates must be its current published gross premium rates for initial issue individual one-year term insurance made available to all standard risks. Rev. Rul. 66-110, 1966-1 C.B. 12; Rev. Rul. 67-154, 1967-1 C.B. 11. Also includible in the employee's gross income are policyholder dividends or other amounts paid in cash to the employee or used to provide the employee additional term insurance or paid-up insurance. Rev. Rul. 66-110. These principles apply to all split dollar plans for income tax purposes regardless of whether the endorsement method, the collateral assignment method, or some other form of split dollar is used. Rev. Rul. 64-328. The IRS has also held that in a split dollar arrangement where the employer provides a benefit to a third party on behalf of the employee, the economic benefit is includible in the employee's gross income, and then treated as a gift from the employee to the third party. Rev. Rul. 78-420, 1978-2 C.B. 67.

None of these rulings specifically addressed the situation that arises in "equity" split dollar plans, where the employee accrues an increasing interest in the policy's cash value. Under such plans, the employer is entitled only to reimbursement for its cumulative premium contributions, with the remainder of the policy benefits belonging to the employee or the employee's designated beneficiary. Consequently, the policy cash value, due to interest credited and other policy earnings, eventually exceeds the employer's interest. This excess is generally referred to as the employee's "equity."

Later, the IRS held in private rulings that the employee's "equity" would be includible in gross income under [section] 83 in the first taxable year in which the employee's interest became substantially vested. Priv. Ltr. Ruls. 7916029 and 8310027. See Treas. Reg. [section] 1.83-3(e). Technical Advice Memorandum 9604001 involved a split dollar plan between the employee's irrevocable life insurance trust and the employer. The IRS again applied [section] 83 and ruled that the employee was taxable annually on increases in the employee's "equity," in addition to the value of life insurance protection. Further, the IRS ruled that each year the employee made deemed gifts to his trust, for gift tax purposes, equal to the total amount includible in the employee's gross income.

Notice 2001-10

In January 2001, the IRS issued Notice 2001-10, in which the IRS provided interim guidance on "equity" split dollar, as well as on the valuation of current life insurance protection. The IRS also announced a new dual approach to the taxation of split dollar plans. The IRS retained the "traditional" approach to split dollar taxation in which it followed its line of reasoning from the private rulings and applied principles of [section] 83 to include in gross income the employee's acquisition of a substantially vested interest in the cash value (reduced by consideration paid by the employee for the cash value interest), in addition to the value of current life insurance protection. However, the IRS provided a moratorium on the taxation of the employee's cash value interest pending further study and the publication of future guidance. The IRS introduced a new alternative approach in which the split dollar plan is characterized as a series of loans by the employer to the employee, taxable under the "below market loan" rules of [section] 7872. The IRS also replaced its antiquated "P.S.58" rates with new, significantly lower term rates in "Table 2001."

Notice 2002-8

Notice 2002-8 revokes Notice 2001-10. However, the general thrust of the IRS analysis in Notice 2001-10 has been carried over to the new notice. Notice 2002-8 provides a more workable approach to the taxation of split dollar plans, as well as reasonable treatment for existing arrangements. In a somewhat abstruse statement, the notice provides that, except for the portion of the notice dealing with the valuation of current life insurance protection, taxpayers are not bound by rules set forth in the notice as to arrangements entered into before the date of publication of final regulations. Nevertheless, the IRS allows taxpayers to rely on Notice 2002-8 or Notice 2001-10.

Expected Comprehensive Regulations

In Notice 2002-8 the IRS announced its intention to provide comprehensive guidance through proposed regulations and outlined, generally, the principles of split dollar taxation that are expected to be included. These regulations will be effective for split dollar arrangements entered into after the date of publication of final regulations. Guidance for arrangements entered into before the date of publication of final regulations is provided in the notice. However, it is silent as to arrangements entered into on the date of publication. Presumably, this omission will be corrected.

The proposed regulations will require taxation of split dollar life insurance under one of two alternative regimes. Under what can be labeled as the "traditional" split dollar regime, the economic benefits of the life insurance policy are treated as transfers from the plan sponsor to the benefited party. Under the alternative "loan" regime, the plan sponsor's payments are treated as a series of loans, rather than a life insurance benefit, to the benefited party. The regime that is applied to a particular arrangement will be determined solely by policy ownership. If the plan sponsor is the formal owner of the policy, then the "traditional" regime will apply. If the benefited party (e.g., the employee or irrevocable life insurance trust) is designated as the formal owner, then the "loan" regime will apply. Consequently, the parties to the arrangement will be able to exercise control over the method of taxation through their choice of policy ownership.

