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Is split-dollar life insurance still a fringe benefit?

Split-dollar life insurance (SDLI) is a method of dividing the economic benefits and burdens of life insurance between a company and an employee, allowing the company to subsidize the employee's coverage. As this article explains, SDLI raises income, estate and gift tax and imputed interest issues; further, a recent IRS ruling may serve to curtail its popularity.

A fringe benefit still available to business owners and key personnel is split-dollar life insurance (SDLI), an arrangement in which an employee and employer share the costs and benefits of a cash value life insurance policy, Often, the employer pays the total premium (or pays an amount equal to the annual increase in the cash surrender value (CSV) of the policy), and the employee pays the balance of the premium (if any). The employee is treated as receiving income of the excess of the value of the insurance protection received over the premiums he paid. If the employee dies or the policy is terminated, the employer receives some (or all) of die policy's CSV and the employee's estate, trust or heirs receive the balance of the payout. SDLI arrangements may be used with any type of permanent life insurance.

In Rev. Rul. 55-713,(1) the IRS held that an SDLI arrangement provided an interest-free loan to the employee (and, hence, taxable income) equal to the annual increases in the policy's CSV Subsequently, in Dean,(2) the Tax Court held that the interest-free loan did not result in taxable income to a controlling shareholder-employee. In response, Rev. Rul 64-328(3) held that an employee had a taxable economic benefit of the value of the insurance protection received in excess of the premiums paid by him; this ruling continues to be the basis for tax law in this area.

This article will explain SDLI and consider various related issues. Recent letter rulings involving SDLI for S corporation shareholders and employees will be reviewed. While these rulings pertain to S corporations, they provide insight as to how to keep policy proceeds out of the insured's estate.

SDLI Mechanics

The effect of the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Revenue Reconciliation Act of 1993 and the Small Business job Protection Act of 1996 on qualified retirement plans, welfare benefit plans and nonqualified deferred compensation plans has enhanced the benefit of SDLI arrangements. Because SDLI arrangements are nonqualified, a corporation can discriminate as to the person(s) covered. From the insured's standpoint, an SDLI arrangement is advantageous; it is less expensive than personally owned life insurance.

In Rev. Rul. 64-328, the IRS ruled that an SDLI agreement between an employee and employer resulted in income to the employee based on the "economic benefit" conferred by the plan. The IRS valued the benefit using the P.S. 58 costs, but later ruled that the insurer's lowest yearly renewable standard term rates could be used.(4) The IRS later ruled that when an SDLI plan involves a second-to-die life insurance policy the cost of one-year term insurance may be based on the rates in joint-life Table 38, U.S. Life Tables and Actuarial Tables rates.(5) Either of these costs is much less than the cost of whole life insurance,

Example 1: A controlling shareholder J, age 45, wants to provide sufficient insurance to pay his estate taxes. He enters into an agreement with Y corporation to provide him with $1,000,000 of life insurance. The premium on this policy is $21,525, which is paid by Y The cost to age 65 based on the insurer's rates is lower than the P.S. 58 rates; thus, the former is used and results in $28,595 of taxable income to J. If J's marginal tax rate is approximately 40%, the cost of this insurance would be $11,438 over 20 years, which is very low given the amount of protection provided.(6)

From an employer's standpoint, SDLI can offer a valuable fringe benefit at annual cost. On the insured's death or on earlier termination of the policy, the employer will have its premiums returned. Because the premiums will be returned, they are not deductible, according to Rev. Rul. 64-328; thus, the cost to the company is the loss of the use of the funds used to pay the premiums.

Premium Splitting

There are numerous ways to split premiums in an SDLI arrangement. In most cases, the employer pays all the premiums and the insured is treated as receiving taxable income. In a "classical split," the employer pays a premium equal to the annual increase in the policy's CSV; the employee pays the balance. In another arrangement, the "P.S. 58 offset" or "contribution" split, the employee contributes the cost to buy a one-year term policy of equivalent coverage; the employer pays the balance of the premium. There are many variations on these approaches.

The split of CSV and death benefits when an insured employee dies is usually determined by the employer's interest in the arrangement. The share of the employer's split can be a return of premiums paid, the policy's CSV at the date of death, or the greater of the two. The employee's estate, trust or heirs receive the balance of the payout.

