Taxation of equity split-dollar arrangements.

Gross Income

The IRS recently ruled in Letter Ruling (TAM) 9604001 that a taxpayer who enters into a split-dollar life insurance arrangement "must include in income each year that the arrangement is in force...any cash surrender buildup in the policies that exceeds the amount that is returnable to [the corporation that paid the insurance premiums] when the arrangement is discontinued." The Service's position for taxing this excess cash surrender value appears to be based on Sec. 83.

Because many split-dollar arrangements are structured such that the insured-employee is entitled to any cash surrender value in the underlying policy that exceeds the amount of the employer's cumulative premium payments on such policy (hereinafter referred to as "equity split-dollar arrangements"), the IRS's conclusion in TAM 9604001 has significant ramifications for many taxpayers. Although a TAM applies only to the taxpayer for whom it was issued, it nevertheless constitutes authority in determining whether there is substantial authority for not reporting the excess cash surrender value of a life insurance policy owned under an equity split-dollar arrangement as income.

Fortunately, however, there appear to be at least two return filing positions under current law for not taxing the excess cash surrender value under a typical collateral assignment equity split-dollar arrangement.

TAM 9604001

In TAM 9604001, an employer, two insurance companies and a trust entered into the following transaction: The employer paid the insurance companies for two paid-up $500,000 life insurance policies on an employee's life; the insurance companies issued the life insurance policies to the trust as owner of the policies; the trust entered into a split-dollar: agreement with the employer; and the trust assigned the policies to the employer as collateral for the trust's obligation under the split-dollar agreements to repay the premiums paid to each insurance company.

Under the terms of the split-dollar agreements, the trust continues as the policies' owner and designated beneficiary of the policy proceeds. In addition, the trustees possess all incidents of ownership in the policies. The agreements further provide that the employer has an unqualified right to receive a portion of the death benefits equal to the total amount of the premiums paid, and that no amount will be paid from the death benefit proceeds to the policies' beneficiary until the full amount due the employer has been paid.

The agreements may be terminated for various reasons, including: []Bankruptcy or cessation of the employer's operations. []Termination of the employee's employment agreement. []Written notice by the trust or the employee.

If the agreements are terminated before the employee's death, the trust must reimburse the employer before the collateral will be returned to the trust. If the policies are canceled or surrendered, the employer is to be reimbursed from the cash surrender proceeds.

The insurance documents indicate that the policies' cash surrender value will exceed the premiums paid in the fourth year of the policies' existence. The split-dollar and collateral assignment agreements also provide that (1) any dividends on the policies are applied to purchase paid-up additional insurance on the employee's life, and (2) the trust may borrow from the policies or pledge or assign them, but only to the extent that a policy's cash surrender value exceeds the premiums paid by the employer.

IRS Position

The Service's conclusion in TAM 9604001, that the excess cash surrender value in an equity split-dollar arrangement between an employer and employee is taxable income to the employee, appears to be based on a theory that, once the cash surrender value of an equity split-dollar policy exceeds the amount required to be returned to the employer, the employer has made a transfer for purposes of Sec.83 of such excess to the employee. To understand this rationale, one must first understand the fictional ownership of a "split-dollar life insurance policy" created by Rev. Rul. 64-328, which provided, in part:

Even if the [split-dollar] arrangement is cast under the collateral assignment system, it should not be treated in substance as involving a loan from employer to employee, since generally the employee is not expected to repay the funds provided by the employer except out of the proceeds of the policy or from funds available to the employee by reason of the surrender or loan value of the policy. Instead, the substance is, whether the endorsement or collateral assignment system is used, that the employer provides the funds representing the investment element in the life insurance contract, which would, in arm's length dealings, entitle it to the earnings accruing to that element. The effect of the arrangement for the sharing of the cost of annual life insurance premiums, however, is that the earnings on the investment element in the contract are applied to provide current life insurance protection to the employee from year to year, without cost to the employee, to the extent the earnings are sufficient to do so. (Emphasis added.)

Thus, the IRS appears to interpret Rev. Rul. 64-328 as saying that, although the employee (or a third party) actually owns the life insurance policy, the employer is deemed to own its cash surrender value portion. Applying this rationale to TAM 9604001, the Service concluded that, because the employer owned the policies' cash surrender value portion, it made a transfer to the employee when (and to the extent) the cash surrender value of a policy exceeded the amount of premiums the employer was entitled to receive from such cash surrender value.