Applying the rules to an employment-related arrangement, if the employer is designated as the formal owner of the policy (e.g., under the endorsement method), the "traditional" regime will govern. During the plan, the employee will include in gross income annually, under [section] 61, the value of current life insurance protection and other economic benefits (e.g., dividends paid to the employee or applied toward additional coverage). Taxation of any interest that the employee accrues in the policy cash value will be governed by [section] 83. However, in a major departure from the IRS' previous position, the proposed regulations will treat the employer as the owner of the policy until the plan is terminated. The regulations will not treat the employer as having made a transfer of property under [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...." 2002-4 I.R.B. at 399. Thus, in an "equity" split dollar plan, the employee will not be subject to tax on his or her increasing interest in the cash value, even if substantially vested, until the plan is terminated. Although the notice does not address the tax consequences in the event of the insured employee's death prior to plan termination, the employee's interest in the policy cash value should be excludible from the designated beneficiary's gross income as death proceeds receivable under [section] 101(a). Rev. Rul. 64-328.

Employee contributions are not addressed by the notice. The interim guidance offered in Notice 2001-10, now revoked by Notice 2002-8, allowed the employee to reduce the amount includible in gross income under [section] 83 by any consideration paid for the cash value interest. However, in the author's opinion, proper treatment would require reduction of the amount includible in gross income, not only by the employee's consideration, but also by the policy earnings attributable to the consideration. Otherwise, the employee would be subject to income tax currently on the policy's cash value build-up in violation of recognized principles of tax law. See Cohen v. Commissioner, 39 TC 1055 (1963), acq. 1964-1 C.B. 4.

Also not addressed are the tax consequences for the employer upon the deemed "transfer" of the cash value interest to the employee. Generally, [section] 83(h) allows an employer a deduction under [section] 162 equal to the amount includible in the employee's income for the employer's taxable year in which the employee's taxable year ends. However, Treas. Reg. [section] 1.83-6(b) requires the transferor to recognize gain to the extent that the transferor has satisfied its obligation with appreciated property. In the typical "equity" split dollar plan only the profit element in the policy will be transferred to the employee. Consequently, the deduction should be offset by the employer's recognition of gain upon disposition of the policy.

The "loan" regime will apply if the employee (or a third party) is designated as the formal owner of the policy and the employee (or third party) is obligated to repay the employer, either out of the policy cash value or otherwise. Payments by the employer will be treated as a series of loans to the employee, each payment being accounted for separately under [section] 7872 (the "below-market loan" rules) and [subsection] 1271-1275 (the "original issue discount" rules). The employee will not be subject to tax on current life insurance protection or any other policy benefits, except under the rules normally associated with personal ownership of life insurance.

Generally, [section] 7872 governs "below-market loans," that is, interest-free loans or loans in which the interest rate is less than the applicable federal rate (AFR) determined under [section] 1274(d). The amount by which the loan interest computed using the AFR exceeds the actual stated interest for the loan is called "foregone interest." In a compensation-related "demand" loan, each year the foregone interest (based on a floating, short-term AFR) is treated as being transferred to the employee as compensation, and then as being transferred back to the employer as loan interest. Thus, the employer includes the imputed interest in gross income, but has an offsetting deduction for the imputed transfer to the employee. The employee recognizes compensation income. However, in the context of a split dollar plan, there would be no offsetting deduction for the imputed interest payment because it would be classified as "personal interest." IRC [section] 163(h)(2); see also [section] 264(a)(3) and (4).

Somewhat different rules apply to "term loans." The imputed taxable transfer to the employee for the entire amount of forgone interest is deemed to occur on the date the loan is made, and the imputed interest is accounted for as original issue discount over the term of the loan. IRC [section] 7872(b). "Term loans," generally, should be avoided due to the lump-sum transfer imputed to the employee in the initial year of the loan.

Section 7872 also applies to "gift loans." These are loans that are in the "nature of a gift" within the meaning of Chapter 12 of the Internal Revenue Code. IRC [section] 7872 (c)(1)(A); Prop. Treas. Reg. [section] 1.7872-4(b). Generally, the rules for "gift loans" are similar to those for compensation-related loans. However, an amount equal to the "foregone interest" is imputed as a gift from the donor to the donee. Also, the taxable loan interest imputed from the donee back to the donor may be reduced in some circumstances. IRC [section] 7872(c)(2) and (d). It appears that these rules would govern so-called "private" split dollar plans between the insured donor and the donor's irrevocable life insurance trust, where the "loan" regime is applicable.

