Attorney Recommends Changes to Proposed Regs Affecting Split-Dollar Life Insurance Arrangements


John R. Keegan of Marcia S. Wagner, Esq. and Associates, P.C., has suggested changes to the proposed regs affecting split-dollar life insurance arrangements.

Date: 19 Jun 2003

Full Text Published by Tax AnalystsTM

June 19, 2003

Internal Revenue Service
P.O. Box 7604
Ben
Franklin Station
Washington, D.C. 20044
CC:PR:RU (Reg-164754-01)
Room 5226

Re: Proposed Regulation Section 1.61-22(d)(3)(ii) Relating to the Valuation of Economic Benefits under Certain Equity Split- Dollar Life Insurance Arrangements


Dear Sir/Madam:

[1] The following is in response to Proposed Regulation Section 1.61-22(d)(3)(ii) issued May 9, 2003 relating to the valuation of economic benefits under certain equity split-dollar life insurance arrangements.

[2] These comments relate to Proposed Regulation Section 1.61- 22(d)(3)(ii)(G) Example 1.

[3] The Facts Section of Example 1 states: "The arrangement also provides that upon termination of the arrangement or E's death, R is entitled to receive the lesser of the aggregate premiums paid or the policy cash value of the contract and E is entitled to receive any remaining amounts. Under the terms of the arrangement and applicable state law, the policy cash value is fully accessible by R and R's creditors by E has the right to borrow or withdraw the portion of the policy cash value exceeding the amount payable to R upon termination of the arrangement or E's death."

[4] The Analysis Section of the Example states: "Under the terms of the equity split-dollar life insurance arrangement, E has the right for year 1 and all subsequent years to borrow or withdraw the portion of the policy cash value exceeding the amount payable to R."

[5] The Analysis Section clearly provides that E's right to borrow or withdraw the portion of the policy cash value exceeding the amount payable to R is an annual right, but the Facts Section seems to suggest that E's right to borrow or withdraw does not exist until termination of the split-dollar arrangement. Thus, it appears that the facts as presented in the Facts Section of the Example are not exactly identical to the facts being analyzed in the Analysis Section. Thus, the facts in the Example should be clarified.

[6] Also, if one interprets the Facts Section so that E's right to borrow or withdraw does not exist until termination of the arrangement, it would appear, based on the Analysis Section that, notwithstanding that the policy cash values are accessible by R and by its creditors and E's right to borrow or withdraw is a future right, i.e., at termination of the arrangement, E would be currently taxed on the portion of the policy cash surrender value in excess of the amount payable to R upon the termination of the arrangement or E's death, minus any amount previously taxed to E. This result is contrary to current taxation principals applicable to deferred compensation and thus, I assume, it is not intended.

[7] Based on the above, I think clarification of the following two points is warranted:

  • In Example 1, E's right to borrow or withdraw the portion of the policy cash value in excess of the amount payable to R upon termination of the arrangement or E's death should be clearly stated in both the Facts Section and the Analysis Section of the Example as an annual right; and
  • It should be clearly stated that, in situations where the cash surrender values are fully accessible by an employer and its creditors and the executive has no right to borrow or withdraw any potion of the cash values until termination of the arrangement or some other future date or event, the executive is not taxed on any portion of the cash values prior to the termination of the arrangement or such other future date or event.


[8] Thank you for your consideration of the above.

Sincerely,

/s/

John R. Keegan
Marcia S. Wagner, Esq. &
Associates, P.C.
Boston, MA

cc: Marcia S. Wagner, Esq.

 



Tax Analysts Information

Code Section: Section 7872 -- Below-Market-Rate Loans; Section 61 -- Gross Income Defined; Section 83 -- Property Transferred for Services; Section 264 -- Nondeductible Premiums
Geographic Identifier: United States
Subject Area: Individual income taxation
Insurance company taxation
Estate, gift and inheritance taxes
Employment taxes
Industry Group: Insurance
Author: Keegan,John R.
Institutional Author: Marcia S. Wagner, Esq. & Associates, P.C.
Tax Analysts Document Number: Doc 2003-16543 (2 original pages) [PDF]
Tax Analysts Electronic Citation: 2003 TNT 142-41
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.)


Attorneys Express Frustration With Proposed Regs on Split-Dollar Life Insurance Plans


Robert S. Balter of Karr Barth Associates and Lawrence D. Brody of Bryan, Cave, LLC, have submitted comments regarding the proposed and supplemental proposed regulations on split-dollar life insurance arrangements.

Date: 8 Jul 2003

Full Text Published by Tax AnalystsTM

From: robert.balter@axa-advisors.com

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Arrangements]

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JULY 8, 2003

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RE: COMMENTS ON PROPOSED & SUPPLEMENTAL PROPOSED REGULATIONS
CONCERNING SPLIT DOLLAR LIFE INSURANCE ARRANGEMENTS

Dear Sir or Madam:

The following comments regarding the proposed regulations on split dollar life insurance arrangements published by the United States Department of the Treasury on July 9, 2002 (hereinafter, Proposed Regulations) and concerning the supplemental proposed regulations published on May 8, 2003 (hereinafter Supplemental Proposals collectively the proposals) are submitted by Robert S. Balter and Lawrence D. Brody and represent solely their individual points of view. Mr. Brody is a partner in the law firm of Bryan, Cave, LLC, One Metropolitan Square, 211 North Broad Street, Suite 3600, St. Louis, MO 63102-2750, 314-259-2000. Mr. Brody is not appearing on behalf of any particular client, nor is Mr. Brody being compensated by any particular client either with respect to time expended in preparing these comments or for appearing to testify. Similarly, Mr. Balter is Director of Business and Estate Planning at Karr Barth Associates Inc., 40 Monument Road, Bala Cynwyd, PA 19004, 610-660-4224 and is the sole owner of his law firm, Robert S. Balter, P.C., 1077 Kipling Road, Rydal, PA 19046, 215-887-1167. Mr. Balter is also a registered representative and is not appearing on behalf of any particular client nor is his time being compensated by any particular client either with respect time expended in preparing these comments or for appearing to testify. Both authors are commenting and appearing solely as interested professionals active with respect to the matters involved.

COMMENT 1 -- OVERALL. Before making any comment with respect to particular aspects of the Proposed Regulations and while welcoming the effort to bring comprehensive clarity to this area of the law, it must be pointed out at the beginning that the Proposed Regulations are enormously complex, almost to the point of being indecipherable.

In contrast to the relative clarity of the preamble to the proposed regulations themselves, the Proposed Regulations are couched in language that is very difficult -- if not actually impossible -- to understand. Mr. Balter especially wishes to state categorically that he has spent literally hours reading over one or two provisions in the Proposed Regulations only to come away concluding that he simply could not derive a coherent thought from the provisions as written. The sentences used are complex and are qualified time and again by independent provisions that introduce additional imprecision by the use of such phrases as generally (seemingly meaning sometimes but not necessarily in your case) and including (seemingly having similar referents).

The failure to use safe harbors is another significant failing of all of the proposals as they stand. Indeed, Mr. Balter submits that one of the major reasons for the more or less hostile reception to these proposals is not just that familiar advantages are being limited, reduced or abolished, but that they are being limited, reduced or abolished so unclearly that no one really seems to know where the new rules begin or end. Safe harbors would help with that.

COMMENT 2. WHO SHOULD DECIDE WHETHER LOAN OR ECONOMIC BENEFIT TREATMENT SHOULD APPLY? Notice 2002-8 currently permits taxpayers to choose to treat a split dollar arrangement either as a loan arrangement or as an economic benefit arrangement under the circumstances described in that notice. Contrarily, the Proposed Regulations (effective with respect to arrangements entered into after the effective date of final regulations) define split dollar arrangements and establish two mutually exclusive regimes the economic benefit regime and the loan regime. Which of these two regimes will apply to any particular circumstance is to be determined by the terms of the Proposed Regulations themselves as applied to the facts of each case rather than by any taxpayer choice.

We believe that the insistence of the Proposed Regulations that their terms determine the outcome, rather than integrating taxpayer elective treatment into the proposals, is one of the major failings of those proposals. A split dollar arrangement, like other contractual arrangements entered into between competent, consenting adults in a free society is fundamentally a voluntary undertaking. There is no adequate reason why tax treatment should be the result of the application of uncertain provisions to facts when those results should be indicative of taxpayer intent in entering into the agreements in the first place, as is generally true with respect to voluntary taxpayer undertakings.

For a variety of reasons, taxpayers might well prefer loan treatment when only economic benefit treatment would be available under the Proposed Regulations if finalized as is or vice versa. The example below illustrates one circumstance in which this may occur.

COMMENT 2 -- EXAMPLE 1. Assume a male employee age 50 enters into a split dollar agreement. The Table 2001 charge is $2.30 per $1,000 of coverage. Assuming $1,000,000 of coverage, the annual charge would be $2,300 at age 50 and $2,520 at age 51, etc. Treated as a loan, the amount subject to loan treatment increases annually by the amount loaned each year. So, assume the premium was $20,000 per year for a $1 million policy and assume we expected the program to be funded in 7 years. In 7 years, the employee would be 57 and the cost per $1,000 would be $5.20 or $5,200 per million. If interest rates remained the same as they were in May of 2003 (3.17% May 2003 mid-term annual AFR), the accumulated premiums would be $140,000 and the annual loan interest charge (assuming all interest is paid currently by the employee) would be $4,438 (and would then remain constant if the interest amount was paid annually and rates remained the same). The result would be an economic benefit charge that is $762 in excess of the interest on cumulative advances because of being treated as an economic benefit arrangement at the outset instead of being treated as an annual loan at the outset. And that overcharge would increase each and every year thereafter.