Policy Ownership

The two traditional SDLI structures are the "endorsement" and the "collateral assignment" methods. Two other techniques are the "undocumented" and the "contractual" methods.

Under the collateral assignment method, the policy is owned by the insured or a third party (e.g., an irrevocable trust).The employer's interest in the policy (e.g., its right to recover premium payments) is contained in a collateral assignment of the policy by the owner. The rights assigned to the employer vary considerably, from virtually all rights in the policy to a "bare bones" collateral assignment.

With the endorsement method, the employer owns the policy, and the employee's rights are contained in an endorsement filed with the insurer. In a traditional endorsement policy, the employee's sole right would be to Dame the beneficiary of the death proceeds in excess of the employer's interest in such proceeds. This method is most often used when the employer wants to maintain control of the policy.

Under the undocumented method, the policy is not used to protect the employer's advances; rather, that is accomplished through a contractual arrangement with the employee. This approach may provide greater certainty in the estate tax area for majority shareholders; because the employer does not have an ownership interest in the policy, there should be no incidents of ownership attributable from the corporation to the controlling shareholder. Care must be taken to ensure the shareholder does not have other incidents of policy ownership.

With the "co-ownership" method (sometimes termed "split ownership") the employee or other owner directly owns a share of the policy's CSV; therefore, there is no transfer of those values from the employer. Such arrangements must be structured to prevent the employer from canceling or surrendering the policy; otherwise, the employee's position may be illusory.

A New Threat?

In Letter Ruling (TAM) 9604001,(7) the Service took a position on the income and gift tax treatment of SDLI that appears inconsistent with the regulations and prior rulings. The taxpayer in the TAM was chairman, chief executive officer and 51% owner of a holding company that owned 98% of a subsidiary. In 1991, the subsidiary, two insurance companies and a life insurance trust entered into the following transactions: (1) the subsidiary paid each of the insurance companies for two paid-up life insurance policies on the taxpayers life; (2) the companies issued the policies to the trust as owner of the policies; (3) the trust entered into SDLI agreements with the subsidiary; and (4) the trust assigned the policies to the subsidiary as collateral for the trust's obligation under the arrangements to repay the premiums the subsidiary had paid to each insurance company.

The SDLI agreements provided that if the subsidiary became bankrupt or if the taxpayer's employment terminated prior to his death, the trust would be required to reimburse the subsidiary for the premiums it had paid. If the policies were canceled or surrendered, the subsidiary would be reimbursed from the cash surrender proceeds. The trust, as owner of the policies, could borrow from them or pledge or assign them to the extent a policy's CSV exceeded the premiums paid by the subsidiary. Dividends on the policies were to be used to purchase additional paid-up insurance on the taxpayer's life.

The Service ruled that, even though in Rev. Rul. 64-328, the employer paid annual premiums, and in the instant case, only one premium was paid (the earnings from which would cover future premium payments), the situations were indistinguishable. Accordingly, the value of the life insurance protection was includible in the taxpayer's income under Regs. Sec. 1.83-1 (a)(2).

The taxpayer had to include in gross income the lesser of the P.S. 58 cost (as provided in Rev. Rul. 55-747(8)), or the current published rates per $1,000 of insurance protection charged by the same insurer for individual one-year term life insurance available to all standard risks. The Service noted that Rev. Rul. 66-110 held that any benefit (e.g., additional insurance on the employee's life) was also includible in the employee's gross income. The policies' CSVs were not taxable to the extent they remained subject to the subsidiary's general creditors and to the subsidiary as a creditor. When the CSVs exceeded the premiums paid by the subsidiary, the taxpayer would have to include such excess in income under Sec. 83(a). Previous rulings had not considered the buildup in `CSVs in life insurance policies to be income taxable to the employee.

Further, noting Rev. Rul. 78-420,(9) the IRS stated that the value of life insurance protection provided by the employer that is annually included in the taxpayer's income is deemed to be transferred by the employee for purposes of Sec. 2511 and is subject to gift tax. The gift includes the P.S. 58 cost and the annual buildup in the CSV.

The inclusion in income of the buildup in CSVs is contrary to the regulations and prior decisions. The Service referred to Sec. 83 in TAM 9604001, but Regs. Sec. 1.83-1(a)(2) states that the cost of life insurance protection to be included in an employee's income is the reasonable net premium cost, as determined by the Service, of the current fife insurance protection (as defined in Regs. Sec. 1.72-16(b)(3)) provided by the Contract. Thus, the TAM creates a new rule.

