AALU and NAIFA Urge Revision of Proposed Split-Dollar Regs


The Association for Advanced Life Underwriting and the National Association of Insurance and Financial Advisors have submitted comments on the proposed regulations (REG-164754-01) affecting the taxation of split-dollar life insurance arrangements.

Document Type: Public Comments on Regulations

Tax Analysts Document Number: Doc 2002-24328 (20 original pages) [PDF]

Tax Analysts Electronic Citation: 2002 TNT 211-28

Citations: (7 Oct 2002)


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Albert J. Schiff of the Association for Advanced Life Underwriting (AALU) and Richard Koob of the National Association of Insurance and Financial Advisors (NAIFA), Falls Church, Va., have both submitted comments on the proposed regulations (REG-164754-01) affecting the taxation of split-dollar life insurance arrangements. (For a summary of REG-164754-01, see Tax Notes, July 15, 2002, p. 361; for the full text, see Doc 2002-16108 (24 original pages) [PDF], 2002 TNT 135-10 , or H&D, July 5, 2002, p. 175.)

According to Schiff and Koob, the AALU and the NAIFA are concerned that the proposed changes will impose current taxation on the equity build-up in a life insurance contract. They assert that the proposed regs are contrary to the rules of section 72. They also assert that the proposed regs will limit the life insurance death benefit tax exclusion currently allowed by section 101. Among other things, the AALU and the NAIFA state that there is excessive complexity in the proposed regs and call for additional simplification and clarification.


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October 7, 2002

Internal Revenue Service
CC:ITA:RU (REG:164754-01)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20044

Re: Comments on REG-164754-01; 26 CFR Parts 1 and 31
Split-Dollar Life Insurance Arrangements

Ladies and Gentlemen:

[1] This letter sets forth the views of the Association for Advanced Life Underwriting (AALU) and the National Association of Insurance and Financial Advisors (NAIFA) with respect to proposed amendments to 26 CFR Parts 1 and 31,1 which were published in the Federal Register on July 9, 20022 (hereafter referred to as the "Proposed Regulations"). The Proposed Regulations generally consider the income, employment, and gift taxation of split-dollar life insurance arrangements.

[2] AALU is a nationwide organization of life insurance agents, many of whom are engaged in complex areas of life insurance such as business continuation planning, estate planning, retirement planning, deferred compensation and employee benefit planning. AALU represents approximately 2,000 life and health insurance agents and financial advisors nationwide. NAIFA, (formerly the National Association of Life Underwriters), is a federation of nearly 1,000 state and local associations representing almost 80,000 life, health and property/casualty insurance agents and investment advisors. Originally founded in 1890, NAIFA is the nation's oldest and largest trade association of insurance agents and financial advisors.


INTRODUCTION


[3] The Proposed Regulations adopt the basic approach signaled in Notice 2002-8, 2002-4 I.R.B. 398, which also provides guidance with respect to split-dollar life insurance arrangements entered into before the date of publication of final regulations in the Federal Register.

[4] Under this proposed approach (applicable generally to split-dollar arrangements entered into after the date of publication of final regulations), in general, where the employer (or donor in a private split-dollar arrangement) owns the insurance contract (or where the arrangement is a "non-equity" arrangement), the employee (or donee) will be taxable annually on the value of life insurance protection provided to him or her either as compensation or as a gift. Under the Proposed Regulations, the value of the increase in the employee's/donee's equity in the contract also will be taxable annually, but no definitive measure of the value of the equity is provided. Transfers of the entire contract (or an undivided interest therein) from one party to another will be taxed to the recipient at the time of transfer.

[5] The Proposed Regulations also provide that, if the employee (or donee) owns the contract, the transaction will be treated as a loan, and deemed transfers of foregone interest may be taxable to the employee (or donee) under Internal Revenue Code Sections 7872 (below market interest rate loans) and/or 1271 - 1275 (the "OID" rules), unless the arrangement is a "non-equity" arrangement.


COMMENTS


[6] AALU and NAIFA respectfully request that the Internal Revenue Service revise and/or clarify the Proposed Regulations as follows:3


1. Taxation and Valuation of Policy Equity as an "Economic Benefit" on a Current Basis Where the Employer is the "Owner" of the Contract


Background

[7] In a surprising departure from the intended rule described in Notice 2002-8, the proposed regulations would impose current taxation on benefits beyond life insurance protection under an equity split-dollar arrangement where the employer is the "owner" of the contract (i.e., an endorsement split-dollar arrangement). Prop. Reg. sec. 1.61-22(d)(3)(i) indicates that for endorsement equity split-dollar arrangements, any right in, or benefit of, a life insurance contract (including, but not limited to, an interest in the cash surrender value) provided during the taxable year to a non-owner under a split-dollar life insurance arrangement is a taxable economic benefit. However, the proposed regulation specifically declines to provide any guidance on how these "economic benefits" might be valued. We believe this proposed current taxation of additional "economic benefits" beyond current life insurance protection is incorrect under normal income tax principles and will, moreover, make it effectively impossible to maintain endorsement equity split-dollar arrangements (because of the implicit tax that would be imposed at a time when the employee does not have access to funds to pay the tax).

Comments

[8] We fail to understand the justificatory statement in the preamble to the proposed regulations:


In general, a mere unfunded, unsecured promise to pay money in the future -- as in a standard nonqualified deferred compensation plan covering an employee -- does not result in current income. However, a non-owner's interest in a life insurance contract under an equity split-dollar life insurance arrangement is less like that of an employee covered under a standard nonqualified deferred compensation arrangement and more like that of an employee who obtains an interest in a specific asset of the employer (such as where the employer makes an outright purchase of a life insurance contract for the benefit of the employee). The employer's right to a return of its premiums, which characterizes most equity split-dollar life insurance arrangements, affects only the valuation of the employee's interest under the arrangement and, therefore, the amount of the employee's current income.