Thus, instead of permitting -- or even facilitating -- the making of intelligent choices by taxpayers taking relevant conditions into account, the Proposed Regulations require taxpayers to engage in speculation over developments involving substantial uncertainties many years into the future simply in order to comply intelligently with the Proposed Regulations.

If the Treasury as far the fiscal soundness of the tax system goes is satisfied with the lesser of these two amounts, why shouldn't Treasury simply allow that? We respectfully submit that the Treasury Department should consider mandating in the regulations that the amount required to be treated as income is the lower of the two amounts, not the amount consistent with a taxpayer's prior practice.

COMMENT 3. TAXPAYER CHOICE OF TREATMENT. Notice 2002-8 currently permits taxpayers to choose to treat a split dollar arrangement either as a loan or as an economic benefit under the circumstances described in that notice. Contrarily, the Proposed Regulations (effective with respect to arrangements entered into after the effective date of final regulations) define split dollar arrangements and establish two mutually exclusive regimes the economic benefit regime and the loan regime. Which of these two apply is determined by the terms of the Proposed Regulations. This approach seems ill-advised for the reasons stated above and for the reasons that follow.

Under the Proposed Regulations and in circumstances both common at this time and likely to be more common after adoption of the Proposed Regulations in any form, taxpayers will still be free to choose the form of treatment, at least in the employer-employee context. No policy reason exists for treating taxpayers in other contexts differently in this regard.

The term split dollar arrangement is defined in the Proposed Regulations by the congruence of the following five factors: (1) An arrangement (2) between an owner and a non-owner when (3) either party pays premiums including payment by means of a loan from one to the other, and (4) one of the parties is entitled to recover the premiums from the death benefit or policy values and (5) the agreement is not group term life insurance.

A special rule concludes that any arrangement is a split dollar arrangement if (1) between an owner and a non-owner, (2) entered into in connection with performance of services, (3) not group term life insurance, (4) the employer or service recipient pays premiums directly or indirectly and (5) the beneficiary is designated by the service provider.

The Proposed Regulations as written give taxpayers a mechanism by which to preserve choice of treatment even after the Proposed Regulations are finalized. Proposed Regulations 1.61-22(b)(3) tells us that under certain circumstances the loan rules apply and under other circumstances the economic benefit rules apply. In particular, we are told that economic benefit analysis does not apply to a split dollar loan except when the employee is not the owner. We know that if the employee is treated as the owner of a trust and that trust owns the policy, the employee will be treated as the owner of the policy.

That means, that, all other things being equal, taxpayers can turn on loan analysis by having a trust own the policy and having that trust be a grantor trust as to the employee and can turn off loan analysis and turn on economic benefit analysis by having a trust that is not a grantor trust as to the employee own the policy. There are methods by which grantor trust status can be turned on and off and status as a grantor trust is determined only during the period he [the grantor] is treated as owner.

This raises a significant question as to what policy is being served by having the regulations -- rather than taxpayers -- choose which regime applies (if indeed there is any policy basis for such a conclusion at all) when the very same regulations give some taxpayers the right to choose which regime applies indirectly as illustrated above.

The example below illustrates this comment in further detail.

Comment 3 -- Example 1. Consider a corporate loan to a trust to permit the trust to buy a policy covering an employee's life and assume the trust beneficiaries are the employee's spouse and descendants. Once the Proposed Regulations are final, that loan will be subject to the special rule treating it as a split dollar arrangement, will be treated as a split dollar loan (assuming the parties so treat it) and not as an economic benefit arrangement if the policy is treated as owned by the employee as it would be since the trust is structured as a grantor trust with respect to the employee. But if the policy is owned by a trust that the employee is not deemed to be the owner of under the grantor trust rules, then the policy will not be treated as owned by the employee since the trust is entitled to more than death benefits under the arrangement. The result is that economic benefit treatment is required if the trust is not a grantor trust as to the employee, but forbidden if it is!!

COMMENT 3 -- CONCLUSIONS. There is no significant policy concern served by this distinction as applied in the employer-employee context and in that context the Treasury would be best served by requiring that the included amount is the lesser of the two amounts and by permitting taxpayers to choose annually which form of treatment they prefer. We submit that such a choice would be harmless to the Treasury in this context and in all others as well.

COMMENT 4 -- DEFINITION OF SPLIT DOLLAR AGREEMENT. Proposed Regulation 1.61-22(b)(1) provides: A split dollar life insurance arrangement is any arrangement between an owner and a non-owner of a life insurance contract that satisfies the following criteria:


(i) Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract;

(ii) At least one of the parties to the arrangement paying premiums under paragraph (b)(1)(i) of this section is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and

(iii) The arrangement is not part of a group term life insurance plan described in section 79.


Consider the application of that definition to a person who buys a life insurance policy on his or her own life and pays the premiums by credit or debit card!! Any arrangement is clearly not a 79 plan, the owner -- as one party to the arrangement paying the premiums -- is clearly entitled to recover those premiums in whole or in part from the cash value and such recovery is secured by the policy (by ownership) and the credit card company clearly pays directly or indirectly, all or any portion of the premiums on the life insurance contract.

Is my Discover Card or my Visa Card agreement a split dollar life insurance arrangement?!? Only the fact that credit and debit card issuers don't generally have an interest in the property purchased with their cards as collateral saves the credit card issuer from qualifying as a non-owner under the definition in the Proposed Regulation 1.61-22(c)(2):


Non-owner. With respect to a life insurance contract, a non-owner is any person (other than the owner of such contract) that has any direct or indirect interest in such contract (but not including a life insurance company acting only its capacity as the issuer of a life insurance contract.


Are we really satisfied, given that brad language, that people in the absolutely simple circumstance described above are excluded from split dollar treatment by the requirement that the credit or debit card issuer must have some direct or indirect interest in such contract and they don't? The language any direct or indirect interest in such contract is very broad and seems to contemplate any sort of interest, not just property interests recognized under pertinent state law.

Consider third party premium financing arrangements under which the third party premium financer does have an interest in the policy. Such third party premium financing arrangements allow owners of illiquid assets to secure the benefits of life insurance and are between completely unrelated parties and entirely at arms length. There are currently such arrangements and they should be excepted by some safe harbor.

Consider payment by my second mortgage, the proceeds of which I used in part to pay premiums on my own policy?

In brief, there is a significant exposure that these rules will be applied in many unintended and unforeseeable ways to virtually any transaction involving a life insurance policy, especially taken together with the rule that the rules determine their own application and scope.

This is an area fundamental to the application of these proposals and literally crying out for clarification and definition in order for practitioners and clients to be able to discern which transactions are and which transactions are not subject to the proposals. These unintended applications could be solved by an exclusion from split dollar treatment, e.g., for credit card agreements, premium financing or checking accounts (although such an exclusion would be effective to that extent). However, they are symptomatic of a much larger problem: the enormous breadth of the definition of the phrase split dollar arrangement. As the Task Force Comments, put it, The use of the phrases any arrangement and pays, directly or indirectly are so broad that they may cover transactions that have not been traditionally considered split-dollar life insurance. Since the term arrangement is not defined at all, the uncertainty of these very broad, interrelated terms is heightened, as is their uncertainty.

Comment 4 -- Conclusions. The definition of the term split dollar arrangement is overly broad and should be refined to include only arrangements that are the result of an agreement evidencing the parties intentions with respect to the material provisions of the agreement. Moreover, a split dollar arrangement should exist only between persons in the specified relationships (employer-employee, donor-donee and shareholder-corporation). The final regulations should also exclude agency arrangements in general (viz., banks and credit cards) as well as third party premium financing arrangements with banks and financial institutions.

Comment 5 -- The Drawbridge is Always Up!! The Proposed Regulations contemplate one treatment applicable to split dollar arrangements under which the non-owner has or may have an equity interest and another applicable to split dollar arrangements under which the non-owner has no equity interest. Unfortunately, the Proposed Regulations implement that intent imperfectly, as we show below. Proposed Regulation 1.61-22(b)(3) provides:


(3) Determination of whether this section or 1.7872-15 applies to a split dollar life insurance (i) Split dollar life insurance arrangements involving split dollar loans under 1.7872-15. Except as provided in paragraph (b)(3)(ii) of this section, paragraphs (d) through (g) of this section do not apply to any split-dollar loan as defined in 1.7872-15(b)(1). Section 1.7872-15 applies to any such loan. See paragraph (b)(5) of this section for the treatment of payments made by a non-owner under a split dollar life insurance arrangement that are not split dollar loans.