Many parties have objected to the TAM because it overrides Rev. Rul. 64-328, which has been the basis for the taxation of SDLI arrangements for over 30 years. The Association for Advanced Life Underwriting (AALU) submitted a memorandum to Treasury in April 1996, contesting the taxation of the buildup of CSVs as set out in TAM 9604001, and requesting that the TAM be revoked or amended.(10) The AALU argues that the Service's position contradicts existing law and represents the unauthorized taxation of a permanent life insurance policy's tax-free CSV buildup.

The AALU noted that in Cohen,(11) the Tax Court held that periodic increments in the CSV of life insurance policies are not income in the years in which they are credited to the policies, and GCMs 38934(12) and 39270(13) hold that the constructive receipt doctrine has no application to the CSV, including the interest element thereon, of a contract taxable under Sec. 72. The memorandum notes that Rev. Rul. 64-328 is consistent with these principles.

If the entire buildup in CSV was assigned to the employer, the employee could avoid taxation on such income; however, this would reduce the benefit of the insurance to the taxpayer. Another possibility for excluding the buildup is for the tax preparer to take the position that TAM 9604001 is contrary to the regulations. If this avenue is taken, the preparer must file Form 8275, Disclosure Statement, with the return to avoid Sec. 6662 penalties. (Under Regs. Sec. 1.6662-4(d)(iii)(3), TAMs issued after Oct. 31, 1976 constitute substantial authority.)

Gift Tax Issues

One of the advantages of an SDLI arrangement is the leverage involved; a gift is measured by the economic benefit conferred, not the entire premium. In the absence of an SDLI arrangement, when a policy is owned by a third party, each time the insured pays a premium, a gift of such premium to the third party results.

However, if the insured transfers the policy to an irrevocable trust or such a trust initially becomes the "subowner" of the policy, a gift occurs. According to Rev. Rul. 81-198,(14) the value of the gift on the initial assignment is the value under Regs. Sec. 25.2512-(6)(a), reduced by the employer's interest. This results in a small (or nonexistent) gift in the early years of a policy; later, when the gift tax value exceeds the employer's premiums paid, the gift becomes significant.

There is also an annual, indirect gift from the insured to the policy owner as long as the arrangement is in effect. The value of the gift, as set out in Rev. Ruls. 78-420 and 81-198, is the economic benefit of the arrangement to the insured. This creates leverage for gift tax purposes, because the gift has been reduced from the amount of the premiums to the economic benefit.

This makes it attractive for larger estates; it allows greater insurance protection that may be covered by the annual exclusion and the unified credit.

A gift of a future interest does not qualify for the $10,000 Sec. 2503 annual exclusion. However, a gift into a trust over which the beneficiaries have Crummey(15) powers should prevent gift tax problems. The beneficiaries must have a bona fide right to demand payment of the transfers made to the trust. Because a plan in which the employer pays the premiums does not generally allow a beneficiary to make a withdrawal, other arrangements must be made; the economic benefit offset approach may resolve this problem. This approach requires the employee or the owner of the policy to pay the portion of the premiums equal to the plan's economic benefit. The insured can transfer the P.S. 58 cost into the trust each year; the trustee can notify the beneficiaries of their withdrawal rights. If the beneficiaries do not demand payment, the trustee can then pay the portion of the premium equal to the economic benefit with the donated funds. Under such an arrangement, the employee has no reportable income.

From various letter rulings, it appears that the Service seems to require notice of the withdrawal right as well as a reasonable time in which to exercise it.(16) In Letter Ruling 9532001,(17) a taxpayer had created an irrevocable trust for the benefit of nine grandchildren, who waived their rights to withdraw the initial gift and revocably waived their rights to receive notices of future withdrawal rights. The Service ruled that, except for the initial gift, the remaining transfers did not constitute gifts of present interests. The lack of future notice made it impossible for the beneficiaries to have the real and immediate use, possession and enjoyment of the transfers.

In Letter Rulings 8121069(18) and 8133070,(19) the IRS approved as present interests transfers of life insurance policies to trusts for which only one withdrawal notice would be given. Other options include a 60-day withdrawal period,(20) a 30-day withdrawal period,(21) a 20-day withdrawal period(22) or a 10-day withdrawal period.(23) It would be prudent to send an annual notice to the beneficiaries and to set an ample time period for a withdrawal to occur.

