Split-dollar: proposals would change rules for split-dollar life insurance. (Federal Tax).

The IRS has proposed regulations for split-dollar life insurance arrangements. Once final, the new regulations would apply to any SDLI arrangement entered into after the final regulations are published in the Federal Register.

Also, an arrangement entered into on or before the final regulations are published that is subsequently materially modified is treated as a new arrangement entered into on the modification date.

Notice 2002-8 contains guidance for arrangements entered into before these regulations are effective. However, taxpayers may rely on the proposed regulations for treating SDLI arrangements entered into on or before the final regulations are published if all parties treat it consistently.

Overview of Proposals

These proposals provide guidance on the taxation of SDLI arrangements, including equity SDLI arrangements, for federal income, employment and gift tax purposes. Therefore, they apply to a SDLI arrangement between:

* An employer and employee;

* A corporation and shareholder; and

* A donor and donee.

SDLI Arrangement Defined--Under these proposals, an SDLI arrangement is defined, generally, as any arrangement that is not part of a group term life insurance plan described in IRC Sec. 79 between a life insurance contract's owner and a non-owner in which either party pays all or some of the premiums and is entitled to recover, conditionally or unconditionally, all or some of those premiums--and such recovery is to be made from, or is secured by, the contract's proceeds.

This definition is intended to apply broadly and, for example, will cover an arrangement under which a contract's non-owner provides funds directly to the owner with which the owner pays premiums--as long as the non-owner is entitled to recover, conditionally or unconditionally, all or some of the contract's proceeds (e.g., death benefits) or has an interest in the contract to secure the right of recovery. In addition, the amount to be recovered by the party paying the premiums need not be determined by reference to the amount of those premiums.

Under a special rule, an SDLI arrangement is any arrangement between a life insurance contract's owner and non-owner in which the employer or service recipient pays, directly or indirectly, all or some of the premiums, and the beneficiary of all or some of the death benefit is designated by the employee or service provider--or is any person whom they would reasonably be expected to name as beneficiary. This special rule does not apply to any Sec. 79 arrangement.

This special rule also applies to arrangements between a corporation and a shareholder in which the corporation pays, directly or indirectly, all or some of the premiums and the beneficiary of all or some of the death benefit is, or would be reasonably expected to be, a person designated by the shareholder.

Mutually Exclusive Regimes--An SDLI arrangement is taxed under the economic benefit or loan regime. Under the economic benefit regime, generally set forth in Prop. Regs. 1.61-22, the life insurance contract owner is treated as providing economic benefits to the non-owner. This generally will govern the taxation of endorsement arrangements.

A special rule requires the economic benefit regime to apply to any SDLI arrangement if:

* The arrangement is entered into in connection with the performance of services and the employee or service provider is not the insurance contract's owner; or

* The arrangement is between a donor and donee (e.g., a life insurance trust) and the donee is not the insurance contract's owner.

Under the loan regime, generally set forth in Prop. Regs. 1.7872-15, the insurance contract's non-owner is treated as loaning premium payments to the owner. Except for specified arrangements, this regime applies to any split-dollar loan as defined in the proposed regulations. The loan regime generally will govern the taxation of collateral assignment arrangements.

Thus, in contrast to Rev. Ruls. 64-328 and 66-110, the proposed regulations generally provide substantially different tax consequences to the parties depending on which party owns the life insurance contract. These proposals require the owner and non-owner of a contract that is part of an SDLI arrangement, as defined under the general or special rule, to fully and consistently account for all amounts under the arrangement under Prop. Regs. 1.61-22 or 1.7872-15.

General federal tax principles apply to SDLI arrangements unless the non-owner's payments are certain payments for economic benefits. For example, if an employer pays premiums on a contract owned by an employee and the payments are not split-dollar loans under Prop. Regs. 1.7872-15, the employee must include the payments in income when paid by the employer to the extent that the employee's rights to the contract are substantially vested.

The proposed regulations provide rules for determining a contract's owner and non-owner.

In addition, Notice 2002-59 (IRB 2002-36, 9/9/02) describes standards for valuing life insurance protection under SDLI arrangements.

Stuart R. Josephs, CPA, has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].