(ii) Exceptions. Paragraphs (d) through (g) of this section apply (and 1.7872-15 does not apply) to any split-dollar life insurance arrangement if

(A) The arrangement is entered into in connection with the performance of services, and the employee or service provider is not the owner of the life insurance contract (or is not treated as the owner of the contract under paragraph (c)(1)(ii)(A)(1) of this section; or

(c)(1)(ii) Definitions Owner Special rule for certain arrangements

(A) In General. Notwithstanding paragraph (c)(1)(i) of this section (1) An employer or service recipient is treated as the owner of a life insurance contract under a split dollar life insurance arrangement that is entered into in connection with the performance of services if, at all times, the arrangement is described paragraph (d)(2) of this section; and

(d)(2) Non-equity split dollar life insurance arrangements. In the case of a split-dollar life insurance arrangement subject to the rules of paragraphs (d) through (g) of this section under which the only economic benefit provided to the non-owner is current life insurance protection (including paid-up additions thereto), the amount of the current life insurance protection provided to the non-owner for the current taxable year equals * * *. * * * (Emphasis supplied.)


Notice that the provisions of 1.61-22(b)(3)(ii)(A) refer to the provisions of (c)(1)(ii)(A)(1) as treating the employee or service provider while in fact those provisions treat the employer or service recipient. The result is the bridge to non-equity treatment as a condition is always up and is not conditional, as it was intended!! Thus, it is quite unclear whether a non-equity arrangement is or is not a condition of treatment under these provisions. Clearly, this needs to be rectified.

Comment 6 -- Reverse Split Dollar: The Covered Leper. In Notice 2001-10 and Notice 2002-8 as well as in the Proposed Regulations, the IRS excluded reverse split dollar from treatment though not from coverage as a split dollar arrangement. This results in an untenable situation.

We believe that any exclusion for reverse split dollar is mistaken and unwarranted. It is mistaken because the definition of split dollar arrangement does not exclude reverse split dollar from its scope and therefore reverse split dollar arrangements are within that definition. As such, they should be afforded the same analysis as any other split dollar arrangement. It is unwarranted because the meaning of the term reverse split dollar is now quite uncertain given the various possible permutations and it is likely to become altogether meaningless, whether the proposals are finalized or not. It would be more constructive to see split dollar as an arrangement under which one party who is not a life insurance carrier is selling the right to a death benefit or portion thereof for some period of time, or under which a person entitled to a death benefit is selling the right to a portion or all of the cash value. This would provide a more logical and comprehensive basis for analysis.

We believe that the label reverse split dollar is now entirely meaningless. The fact is that split dollar involves the sharing of policy costs and benefits between two or more parties. The particular manner in which those costs and benefits are shared is fundamentally irrelevant to whether the arrangement is or is not a split dollar arrangement and the proposed regulations recognize that fact and indeed seem to be based in large part on that conclusion.

It follows that operational rules for reverse split dollar need to be provided just as much as operational rules for more traditional split dollar needs to be provided. And it does not seem to us that it will do in any sense to say they are included in the definition but none of the rules apply. After all, all of the rules need to be consistent.

The result of a provision excluding reverse split dollar would likely be court cases to determine whether or not a particular split dollar arrangement is or is not within the reverse split dollar exclusion. There is simply no justification for not including all split dollar arrangements within the definition in the final analysis, whatever the results may be.

Comment 7 -- The Supplemental Proposals Overall and Income from Loans. Just as we had certain general comments with respect to the clarity and some of the content of the Proposed Regulations, we begin our commentary with respect to the Supplemental Proposals by declaring our belief in the rule of law in general, and in the Constitution and the separation of powers in particular. We do not believe that taxing split dollar, however laudatory a goal that might be, is worth, for example, overturning settled Supreme Court decisions, substituting a gross receipts tax for a net income tax, or finding income from the grant of the right to do things which, if done, do not give rise to income themselves. And so, the very idea that the right to borrow an activity necessarily increasing assets and liabilities equally in a system taxing accretions to net worth must be out of the question. Indeed, the Supreme Court has held that borrowing does not give rise to taxable income in Commissioner v. Wilcox, 327 U.S. 404 (1946):


The very essence of taxable income, as that concept is used in Section 22(a) [the predecessor to IRC 61)], is the accrual of some gain, profit or benefit to the taxpayer. This requirement of gain, of course, must be read in its statutory context. Not every benefit received by a taxpayer from his labor or investment necessarily renders him taxable. Nor is mere dominion over money or property decisive in all cases. In fact, no single conclusive criterion has yet been found to determine in all situations what is sufficient gain to support the imposition of an income tax. See Magill, Taxable Income (1945). For present purposes, however, it is enough to note that a taxable gain is conditioned upon (1) the presence of a claim of right to the alleged gain and (2) the absence of a definite, unconditional obligation to repay or return that which would otherwise constitute a gain. Without some bona fide legal or equitable claim, even though it be contested or contingent in nature, the taxpayer cannot be said to have received any gain or profit within the reach of Section 22(a). See North American Oil v. Burnet, 286 US 417, 424, 52
S. Ct. 613, 615. Nor can taxable income accrue from the mere receipt of property or money which one is obliged to return or repay to the rightful owner as in the case of a loan or a credit. 327 US at 407-408 (emphasis supplied.)


While this case was itself overruled in rationale in Rutkin v. United States and in fact in James v. United States, the Court at every turn has reaffirmed, reiterated and clarified the prior holdings regarding loans, e.g., in James when Chief Justice Warren wrote decisively for the Court:


When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent. North American Oil v. Burnet [286
US 417], at p. 424. In such a case, the taxpayer has actual command over the property taxed -- the actual benefit for which the tax is paid, Corliss v. Bowers [281 US 376). This standard brings wrongful appropriations within the broad sweep of gross income; it excludes loans. 366 US 219 (emphasis supplied).


It seems somewhat radical to treat the ability to borrow against a life insurance policy as a wrongful appropriation it would be, after all, a perfectly legal and entirely consensual arrangement under which all parties fully expect to be entirely repaid.

Of course, when a taxpayer borrows, there is consensual recognition, express or implied, of an obligation to repay and there is a loan. It seems clear that the law of the United States (at least in the absence of legislative change) is that no taxable gain is present. A very large part of our tax on net income would have to be overturned to change this result.

The Supplemental Proposals generally seem to emanate from a tabula rosa point of view: what would or might be good policy if we had no other constraints. In a government of checks and balances, however, government decisions based on policies without regard for existing constraints is all but un-American! A gross receipts tax might be nice, but that isn't the tax Congress has chosen and in our system Congress has the right to make that choice. We respectfully submit that no Executive Branch agency or Department can remake that choice after 87 years of statutory law, not to mention the long settled decisions of the Supreme Court of the United States cited above.

Comment 8. Example 1. For the foregoing reasons, Example 1 (proposed regulation 1.61-22(d)(3)(ii)(G)(1)) is mistaken to the extent that it would impose an income tax on the right to borrow and should be withdrawn.

Comment 9. Example 2 and State Law. Proposed Regulation 1.61-22(d)(3)(ii) provides rules for valuation of endorsement equity split dollar agreements. It should be mentioned at the outset that neither submitter believes he has ever done or even seen such an arrangement. Example 2 posits a situation under which an equity split dollar arrangement is entered into with the employer paying all of the premiums and under which the employer is entitled to recover the lesser of premiums paid or cash value. The arrangement in the example specifically prohibits the employee from having any access to the policy cash value but the cash value is not available to the employer's creditors. The example concludes that the employee is deemed to have current access to the policy cash value in excess of the repayment obligation even though such access by the employee is forbidden under the split dollar arrangement. This result is not warranted by any law or public policy.

Proposed Regulation 1.61-22(d)(3)(ii) states that under such an arrangement, the value of the economic benefits provided to a non-owner for a taxable year under the arrangement includes (2) The amount of policy cash value to which the non-owner has current access within the meaning of paragraph (d)(3)(ii)(C) of this section (to the extent not actually taken into account for a prior taxable year);

Proposed Regulation 1.61-22(d)(3)(ii)(C) provides that a non-owner has current access to policy cash value that is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner's general creditors.

Whether cash values in a life insurance policy are or are not accessible to a policy owner's creditors is often not a matter of choice between the owner and the non-owner. Every state (North Carolina by its state constitution and including the District of Columbia) has some provision exempting all or part of the cash value of some life insurance policy from the claims of some creditors, sometimes absolutely, sometimes on condition as to amount, sometimes on conditions as to the identity of the beneficiary and one state limits the exemption depending on whether or not the right to change the beneficiary has been reserved.

The result is that the definition of current access has the effect of imposing income taxation on grounds the parties cannot change by any agreement they might make (other than by agreeing not to enter into such a split dollar agreement at all). Such a result is unwarranted in this context since the income tax is supposedly being imposed on advantages transferred voluntarily from an employer to an employee as compensation for services and therefore consensually. Moreover, the result of the employee being deemed to have access is to impose the income tax without an accretion to the employee's wealth of any kind. It is a case of imposing the tax without having any income to impose it on and that should be out of the question.

Furthermore, the same agreement would have different income tax consequences if undertaken in North Dakota than it would if entered into in Kansas assuming that only Pennsylvania residents are involved. That is true because North Dakota would provide no exemption from creditors claims (since no North Dakota resident is involved) with the result that the parties agreement with respect to access would control while Kansas would provide an entire exemption from creditors claims no matter who owns the policy, mandating that the employee has access no matter what agreement the parties might make. Such a result is an unwarranted intrusion on the freedom of parties to contract and is unwarranted. There is simply no good reason for not respecting the terms of the split dollar arrangement as written, just as the parties will be required to do by the law in every state. This example -- and the rationale underlying it -- should be withdrawn.