[9] The above statement takes concepts that apply (with significant qualifications) to deferred compensation arrangements and attempts to apply them to arrangements that are completely dissimilar. In addition, the statement (and the proposed regulation) does not address why, even if split-dollar arrangements could be compared to deferred compensation arrangements, there should be current taxation under an endorsement equity arrangement if the employee is not vested in the equity amounts and/or if the policy (which the employer owns) remains subject to the claims of the employer's creditors. More fundamentally, the proposed rule would subject to current taxation amounts that the employee simply cannot access currently. Were this rule to stand (i.e., if the employee were required to pay tax currently on the equity build-up), it is unlikely that most employees could afford to participate in endorsement equity split-dollar arrangements.

[10] It is economically incorrect to impose any tax on equity build-up because doing so would amount to double taxation. That is, there is already a tax on the equity build-up effectively included in the measure of the current life insurance protection that is taxed to the employee. This can be demonstrated by consideration of a simple example in which a policy has $1,000 of death benefits, a $100 cash surrender value, and cumulative employer premium payments of $50. In a non-equity split-dollar arrangement, the employee will be taxed on $900 of current life insurance protection ($1,000 face death benefit less $100 due to employer). In an equity split-dollar arrangement, the employee will be taxed on $950 of current life insurance protection ($1,000 face death benefit less $50 due to employer). Thus, under an equity split-dollar arrangement, the equity build-up is already included in the measure of income that is taxed to the employee.

[11] The suggestion of taxing to the employee (or the non- owner) the equity build-up in a life insurance would depart from principles almost as old as the income tax by imposing a tax on the "inside-buildup" in a life insurance contract. This proposed concept of taxing life insurance contracts is contrary to the specific statutory principles of Internal Revenue Code sec. 72.

[12] Imposing any current tax on equity build-up would also raise significant administrative and valuation concerns. How, for example, is one to determine the amount of equity build-up that is potentially taxable to an employee under a variable life insurance contract where there may be gains in some years and losses in other years? The preamble to the proposed regulations offers one "potential approach" for taxing the economic benefit in an endorsement equity split-dollar arrangement: subtracting from current premium payments made by the contract owner the net present value of the amount to be repaid to the owner in the future. This "approach" would appear to be more punitive to employees than the concept rejected by Notice 2002-8 (i.e., taxing the equity build-up under section 83 as it exceeds the amount to which the employer is entitled). This "potential approach" would also have the effect of imposing a double tax on the employee because, under the approach, the employee would be taxed on not only the current life insurance protection provided by the premium, but also on the premium itself (reduced only by the present value of the amount to be repaid to the owner).

[13] Beyond strong opposition to the concept of taxing currently any equity build-up in an equity split-dollar arrangement, it is difficult for us to comment on the impact of the proposed regulation because it omits the key concept -- that is, the method of valuing the income that is to be included currently. While we strongly urge dropping this concept from the final regulations, we would note that normal concepts of administrative procedure would require delaying the effective date of any rule currently taxing equity until there has been a proposal regarding the valuation method and an opportunity for taxpayers to comment on that proposal.


2. Taxation of Loan Proceeds Distributed to Non-owners Under an Endorsement Split-Dollar Arrangement


Background

[14] The proposed regulations would impose a tax on amounts borrowed from a life insurance policy under an endorsement split- dollar arrangement (e.g., a policy owned by the employer). Specifically, Prop. Reg. sec. 1.61-22(e)(1) would treat any borrowing by an employee (or a non-owner) as if the borrowing were made by the owner of the policy (subject to the rules of section 72) and then transferred by the owner (e.g., the employer) to the non-owner (e.g., the employee) as compensation.

Comments

[15] This proposed treatment of common loan transactions under split-dollar life insurance arrangements is contrary to the rules of Internal Revenue Code section 72, which clearly establish the manner of taxing distributions (including loans) from a life insurance policy. Moreover, even if it were correct to treat the policy borrowing as being made, in the first instance, by the policy owner, it is not at all clear why there should be constructive compensation resulting from the deemed transfer of the loan proceeds to the employee. Given the fact that the employee has borrowed the funds from the policy, it would be more appropriate to treat this as a further constructive loan from the employer to the employee, subject to the rules of Internal Revenue Code section 7872.


3. Availability of Alternative Term Rates to Value "Economic Benefit"


Background

[16] Notice 2002-8 indicated (in interim guidance) that, for split-dollar arrangements entered into by January 28, 2002, taxpayers may use any of the following to value the cost of life insurance protection provided to an employee or donee who is not the owner of the life insurance contract:


[17] Under Notice 2002-8, for split-dollar arrangements entered into after January 28, 2002, and prior to the effective date of final regulations, taxpayers may use either of the following to value the cost of life insurance protection provided to an employee or donee who is not the owner of the life insurance contract:


[18] The Proposed Regulations, however, state only that, after the effective date of final regulations, the current cost of life insurance protection will equal the amount of life insurance protection provided to the non-owner, "multiplied by the life insurance premium factor designated or permitted in guidance published in the Internal Revenue Bulletin."4

Comments

a. General

[19] AALU and NAIFA believe that the insurer's lower alternative term rates (subject to the limitations set forth in Notice 2002-8 for arrangements entered into after January 28, 2002) should be available to value the cost of current life insurance protection after the effective date of final regulations.

[20] First, there is no authority in the Internal Revenue Code for taxing property at a value that is greater than its fair market value.5

[21] Second, "fair market value" for purposes of the Internal Revenue Code is generally defined as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts."6 The insurer's lower alternative term rates -- where they are readily available and regularly sold -- accurately and (perhaps with as much importance) expeditiously measure the value that would be reached by applying the more general willing buyer/willing seller standard to the cost of life insurance protection.7

[22] Lastly, where Congress has sanctioned a deviation from the willing buyer/willing seller standard to value the cost of life insurance protection, it has provided specific statutory authority for the promulgation of an exclusive rate table. Thus, section 79(c) of the Code reads as follows:


"(c) DETERMINATION OF COST OF INSURANCE. -- For purposes of this section and section 6052, the cost of group-term insurance on the life of an employee provided during any period shall be determined on the basis of uniform premiums (computed on the basis of 5-year age brackets) prescribed by regulations by the Secretary."