For the typical split dollar plan, premium advances to the employee should be treated as "demand loans" as that term is defined in [section] 7872(f)(5) and the proposed regulations. This is because the typical split dollar plan terminates upon termination of employment or upon the demand (with notice) of either party, at which time the employer is entitled to repayment of the cumulative amounts advanced. However, note that "term loan" treatment could be triggered inadvertently in a split dollar arrangement in which it is agreed that the arrangement will not end before the employee's death. In such circumstances, proposed regulations state that the actuarial determination of the employee's life expectancy constitutes an "ascertainable period of time," which causes the loan to be treated as a "term loan." Prop. Treas. Reg. [section] 1.7872-10(a)(2).

A split dollar plan between the insured's employer and a third party (e.g., an irrevocable life insurance trust) apparently would be treated as two successive below-market loans. Prop. Treas. Reg. [section] 1.7872-4(g). This successive loan treatment raises the potential for double taxation of the employee, who would be subject to income tax both on the deemed transfer from the employer and on the imputed interest income from the third party. This seems to be an unfair result for what is essentially a single integrated arrangement. Hopefully, the IRS will address this issue in a future pronouncement. As a possible solution, where the third party policy owner is the insured employee's irrevocable life insurance trust, structuring the trust as a grantor income trust under IRC [subsection] 671-678 could effectively eliminate the imputed interest income to the employee.

Clearly, the "below-market loan" rules in [section] 7872 add complexity, as well as some potential pitfalls, to split dollar arrangements. However, it is important to note that application of [section] 7872 can be eliminated by requiring the payment of interest equal to the AFR. [section] 7872(c); Prop. Reg. [section] 1.7872-3(a). Under this approach, the parties could arrange for the payment of sufficient interest, which would eliminate the application of [section] 7872, along with payment of a corresponding cash bonus to the employee. This strategy would achieve a tax result similar to that provided under [section] 7872, without the attendant complications.

Rigid Ownership Rule can be Problematic

The simple rule of assigning the tax regime based on policy ownership seems to be a convenient solution. However, this approach can be problematic in certain situations. Some common planning techniques utilize employee or third party ownership. This raises a potential problem if the parties to a "post-final regulation" plan prefer to use the "traditional" regime.

For example, split dollar plans for controlling shareholder employees commonly use the collateral assignment method, providing the corporation only minimal rights in order to avoid inclusion of death proceeds in the insured's gross estate under [section] 2042. See Rev. Rul. 82-145, 19822 C.B. 213. To obtain "traditional" treatment under the expected regulations, it would be necessary that the corporation (or other entity) be formally designated as the owner. However, unrestricted ownership would result in inclusion of the proceeds receivable by the insured's irrevocable trust (or other third party) in the insured's gross estate. The apparent solution to obtain both "traditional" treatment and estate tax exclusion would be to "formally" designate the corporation as owner, but severely restrict its rights to only reimbursement for corporate outlays. However, it is uncertain whether this approach would achieve its dual objectives.

The collateral assignment method is also useful in split dollar plans to neutralize potential "transfer for value" rule issues that may arise as interests in the policy are transferred or released. See [section] 101(a)(2); Treas. Reg. [section] 1.101-1(b)(4). Under the expected regulations, parties preferring "traditional" treatment would be effectively foreclosed from using this simple and effective way of dealing with the tax implications of the "transfer for value" rule. However, note that other strategies that rely on statutory exceptions to the "transfer for value" rule could be employed to eliminate the impact of any violation of the rule. See [section] 101(a)(2).

Arrangements Entered into Before Final Regulations

Guidance for existing split dollar arrangements and new arrangements entered into before the date of publication of final regulations is provided in the notice. Generally, for these arrangements, the IRS allows parties to choose either the "traditional" regime or the "loan" regime of taxation for their split dollar arrangement, regardless of who owns the policy. However, the notice does not specify how this election is to be made.

The rules governing these arrangements are essentially identical to those outlined above for "post-final regulation" plans. However, for "traditional" arrangements entered into before publication of final regulations, the arrangement will not be treated as terminated as long as the parties continue to treat and report the value of the life insurance protection as an economic benefit provided to the benefited person. An arrangement that meets this requirement will be treated as continuing regardless of the employer's remaining economic interest in the policy.

Parties may also elect "loan" regime treatment. In such cases, the IRS will not challenge reasonable efforts to comply with the "below-market loan" and "original issue discount" rules. To obtain "loan" treatment, the parties must treat all of the employer's payments from the inception of the arrangement as loans entered into as of the beginning of the first taxable year in which such payments are treated as loans. In offering this alternative, the IRS makes no distinction between new or existing arrangements. Neither does it specify a time limit on conversion of an existing "traditional" arrangement to the "loan" regime. Thus, it appears that a "traditional" arrangement could be converted to the "loan" regime at any time. Where the employee has not yet accrued any "equity," conversion to the "loan" regime should not result in any tax. However, if the employee has already accrued "equity," it appears that conversion to a "loan" arrangement would be treated as a termination of the "traditional" arrangement, and therefore cause taxation of the "equity" to the employee, unless the conversion is covered by the "grandfather" rule described below.