COMMENT 10 -- THERE IS NO ORDERING RULE BETWEEN DIFFERENT TYPES OF SPLIT DOLLAR. In much of the small business world, owners are employees. it should probably be left to owner-employees to determine in their agreement whether the arrangement is being entered into by the owner in his or her capacity as a shareholder or in his or her capacity as an employee. If that is so, a statement to that effect in the final regulations would be helpful. As it stands now, we did not see any provision addressing this possible overlap.

COMMENT 11 -- THERE SHOULD BE SAFE HARBORS. There is no question that split dollar life insurance can become very creative (some would say abusive although we're not sure abusive of what), but there are also a great many transactions that might involve split dollar arrangements particularly under the broad definitions of that term the consequences of which should be settled and clear. This would certainly facilitate taxpayer decision-making in this area. We have in mind here especially transactions between disinterested parties trying to provide an employee benefit or a supplemental retirement plan contingent on performance with the company for, say, the next 10 years or the provision of funds for a buyout between unrelated persons or by an unrelated company situations in which there is no motive for abuse and realistically little opportunity as well. Perhaps split dollar loans using applicable federal rates might be an appropriate subject for a safe harbor, as well.

COMMENT 12 -- CONSTRUCTIVE RECEIPT. The Supplemental Proposals rely on constructive receipt with respect to policy cash values to support the theories of income taxation set forth. It should be understood that this is not the first time the question of constructive receipt of the postings to a cash value life insurance policy has arisen. In Theodore H. Cohen, 39 TC 1055 (1963), the taxpayer argued that annual increases in the cash surrender values of life insurance policies were constructively received by him during prior barred years and therefore increased his basis in the year of surrender. The IRS opposed this contention and prevailed, establishing the principal that annual incremental increases in policy cash values are not constructively received. Citing Regulations 1.451-2(a), the Tax Court held that:


[P]etitioner's right to receive the cash surrender value including periodic increments thereof was subject to such substantial restrictions as to make inapplicable the doctrine of constructive receipt. 39 TC at 1063.


[1] IRS acquiesced in that decision at 1964-1 CB 4.

That decision was followed in Abram Nesbitt 2D, 43 TC 629 (1965) following the Cohen rationale and holdings. These prior Tax Court cases seem inconsistent with and contrary to the positions proposed in the Supplemental Proposals since the same sort of restrictions would be applicable in the split dollar context, except that those restrictions would actually be augmented by any additional restrictions from the split dollar arrangement. It is difficult to see how additional restrictions could conceivably create so much greater access to the annual policy increments that constructive receipt results when lesser restrictions make that doctrine inapplicable by their force.

REQUEST TO SPEAK ON JULY 29, 2003. We hereby request as well the opportunity to speak at the hearing on July 29, 2003. Of course, we would expect to discuss any of the above comments, as you may wish, and these comments therefore form an outline of topics to be discussed. In addition, other topics we would like to address at the hearing include:


1. Income taxation of split dollar plans.

2. Gift taxation of split dollar plans and particularly whether gift taxation is always determined by reference to income taxation.

3. Whether the proposed disallowance of basis in contributory plans will accomplish anything once the policies are devised that provide the contributing party with an interest in the policy proportionate thereto.

4. Ownership in the context of split dollar arrangements.


We look forward to joining with you in attempting to bring clarity to this area of income, gift, estate and generation skipping taxation.

Sincerely,

Robert S. Balter and Lawrence D.
Brody

 



Tax Analysts Information

Code Section: Section 7872 -- Below-Market-Rate Loans; Section 61 -- Gross Income Defined; Section 72 -- Annuities; Section 101 -- Death Benefits
Geographic Identifier: United States
Subject Area: Individual income taxation
Employment taxes
Estate, gift and inheritance taxes
Insurance company taxation
Author: Balter, Robert S.; Brody, Lawrence D.
Institutional Author: Karr Barth Associates Inc.; Bryan, Cave LLC
Tax Analysts Document Number: Doc 2003-16792 (10 original pages) [PDF]
Tax Analysts Electronic Citation: 2003 TNT 142-42
Cross Reference: For a summary of the REG-164754-01, see Tax Notes, July 15,
2002, p. 361; for the full text, see Doc 2002-16108 (24
original
pages), 2002 TNT 135-10 , or H&D, July 5, 2002, p. 175.
For a summary of Notice 2002-8, 2002-4 IRB 398, see Tax Notes,
Jan. 7, 2002, p. 35; for the full text, see Doc 2002-386 (7
original pages) [PDF], 2002 TNT 3-5 , or H&D, Jan. 4,
2002, p. 129.)


Insurance Company Urges Modifications to Proposed Split-Dollar Life Insurance Regs


Lynne F. Stebbins of the Guardian Life Insurance Company of
America has submitted comments on the proposed regulations affecting the taxation of split-dollar life insurance arrangements.

Date: 7 Jul 2003

Full Text Published by Tax AnalystsTM

From: lynne f stebbins@glic.com
Subject: IRS Email Sorter [taxregs: Split Dollar Life Insurance
Arrangements]
X-Mailer: www.irs.gov Comment Sorter CGI 1/2001
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SORTER FORM SUBMISSION
SOURCE IP ADDRESS: 63.72.235.4
reg=Split Dollar Life Insurance Arrangements
category=taxregs
email=lynne_f_stebbins@glic.com

Please be advised that the original hard copy of the document
submitted below is being sent overnight for arrival 7/9/03. Footnotes
in that document are properly placed. If you have any questions,
please call me at 212-598-8072.

The Guardian Life Insurance Company of America
Lynne F Stebbins, Esq., CLU, ChFC
Vice President
7 Hanover Square, H 25 H
New York, NY 10004

July 7, 2003

CC:PA:RU (REG-164754-01)
Internal Revenue Service
Courier's Desk
1111 Constitution Avenue, N.W.
Washington, DC 20224

Delivered via electronic mail (printed copy to follow)

RE: Split-Dollar Life Insurance Arrangements RIN1545-BA44

Dear Sir/Madam:

[1] The Guardian Life Insurance Company of America (Guardian) is a mutual life insurance company licensed to conduct an insurance business in all 50 states of the United States and the District of Columbia. As an issuer of life insurance products used in connection with split-dollar life insurance arrangements and a member company of the American Council of Life Insurers (ACLI), Guardian is in agreement with the comments submitted by ACLI in its letter dated July 8, 2003, regarding the proposed regulations on the economic benefit taxation of split-dollar life insurance arrangements. Guardian's comments below address what we believe to be significant areas of concern relating to the proposed regulations.

[2] Guardian appreciates the significant investment of time and effort the Department of Treasury and the Internal Revenue Service have devoted to creating an appropriate tax treatment for modern split dollar arrangements. We believe the proposed regulations would, with the modifications and clarification described in this letter and in the letter submitted by ACLI, provide a workable structure for treatment of split dollar life insurance arrangements within the basic statutory provisions and tax principles that apply to life insurance products.

[3] General Discussion1

Two Regimes

[4] Guardian wishes to reiterate the concern, addressed in detail in the ACLI comment letter, about the rigid nature of the two regime system. Guardian has made significant efforts to understand the regimes established in the 2002 proposed regulations and to communicate the nature of these regimes to our field representatives. We find the rigidity of the regimes is inconsistent with the nature of life insurance, the property financed by the use of a split dollar arrangement. Life insurance is property, and like any other property can be divided into separate parts. During the life of the insured, a life insurance policy has two elements: the amount at risk (the pure mortality protection) and the cash surrender value. It follows then, that both parts of the life insurance policy can be divided and managed as well as owned by more than one party. We recognize some aggressive tax planners have promulgated variations of split dollar, which blur the lines of ownership and which are considered abusive by the Service. We agree that such abusive arrangements should be eliminated. Conservatively drafted split dollar arrangements, however, allow taxpayers to purchase the valuable benefits life insurance provides, and the elimination of abusive arrangements should not jeopardize the benefits of life insurance financed with non-abusive forms of split dollar.

[5] We respect the Service's efforts to draw clearer lines of demarcation concerning policy ownership, but clear lines do not necessarily mean one party must own the entire policy, particularly when ownership for tax purposes fails to follow the titling on the property itself. Further, we respect the Service's efforts to outline clearly when taxation should occur and agree in principle that an employee should not gain a permanent benefit without corresponding taxation at an appropriate time.

[6] In that regard, the difficulty we find with the rules set forth in both the 2002 and 2003 proposed regulations is two-fold. First, by forcing an owner vs. a non-owner scheme in every situation, the rules fail to take into consideration that the underlying life insurance policy is actually property, easily and clearly divisible, which can be managed to provide an employee benefit taxed appropriately when ownership of cash value shifts from the employer to the employee. Second, the owner vs. non-owner scheme forces parties into circumstances and consequences unrelated to the nature of the split dollar arrangement which give no greater clarity or certainty to taxation, and in fact create more confusion.