[23] No such statutory authority exists for the promulgation of an exclusive rate table to value the cost of life insurance protection for purposes of section 61 of the Internal Revenue Code. Therefore, the willing buyer/willing seller standard that is embodied in the insurer's alternative term rates should continue to be applicable to value that cost.


b. "Interim" Nature of Rate Guidance in Notice 2002- 8


[24] Notice 2002-8 states that, "[p]ending the consideration of comments and publication of further guidance," taxpayers may use the insurer's lower alternative term rates for arrangements entered into before or (in certain circumstances) after January 28, 2002, and before the effective date of future guidance.

[25] The final regulations should make clear that taxpayers may continue to use the insurer's lower alternative term rates to value the cost of life insurance protection with respect to those split- dollar arrangements entered into prior to the effective date of final regulations even after the effective date of final regulations. This clarification is particularly important for those taxpayers who may choose, pursuant to Par. 2 of Section IV of Notice 2002-8, to continue to report the economic benefit of life insurance protection in cases where the value of current life insurance protection is treated as an economic benefit provided by a sponsor to a benefited person under a split-dollar life insurance arrangement entered into prior to the date of final regulations.

c. Survivorship Rates

[26] Notice 2002-8 states that taxpayers should make appropriate adjustments to the Table 2001 premium rates if the life insurance protection covers more than one life. Again, while we consider the limited approval of survivorship rates that was provided in Notice 2002-8 to be a helpful development, that approval used Table 2001, which arguably does not apply to arrangements entered into after the issuance of final guidance. AALU and NAIFA would like to see more definitive guidance issued with respect to these rates.

[27] Under the rules that existed prior to Notice 2002-8, there was very little guidance concerning the extent to which U.S. Life Table 38, which determines the value of insurance protection based on the probability that two insureds will die during the one-year term of a policy (thus producing a relatively low economic benefit in any one year), may be used to value the economic benefit provided under a second-to-die policy that insures the lives of the employee and his spouse. The only guidance on this issue to date consists of the so- called "Greenberg to Greenberg" information letter dated August 10, 1983. This letter, from Norman Greenberg, Chief, General Actuarial Branch, Department of the Treasury to Morton Greenberg, Advanced Underwriting Director and Counsel, the Manufacturers Life Insurance Company, implicitly approves the use of Table 38 to value the cost of insurance protection under a second-to-die policy. (See also PLR 9709027.) We understand, however, that a number of IRS agents have, in the past, argued against the use of the Table 38 rates on audit.

[28] We suggest that an actuarially verifiable rate table should be published in final regulations so that taxpayers may, with certainty, determine the value of current life insurance protection on two lives that is provided under a split-dollar life insurance arrangement, in a qualified retirement plan, or under employee annuity contracts. Lawrence P. Katzenstein has published a two-life table, extrapolated from the Table 2001 rates, for survivorship life that could be formally adopted for this purpose.8 In the absence of an approved table, "reasonable efforts" to comply should be approved.


4. Recognition of Income by Employer/Donor for Cost of Life Insurance Protection Contributed by Employee/Donee


Background

[29] Under the Proposed Regulations,9


"[a]ny amount paid by a non-owner, directly or indirectly, to the owner of the life insurance contract for current life insurance protection or for any other economic benefit under the life insurance contract is included in the owner's gross income and is included in the owner's investment in the life insurance contract for purposes of section 72(e)(6) (but only to the extent not otherwise so included by reason of having been paid by the owner as a premium or other consideration for the contract)." (Emphasis supplied.)


Comments

[30] This rule, which, if adopted in final form, would spell an end to contributory split-dollar arrangements, is contrary to well- established principles of Federal income taxation.

[31] In a typical split-dollar arrangement, the employer (or donor, in a gift tax context), through its premium payment, is entitled either to a return of its premium payments, or, in the case of nonequity split dollar, to the greater of the premiums paid or the cash value of the life insurance contract. The employee (or donee in a gift tax context) is entitled to current life insurance protection.

[32] As was recognized in Rev. Rul. 64-328, 1964-2 C.B. 11, if each party pays for the benefit received -- i.e., the employee/donee contributes the cost of current life insurance protection and the employer/donor pays the balance of the premium -- neither party should have income as a result of the payment. Each party is getting what he, she, or it paid for. The benefit of the contributory premium payment for the value of life insurance protection in the typical split-dollar arrangement does not inure to the employer/donor, but to the employee/donee,10 who is either the insured, or, in the case of a third-party owner, such as a trust, the assignee of the insured. In general, one taxpayer does not realize income as a result of a payment in consideration for the receipt of property or services from a third party by another taxpayer. The Proposed Regulations, in essence, "create" income in this situation.

[33] While it is true that the term "gross income" means "all income from whatever source derived,"11 encompassed within that definition is the requirement that the income be "derived" -- i.e., realized -- before it is recognized for tax purposes. In light of this requirement, the courts have long accepted the principle that a mere increase in the value of property does not constitute a realization of income with respect to that property.12 Therefore, even assuming that there is some incremental increase to the cash value of a life insurance contract by reason of the payment of the cost of life insurance protection by the non-owner (employee or donee) of the contract, that increase is (i) incidental to the provision of insurance protection to the party paying for it, and (ii) subject to taxation to the owner when, and if, the owner surrenders the contract, to the extent that the proceeds receivable by the owner exceed its investment in the contract.

[34] The typical split-dollar arrangement may be likened to the purchase, by two individuals, of a life interest (which is analogous to the cash value of a life insurance policy) and a remainder interest (which is analogous to the death benefit) in the same piece of real property. If the expenses attributable to the property are borne by each party in accordance with his or her interest (i.e., current expenses paid by the life tenant, and capital improvements paid by the remainder beneficiary), neither party realizes income as a result of the payment of those expenses by the other.