Estate Tax Issues

Incidents of Ownership

For Federal estate tax purposes, SDLI arrangements generally are covered by Sec. 2042, which imposes two tests to determine whether life insurance is included in an estate. The proceeds are includible if (1) they are receivable by or for the benefit of the insured's estate or (2) the decedent held any "incidents of ownership" in the contract.(24) To avoid inclusion of the proceeds under Sec. 2042, a party other than the insured must be involved in the arrangement.

Sec. 2042(2) specifies the incidence of ownership test, but it does not explain what an "Incident of ownership" is. In 1974, Regs. Sec. 20.2042-1 (c) (6) was issued, expanding the attribution of ownership to controlling, as well as to sole, shareholders. The question arose in Est. of Levy(25) as to whether Treasury had exceeded congressional intent. In that case, the decedent had owned 80.4% of a corporation's issued and outstanding voting stock and all of its issued and outstanding nonvoting stock. The corporation owned SDLI policies on the decedent's life that were payable to his surviving spouse. The corporation was entitled to the policies' CSV and had the right to change the beneficiary of the CSV, the right of assignment, and the right to modify or borrow against the policies. The decedent, apart from his stock ownership, held no incidents of ownership in the policies. The policy proceeds were not included in the decedent's estate; the Service contended that they were includible under Sec. 2042.

The estate's position was that the committee reports of the Revenue Act of 1942(26) precluded the attribution of corporate incidents of ownership to any stockholder other than a sole stockholder; thus, Regs. Sec. 20.2042-1 (c)(6) was invalid. The estate also contended that, in any case, the regulation should not apply retroactively to the estate.

The Tax Court held that because the decedent had the power to elect the board of directors, who, in turn, would be amenable to his wishes as to the exercise of the incidents of ownership held by the corporation, he could indirectly exercise such power. The court concluded that the Sec. 2042 legislative history supported applicability to controlling shareholders before and after the 1974 amendments to the regulations.

If the insured does not retain any incidents of ownership, the policy proceeds should not be includible in his estate. However, ownership of the policy by a corporation more-than-50% owned by the insured may present attribution problems. While attribution between spouses was held not to be required in Letter Ruling 907012,(27) under Regs. Sec. 20.2042-1 (c)(6), an individual will be treated as owning shares held by (1) him, (2) him and another person jointly or (3) the trustee of a voting trust or any other trust with respect to which the individual is treated as owner.

Because property acquired during marriage is considered equally owned by spouses in most community property states, in such states it would not be possible for a married person to own more than 50% of a Corporation's stock. For taxpayers in community property states, therefore, attribution problems may be minimized. But if the stock was acquired before marriage, state law may not place the stock into community property status, which would put the stockholder in the same position as a married taxpayer in a common-law jurisdiction.

It may be possible to reduce a shareholder's interest in a corporation to 50% or less if other family members are involved; if so, the attribution problems of a controlling shareholder will not arise. Because minority interest and lack of marketability discounts may be taken on gifts of stock, gifting may make sense even if significant gift taxes have to be paid. Additionally, if a shareholder dies with less than a controlling interest, the estate may take similar discounts on the decedents stock. However, in many cases a controlling shareholder may not want to give up control, or may not have family members who are capable of running the business, in which case gifts of stock may not be practical.

In Rev. Rul. 76-274,(28) the Service discussed three scenarios involving SDLI policies of controlling stockholders. In the first, the corporation loaned the shareholder the funds to buy the policy; the corporation was the owner of the policy and could release, surrender, transfer or assign it without the consent of the subowner (the controlling shareholder). A third party was the beneficiary. More than three years before his death, the subowner assigned his rights and interest in the policy to a third party. The IRS held that the corporation's rights were attributable to the controlling stockholder; thus, the proceeds paid to the third party were includible in the shareholder's estate.

In the second situation, the corporation's only rights were to (1) borrow against the policy to the extent of the CSV and (2) assign its rights in the policy to the subowner on payment of the premium funds loaned by the corporation. The insured retained his rights as subowner until his death and did not assign them. The corporation could not jeopardize the rights of the subowner; because the insured had substantial control of the policy until his death, and the corporation was merely a secured lender, the proceeds payable to his beneficiary were includible in the insured's estate.

