LTR 9604001

Section 61 -- Gross Income Defined

UIL Number(s) 0061.09-00, 0083.05-00, 0083.08-00, 2501.01-00,
2511.00-00

Summary

SPLIT-DOLLAR ARRANGEMENT RESULTS IN CURRENT INCOME TO INSURED.

The Service has ruled in technical advice that a corporate officer whose life is insured under policies purchased through a split-dollar arrangement is taxable on the value of cost-free life insurance purchased on his behalf.

An individual is the chief executive officer, chairman, and 51 percent owner of a holding company that owns 98 percent of a subsidiary. The subsidiary, two insurance companies, and a trust entered into a transaction under which (1) the subsidiary paid single premiums to each of the insurers for two paid-up $500,000 life insurance policies on the executive's life; (2) the insurance companies issued the policies to the trust as the owner of the policies; (3) the trust entered split-dollar agreements with the subsidiary; and (4) the trust assigned the policies to the subsidary as collateral for the trust's obligation under the split-dollar agreements to repay the premiums it paid to each insurer.

Under the arrangement's terms, the trust owns the policies and is the designated beneficiary of the policy proceeds. The subsidiary, though, has an unqualified right to receive a portion of the death benefits equal to the total amount of the premiums paid. No amount may be paid from the death benefit proceeds to the beneficiary designated under the policy until the full amount due the subsidiary has been paid. The split-dollar arrangements may be terminated on the subsidiary's bankruptcy or cessation of operations, the termination of the executive's employment, or written notice by the trust or the executive.

The agreements among the parties also provide that any dividends on the policies are applied to purchase additional insurance on the executive's life. In addition, the owners of the policies may borrow from the policies or pledge or assign them, but only to the extent that the cash surrender value of a policy exceeds the amount of the premiums paid by the subsidiary.

In concluding that the executive receives taxable income through the arrangement, the Service relied on Rev. Rul. 64-328, 1964-2 C.B. 11, as amplified by Rev. Rul. 66-110, 1966-1 C.B. 12. In Rev. Rul. 64-328, an employer provided funds to pay part of the annual premiums to the extent of the increase in the cash surrender value each year, and the employee paid the balance of the annual premiums. The employer was entitled to receive, out of the proceeds of the policy, an amount equal to the cash surrender value, or at least a sufficient part of that value to equal the funds it provided for premium payments. Generally, the arrangement caused the employee to pay a substantial part of the first premium, but much less in later years. Rev. Rul. 64-328, the Service notes, concludes that "the amount to be included in income each year that a split-dollar arrangement is in effect is the annual value of the benefit received by the employee out of the arrangement, which is an amount equal to the one-year term cost of the declining life insurance protection to which the employee is entitled from year to year, less the portion, if any, provided by the employee."

The Service acknowledged that the split-dollar arrangement in the instant ruling differs from that discussed in Rev. Rul. 64-328. In the instant case, the subsidiary supplied a single premium to the insurance companies large enough so that the earnings would cover the annual premiums attributable to the death protection portion of the policies. In the revenue ruling, though, the employer paid annual premiums on the policy. The Service called that difference insignificant, noting that "because the cash value in the policies remained subject to the subsidiary's general creditors, the conclusion in Rev. Rul. 64-328 shouuld apply because [the executive] is in the same position as the employee in the revenue ruling after the employer has paid the premiums on the policy for a period of three years."

In sum, the Service concluded that the executive must include in income each year that the arrangement is in force (a) an amount equal to the one-year term cost of declining life insurance and (b) any cash surrender buildup in the policies that exceeds the amount that is returnable to the subsidiary when the arrangement is discontinued.

The Service also ruled that the executive made a taxable gift to the trust each year equal to the amount included in his income each year under the split-dollar arrangements. The Service cited Rev. Rul. 78-420, 1978-2 C.B. 67, in which the split-dollar arrangement called for the employee's wife to be the owner of the policy. Under that ruling, the value of the life insurance protection provided by the employer that was included in the employee's income was deemed transferred to the wife for gift tax purposes.

Full Text



Date: September 8, 1995

Control No.: TR-32-168-94

District Director: * * *
Taxpayers' Names: * * *
Taxpayers' Address: * * *
Taxpayers' TIN: * * *
Taxable Years at Issue: * * *
Date of Conference: * * *


LEGEND:
Taxpayer = * * *
Trust = * * *
Holding = * * *
Subsidiary = * * *
a = * * *

[1] ISSUES

(1) When Subsidiary paid single premiums on two life insurance contracts as described below, what amount was includible each year in Taxpayer's gross income?

(2) If Trust was designated as the owner of the insurance policies, did Taxpayer make a gift subject to the gift tax?