[35] Given the paucity of support for income recognition by the employer in a compensatory context, the premise for income recognition by the donor in a non-compensatory context is literally non-existent. A private split-dollar arrangement can, in appropriate circumstances, engender gift or estate tax consequences: It has never been held to result in income to either the donor or the donee.13

[36] In short, we believe it would be inappropriate to construct phantom income for the employer. Further, the proposed addition to employer basis by virtue of an employee's premium payment strikes us as an artificial mechanism that serves no purpose other than to correct for the first "mistake" (i.e., the creation of phantom income). Income will be just as clearly reflected -- indeed, more so -- if the owner's basis simply reflects only the premium payments that it has made. Thus, for example, if the annual premium is $10x, the employer pays $9x, and the employee pays $1x, we would limit the employer's addition to basis to $9x. Elsewhere, herein, we also emphasize that the employee (i.e., the non-owner) should receive an addition to basis for the payments he or she makes.


5. Disallowance of Basis for Payment of (or Recognition of Income Attributable to) Cost of Life Insurance Protection by Employee/Donee Where Employer/Donor is "Owner" of the Contract


Background

[37] The Proposed Regulations14 provide that:


"[n]o amount allocable to current life insurance protection provided to the transferee (the cost of which was paid by the transferee or the value of which was provided to the transferee) is treated as consideration paid to acquire the contract under section 72(g)(1) to determine the aggregate premiums paid by the transferee for purposes of determining the transferee's investment in the contract under section 72(e) after the transfer."


Comments

[38] This rule directly contradicts section 72(e)(6) of the Code, which reads:


"(6) INVESTMENT IN THE CONTRACT. -- For purposes of this subsection, the investment in the contract as of any date is --


(A) the aggregate amount of premiums or other consideration paid for the contract before such date, minus

(B) the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income . . ." (Emphasis supplied.)15

[39] Existing regulations under section 72(e) of the Code also recognize that an employee may have basis in a life insurance contract as a result of the payment of premiums by the employer, where that payment is included in the income of the employee. Thus, Treas. Reg. 1.72-8(a)(1), states: that ". . . for the purposes of section 72(c), (d) and (e), amounts contributed by an employer for the benefit of an employee or his beneficiaries shall constitute consideration paid or contributed by the employee to the extent that such amounts were includible in the gross income of the employee. . . ."

[40] While the government legislatively16 has made a number of efforts over the years to reduce the basis of a life insurance by the cost of pure insurance protection, it has never, to the best of our recollection, sought to take the position for regulatory purposes that such a reduction, in fact, constitutes existing law.17 Nor, in our view, should it do so now in the absence of an amendment to section 72(e) of the Code.


6. Modifications to Section 101 Exclusionary Rule for Proceeds of Life Insurance


Background

[41] The proposed regulations include what appears to be an attempt to limit the tax-free exclusion of life insurance death benefits under Internal Revenue Code section 101. The preamble to the proposed regulations contains the following statement:


Amounts received by reason of death are treated differently. Under sec. 1.61-22(f), any amount paid to a beneficiary (other than the owner) by reason of the death of the insured is excludable from the beneficiary's gross income under section 101(a) as an amount received under a life insurance contract. This result applies only to the extent that such amount is allocable to current life insurance protection provided to the non-owner pursuant to the split-dollar life insurance arrangement, the cost of which was paid by the non-owner, or the value of which the non-owner actually took into account under the rules set forth in Sec. 1.61-22. Amounts received by a non- owner in its capacity as a lender are generally not amounts received by reason of the death of the insured under section 101(a). Cf. Rev. Rul. 70-254 (1970 C.B. 31).


[42] This attempted limitation of the section 101 death benefit exclusion, is also contained in proposed regulation sec. 1.61- 22(f)(2)(ii).

Comments

[43] As a matter of law, the stated limitation is simply incorrect. Section 101(a) provides an exclusion for "amounts received . . . under a life insurance contract, if such amounts are paid by reason of the death of the insured." Section 101 does not condition this exclusion on the beneficiary of the life insurance contract having paid for the coverage (or having recognized income as a result of receiving the coverage). Moreover, the reference in the preamble to amounts received by a non-owner in its capacity as a lender is inapposite. Without conceding that the cited revenue ruling is correct (and, on this, we have clear doubts18), we would note that the non-owner party to a split-dollar life insurance arrangement is not acting as a lender (in contrast to the homesite seller in Rev. Rul. 70-254 who sold on the installment basis and the finance company in the case cited in the revenue ruling). The fact that the proposed regulations may construct a loan for purposes of section 7872 does not mean the life insurance policy beneficiary is receiving policy death benefits in any capacity as a lender.

[44] Further, we are at a loss to explain the reference, on page 19 of the preamble, to "[a]mounts received by a non- owner in its capacity as a lender . . ." (emphasis supplied), except, perhaps, as a reference to collateral assignment split- dollar/loans, which reference would appear to be inapposite in a discussion of economic benefit/endorsement split-dollar. If the reference is meant to refer to amounts (in excess of basis) received by an employer or donor under a nonequity endorsement split-dollar arrangement, then the reference should, pursuant to Prop. Reg. 1.61-22(c)(1)(ii), be to the "owner in its capacity as a lender . . ." At a minimum, clarification (and perhaps an example) is needed to illustrate the meaning of this sentence.

[45] Finally, any rule such as that suggested by the preamble or by Prop. Reg. Sec. 1.61-22(f)(2)(ii) would have the effect of taxing a portion of the total death benefits (and inside buildup) under a life insurance policy and thereby would depart from more than 80 years of settled law. The Treasury Department cannot by fiat simply read a provision out of the Internal Revenue Code. Nor can it impose by regulation a limitation on the statutory death benefit exclusion when the underlying statute has not granted the authority to impose such a limitation. We believe that this proposed limitation on section 101(a) is invalid and strongly recommend that it be deleted when the final regulations are issued.