[7] Guardian strongly encourages the Service to abandon the two regime structure for split dollar. In its now-revoked Notice 2001-10, the Service stated, In sum, therefore, any payment made by an employer under a split-dollar arrangement must be accounted for as a loan (see paragraph 2), as an investment in the contract for the employer's own account (see paragraph 3), or as a payment of compensation (see paragraph 6). Guardian believes the Service should follow the structure stated there and allow the parties to elect of one of three types of methods:


1. Section 7872 ONLY:2

a. A loan arrangement where the employee (or employee's designee) has record title to the policy and uses loan treatment as outlined in the proposed regulations of July 2002; or

b. An arrangement where the employee (or employee's designee) has title to the life insurance policy and collaterally assigns an amount equal to the premiums advanced to the employer (a classic equity arrangement); or

2. Section 61 ONLY : A non-equity endorsement structure where one party has record title to the life insurance policy and endorses all or a portion of the death benefit to the other party or other party's beneficiary and at no time is cash surrender value available to the party entitled to the death benefit.3 The party owning the death benefit must pay premiums or be taxed on the amount equal to the calculated economic benefit, and as such is accorded cost basis in its portion of the policy; or

3. A combination of Section 61 and Section 83: The employer and employee determine at the outset of the arrangement that the employer owns the cash surrender value of the policy and the employee owns the death benefit in excess of the greater of cash surrender value or premiums paid. This form of ownership can be formally listed on the policy data page and reflected in the insurance company records.4 The employee would pay the cost of the economic benefit directly to the insurance company or reimburse the employer for such payment. If the employer pays the entire premium, then the employee would be taxed on the economic benefit under IRC 61. In either case, the employee would be entitled to cost basis. Taxation under IRC 83 would occur if: 5

a. The employer formally transfers cash surrender value to the employee;

b. The employee takes a distribution in the form of a loan or withdrawal from the policy; or

c. The split dollar arrangement is later terminated without the employee having provided full and adequate consideration to gain the release of the collateral assignment against the policy.


[8] The transfer of property (i.e., the cash surrender value of the life insurance) from an employer to an employee is rightfully a transfer under IRC 83, and it follows that the employee should be accorded cost basis of the property so transferred and taxed. The intricacies of this third arrangement are clearly outlined in the ACLI comment letter with which Guardian concurs. We further believe that mandating an either-or approach to complex split dollar issues unduly burdens purchasers of life insurance who choose to properly finance their purchase by use of a split dollar arrangement, and who are willing to bear appropriate tax consequences.

Split Dollar is Not a Form of Non-Qualified Deferred Compensation

[9] Guardian agrees with the Service that the benefits arising under a split dollar arrangement should be properly accounted for and appropriately taxed. Clarity and fairness is in the best interest of taxpayers and of issuers of life insurance products such as Guardian. That said, however, we believe much of the discussion of the proposed regulations, particularly the 2003 proposed regulations, is being muddied both at the Service and in Congress by confusion with inapposite rules governing non-qualified deferred compensation. It is incumbent upon the Service, as it makes rules regarding split dollar, to understand that split dollar never was and never should be considered to be a form of non-qualified deferred compensation.

[10] A split dollar arrangement can provide pre-retirement death benefit protection while a separate non-qualified deferred compensation agreement provides for the transfer of the policy or its cash surrender value from the employer to the employee after retirement. However arranged, the split dollar arrangement in and of itself did not provide for a deferral of what otherwise would be compensation. Was there an issue in the past with employee equity? Yes. Based on the principles of Section 72, employee equity was thought by many to be taxed only upon surrender of the policy because, generally, the employee owned the policy. Misunderstanding alone, however, does not turn a split dollar arrangement into non-qualified deferred compensation. It is because of this misunderstanding that Guardian is concerned about the current access language in the Preamble to the 2003 Proposed Regulations (Section b.) and in Proposed Regulation 1.61-22(d)(3)(C).

[11] The proposed language echoes language commonly found in deferred compensation agreements, and taxation under IRC 61 is based on principles more commonly found in deferred compensation agreements such as constructive receipt, economic benefit and cash equivalence. This confusion between split dollar and non-qualified deferred compensation can be avoided entirely if we start from the premise that the employer owns the cash value of the policy, which can be transferred to an employee at a specific time through mechanisms such as a withdrawal or policy loan taken by the employee (or taken by the employer for the employee's benefit) or at a lifetime termination of the arrangement. The alternative listed above as Method 3 includes taxation under both IRC 61 for taxation of the value of current life insurance protection and IRC 83 in specific circumstances where policy cash value is formally transferred to or withdrawn or borrowed by an employee. This approach is consistent with the preview of proposed taxation described in IRS Notice 2001-10.

[12] Under the economic benefit approach, commonly seen in non-equity endorsement arrangements described in Method 2 (Section 61) above, the line of demarcation between cash surrender value and death benefit should be clear. Confusion results, however, from language in the 2003 proposed regulations about current access. In practice, rarely, if ever, is an endorsement arrangement executed and maintained which gives cash value to the assignee of the death benefit. The simplest way to deal with this equity endorsement problem is to prohibit access to the cash value by anyone other than the named owner of the policy.

[13] Further, taxation of undistributed cash surrender values of a life insurance policy is contrary to IRC 72, which governs life insurance policy taxation (as opposed to taxation of the arrangement). IRC 72 provides that gain, if any, is taxed only upon surrender. The purpose of the cash surrender value of life insurance is to support a much-needed death benefit to the insured's beneficiaries. Where no actual access ever occurs, taxation based on the Service's definition of current access is tantamount to taxing the inside cash value buildup in a life insurance policy. Split dollar is simply a method to economically purchase a death benefit. Taxation of the benefits of split dollar should not be confused with the taxation of the underlying insurance policy.

Pre-January 28, 2002 Arrangements

[14] Guardian is extremely concerned about the economic benefit taxation of arrangements in existence prior to January 28, 2002 (grandfathered arrangements). IRS Notice 2002-8 states that taxpayers who have entered into such arrangements may continue those arrangements under revenue rulings 64-328 and 66-110. That Notice further states that so long as tax continues to be paid on the economic benefit, the employee's equity will not be taxed as it accrues under IRC 83, and that such equity would be taxed under IRC 83 at the lifetime termination of the arrangement. Nothing in IRS Notice 2002-8 indicated the Service intended to tax the employee equity of a pre-January 28, 2002 arrangement as it accrues as part of the economic benefit calculation.

[15] A similar concern was voiced by the representative of another insurer on October 23, 2002, during the public hearing on the 2002 proposed regulations. A member of the IRS staff, Rebecca Asta (author of the IRC 7872 section of the proposed regulations) responded: . . . in 2002-8 we only said the equity would not be taxed under Section 83; we never said it wouldn't be taxed under Section 61. If the Service intends to tax employee equity each year by making it subject to inclusion as an economic benefit under IRC 61, then in fairness to taxpayers the Service must immediately state that position clearly and unambiguously.

[16] This matter is urgent because taxpayers are in the process of making long-term decisions about their existing split dollar arrangements, decisions which must be made before January 1, 2004. According to IRS Notice 2002-8, the taxpayer may choose among three options: 1) continue the arrangement under their current structure and risk 83 taxation if the plan terminates during lifetime; 2) terminate the plan or 3) adopt loan treatment. Clearly, if a taxpayer believed his or her arrangement was grandfathered and thus chose to continue the arrangement under the old rules, the taxpayer would have been deceived if he or she finds the Service imposes tax on equity as it accrues under IRC 61 as part of the economic benefit calculation. Taxpayers should be able to make informed decisions affecting their income tax, and in many cases gift tax as well, and should not find out later that the Service never gave the taxpayers all the facts on which a proper decision could be based.

[17] Guardian respectfully urges the Service to re-examine its approach to the taxation of split dollar arrangements entered into after the publication of final regulations, allowing for a choice among three reasonable methods, any of which meet the Service's goals of fairness, clarity, transparency and proper matching of benefit with taxation. Guardian further requests a public statement in the form of an IRS Notice prior to October 1, 2003, that unequivocally states that the annual economic benefit calculation for pre-January 28, 2002 grandfathered arrangements will not include the employee's equity except at termination of the arrangement during lifetime.

Contributory Split Dollar

[18] Consistent with the fact that life insurance is property that can be owned by two or more parties, both parties should be able to contribute to the premium of a policy subject to a split dollar arrangement without having one party's contribution characterized as income. Parties to a split dollar arrangement should be able to determine the amounts of premium and death benefits shared and such agreement should be documented in the written terms of the agreement. Further, both parties should also be credited with cost basis for their respective contributions or the amounts on which they were taxed.

Material Modification

[19] It is important that the Service clearly define what it means by the term, material modification. Guardian believes that substitution of a policy (such as a replacement under an IRC 1035 exchange) in an existing split dollar arrangement does not constitute a material modification of the split dollar arrangement.

[20] Moreover, where additional policies are added to a split dollar arrangement providing only a death benefit in correlation to an employee's salary, the addition of policies should not be deemed a material modification of the split dollar arrangement. Neither should a material modification to the arrangement occur when new employees are added to an existing split dollar arrangement covering a class or classes of employees. Split dollar arrangements are exactly that arrangements and should not be tied to specific policies which may be exchanged, replaced or surrendered subject to the existing split dollar arrangement.

Use of Insurer's Alternative Term Rates in the Calculation of the Cost of Current Life Insurance Protection

[21] In (the now revoked) IRS Notice 2001-10, the Service stated that no assurance is provided that such published premium rates may be used to determine the value of life insurance protection for periods after the later of December 31, 2003, or December 31 of the year in which further guidance relating to the valuation of current life insurance protection is published. The no assurance language has not been repeated in either IRS Notice 2002-8 or in the proposed regulations. Guardian still is concerned about whether the use of the insurer s alternative term rates will be allowed and what will be considered an acceptable alternative term rate.