In the third situation, the facts were the same as in the second scenario, except that a third party was the policy subowner. The ruling held that because neither the corporation nor the insured had any incidents of ownership at the insured's death, the proceeds were not includible in his estate. However, in Rev. Rul. 82-145,(29) the Service reversed this result, stating that because the corporation could borrow against the policy's CSV, it possessed an incident of ownership under Regs. Sec. 20.2042-1 (c)(2) attributable to the insured's estate under Regs. Sec. 20.2042-1 (c)(6).

It may be preferable not to give a corporation any interest in the policy. When dealing with insured majority stockholders, care must be taken to limit the corporations interest in a policy to a recovery of the premiums paid (i.e., a bare bones collateral assignment). This approach does not grant the employer a right to surrender the policy or to borrow against its CSV

The Three-Year Rule

Under Sec. 2035(d), if an insured dies within three years of transferring incidents of ownership in a policy on his life, the policy proceeds will be includible in his estate. To avoid this, a third party (e.g., a trust or spouse) should be the initial purchaser of the policy(30) The IRS has staunchly litigated cases involving a trust's purchase of the policy, arguing that the insured constructively transferred an interest in the policy, but has consistently lost.(31)

The three-year rule may also apply when an individual's controlled corporation owns a policy on his life, and the insured disposes of sufficient shares to reduce his voting interest in the corporation to less than 50%. The IRS has held that the insured must survive the transfer of shares by three years to avoid inclusion of the policy proceeds payable to the corporation in his estate.(32) Similarly, if the corporation releases its incidents of ownership in a policy on the life of its controlling shareholder, he must survive the release by at least three years to avoid inclusion of the proceeds in his estate.

For planning purposes, for an individual who is not currently (but may become) a controlling shareholder, it may be appropriate to eliminate the risk of future application of the three-year rule by preparing a "restricted" collateral assignment, SDLI agreement.

One Class of S Stock

Regs. Sec. 1.136 1-1 (c)(4) requires that all shares of stock of an S corporation have identical rights as to distribution and liquidation proceeds; further, the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements relating to distribution and liquidation proceeds have to be reviewed to determine whether all stock has the same rights. If SDLI is made available to some S shareholders and not others, the IRS could contend that a second class of stock exists, terminating the corporation's S status.

In Letter Ruling 9331009,(33) shareholders who participated in an SDLI arrangement with their S corporation were required to reimburse the corporation for the economic benefit of the plan (an offset plan). The participating shareholders were not employees. The ruling refers to Rev. Rul. 79-50,(34) which stated:

... when there is a split-dollar arrangement, in which a corporation pays the portion of the premiums equal to the increases in the CSV and the shareholder pays the balance, if any, of the premiums, and in which, from the proceeds payable upon the employee's death, the employer receives at least an amount equal to the funds it has provided, with the beneficiary receiving the balance, the value of the insurance protection in excess of the premiums paid by the employee must be included in the employee's income ... The benefit flowing from the corporation to the taxpayer is a distribution within the meaning of...[Sec.] 301(a)... made by the corporation to a shareholder with respect to its stock and must be treated in accordance with...[Sec.] 301(c).

In Letter Ruling 9331009, the Service ruled that because the stockholders were required to pay the corporation each year an amount equal to the economic benefit the policy conferred on them, a second class of stock was not created within the meaning of Sec. 1361 (b)(1)(D). It appears there may be little difference between the payments required in Rev. Rul. 79-50 and those of the taxpayer in Letter Ruling 9331009, but the tax impact is very different. The taxpayer requested a ruling only as to whether a second class of stock would be created under an SDLI arrangement, and the IRS did not express an opinion on the Federal income tax consequences of any other issue. A similar set of facts existed and a similar conclusion was reached in Letter Ruling 9318007.(35)

Because the premiums are nondeductible, SDLI plans are often more attractive for C corporations; C corporations often have a lower marginal tax rate than do S shareholders. While this possible benefit is not available in S corporations, the use of the SDLI arrangement is nevertheless beneficial, because the transfer of the policy to an irrevocable trust results in a gift amount substantially lower than if the SDLI arrangement were not used, This is because the economic benefit, which is less than the premiums paid, determines the gift.