7. Section 1035 Exchanges and Other "Material Modifications"


Background

[46] The Proposed Regulations will apply "to any split- dollar life insurance arrangement entered into after the date these regulations are published as final regulations in the Federal Register." (Emphasis supplied.) If an arrangement entered into on or before the date of publication of final regulations is "materially modified," it will constitute a new "arrangement" entered into on the date of modification.19

[47] The introduction to the Proposed Regulations requests comments regarding "whether certain material modifications should be disregarded in determining whether an arrangement is treated as a new arrangement for purposes of the effective date rule." In particular, comments are requested concerning "whether an arrangement entered into on or before the effective date should be subject to [the new] rules if the only material modification to the arrangement after that date is an exchange of an insurance policy qualifying for nonrecognition treatment under section 1035."

Comments

[48] AALU and NAIFA believe that the following changes with respect to either the life insurance contract or the split-dollar life insurance agreement (both of which, at a minimum, must be regarded as integral parts of the arrangement) should not be deemed to be "material" for purposes of the effective date rules.

a. Section 1035 Exchanges

[49] An arrangement should not be deemed to have terminated (and a new arrangement to have begun) merely because there has been a qualified tax-free exchange, under Code Section 1035, of the life insurance contract that is the subject of the arrangement. It should be emphasized that the term "split-dollar" does not describe a type of insurance policy, but rather a form of arrangement to share, or "split," the premium payment on a life insurance policy between two parties, typically an employer and an employee. At a minimum, a split-dollar "arrangement" will consist, in most cases, of a life insurance contract (or policy binder), a written split-dollar agreement, and a written collateral assignment or endorsement of the contract. An exchange of the policy that qualifies for tax-free treatment, but that does not modify, in any other respect, the substantive terms of the split-dollar agreement, should not be considered to be a termination, or even a substantial modification, of an existing arrangement.

[50] In this respect, it is instructive to look at previous transition rules under other Code sections dealing with life insurance.20 Most of these were phrased with reference to changes to an existing "contract," not an existing "arrangement." Thus, while certain exchanges of contracts were considered to be material modifications or changes under these rules, that is because the effective dates of these acts were dates tied to an existing contract, a much narrower concept than arrangement. That is not the case here.

[51] Further, as a policy matter (and as a matter of economic efficiency), there is no reason to tie an arrangement to an existing policy where the employee and employer both might be benefited by the ability to substitute a less costly contract for an existing one, while leaving the terms of the underlying arrangement intact.

b. Transfers to Related Parties

[52] The transfer by an employee/owner of a life insurance contract that is subject to an existing split-dollar agreement with an employer to a life insurance trust, of to the employee's spouse or other family members, should not constitute a new "arrangement." Any such transfer, which is usually done for estate planning purposes, would not affect the underlying terms of the split-dollar agreement with the employer. At most, it would involve the addition of the name of the transferee to the agreement and the assignment or endorsement. Income would continue to be taxed to the employee in accordance with the treatment of the arrangement as a loan or economic benefit contract, and the measure of that compensation would be treated as a gift to the third party transferee.

[53] Another common situation involves the acquisition (with or without consideration) of the employer's interest in a life insurance policy by the employee-insured, after which the arrangement is continued by the employee-insured as private split-dollar (via, e.g., a new agreement with a life insurance trust). This situation may occur where the employee terminates employment prior to "rollout," and wants to continue the policy in split-dollar. It may also occur where the responsibility for the payment of premiums changes from corporation to employee as the result of the anti- executive loan provisions of the Sarbanes-Oxley Act of 2002. (See the discussion in Subparagraph c., immediately below, and on page 20, infra.) Conversion of a split-dollar plan from corporate to private in these situations by substituting the insured for the corporation would permit the split-dollar plan to continue in place -- an advantage that could be particularly important in the case of a pre-January 28, 2002, existing plan where there is substantial equity and the insured wants to preserve the favorable tax treatment of that equity under Notice 2002-8 by terminating the plan or switching it to a loan before January 1, 2004. In most cases, with a collateral assignment split-dollar plan, the only plan change that would be necessary would be the assignment by the corporation of its security interest in the policy to the employee (or a related person), and the possible modification of the collateral assignment to limit the insured's incidents of ownership when he takes over the corporation's position. Such minimal amendments should not be viewed as material modifications.

[54] Similarly, a transfer by the employer/owner of a split- dollar arrangement pursuant to a sale, liquidation, merger, reorganization or other change in the identity of the employer should not be viewed as a material modification of the arrangement, so long as all of the obligations and rights of the original employer with respect to the original arrangement are assumed by the new employer.

c. Changes in Premium Split

[55] If an employee currently is paying a portion of the premium equal to the cost of life insurance protection, the amendment of the split-dollar agreement to provide that the entire premium will, in the future, be paid by the employer should not be deemed to be a new arrangement. Any change in the premium split should affect only the amount of income and/or gift recognized under the arrangement, and should not be considered to be a termination or substantial modification of the arrangement itself.

d. Structural Changes in Benefits

[56] Some split-dollar plans are structured to provide a level of life insurance protection that may increase with increases in salary or changes in status of the insured employee. Further guidance should clarify that automatic increases based on changes in status or compensation do not constitute a new "arrangement." Changes that are made to the arrangement as a result of external factors, such as those recited above, should not be deemed to be a new arrangement so long as the changes are limited to predetermined increases in the amount of insurance coverage, and so long as the plan pursuant to which the increases are determined was in place on the date that the original arrangement was entered into.

e. Substitution of Insureds

[57] In some cases, an insured employee may leave his employment, and be replaced by another employee in the same position. If the split-dollar life insurance arrangement is tied to the position (e.g., "executive vice president"), rather than to the individual, the substitution of one individual employee for another in the same position should not be deemed to constitute a new arrangement for purposes of the effective date rules.


f. Conversion of Nonequity Endorsement Arrangements to Loans


[58] The Proposed Regulations (preamble, page 13) reserve the issue of the consequences of a modification to the ownership arrangement of a policy ("for example, such as subsequently providing the employee or donee with an interest in the cash value of the life insurance contract").