Alternative Positions

* Alternative 1: If one accepts the fictional ownership of a split-dollar life insurance policy created by Rev. Rul. 64-328 and further agrees that Sec. 83 is applicable to a collateral assignment split-dollar arrangement involving an employer and an employee, the key issue for determining the income tax consequences of a collateral assignment equity split-dollar arrangement is determining when the Sec. 83 transfer actually occurs. As discussed, the IRS takes the position that the transfer occurs in the year there is excess cash surrender value (i.e., when the cash surrender value in the policy exceeds the amount of the employer's insurance premiums) and every year thereafter.

An argument can be made, however, that the Sec. 83 transfer occurs on entering into a split-dollar arrangement. In other words, in the case of a typical collateral assignment equity split-dollar arrangement, the employer transfers to the employee the portion of the life insurance policy attributable to the future excess cash surrender value on the day the equity split-dollar arrangement is established, and not when the excess cash surrender value is actually generated.

Under a typical collateral assignment equity split-dollar arrangement, the policy's owner has all incidents of ownership in the policy and can borrow from the policy or pledge or assign it to the extent the policy's cash surrender value exceeds the insurance premiums paid by the employer. Thus, from the inception of the equity split-dollar arrangement, the owner of the split-dollar insurance policy has an interest in the policy's future excess cash surrender value and that interest is both transferable and not subject to a substantial risk of forfeiture. Accordingly, applying the fictional ownership established under Rev. Rul. 64328 to a typical collateral assignment equity split-dollar arrangement, it can be argued that the Sec. 83 transfer of the right to receive the excess cash surrender value occurs on entering into the equity split-dollar arrangement, and not when the excess cash surrender value is actually generated.

Regs. Sec. 1.83-3(e) provides that, for the transfer of a life insurance contract, only its cash surrender value is considered to be property. Based on the Service's analysis of Sec. 83 in TAM 9604001, the IRS seems to interpret this regulation to mean that a life insurance policy cannot be transferred within the meaning of Sec. 83 unless the policy has a cash surrender value. However, another interpretation of Regs. Sec. 1.83-3(e) is that, although only the policy's cash surrender value portion will generate tax under Sec.83 (i.e., the pure insurance element of a permanent life insurance policy will not be subject to tax under Sec. 83), a permanent life insurance policy that does not currently have a cash surrender value is nevertheless property and may be transferred for purposes of Sec.83.

* Alternative 2: An alternative argument is that Sec. 83 simply does not apply to collateral assignment split-dollar arrangements. In other words, the employer never owns the cash surrender value in the insurance policy. Rather, the employer merely allows the policy's owner to use the premium payments to pay for life insurance coverage and generate cash surrender value in the policy. As a result, there cannot be a transfer under Sec. 83 of any excess cash surrender value, as the employee or third party always owned the entire policy.

As discussed, Rev. Rul. 64-328 provides that the substance of a split-dollar arrangement is "that the employer provides the funds representing the investment element in the life insurance contract, which would, in arm's length dealings, entitle it to the earnings accruing to that element." The Service apparently interprets the quoted language to mean that the employer actually owns the policy's cash surrender value. However, in the context of a collateral assignment equity split-dollar arrangement, one can reasonably interpret this language to mean merely that the employer allows the employee to use employer funds (the premium payments) to purchase life insurance coverage and generate cash surrender value in the policy. Rather than treating the employee's use of the employer's funds as interest-free loans (as the IRS originally did in Rev. Rul. 55-713), the Service chose (in Rev. Rul. 64-328 and every related ruling issued since) to tax the employee only on the value of the insurance coverage.

Sec. 83(a) provides that, if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value (FMV) of such properly et the first time the rights of the person with the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture (whichever occurs earlier) over (2) the amount paid for such property (if any), is includible in the gross income of the person who performed such services in the first tax year in which the rights of the person with the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture (whichever is applicable). Pursuant to Regs. Sec. 1.83-3(a) (3), if the property is required to be returned on the occurrence of an event certain to happen (such as a termination of employment), that requirement will be treated as evidence that a "transfer" may not have occurred. Thus, because the employee (or a third party) owns the entire insurance policy under a collateral assignment split-dollar arrangement, there can be no transfer for purposes of Sec. 83 of the policy's excess cash surrender value (i.e., the employer owns no property to transfer). Further, because the policy's owner is required to reimburse the employer for its premium payments, there is no transfer for purposes of Sec.83 of those premium payments.