QTIP Trusts

In Letter Ruling 9511046,(36) an S corporation jointly owned by a husband and wife entered into an SDLI arrangement with the husband's irrevocable life insurance trust to purchase a second-to-die (survivorship) whole life contract insuring the couple. While the trust would own the policy, the couple would pay the premiums.

Each spouse was also the trustee of a revocable inter vivos trust that held each's 50% of the S stock. On the husband's death, if his spouse survived him, his trust would become Irrevocable, and all of the S stock held by the trust would be allocated to an irrevocable trust that would be eligible for qualified terminable interest property (QTIP) treatment at the executor's election. The trust would also be a qualified subchapter S trust. At the death of the taxpayer's spouse, the principal of the QTIP trust would continue to be held in trust for the benefit of the taxpayer's descendants. If the taxpayer outlived his spouse, he would be the primary beneficiary of the QTIP trust.

The S corporation could not borrow any portion of the policy's CSV As policy owner, the irrevocable life insurance trust was entitled to all rights, benefits and privileges granted by the policy. Only the trustee could surrender or terminate the agreement. If the policy was surrendered, the corporation would have a security interest in the policy's net CSV of the lesser of the premiums paid by the corporation or the net CSV If the agreement was terminated, the trustee was required to pay the corporation the lesser of these amounts.

The IRS ruled that, because the corporation had no incidents of ownership in the policy, neither would the surviving spouse. Thus, none of the insurance proceeds would be includible in the estate of the second spouse to die.

Some commentators have felt that Letter Ruling 9511046 is deficient because it cites Rev. Rul. 76-274 but not Rev. Rul. 82-145. However, in both revenue rulings, the corporation had the right to borrow against the policy's CSV; in the letter ruling, the corporation had no such right.

Second-to-Die Policies

Second-to-die policies often provide insurability when an employee or stockholder either is not insurable or only at very high rates. Second-to-die policies also provide a low-cost method of funding a trust.(37)

Example 2: H and W, each 45 years old, establish a trust and arrange for an SDLI agreement with H's controlled corporation. The trust acquires a second-to-die policy of $1,000,000 on the couple. Because the trust is the initial purchaser of the policy, the Sec. 2035 three-year rule is avoided. H then gives the trust each year an amount equal to the economic benefit received. Throughout the life of the policy, the annual exclusion covers the value of the gift. The corporations premium, payments far exceed the income tax ramifications to H.

After the death of either H or W, the calculation of the economic benefit involves use of the P.S. 58 rates; because there may have been a buildup in a policy's CSVs, the surviving spouse may find the gift costs associated with the policy dramatically increased. To avoid this result, the plan can be structured so that the corporation's interest in the policy can be terminated by the insured or a third party by paying it for its interest in the policy (a "roll-out"). This is beneficial; the policy will be paid up after 15 or 20 years, depending on how it is structured, while the economic benefit to the insured increases. A policy roll-out may have income tax implications if there is any equity in the policy when it occurs. Also, there may be a problem with the Sec. 101(a)(2) transfer for value rules. For example, if a roll-out occurs and a trust pays the corporation for its interest, a transfer for value has occurred, which may mean the proceeds received on the policy would be taxed to the trust. Even if a corporation endorsed the at-risk portion of a policy to another stockholder under an SDLI arrangement, the transfer for value rule is violated. (Sec. 101(a)(2) applies to the transfer of a life insurance contract, or any interest therein.)

Various steps may be taken to minimize income taxes. Policy dividends may be made payable to the corporation, to reduce the amount to be repaid on a roll-out. Also, the corporation could release its interest to the policy owner, who would then have to pay tax on the release as income rather than borrowing to reimburse the employer. This would reduce the funds needed for the release it third-party ownership situations (e.g., with a trust), the income would also result in a gift to the trust from the insured.

In a roll-out, the transfer for value issue can be avoided by transferring the policy to the insured, as long as the insured is an officer or shareholder of the corporation. If a corporation transfers a policy to an insured officer or shareholder to begin a collateral assignment arrangement, the transfer for value rules will likewise not apply, because the insured is always an exempt transferee under Regs. Sec. 1.101-1(b)(3)(ii). But because the insured must transfer the policy to the third party, the Sec. 2035 three-year rule comes into play.