[59] AALU and NAIFA suggest that the Proposed Regulations make clear that a nonequity endorsement split-dollar arrangement may be converted to a loan (via the transfer of the contract to the employee or donee) at any time (whether pre- or post-final regulations) without triggering adverse tax consequences or being considered a "material modification" of an existing arrangement. This treatment is already available for certain pre-final regs. equity collateral assignment plans under Notice 2002-8. The adoption of such a rule would provide considerable flexibility with no apparent potential for abuse.

8. Meaning of "Arrangement"

Background

[60] The Proposed Regulations will apply to split-dollar life insurance "arrangements" entered into after the date of publication of final regulations. Notice 2002-8 safe harbors, valuation rules, no inference rule, etc. apply to "arrangements" entered into prior to publication of final regulations, or, in some cases, prior to January 28, 2002, and "arrangements" terminated prior to January 1, 2004. The term "arrangement" -- in the context of the documentation necessary to establish that an "arrangement" was in place on or before a certain date -- is not defined in the Proposed Regulations or in Notice 2002-8.

Comments

[61] AALU and NAIFA request that the Proposed Regulations be clarified to specify which agreements and/or documentation constitute an "arrangement" for purposes of the effective date provisions in the Proposed Regulations and in Notice 2002-8. The documentation may include a signed split-dollar agreement, a completed policy application, a binder premium payment, and a conditional receipt, and may also include a collateral assignment or endorsement of the policy.

[62] AALU and NAIFA also suggest that, in the absence of clarification, there should be no inference that the same definition of "arrangement" applies under the Proposed Regulations and the Notice. For purposes of Notice 2002-8, taxpayers should be permitted to rely on any reasonable interpretation of "arrangement" in determining whether an arrangement existed prior to January 28, 2002, or prior to the publication of final regulations, as the case may be.

9. Section 7872/OID Rules

Background

[63] Under the Proposed Regulations,21 a payment made pursuant to a split-dollar life insurance arrangement is a split- dollar loan and the owner and non-owner are treated, respectively, as borrower and lender, subject to the rules of sections 7872 and, where applicable 1271-1275 (the "OID" rules), if:


"(i) the payment is made either directly or indirectly by the non-owner to the owner; (ii) the payment is a loan under general principles of Federal tax law or, if not a loan under general principles of Federal tax law, a reasonable person would expect the payment to be repaid in full to the non-owner (whether with or without interest); and (iii) the repayment is to be made from, or is secured by, either the policy's death benefit proceeds or its cash surrender value."


Comments

[64] AALU's and NAIFA's principal concern with the "loan regime" regulations is their excessive complexity, which could be ameliorated by additional simplification and clarification. For example:

a. Multiple Loans

[65] Prop. Reg. 1.7872-2(a)(3) states that "[i]n general, each extension of credit or transfer of money by a lender to a borrower is treated as a separate loan." Presumably, therefore, each premium payment made under a life insurance contract will be treated as a separate loan. This will make for a record-keeping nightmare if multiple premiums are due during a single year. For example, it would appear that the payment of monthly premiums would result in twelve separate loans in each year that the split-dollar arrangement is outstanding.22 We believe that an election should be available to treat all advances made under a split-dollar agreement during a single year as a single loan (made on a specified date during the year) for purposes of Prop. Reg. 1.7872-15.

b. Nonrecourse Loans

[66] Under the Proposed Regulations,23 a split-dollar loan that is nonrecourse to the borrower is taxed under the rules24 applicable to contingent payment split-dollar loans, which are, in turn, based on the "noncontingent bond method" of Reg. 1.1275-4(b).25 Taxpayers can avoid the characterization of a nonrecourse split-dollar loan as a contingent payment split-dollar loan by filing the representation described in Prop. Reg. 1.7872-15(d)(2). However, given that there inevitably will be some failures -- advertent or inadvertent -- to file this representation, there should be an example in the Proposed Regulations describing exactly how the noncontingent bond method/contingent payment split-dollar method should be applied to a nonrecourse split-dollar loan as to which there are, in fact, no contingencies, in a case where the loan has only fallen into the "contingent" category because it is nonrecourse.26

[67] In addition, there should be some clarification of the meaning of "nonrecourse." If a life insurance trust having no assets other than a policy of insurance undertakes a recourse loan, and, in the early policy years, the policy cash value is insufficient to repay the employer's (or donor's) premium loans, is this, in effect, a nonrecourse loan? If so, what is the tax treatment, and does that treatment change as the policy builds up equity sufficient to repay the loan?

c. Gift Loans

[68] Foregone interest on split-dollar term loans payable on the death of an individual, gift term loans (which would be the norm in a private split-dollar transaction) and split-dollar term loans conditioned on the future performance of substantial services by an individual will be determined annually, in a manner similar to a demand loan, but using an AFR that is appropriate for the loan's term and that is determined when the loan is issued. However, demand loan treatment for gift split-dollar term loans is limited to the income tax consequences of the loan.27 The gift tax consequences of a gift split-dollar term loan are determined in accordance with the rules generally applicable to gift term loans, which require the difference between the face amount of the loan and the imputed loan amount to be taken into account as a gift to the donee in the year the loan is made.28

[69] AALU and NAIFA believe that the gift tax treatment of a split-dollar term loan should be consistent with the income tax treatment, particularly where the gift element of the loan is attributable to the relationship between the lender or borrower and an indirect participant (for example, when a split-dollar loan is made from an employer to an employee's irrevocable life insurance trust). Again, at a minimum, an example clarifying the disparate treatment in this situation would be helpful.