[22] The National Association of Insurance Commissioners has specific requirements for policy illustrations, and prospective policyowners need a split dollar illustration which demonstrates the potential cost of current life insurance protection in 2004 and beyond. Therefore, insurers need an immediate, clear and unequivocal statement from the Service, preferably in a Notice, which either revokes use of alternative term rates or sets forth specific requirements for term policies for 2004 and later. This uncertainty cannot continue.

[23] Guardian also objects to use of individual proprietary company market data, i.e, regularly sells to determine whether a term policy might qualify as an alternative to the life insurance premium factors. Guardian, as well as other companies, does not regularly sell much term insurance at all. Further, term insurance sold today is very different from the term insurance available in 1966 when the characteristics of such alternative term insurance were described in Revenue Ruling 66-110. Although a standard risk at that time was a male smoker, today upwards of 85% of policies are issued non-smoker. To the extent the Service continues to allow alternative term rates, Guardian strongly suggests companies be allowed to develop for this purpose a unisex, unismoke one-year term product which is published, included in the company's illustration system and available for sale through its normal distribution channels.

Specific Comments


1.61-22 (d)(3)(B) Valuation of current term life insurance protection


[24] Guardian requests use of the value of the life insurance policy at its anniversary date instead of the average death benefit for the taxable year. Insurance company systems, particularly administrative systems for traditional whole life insurance policy contracts, report cash surrender value and death benefit as of the policy anniversary. The policy anniversary date is a fixed and determinable date for which insurance companies have reporting systems in place.

[25] In the first year of a whole life policy, generally the death benefit is the face amount of the life insurance policy, and thus at any time during the first year the death benefit would be approximately the same. During the second year or later, the death benefit might rise assuming the election of paid-up additions. When paid-up additions are surrendered to pay premiums, the death benefit could fall. In any event, although death benefit reported on the policy anniversary is not a strict average of death benefit available over the course of a year, it is a reasonable approximation of the average death benefit. To require insurers to install new systems or to manually calculate the average death benefit for policies subject to split dollar arrangements is an unnecessary and extremely costly burden. Further, the annual statement sent at the time of the policy anniversary contains all the death benefit information the taxpayer would need to calculate the economic benefit.

Calculation

[26] Guardian believes there is a calculation problem with the following: The cost of the current life insurance protection provided to the non-owner in any year equals the amount of the current life insurance protection provided to the non-owner multiplied by the life insurance premium factor designated or permitted in guidance published. . . . Certainly, if no cash value is included in the economic benefit calculation, that methodology would be correct. If, however, a non-owner had current access to a portion of the cash surrender value and thus had such cash surrender value included in the economic benefit calculation, the non-owner would be taxed twice on the same benefit. In the event a portion of the death benefit is included in an annual economic benefit calculation, then such amount should first be subtracted from the death benefit amount. This is necessary because if such cash value was withdrawn or used to secure a policy loan, that same amount would be deducted from any death benefit paid. Only if that cash value is deducted from the total death benefit would it then be proper to apply the life insurance premium factor. Any other method would result in double taxation. The formula would be:


Cost of current life insurance protection = (DB CTCV PTCV) x LIPF where DB = Death benefit on policy anniversary, CTCV is currently taxable cash surrender value, PTCV = previously taxed cash surrender value and LIPF = appropriate life insurance premium factor.

1.61-22(d)(3)(C) Current access


[27] The definition of current access as stated is overbroad and ignores any written, enforceable agreement by the parties to treat an arrangement as a non-equity arrangement. Current access should be just that: the non-owner has a non-forfeitable interest in some or all of the cash surrender value. As such, the owner has, in fact, transferred a portion of the policy under IRC 83 in the form of cash surrender value to the non-owner, and cost basis should be credited to the non-owner for having paid the tax to secure the portion of the policy the non-owner now owns.

[28] The Preamble even states that if state law provides any protection against creditors for life insurance, then by virtue of a state law, which the non-owner cannot control, the non-owner is taxed on the cash surrender value. The draconian effect of that position is to effectively outlaw any non-equity arrangement in states where creditor protection laws are applied to life insurance cash values.

[29] Guardian believes that the purpose of the proposed regulations is to properly account for and tax benefits under a split dollar arrangement. The split dollar arrangement itself has no state protection from creditors, and IRC 72 governs taxation of the underlying life insurance policy. A rule which prevents a citizen of a jurisdiction providing for limited creditor protection of cash values from being able to agree with his or her employer to a non-equity split dollar arrangement is absurd, unfair and in violation of generally settled federal tax principles. This rule, we believe, again is the result of the Service confusion of split dollar with non-qualified deferred compensation. Further, taxation of current access as defined in these proposed regulations can cause taxation of the inside cash value buildup of a life insurance policy, appearing to be an improper attempt to have split dollar rules override the long-standing IRC 72 which properly governs taxation of the policy itself.

1.61-22(d)(3)(D) Valuation date (1) General Rules

[30] Guardian urges the Service to use the policy anniversary date as the valuation date for the purpose of determining cash surrender value. The policy anniversary date is a fixed and determinable date for which insurance companies have reporting systems in place. For traditional whole life policies, dividends, if any, are credited on the policy anniversary date, and the current year's guaranteed cash value becomes fully credited to the policy on that date. For universal life policies, interest is credited daily, but the value reported on the policy anniversary will not be significantly different from the cash value as of December 31. For variable life insurance policies, the policy anniversary date will be as reasonable a representation of the cash surrender value as any, given the vagaries of the market governing the cash values.

[31] If the policy anniversary date is used for valuation purposes, it is possible that in the first year of a split dollar arrangement there might be a slight variance between the values as of the anniversary date and December 31. The calculation on the second policy anniversary would in any case catch what might have been missed in the first year. In subsequent years there would be no issue. To require insurers to install new systems or to manually calculate December 31 cash surrender value for policies subject to split dollar arrangements is an unnecessary and extremely costly burden. Further, the annual statement sent at the time of the policy anniversary contains all the cash surrender value information the taxpayer would need to calculate the economic benefit.

1.61-22(d)(3)(E) Policy cash value

[32] This rule ignores for tax purposes the fact that surrender charges are a true policy cost. Guardian believes a taxpayer should not be taxed on amounts that would not be available if the policy were surrendered. Additionally, the phantom income that would result would be a most inequitable consequence. Guardian suggests this rule be made consistent with other sections of the Code, such as the rules governing valuation of a policy for gift tax purposes. Further, any surrender charge should be prorated between the interests of the owner and non-owner in the cash surrender value. For example, if the owner owned 80% of the cash surrender value, 80% of the surrender charge would be attributed to the owner and 20% of the surrender charge would be attributed to the non-owner. That methodology would help prevent all the non-owner's cash surrender value being swallowed by the surrender charge. Once the surrender charge period has expired and all amounts are available under the policy, then it would be appropriate to use the entire cash value for the purposes of economic benefit calculation.

1.61-22(h) Examples

[33] The examples should be recalculated with the appropriate method for determining cost of current life insurance protection as outlined above. Example 2 should delete any reference to state law creditor protection for reasons stated above in the discussion on current access.


1.61-22(j)(2)(iii) Valuation of economic benefits; 1.83-6(a)(5)(B)(3) Valuation of economic benefits


[34] Guardian questions whether the Service meant to use the date of
December 31, 2003 instead of 2002. Beginning with IRS Notice 2001-10, the Service has consistently referred to the end of 2003 as the date to which the old rules would cease to apply. Please either clarify the Service does in fact intend to apply these economic benefit rules to arrangements entered into prior to the publication of the final split dollar regulations or correct the date to read December 31, 2003.

[35] Thank you for your consideration of our comments. We look forward to the opportunity to work with the Service and Treasury in resolving the concerns we have raised.

Sincerely,

[signed]
Lynne F Stebbins, Esq., CLU, ChFC
Vice President, Advanced Planning
& Professional Services

* * * * *


From: lynne f stebbins@glic.com
Subject: IRS Email Sorter (taxregs: Split Dollar Life Insurance
Arrangements]
X-Mailer: www.irs.gov Comment Sorter CGI 1/2001
X-FileSource: /var/IRS/data/apps/comments/bad/bad_taxregs105768928811
Content-Type: text/plain; charset=us-ascii

SORTER FORM SUBMISSION
SOURCE IP ADDRESS: 63.72.235.4
reg=Split Dollar Life Insurance Arrangements
category=taxregs email=lynne_f_stebbins@glic.com

Re: Proposed Regulations Regarding Split-Dollar Life Insurance
Arrangements

Dear Sir or Madam:

[36] The Guardian Life Insurance Company of America ("Guardian") respectfully requests time to testify at the hearing on this issue scheduled for July 29, 2003.

[37] Lynne Stebbins will testify on behalf of Guardian. The topics to be covered are:


1. The clarity of the proposed rules structured under two regimes;

2. Economic benefit calculations;

3. Calculation of the cost of current insurance protection; and

4. Insurer's alternative term rates.


[38] If you have any questions, please call me at 212-598-8072.