Conversion could be beneficial. For example, parties may decide that "loan" treatment is preferable to avoid taxation of the employee's "equity" upon termination during the employee's life. Also, conversion may be helpful for insureds who are advanced in age. For them, the imputed "foregone" interest under [section] 7872 could be lower than the economic benefit under the "traditional" approach. This could mean substantial income tax savings and reduced gifts, for gift tax purposes, to a third party owner (e.g., an irrevocable trust). In any event, the decision to convert to "loan" treatment should be made only after comparing both approaches under various assumptions relating to the policy, plan design, life expectancy, taxes, and the AFR.

The notice offers a valuable grandfather rule for "equity" split dollar arrangements entered into before January 28, 2002. For such plans, the IRS will not assert that there has been a taxable transfer of property under [section] 83 to a "benefited person" upon termination of the arrangement if the arrangement is terminated prior to January 1, 2004. Additionally, the IRS will allow a "traditional" arrangement to be converted to a "loan" arrangement, tax-free, if the conversion is accomplished before the stated deadline and all the sponsor's payments from the inception of the arrangement are treated as loans beginning on January 1, 2004. In this context, the notice uses the term "benefited person" instead of the term "employee," which indicates that the benefits of this provision may extend to gift taxes as well as income taxes. Clearly, this represents an outstanding tax saving opportunity for seasoned plans in which the employee (or other third party owner) possesses a significant amount of "equity."

The notice does not define the term "arrangement" for the purpose of determining what is protected by this grandfather rule. Certainly, it includes arrangements evidenced by a written agreement, although it would seem that lesser evidence indicating an agreement or understanding between the parties should be sufficient. Also, the notice does not indicate to what extent a modification to an arrangement on or after January 28, 2002, could jeopardize its grandfathered status. In this regard, it is important that parties proceed cautiously if they are contemplating a change relating to the plan design, agreement, supporting documentation, or policy.

Valuation of Life Insurance Protection

The notice also provides interim guidance relating to term rates used to measure life insurance protection. For arrangements entered into before the effective date of future guidance (i.e., not limited to expected regulations), the notice continues to allow taxpayers the choice of using government rates or the insurer's rates, if lower, to measure the economic benefit of life insurance protection.

The notice confirms the replacement by Notice 2001-10 of the government's "P.S.58" rates with "Table 2001." These rates are available to measure the value of life insurance protection, not only for split dollar arrangements, but also for qualified retirement plans and employee annuity contracts. Taxpayers are instructed to make appropriate adjustments to "Table 2001" rates if the life insurance protection covers more than one life (e.g., in survivorship, or "second-to-die," policies). The notice continues to permit the use of the government's "P.S.58" rates for arrangements entered into before January 28, 2002, where a contractual arrangement between an employer and an employee specifies the use of "P.S.58" rates to measure "the value of current life insurance protection provided to the employee (or to the employee and one or more additional persons)...." 2002-4 I.R.B. at 398.

Generally, taxpayers may continue to use the insurer's rates, if lower, so long as they comply with the requirements of Rev. Rul. 66-110 and Rev. Rul. 67-154. However, with respect to arrangements entered into after January 28, 2002, for periods after December 31, 2003, the insurer's rates cannot be used unless they meet the following additional requirements: 1) the insurer generally makes the availability of the rates known to persons who apply for term insurance coverage, and 2) the insurer regularly sells term insurance at such rates to individuals applying for coverage through the insurer's normal distribution channels.

Conclusion

In Notice 2002-8 the IRS effectively addresses long-standing issues for split dollar plans concerning taxation of the employee's "equity" and the valuation of life insurance protection. In the process, the IRS fundamentally changes its approach to the taxation of split dollar life insurance, leaving taxpayers a choice of two theoretical alternatives. Although questions remain concerning the application of rules set forth in the notice and the content of the expected proposed regulations, the notice provides useful guidance, resolves much of the uncertainty that has surrounded these plans in recent years, and generally confirms the validity of this popular planning tool.

Michael Parrott, J.D., CLU, ChFC, serves as executive vice president, advanced planning, for Financial Resource Alliance, in Jacksonville and is a member of the Florida and Georgia bars. He received his Bachelor of Business Administration from Stetson University and his Juris Doctorate from Emory University School of Law.

This column is submitted on behalf of the Tax Law Section, Richard A. Josepher, chair, and Michael D. Miller and Lester B. Law, editors.