10. Split-Dollar Loan Characterization Not Applicable to Other (non-tax) Laws


Background

[70] The Sarbanes-Oxley Act of 2002 (P.L. 107-204), enacted July 30, 2002, includes a prohibition on extensions of credit in the form of personal loans to directors or executive officers of public companies. Some have expressed concern that the proposed Treasury regulations, with their general treatment as loans of employer premium payments under collateral assignment split-dollar arrangements, could suggest that those premium payments would also be loans for purposes of the Sarbanes-Oxley Act.

Comments

[71] AALU and NAIFA believe that a convention such as the one proposed by the Treasury Department for purposes of measuring income (or gifts) from a split-dollar life insurance arrangement should not be construed to have any application beyond the tax law and would recommend that the Treasury include in final split-dollar regulations a statement to the effect that the treatment of a payment as a loan for purposes of the affected tax regulations should not be seen as an indication that the Treasury Department views any such payment as a loan for purposes of any other laws. Such a statement would be consistent with the preamble to proposed section 7872 regulations published in the Federal Register on August 20, 1985. In that preamble, the Treasury stated, "Because the purpose of section 7872 is to eliminate the use of below-market loans as a vehicle for tax avoidance, the term 'loan' is interpreted broadly in the regulations." [Emphasis added]

[72] While we do not believe that split-dollar arrangements should give rise to any loans for purposes of the Sarbanes-Oxley Act, without definitive guidance from the Securities and Exchange Commission, there cannot be any assurance that this is the case. Because the Sarbanes-Oxley Act contemplates criminal penalties for violation of the loan prohibition, public companies with collateral- assignment split-dollar arrangements in place may understandably be hesitant to make future premium payments under such arrangements without clear SEC guidance. However, to the extent that companies alter premium payment responsibilities (or cease making premium payments), the question arises whether there has been a "material modification" to an existing split-dollar life insurance arrangement (including for purposes of the transition rules contained in Notice 2002-8) so as to constitute a new arrangement. (See the discussion of "Changes in Premium Split," in Section 7, above.) We do not believe the Treasury Department would want taxpayers to be forced to choose between the Scylla of potential criminal penalties and the Charybdis of lost transition rule protections. Accordingly, we would strongly recommend that the Treasury Department include in final regulations a statement that a modification in premium payment responsibilities under an existing split-dollar arrangement involving a director or executive officer of a public company will not constitute a material modification.


* * * *


[73] AALU and NAIFA is appreciative of the opportunity to comment on the Proposed Regulation.

Sincerely,

/s/
Albert J. Schiff, CLU
AALU President
Falls Church, VA

/s/
Richard Koob, CLU, ChFC, AEP
NAIFA President
Falls Church, VA

FOOTNOTES


1See, Prop. Regs. 1.61-2, 1.61-22, 1.83-1, 1.83-3, 1.83-6, 1.301-1, 1.1402(a)-18, 1.7872-15, 31.3121(a)(1), 31.3231(e)-1, 31.3306(b)-1, and 31.3401(a)-1.

267 Fed. Reg. No. 131, pp. 45414-45437.

3Comments 1-6 deal with economic benefit/endorsement regime split-dollar and nonequity collateral assignment split-dollar entered into after the date of final regulations. AALU and NAIFA do not intend any inference that the proposed rules discussed in Comments 1-6 apply to pre-final regulations equity collateral assignment split-dollar arrangements.

4Prop. Regs. 1.61-22(d)(2).

5See, e.g., Reg. 1.61-2(d), concerning the taxation of noncash compensation, and Reg. 1.61-2T(b), concerning the valuation of fringe benefits.

6 Reg. 1.170A-1(c)(2). See also Reg. 20.2031-1(b) (estate tax) and Reg. 25.2512-1 (gift tax). The "IRS VALUATION GUIDE For Income, Estate and Gift Taxes" states, at Section 1-1, that the above definition "should be the same regardless of the tax implications of the issue."

7Cf. Reg. 25.2512-6(a) (Valuation of certain life insurance and annuity contracts), which states that "The value of a life insurance contract or of a contract for the payment of an annuity issued by a company regularly engaged in the selling of contracts of that character is established through the sale of the particular contract by the company, or through the sale by the company of comparable contracts."

8See Mr. Katzenstein's website -- www.tigertables.com.

9Prop. Reg. 1.61-22(f)(3).

10Under the Proposed Regulations, this particularly will be the case in a nonequity collateral assignment arrangement where the employee/donee will be the actual, although, not the deemed, owner of the contract. In that case, to impute income to the employer/donor, whose only interest in the life insurance contract is as a collateral assignee, is even less defensible.

11Code 61(a).

12Cf. Eisner v. Macomber, 252 U.S. 189 (1920) and Helvering v. San Joaquin Fruit and Investment Company, 297 U.S. 496 (1936).

13See, e.g., PLRs 9636033 and 9745019.

14Prop. Reg. 1.61-22(g)(4)(iii).

15See also Reg. 1.72-6. Reg. 1.56(g)-1(c)(5)(ii) also recognizes that the adjusted basis of a cash value life insurance contract is the section 72(e)(6) "investment in the contract," modified only to take into account certain adjusted current earnings (ACE) adjustments.

16See, e.g., "The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity," p. 256 (May 1985), and "Description Of Possible Committee Amendment Proposed By Chairman Rostenkowski To H.R. 4333," [Joint Committee Print]; H.R. 4333; JCX- 13-88 (June 21, 1988).

17See, e.g., PLRs 7916029 and 8310027, which allowed the term cost paid by employees in a reverse split-dollar arrangement as an offset to the gain realized on "rollout."

To find any authority in support of the bifurcation of the basis of a life insurance contract, one must go back to the 68-year-old Century Wood Preserving Co. v. Comr., 69 F.2d 967 (3d Cir. 1934), and another case which is only 67-years-old, London Shoe Co., Inc. v. Comr., 80 F.2d. 230 (2d Cir. 1935), both of which concerned the determination of basis for the purpose of computing loss -- as contrasted to gain -- on the disposition of a life insurance contract, and the correctness of which, even if they were recent cases, would be subject to some question.