With second-to-die life insurance, the transfer problem is significantly reduced; both insureds must die within three years of the transfer, with the spouse of the controlling shareholder dying first, if the proceeds are to be included in the controlling shareholder's estate. If the controlling shareholder dies first, nothing is included in his estate, because the death benefit is not yet payable.

The use of a partnership or limited liability company (LLC) in which the trust and the insured are the partners or members can avoid these problems.(38) Because a trust would be a partner of the insured, the transfer for value issues tinder Sec. 2042 would be eliminated, as would the Sec. 2035 problem. Or, a family limited partnership could be used, with the trust and family members as partners with the insured; this could provide additional estate planning strategies and would remove some of the obstacles of transferring SDLI insurance to a trust.

Imputed Interest

Another issue raised in Letter Ruling 9331009 was whether the arrangement, resulted in a below-market interest rate. The Service stated that no opinion was expressed or implied concerning the application of Sec. 7872 to the situation. While some tax advisers believe this to be a positive sign, the IRS is reviewing the relationship between SDLI plans and interest-free loans.(39) If an SDLI arrangement is characterized as a series of interest-free or below-market interest rate loans, an employee would report the forgiven interest and not the P.S. 58 amount as income. As the loan balance grows, the interest factor could easily exceed the P.S. 58 amounts. A recent article noted that, under either traditional approach, the Service could make a plausible argument that an interest-free loan has taken place.(40) If interest is imputed, SDLI will no longer be a viable planning technique.

On the other hand, such premium advances and other loans from an employer to an employee would have to exceed $10,000 under the Sec. 7872(c)(3) de minimis rule before interest income would result. Because the Service has stated that it would grandfather existing agreements if a rule change were enacted, contracts entered into before any change would not be affected.(41)

Other Issues

SDLI may also provide the owner of a business with nontax advantages over other types of remuneration. Often, business owners are concerned with the impact a large salary may have on employees and bankers. Lenders may object to high salary payments if they have loaned a firm substantial amounts. A large salary relative to others in the firm may cause discontent; some employees may feel they are comparatively underpaid. There also may be a concern about the deductibility of salaries under Sec. 162. Shifting income to premiums for SDLI is one method to defuse the perceived high-salary issue.

Under SDLI, the CSV of the policy is maintained on the corporation's books, which may be desirable for financial statement purposes. Also, providing funds in this manner may be preferable to having the corporation own the insurance, because the buildup in the policy may add to alternative minimum tax problems. For these reasons, shifting income to sources other than salary, such as SDLI, makes sense.

If SDLI arrangements involve gifts to or for the benefit of "skip persons," such as grandchildren, the generation-skipping tax (GST) comes into play. Using an SDLI arrangement may permit leveraging; the deemed gift is less than the premiums paid for the benefit. Therefore, larger estates may effectively expand the amount passing to skip generations by using long-term trusts with GST implications. Coverage of the impact GST may have on SDLI arrangements is beyond the scope of this article.


For key personnel in many corporations, life insurance is a practical approach to estate planning. SDLI with an employer provides additional insurance at greatly reduced costs to the insured. With tax laws restricting many fringe benefits available to key personnel and shareholder-owners, SDLI remains an avenue worth investigating.


* There are at least three ways to split the cost of the premiums under the SDLI arrangement.

* There are various ways to structure who will own the policy.

* The insured must have no incidents of ownership in the policy to avoid inclusion of the proceeds in his estate.

(1) Rev Rul. 55-713, 1955-2 CB 23, revoked by Rev. Rul. 64-328, 1964-2 CB 11.

(2) J. Simpson Dean, 35 TC 1083 (1961).

(3) Rev. Rul. 64-328, note 1, amplified by Rev. Rul. 66-110, 1966-1 CB 12. Rev. RUL 66-110 was amplified by Rev. Rul. 67-154, 1967-1 CB 11. Rev. Rul. 78-420, 1978-2 CB 67, amplified Rev. Ruls. 64-328, note 1, 66-110 and 67-154.

(4) See Rev. Rul. 66-1 A note 3.The P.S. 58 cost is the cost to purchase a one-year term policy of equivalent coverage. The P.S. 58 rates are included in Rev. Rul. 55-47, 1955-2 CB 228.

(5) See General Information Letter from Norman Greenberg, Chief, IRS Actuarial Branch (8/19/83).