Tax Consequences of Each Position

* Alternative 1: When the split-dollar arrangement is established, the employee should include in income under Sec. 83(a) the excess of (1) the FMV of the right to receive the future excess cash surrender value in the policy over (2) any amount paid for that right. The FMV of the right to receive the policy's future excess cash surrender value should be based on all relevent facts and circumstances, including the type of life insurance policy used in the arrangement and the estimated period of time before the excess cash surrender value will accrue. In any event, the FMV of the right to receive the policy's future excess cash surrender value should, in most cases, be significantly less than its actual excess cash surrender value.

Pursuant to Rev. Rul. 64-328, the employee must include in his income each year the value of the insurance protection (i.e., the P.S. 58 amount or, if lower, the current published premium rates per $1,000 of insurance protection charged by the insurance company for individual one-year term life insurance available to all standard risks) in excess of any premiums he pays under the agreement.

There is no taxable event when the policy's cash surrender value exceeds the amount required to be returned to the employer because the employee already owns that excess cash surrender value and the build-up in cash surrender value of a policy (meeting the definition of life insurance under Sec. 7702(a)) is not subject to current income tax pursuant to Secs. 7702(g) and 72.

Under Rev. Rul. 78-420, if the life insurance policy under a split-dollar arrangement is owned by a third party (e.g., the employee's children or a trust for the benefit of the employee's children), the value of the life insurance protection provided by the employer that is included in the employee's income is treated as a gift by the employee to such third party and subject to gift tax under Sec. 2501. In addition, it appears the FMV of the right to receive the policy's future excess cash surrender value should be reported as a gift in the year the split-dollar arrangement is established. However, the actual build-up in the policy's cash surrender value in excess of the amount required to be returned to the employee should not be treated as a gift; as discussed, that amount is not includible in the employee's income and the policy's excess cash surrender value portion was transferred to the third party when the split-dollar arrangement was established.

If this alternative position is accepted, it appears employees who established collateral assignment split-dollar arrangements before 1995 can file their 1995 (and future year) income and gift tax returns just as they did before TAM 9604001 was issued. However, unless the employee reported as income, for the year the split-dollar arrangement was established, the FMV of the right to receive the future excess cash surrender value of the life insurance policy (less any amount paid for such right), he may have understated his income tax Liability for that year.

Further, if the life insurance policy under the collateral assignment split-dollar arrangement is owned by a third party (e.g., the employee's children or a trust for the benefit of the employee's children) and the employee did not retort the value of the right to receive the policy's future excess cash surrender value as a gift for the year the split-dollar arrangement was established, the employee may have also understated his gift tax liability (or use of his unified credit) for that year.

Thus, taking into account the applicable statute of limitations, the employee should determine his exposure to underreported income tax and gift tax. It may be necessary to file amended returns for open tax years.

For collateral assignment split-dolar arrangements established in 1995 (and, barring any applicable changes in the tax law, collateral assignment split-dollar arrangements established in years after 1995), a reasonable amount should be reported on the employee's relevant income tax return (and, if applicable, gift tax return) reflecting the FMV of the policy's excess cash surrender value portion. A good faith effort should be made to determine the FMV of that portion of the policy, taking into account all relevant facts and circumstances.

* Alternative 2: Pursuant to Rev. Rul. 64-328, the employee must include in his income each year the value of the insurance protection (i.e., the P.S. 58 amount or, if lower, the current published premium rates per $1,000 of insurance protection charged by the insurance company for individual one-year term life insurance available to all standard risks) in excess of any premiums he provides under the agreement.

There is no taxable event when the policy's cash surrender value exceeds the amount required to be returned to the employer, because the employee already owns that excess cash surrender value, and the build-up in the policy's cash surrender value (meeting the definition of life insurance under Sec. 7702 (a)) is not subject to current income tax pursuant to Secs. 7702 (g) and 72. Pursuant to Rev. Rul. 78420, if the life insurance policy under a split-dollar arrangement is owned by a third party (e.g., the employee's children or a trust for the benefit of the employee's children), the value of the life insurance protection provided by the employer included in the employee's income is treated as a gift by the employee to that third party and subject to gift tax. However, the actual build-up in the policy's cash surrender value in excess of the amount required to be returned to the employer should not be treated as a gift because, as discussed, that amount is not includible in the employee's income and there is no transfer of property for purposes of Sec.2501 (a).

As a result, if this alternative position is accepted, it appears an employee insured under a collateral assignment split-dollar arrangement can file 1995 (and future year) income and gift tax returns just as he did before TAM 9604001 was issued.

FROM PETER I. ELINSKY, CPA, J.D., LL.M., AND MARK T. WATSON, CPA, MS, WASHINGTON, D.C.