FACTS

[2] Taxpayer is Chairman and C.E.O. of Holding and owns 51 percent of Holding. Holding owns 98 percent of Subsidiary. The corporate minutes of Subsidiary and other information submitted indicate that in 1991 Subsidiary, two insurance companies, and Trust entered into the following transaction: (1) Subsidiary paid a dollars to each of the insurance companies for two paid-up $500,000 life insurance policies on the life of Taxpayer; (2) the insurance companies issued the life insurance policies to Trust as owner of the policies; (3) Trust entered into "split dollar" agreements with Subsidiary; and (4) Trust assigned the policies to Subsidiary as collateral for Trust's obligation under the split-dollar agreements to repay the a dollars in premiums it paid to each insurance company.

[3] Under the terms of the split-dollar agreements, Trust continues as the owner of the policies and designated beneficiary of the policy proceeds. In addition, the trustees possess all incidents of ownership in the policies. Article 7.b of the agreement provides that Subsidiary has an unqualified right to receive a portion of the death benefits equal to the total amount of the premiums paid. No amount shall be paid from the death benefit proceeds to the beneficiary designated under the policy until the full amount due Subsidiary has been paid. The agreements may be terminated for a number of reasons, including: (a) bankruptcy or cessation of operations of Subsidiary; (b) termination of Taxpayer's employment; and (c) written notice by Trust or by Taxpayer. If the agreements are terminated prior to Taxpayer's death, then Trust must reimburse Subsidiary before the collateral will be returned to Trust. If the policies are cancelled or surrendered, Subsidiary is to be reimbursed from the cash surrender proceeds. The insurance documents indicate that, in year four of the policies, their cash surrender value will exceed the amount of premiums paid.

[4] The split-dollar and collateral assignment agreements provide the following additional pertinent information:


(1) Any dividends on the policies are applied to purchase paid-
up additional insurance on the life of Taxpayer.

(2) The owners of the policies may borrow from the policies or
pledge or assign the policies, but only to extent that the
cash surrender value of a policy exceeds the amount of the
premiums paid by Subsidiary.

LAW AND ANALYSIS - Issue (1):

[5] Section 61(a)(1) of the Internal Revenue Code generally provides that gross income includes compensation for services.

[6] According to section 451(a) of the Code, the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.

[7] If, in connection with the performance of services, property is transferred to any person other than the person for whom the services were performed, the excess of the fair market value of the property over the amount paid for the property is included in the service provider's gross income in the first taxable year in which the rights of the service provider in the property are transferable or are not subject to a substantial risk of forfeiture. See, generally, section 83(a) of the Code.

[8] According to section 1.83-3(e) of the regulations, the term "property" includes a beneficial interest in assets (including money) which are transferred or set aside from the claims of creditors of the transferor, for example, in a trust or escrow account. In the case of the transfer of a life insurance contact, the term "property" includes only the cash surrender value of the contract.

[9] Property is considered "transferred" for purposes of section 83(a) of the Code when a person acquires a beneficial interest in the property. Evidence that a "transfer" may not have occurred is when the property is required to be returned upon the occurrence of an event that is certain to happen, such as a termination of employment. See section 1.83-3(a)(1) and section 1.83- 3(a)(3).

[10] Section 1.83-1(a)(2) provides that the cost of life insurance protection under a life insurance contract is taxable generally under section 61 of the Code during the period the contract remains substantially nonvested. This of course would also be the case during a period when a service provider receives insurance protection from a life insurance contract that is not "property" because it has not been set aside from the claims of the employer's creditors or is not "transferred" to the employee.

[11] The Service's position in the area of a traditional "split dollar" life insurance arrangement is set out in Rev. Rul. 64-328, 1964-2 C.B. 11, as amplified by Rev. Rul. 66-110, 1966-1 C.B. 12, Rev. Rul. 67-154, 1967-1 C.B. 11, and Rev. Rul. 78-420, 1978-2 C.B 67.

[12] Rev. Rul. 64-328 describes the split-dollar arrangement that was popular at the time the Rev. Rul. was published. An employer and employee typically joined in purchasing an insurance contract, in which there was a substantial investment element, on the life of the employee. The employer provided funds to pay part of the annual premiums to the extent of the increase in the cash surrender value each year, and the employee paid the balance of the annual premiums. In Rev. Rul. 64-328, the employer was entitled to receive, out of the proceeds of the policy, an amount equal to the cash surrender value, or at least a sufficient part thereof to equal the funds it provided for premium payments.

[13] Two systems are discussed in Rev. Rul. 64-328 that were used to secure the repayment of the premiums paid by the employer, the "endorsement system" and the "collateral assignment system." In the endorsement system the employer owns the policy and was responsible for the payment of the annual premiums. The employee was then required to reimburse the employer for the employee's share of the premiums. Under the collateral assignment system, the employee in form owns the policy and pays the entire premium thereon. The employer in form made annual loans, without interest (or below the fair rate of interest), to the employee of amounts equal to the yearly increases in the cash surrender value, but not exceeding the annual premiums. The employee then executed an assignment of the policy to the employer as collateral security for the loans. The loans were generally payable at the termination of employment or the death of the employee.