Very truly yours,

/signed/

Lynne F Stebbins, Esq., CLU, ChFC
Vice President
The Guardian Life Insurance
Company of America
7 Hanover Square, H 25 H
New York, NY 10004

FOOTNOTES


1 This discussion will focus on the typical split dollar relationship of employer/employee.

2 Devices such as vesting or transfers of cash value to the party with rights in the death benefit only during the term of the split dollar arrangement could be specifically prohibited in this type of arrangement. To the extent such devices are used, the plan could be treated as entirely distributed, making all premiums paid taxable under IRC 61.

3 If an employer owns the policy, terminates the split dollar arrangement and transfers the policy to the employee, the employee would be taxed on the fair market value of the policy at the time of transfer under IRC 83. At no time while the split dollar agreement is in effect, however, would there be a blurring of the line between ownership of cash value and endorsement of death benefit. Similar treatment would apply where the employee (or designated third party) holds record title to the life insurance policy and collaterally assigns the greater of cash value or premiums paid to the employer.

4 If an employer owns the policy, terminates the split dollar arrangement and transfers the policy to the employee, the employee would be taxed on the fair market value of the policy at the time of transfer under IRC 83. At no time while the split dollar agreement is in effect, however, would there be a blurring of the line between ownership of cash value and endorsement of death benefit. Similar treatment would apply where the employee (or designated third party) holds record title to the life insurance policy and collaterally assigns the greater of cash value or premiums paid to the employer.

5 Transfer of an interest in the cash surrender of a life insurance policy is property as defined by IRC 1.83-3(e) and is properly taxed under IRC 83, not IRC 61. IRC 1.61-2(d)(6).


END OF FOOTNOTES

 



Tax Analysts Information

Code Section: Section 7872 -- Below-Market-Rate Loans; Section 61 -- Gross Income Defined; Section 72 -- Annuities; Section 83 -- Property Transferred for Services; Section 101 -- Death Benefits
Geographic Identifier: United States
Subject Area: Insurance company taxation
Individual income taxation
Author: Stebbins, Lynne F.
Institutional Author: Guardian Life Insurance Company of America
Tax Analysts Document Number: Doc 2003-16793 (10 original pages) [PDF]
Tax Analysts Electronic Citation: 2003 TNT 142-43
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.
For a copy of ACLI's letter, see Doc 2003-15887 (17 original
pages) [PDF], or 2003 TNT 134-73 .


MassMutual Opposes Taxation of Inside Build-Up of Split-Dollar Arrangements


Kenneth Cohen and Susan Schechter of MassMutual have submitted comments on the proposed regulations affecting the taxation of split- dollar life insurance arrangements.

Date: 8 Jul 2003

Full Text Published by Tax AnalystsTM

July 8, 2003

CC:PA:RU (REG-164754-01)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20044

Dear Sir or Madam:

[1] This letter serves as the comments of Massachusetts Mutual Life Insurance Company ("MassMutual") on the supplemental proposed regulations, published in May 2003, affecting the taxation of split dollar life insurance arrangements ("SDLI"). Please be advised that MassMutual wishes to testify at the public hearing scheduled for July 29, 2003. Susan Schechter will testify on our behalf on the outline of points contained in this letter:

1. The Premise of the Regulatory Approach

2. Misapplication of the Rules of Constructive Receipt

3. Recharacterization as Deferred Compensation

4. Section 83 Overrides Constructive Receipt

5. The Principles of Notice 2002-8

6. Extension of Notice 2002-8 Safe Harbors

[2] MassMutual is one of the largest sellers of SDLI in the United States. Since the publication of Notice 2001-10 in January 2001, MassMutual has had the opportunity to comment on the proposed treatment of SDLI. We submitted comments on the first set of proposed regulations published in July 2002, and we testified at the prior public hearing. We have greatly appreciated the attention and consideration that the Department of Treasury and the IRS have given to our commentary. We continue to strongly advocate the position set forth in our comments and testimony. In the spirit of that participation, we hope you will accept the comments we offer here.

[3] We continue to view the entire regime of "'owner and non-owner" as a legally unsupportable fiction. The supplemental regulations drive that fiction further, distorting the longstanding tax treatment of life insurance ownership in order to achieve a preordained result: taxation of inside buildup. As in the first set of proposed regulations, the rules are driven by nominal policy ownership, rather than by the contractual basis of shared policy ownership. Without any change in the law, the legal foundation of this sweeping alteration of life insurance treatment -- simply because ownership is split -- is unclear.

[4] We were greatly disappointed at the tone and turn of the proposed regulations from the sense of the guiding principles set forth in Notice 2002-8. The supplemental regulations carry our disappointment even farther. The supplemental regulations simply ignore the rules applicable to life insurance taxation and impose a form of deferred compensation "constructive receipt" treatment that has never before been applied to life insurance and that is wholly inappropriate.

[5] We believe we correctly read Notice 2002-8 as a commitment by the IRS not to tax inside build-up prior to its actual realization by any insured. Yet, in a substantial change from the announced position, the proposed regulations now impose current taxation on inside build-up under a theory neither espoused nor contemplated by Notice 2002-8.

[6] We focus our comments on the conceptual approach.

The Premise of the Regulatory Approach

[7] The proposed regulations are based on the premise that most equity endorsement SDLI give the insured access to the policy equity. The "Background and Overview" section (paragraph 2b.) of the proposed regulations describes an owner-created "pool of assets" in which the employee-insured (the non-owner) has "certain rights" such as "rights of withdrawal, borrowing, surrender or assignment." In the first place, this "pool of assets" approach diverts focus from the policy itself, which is the asset and the core of the SDLI. A life insurance policy is an integrated asset, not an unbundled compilation of rights.

[8] Secondly, the endorsement split dollar method is typically used to concentrate control over the policy in the hands of the employer, and rarely are such access rights ever given to the employee under the SDLI. The preamble statement that "access" is typical is unsupported and untrue.

[9] In our experience, endorsement split dollar is a form used by employers who wish to exercise substantial control over the policy, do not plan to roll the policy out to the employee, and who wish to deny even the possibility of access to the insured-employee. Retaining nominal ownership of the policy, the employer protects its financial exposure (repayment of its premium outlay) from potential dissipation by the employee-insured. In the typical SDLI, employee-insureds have no access to the equity, in the traditional meaning of the word (i.e., ability to reach and use the funds); employees merely have the right to name a beneficiary for the employee's share of the death benefit. The premise that the employee- insured has free access to use and/or realize the equity during the course of the SDLI arrangement is faulty.1

[10] The same paragraph of the preamble states that this pool of assets held by the insurer effectively places the cash value "beyond the reach of the employer or the employer's general creditors in many cases." This is untrue. Through policy ownership, employers in endorsement plans have full control of and access to policy cash values. Some plans may cap the employers right to borrow at its cumulative premium outlay to prevent the employer from "stripping" the policy with large loans and accumulating unpaid interest that would jeopardize the coverage. The proviso gives the employee-insured no right to actually reach the equity, through borrowing or otherwise.

[11] SDLI should be taxed according to its terms. If an SDLI gives the employee-insured the right to request a loan or distribution, then any disbursement of funds by the employer pursuant to that request may be taxed under section 83 when it occurs. However, existence of policy equity alone should not trigger taxation.

Misapplication of the Rules of Constructive Receipt

[12] Based on these questionable premises and assumptions, the supplemental regulations conclude that it is appropriate to apply "the doctrines of constructive receipt, economic benefit and cash equivalence," These doctrines have previously been determined to be inapplicable to life insurance, but rather used primarily in the taxation of non-qualified deferred compensation plans. The government's departure from treating SDLI as a life insurance benefit is unfounded and inconsistent with the Code and regulations.

[13] We commented previously on the rules of section 72 and our view that there is nothing in section 72 that renders it inapplicable to split dollar arrangements or ownership interests created through split dollar arrangements.

[14] Section 72 has been revised over time, extensively in 1982 to address concerns about annuity contracts, and again in 1988 to address MEC issues. Nowhere is there an indication that Congress thought these rules were inappropriately applied to split dollar arrangements or should be limited when applied to equity SDLI, arrangements which were prevalent and known to Congress, the IRS and the Treasury since 1964. In every revision, Congress retained one basic: that constructive receipt rules are not applied to life insurance or annuity contracts.

[15] To emphasize the point, we note that the IRS itself confirmed the inapplicability of constructive receipt in several recent private letter rulings. In PLR 200313016 (3/23/2003) and PLR 200151038 (12/21/2001), the Insurance Branch of the IRS responded favorably to a policyowner concern that certain commutation rights under an annuity contract might give rise to constructive receipt, stating:


"no amount should be considered constructively received . . . before its actual payment under the proposed distribution methods for several reasons. First, section 72 provides a comprehensive scheme for the taxation of life insurance, endowment, and annuity contracts. . . . Both section 72(a) and (e) literally require that amounts be "received" by the holder before they are included in gross income, (emphasis added)"


[16] In the ruling, the IRS then went on to consider whether "received" in section 72 reaches amounts that are only "constructively received" and answered that query in the negative: "Thus the TEFRA changes to section 72 do not indicate that Congress intended to change prior law, which did not apply the doctrine of constructive receipt to annuity contracts." The Branch went on to point out that the treatment of a loan under section 72(e)(4) and the denial of interest deductions on indebtedness under section 264(a)(3) would be rendered unnecessary if constructive receipt were applicable to contracts covered by section 72: "If such increases in cash value were taxable under the doctrine of constructive receipt there would be no abuse for section 264 to correct."