18For example, the analysis in the revenue ruling turns in part on the homesite seller being able to deduct, as an ordinary and necessary business expense under section 162, the premiums it paid on the lives of homesite purchasers. Section 264(a)(1) has, since 1997, denied any such deduction.

19Effective date provisions reflecting the "material modification" language appear in Prop. Reg. 1.61-22(j); 1.83-6(a)(5)(ii); 1.301-1(q)(4) and 1.7872-15(n).

20See, e.g., Code 72(e)(11) and 72(v), as amended by 5012 of the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647). The transition rules (contained in 5012(e), as amended by 7815 of P.L. 101-239) delineate certain "material changes" to a contract.

Similar transition rules with respect to amendments to Code 72(q) and the addition of Code 72(s) in the Deficit Reduction Act of 1982 ("DEFRA," P.L. 98-369 222(c)(2)) are set forth for contracts issued before the effective date. For purposes of the DEFRA changes, the Conference Report states that "an annuity contract issued in exchange for another will be considered a new contract subject to the new penalty and distribution-at- death rules." H. Rept. No. 98-861, 98th Cong. 2d. Sess. (Conference Report) (June 23, 1984); 1984-3 C.B. (Vol. 2), p. 332. (Emphasis supplied.)

Section 7702 of the Code was added by 221(d) of DEFRA, supra, in 1984. Section 7702 provides a statutory definition of the term "life insurance contract." In general, it applies to contracts issued after December 31, 1984. The Blue Book to DEFRA provides that "[c]ontracts issued in exchange for existing contracts after December 31, 1984 are to be considered new contracts issued after that date." Report of the Joint Committee on Internal Revenue Taxation on the Deficit Reduction Act of 1984, 98th Cong., 2nd Sess., p. 656 (Dec. 31, 1984). See also S. Rept. No. 98- 169, 98th Cong., 2nd Sess., pp. 579-580 (April 2, 1984). (Emphasis supplied.)

See also, Code 101(g) (dealing with accelerated death benefits) and 7702B (qualified long-term care insurance), both of which were added to the Code by the Health Insurance Portability And Accountability Act of 1996, P.L. 104-191. The effective date provisions and/or committee reports to both delineate transition rules in terms of changes or material modifications to a contract. See P.L. 104-191 321(f), 332(a); Joint Committee on Taxation, "General Explanation of Tax Legislation Enacted in the 104th Congress," (JCS- 12-96), pp. 344, 350 (Dec. 18, 1996); H. Rept. No. 104-736, 104th Cong. 2d Sess (Conference Report), pp. 300, 308 (July 31, 1996).

21Prop. Reg. 1.7872-15.

22We note also that, in the case of a split-dollar demand loan, the interest rate for testing for "adequate stated interest" is the "blended annual rate" for the year, which is not usually available until June of each year. If each payment is a separate loan, an alternate rate should be available for premium payments made during the first 6 months of the year. See, e.g., Prop. Reg. 1.7872-3(b)(3)(i) and (ii).

23Prop. Reg. 1.7872-15(d).

24Prop. Reg. 1.7872-15(j).

25The "contingent debt instrument" regulations, issued under the authority of Code 1275(d), are some of the most complex in the Internal Revenue Code. The IRS released four different sets of proposed regulations before finalizing these regulations in 1996. See T.D. 8674. The final regulations do not even offer a clear definition of "contingent payment." Thus, their application to the split-dollar loan situation, for which they were not designed, is, to say the least, not intuitive.

Further, we note that it is by no means clear that the contingent payment debt instrument regulations even apply to nonrecourse obligations for purposes of the OID rules, and that the argument for applying those regulations to nonrecourse split-dollar loans must be viewed as equally tenuous. One commentator has stated that:

"Under the final [contingent payment debt instrument] regulations [T.D. 8674], the possibility of impairment of a payment by insolvency, default, or 'similar circumstances' is not even a 'contingency' and therefore is automatically ignored. Final reg. section 1.1275-2(h). Thus, assuming that a financial instrument is treated as indebtedness for federal income tax purposes, the fact that it is nonrecourse, or issued by a poor credit risk, will not by itself cause the instrument to be a CPDI." Miller, "A Look At The Final Contingent Payment Debt Instrument Regs.," 96 TNT 142-78 (1996).

See also, FSA 1999-586 (June 30, 1993), citing GCM 39556 (Sept. 16, 1986), to the effect that: ". . . interest on a nonrecourse OID instrument is not contingent interest deductible only in the taxable year in which the debt is paid. In sum, it is our position that because the loan is legitimate, taxpayer should be allowed to currently accrue its deductions on a constant yield to maturity basis." The FSA also concludes that the argument that a valid nonrecourse debt is per se contingent could not be sustained in litigation.

26We assume that the result in this case, as under the OID contingent payment debt regulations, would be that interest would not be deductible until the loan was repaid. However, since interest on a split-dollar loan will, in most cases, be nondeductible, we are unclear concerning the ultimate effect in the nonrecourse situation and would be greatly aided by an example.

27Prop. Reg. 1.7872-15(d)(5)(iv)(D).

28See Code Sections 7872(d)(2) and (b)(1).


END OF FOOTNOTES

 



Code Section: Section 72 -- Annuities; Section 79 -- Group Term Insurance; Section 101 -- Death Benefits; Section 1035 -- Exchanges of Insurance Policies; Section 7872 -- Below-Market-Rate Loans
Geographic Identifier: United States
Subject Area: Insurance company taxation
Industry Group: Insurance
Cross Reference: For a summary of REG-164754-01, see Tax Notes, July 15, 2002, p. 361;
for the full text, see Doc 2002-16108 (24 original pages) [PDF], 2002 TNT
135-10 , or H&D, July 5, 2002, p. 175.
Author: Albert J. Schiff; Richard Koob
Institutional Author: Association for Advanced Life Underwriting; National Association of Insurance and Financial Advisors