SPLIT-DOLLAR REGULATIONS FINALIZED

by Kirk Snouffer

In January 2001, the IRS issued a Notice announcing significant changes in the taxation of split-dollar insurance arrangements (hereafter referred to as “split-dollar arrangements” or “SDAs”).  In early 2002, the IRS issued Notice 2002-8 to replace its earlier notice.  After publishing proposed regulations and receiving comments thereon, the IRS issued final regulations on September 17, 2003 that address the taxation of SDAs entered into after that date.

Notice 2002-8 addresses the tax aspects of split-dollar arrangements entered into before publication of the final regulations.  A split-dollar arrangement is one in which one party, usually an employer, pays most or all of the premiums on an insurance policy owned by another party, an employee or a trust established by the employee.  The owner of the policy is typically obligated to repay the employer the lesser of the cumulative premiums paid or the cash value of the policy.  This obligation is typically secured by a collateral assignment of the policy to the employer. 

Prior to the issuance of Notice 2002-8, an SDA had established tax consequences.  In an employer-employee situation, the employee was deemed to receive income each year as a result of the premium payments by the employer.  The amount of the income was equal to the cost of providing one-year term life insurance in an amount equal to the death benefit payable upon the employee’s death to the employee or his designee.  The amount of this deemed income usually was determined by reference to the insurance company’s published rates for one-year term insurance. 

If a trust were the owner of the policy, the employee was deemed to make a gift to the trust each year equal to the amount of income the employee was deemed to received.  Both the income and the gift tax costs could be eliminated if the trust reimbursed the employer each year for an amount equal to the deemed income that would otherwise accrue to the employee.

There are also “private” split-dollar arrangements involving one individual who advances premiums on behalf of the policy owner, who is either another individual or a trust established by the other individual.  The premium payer’s right to receive repayment is again typically secured by an assignment of the policy to the premium payer.  In a private SDA, the premium payer is deemed to make a gift to the individual who owns the policy.  If the policy is owned by a trust, the individual who established the trust is then deemed to make a gift to the trust.

Notice 2002-8 has little impact on many split-dollar arrangements entered into before January 28, 2002.  These arrangements can be continued without change in tax treatment, although the measure of the value of one-year term insurance may increase in the future as a result of certain changes required by Notice 2002-8.  There is, however, one type of split-dollar arrangement for which Notice 2002-8 has serious implications: the “equity” split-dollar arrangement. 

In an equity SDA, the cash value of the policy is expected to increase substantially above the amount of the premiums the employer (or other premium payer) has advanced.  The goal of an equity SDA typically is to allow the employer to be repaid in full during the insured’s lifetime so that the SDA can be terminated.  The “equity” remaining in the policy (i.e., its cash value after termination of the SDA) was projected to be sufficient to allow continuation of the insurance coverage without additional premium payments or with much lower premiums.

Prior to Notice 2002-8, most tax advisers believed that the equity in the policy after termination of the SDA would not be subject to income or gift taxes.  As a result, an equity SDA was attractive because an employee or his trust would own a paid-up policy when the arrangement was terminated, and there would be no further income and gift tax consequences once the arrangement was terminated.

The final regulations directly address the treatment of policy equity after September 17, 2003.  For SDAs entered into before January 28, 2002, the date of Notice 2002-8, the IRS has provided only limited guidance about the future taxation of policy equity.  The Notice contains safe-harbor provisions that should be considered.  The IRS will not seek to tax equity in a policy subject to an SDA entered into before 1-28-02 if: (1) the arrangement is terminated before December 31, 2003; or (2) for all periods beginning January 1, 2004, all premium payments made by the employer (or the premium payer) since the inception of the arrangement are treated as loans.  If no interest is paid or accrued on these loans, there will be income and gift tax implications.

Although the Notice does not directly address the treatment of an equity SDA after 2003, it seems likely the IRS would seek to impose income taxes on any equity remaining in an insurance policy upon the termination of a split-dollar arrangement after 2003, unless the parties to the arrangement satisfied the requirements of the regulations issued last month.

The purpose of this letter is to advise you of these changes in the event you are a sponsor of or participant in a split-dollar arrangement.  Although many businesses and individuals will not be significantly affected by the changes announced by the IRS, every party to an existing SDA must consider the possible impact of Notice 2002-8 in their situations.

Those clients or businesses that are or may become involved in an equity split-dollar arrangement need to review those arrangements and address the issues discussed in Notice 2002-8 and the new regulations, so that any needed changes may be implemented before December 31, 2003.  If you have any questions concerning these matters, please do not hesitate a member of our Tax and Estate Preservation Group.