[17] This comprehensive scheme of life insurance taxation is now being tossed aside through the fiction that the employee-insured is a "non-owner" and is without entitlement to the benefits of section 72. Nothing in the history of section 72, or its prior interpretations, supports this limitation of its reach.

Recharacterization as Deferred Compensation

[18] The supplemental proposed regulations extend deferred compensation taxation to a benefit that has not been so treated in almost 40 years of IRS rulings. Split dollar is a life insurance benefit warranting treatment under life insurance tax principles. SDLI is an affordable means of providing permanent life insurance benefits not otherwise available through employee benefits plans. While life insurance can and has been used as an source of deferred compensation investment planning, that use does not convert SDLI into deferred compensation.

[19] Characterization and treatment as deferred compensation is inappropriate. But worse, the proposed tax treatment of SDLI is harsher than the tax treatment applicable to cash deferred compensation. For SDLI, the proposed regulations create a 3-pronged test for "access," defining that term more broadly than normal usage. The three prongs are: 1) actual access by the employee (rights to withdraw, take loans, pledge or assign the equity), or 2) restricted access by the employer, or 3) restricted access by the employer's creditors. If any one of these features exists, the employee-insured has "access" and has constructive receipt (regardless of whether any of the equity cash value is actually accessible or realizable by the employee).

[20] Under this 3-prong test, no rabbi trust could avoid constructive receipt, In the IRS' prototype rabbi trust, the trust itself serves to set the amounts aside and beyond the reach of the employer. That is the purpose of a rabbi trust. But because the amounts are subject to the employer's creditors, no constructive receipt occurs. Creditor's reach would not be an issue if the employer had not established the trust and had maintained an "unfunded" promise. Nonetheless, applying the SDLI definition of access, the rabbi trust would fail prong 2, creating constructive receipt. Obviously, this is incorrect.

[21] The 3-prong definition of access for this purpose stretches the standards of constructive receipt. Treas. Reg. 1.451-2 provides:


"Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time . . . . However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. . . . ." (emphasis added)


[22] In the SDLI, if the first prong is satisfied (the employee cannot access or reduce the equity into cash through withdrawal, loan or pledge), then the SDLI does not make the equity available "so that he may draw upon it at any time." The second two-prongs exceed the standard.

[23] In SDLI, merely policy ownership is not a "set-aside." Therefore, the only issue should be whether the employee DOES access the cash value. Rights of access do not give rise to constructive receipt in life insurance. Re-read Section 72 and ask: if an owner with full access to cash values is not in constructive receipt of those values under section 72, how is the "non-owner" with no greater right of access in constructive receipt? And, if the owner is not in constructive receipt, how can the owner give what it hasn't received to the non-owner? We can divine no basis for treating SDLI as deferred compensation and regulating it more harshly than cash deferred compensation. We strongly urge that the proposed regulations be revised to adopt a definition of "access" that covers real access: realization and/or use of the equity by the employee.

[24] Ironically, the treatment of SDLI as deferred compensation seems only to occur on the income side. While the employee-insured would be in constructive receipt of the equity, the employer would be denied a deduction for those amounts. This is an economic mismatch of income and deductions and is contrary to Treas. Reg. 1.404(a)-(12)(b)(2), which provides an employer deduction when the employee reports taxable income. There is no legal authority for this mismatch. Whatever treatment is imposed should be handled consistently on the employer and employee sides.

Section 83 Overrides Constructive Receipt

[25] Even assuming arguendo that section 72 doesn't govern the "non-owner," the only other possibility is that there has been a deemed transfer of property (the employer's equity value) to the employee-insured. So characterized, this is a property transfer in compensation for services, and is governed by section 83. Section 83 specifically requires that there be a transfer, not a deemed transfer.

[26] To avoid this rule, the regulations rely on constructive receipt. But that reliance ignores that the "asset" isn't cash, but property (life insurance policy equity). And, property cannot be received (constructively or actually) without being transferred. If there's a transfer of property, section 83 (not section 61) sets the basis for taxation. To impose constructive receipt treatment runs afoul of Treas. Reg. 1.61-2(d)(6), which provides that "property transfers" made in connection with services are governed by section 83 and not by the constructive receipt principles of section 61. Again, all proper governing provisions require a realization event, not merely the growth of equity.

[27] We further note that the proposed regulations would treat the "value" of a section 83 transfer as the policy equity without regard to surrender charges. This is an unfair result, even under the "access" theory of the regulation. The employee-insured should not be taxed on income that the employee cannot turn, into cash. If the policy were transferred to the employee-insured and surrendered the same day, these proposed rules would impose tax on the full cash value while the actual proceeds realized would be net of surrender charges. This is inequitable, unwarranted and contrary to basic concepts of fair market value.

The Principles of Notice 2002-8

[28] In our prior comments, we noted that the proposed regulations had abandoned the announced principles of Notice 2002-8 that the employee's equity growth would not be currently taxable on an annual basis under section 83. The supplemental regulations attempt to avoid the inconsistency by stating that the Notice did not say the IRS would not find current income through principles of constructive receipt applicable to "access."

[29] In truth, the Notice did not say it wouldn't. But then, the Notice didn't say it would. In fact, the Notice didn't say anything further on this critical point of equity taxation, despite the fact that that issue had been a matter of pointed debate since the 1996 Technical Advice Memorandum and an item of substantial consideration and discussion in Notice 2001-10. Rather, after the debate and the year of commentary following Notice 2001-10, Notice 2002-8 announced the principle stated above. We, and most commentators, rightly saw this as a commitment not to tax SDLI policy equity absent realization. The "access" approach wasn't mentioned or implied. As now proposed, it represents an abandonment of the previously announced principles. We urge you to reconsider this abandonment.

Extension of Notice 2002-8 Safe Harbors

[30] Given the publication of supplemental proposed regulations, participants in SDLI are unable to predict when the final regulations will become effective. Even assuming the regulations will be issued as final in the third or fourth quarter of 2003, that uncertainty, coupled with the unexpected change of equity tax treatment if sustained, places an unfair burden on those attempting to determine whether to utilize the safe harbors provided in Notice 2002-8 for prior arrangements. Not knowing what all the alternatives are makes considered and full evaluation of these alternatives difficult and potentially rushed. This is more true as the guidance regarding valuation of the term cost remains to be issued. Until taxpayers can fully understand how these new regulations will look in final form, and understand what guidance on term cost valuation applies, the safe harbors should be extended.

Conclusion

[31] Taxation of the employee is more appropriately analyzed under a section 72/83 approach. This would require, not theoretical access, but an actual transfer of policy equity to the employee, either through withdrawals, policy loans, or the assignment or pledge of value. Some "use" of the equity is required. And, if that constitutes compensation under section 83, the employer should be entitled to a corresponding deduction.

[32] In the end, we believe and, based on Notice 2002-8 we thought you believed, that the equity in equity SDLI should only be taxed following some form of realization event. We believe you were correct to announce this principle in Notice 2002-8 in January 2002, and we believe you are wrong in abandoning this principle in the proposed regulations published in July 2002 and supplemented in May 2003.

[33] We urge you to modify these proposed regulations consistent with our comments. Thank you for your time and attention.

Very truly yours,

Kenneth S. Cohen                   Susan E. Schechter
Senior Vice President and          Vice President and
Associate General Counsel          Associate General Counsel

Massachusetts Mutual Life Insurance Company
1295 State Street
Springfield, MA 01111

FOOTNOTE


1Restricted access exists also in the collateral assignment form of SDLI, both through the collateral assignment document as well as the SDLI agreement itself.


END OF FOOTNOTE

 



Tax Analysts Information

Code Section: Section 7872 -- Below-Market-Rate Loans; Section 72 -- Annuities; Section 61 -- Gross Income Defined; Section 83 -- Property Transferred for Services; Section 264 -- Nondeductible Premiums
Geographic Identifier: United States
Subject Area: Insurance company taxation
Industry Group: Insurance
Author: Cohen, Kenneth S.; Schechter, Susan E.
Institutional Author: Massachusetts Mutual Life Insurance Co.
Tax Analysts Document Number: Doc 2003-16794 (7 original pages) [PDF]
Tax Analysts Electronic Citation: 2003 TNT 142-44
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.
For a summary of Notice 2002-8, 2002-4 IRB 398, see Tax Notes,
Jan.
7, 2002, p. 35; for the full text, see Doc 2002-386 (7
original
pages), 2002 TNT 3-5 , or H&D, Jan. 4, 2002, p.
129.
For a summary of Notice 2001-10, 2001-5 IRB 459, see Tax
Notes, Jan. 15, 2001, p. 323; for the full text, see Doc 2001-
1095 (21 original pages) [PDF], 2001 TNT 7-10 , or H&D,
Jan. 10, 2001, p. 798.
For summaries of Cohen and Schechter's previous letters, see Tax
Notes, Nov. 4, 2002, p. 637 & Apr. 8, 2002, p. 172; for the full
texts, see Doc 2002-24304 (6 original pages) [PDF], or 2002 TNT
211-27 & Doc 2002-8046 (1 original page) [PDF], or 2002 TNT
65-25 .