(6) These figures were provided by a large mutual insurance company and are likely to be competitive with policies offered by other firms.

(7) IRS Letter Ruling (TAM) 9604001 (9/8/95)

(8) Rev. Rul. 55-747, note 4.

(9) Rev. Rul. 78-420, note 3.

(10) "Taxation of Split-Dollar Life Insurance," Association for Advanced Life Underwriting (4/16/96), p. 1.

(11) Theodore H. Cohen, 39 TC 1055 (1963).

(12) GCM 38934 (7/9/82).

(13) GCM 39270 (4/9/82).

(14) Rev. Rul. 81-198, 1981-2 CB 188.

(15) D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968) (22 AFTR2d 6023, 68-2 USTC [paragraph] 12,541), aff'g and rev'g TC Memo 1966-144; see Schenkel, "Will a Crummey Beneficial Interest Qualify for an Annual Gift Tax Exclusion?," 28 The Tax Adviser 378 (June 1997).

(16) See, e.g., IRS Letter Ruling 7946007 (7/26/79).

(17) IRS Letter Ruling 9532001 (8/11/95).

(18) IRS Letter Ruling 8121069 (2/26/81).

(19) IRS Letter Ruling 8133070 (5/21/81).

(20) IRS Letter Ruling 7947066 (8/23/79).

(21) IRS Letter Ruling 8004172 (11/5/79).

(22) IRS Letter Ruling 8251064 (9/20/82).

(23) IRS Letter Ruling 8111123 (12/19/80).

(24) "Incidents of ownership" refers to the rights of the insured or his estate in the economic benefits of the policy, including the power to change a beneficiary; assign, surrender or cancel the policy; revoke an assignment; pledge the policy for a loan; or obtain a loan from the insurer against the policy's CSV; see Regs. Sec. 20.2042-1 (b) (2).

(25) Est. of Milton L. Levy, 70 TC 873 (1978).

(26) H. Rep. No. 77-2333, 77th Cong., 1st Sess. (1942), 1942-2 CB 372.

(27) IRS Letter Ruling 9037012 (6/14/90).

(28) REV. Rul. 76-274, 1976-2 CB 278, modified by Rev. Rul. 82-145, 1982-2 CB 213.

(29) Rev. Rul. 82-145, id.

(30) See Est. of Joseph Leder, 89 TC 235 (1987) (the proceeds of a policy purchased by the decedent's spouse for which the premiums were paid by the decedent's wholly owned corporation were not includible in his estate because he possessed no incidents of ownership in the policy).

(31) See, e.g., Est. of Eddie L. Headrick, 918 F2d 1263 (6th Cir. 1990) (66 AFTR2d 90-6038, 90-2 USTC [Paragraph]60,049), aff'g 93 TC 170 (1989) (the proceeds of life insurance policies purchased by an inter vivos trust to which the decedent contributed funds to pay the premiums were not includible in his estate).

(32) Rev. Rul. 82-341, 1982-2 CB 209.

(33) IRS Letter Ruling 9331009 (5/5/93).

(34) Rev. Rul. 79-50. 1979-1 CB 138, citing Rev. Rul. 64-328, note 1.

(35) For a discussion of IRS Letter Ruling 9318007 (1/29/93), see Tax Clinic, "Letter Ruling on Split-Dollar Insurance Requires Caution for S Corporations," 25 The Tax Adviser 299 (May 1994); see also IRS Letter Ruling 9735006 (5/20/97).

(36) IRS Letter Ruling 9511046 (12/22/94).

(37) Because a second-to-die policy will pay a benefit only after the second insured has died, the premium rates are lower.

(38) The use of SDLI arrangements with partnerships has been addressed in IRS Letter Rulings 9042023 (7/19/90), 9235029 (5/29/92) and 9239033 (6/30/92); with LLCs, in IRS Letter Ruling 9625014 (3/20/96).

(39) Insurance-Related Compensation, 386-2d T.M., p. A-60, states that the IRS has a ruling project on this issue under consideration.

(40) See Garcia, "Service May Heighten Focus on Split-Dollar Insurance Arrangements," 70 Tax Notes 145 (1/8/96).

(41) See LR-165-84 (8/20/85), 1985-2 CB 812, 814.
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Author:Swanson, Robert D.
Publication:The Tax Adviser
Date:Jan 1, 1998
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