[14] Under the described split-dollar arrangements, Rev. Rul. 64-328 noted that the practical effect was that, although the employee pays a substantial part of the first premium, after the first year the employee's share of the premium decreases rapidly, and in some cases it even becomes zero after a relatively few years. (In the table set out in the Rev. Rul., at page 14, the employee is not required to make further premiums after three years.) Thus, the Rev. Rul. concludes that the amount to be included in income each year that a split-dollar arrangement is in effect is the annual value of the benefit received by the employee under the arrangement, which is an amount equal to the one-year term cost of the declining life insurance protection to which the employee is entitled from year to year, less the portion, if any, provided by the employee.

[15] In amplifying Rev. Rul 64-328, Rev. Rul. 66-110 concludes that any benefit received from a split-dollar arrangement in addition to the current insurance protection discussed in Rev. Rul. 64-328 is also includible in the employee's gross income. According to Rev. Rul. 66-110, that additional benefit may be a policyholder dividend distributed directly to the employee or it may be paid in the form of additional one-year term insurance, or paid-up life insurance for a period of more than one year.

[16] The collateral assignment split dollar arrangement in this case is different than the one discussed under Rev. Rul. 64-328. Rather than paying annual premiums on the policy, Subsidiary supplied a single premium to the insurance companies large enough so that the earnings would cover the annual premiums attributable to the death protection portion of the policies. However, because the cash value in the policies remained subject to the Subsidiary's general creditors, the conclusion in Rev. Rul. 64-328 should apply because Taxpayer is in the same position as the employee in the revenue ruling after the employer has paid the premiums on the policy for a period of three years. In the revenue ruling, after three years, the earnings on the built up cash surrender value of the policy equaled or exceeded the premium due from the employee. Therefore, the employer was obligated to pay the entire premium with no payment due from the employee. Here, the only factual difference is that Subsidiary attained the fully paid up status by making one premium payment on each policy so that thereafter neither Taxpayer nor Subsidiary was required to make further payments on the policies. We find that difference to be insignificant.

[17] Accordingly, the holdings in Rev. Rul. 64-328 and Rev. Rul 66- 110, are applicable to the facts in this case.

[18] The provisions of sections 61 and 83 of the Code do not alter the application of the holdings of the above-cited revenue rulings. (Section 83 was enacted after the Rev. Ruls. were published.) Under section 61 of the Code and section 1.83-1(a)(2) of the regulations, the insurance protection provided to Taxpayer is includible in Taxpayer's gross income. The cash surrender values in the policies are not taxable to Taxpayer under section 83 because they remained subject to the claims of Subsidiary's general creditors and to the claims of Subsidiary as a creditor. Thus they were not "property" "transferred" to an employee. The only income therefore reportable by Taxpayer in the years at issue is the value each year of the cost-free life insurance protection under section 61. Income will be reportable in later years under section 83 to the extent that the cash surrender values of the policies exceed the premiums paid by Subsidiary because this is the amount that is returnable to Subsidiary.

[19] Having determined that Taxpayer in years at issue received income attributable to cost-free life insurance, the question remains as to its value. Rev. Rul. 64-328 also provides that the table contained in Rev. Rul 55-747, 1955-2 C.B. 228, may be used to compute the one-year term cost per $1,000 of the insurance protection. However, Rev. Rul. 66-110, amplified by Rev. Rul. 67-154, 1967-1 C.B. 11, provides that, in any case where the current published premium rates per $1,000 of insurance protection charged by the same insurer for individual one-year term life insurance available to all standard risks are lower than those set forth in Rev. Rul. 55-747, the lower rates may be used.

[20] Rev. Rul. 67-154 provides that in referring to rates that may be substituted for those in Rev. Rul. 55-747, Rev. Rul. 66-110 contemplates gross premium rates charged by an insurer for initial issue insurance, available to all standard risks. Rev. Rul. 67-154 further provides that dividend option rates are not available to all standard risks since an individual seeking to purchase only a basic policy of term insurance could not obtain it at those rates.

[21] The question of whether Taxpayer has included the proper amount in income under the split-dollar arrangement in this case depends upon whether Taxpayer has used rates that are, in fact, published gross premium rates charged by an insurer for initial issue insurance, current for the years at issue and available to all standard risks. This question is a question of fact to be resolved by the District Director, while keeping in mind these factors:


1) The rates used must be those of the same insurer and not
those of a parent corporation or brother/sister corporation
in the same related group of corporations.

2) The rates used must be for one-year term insurance available
for all standard risks. The requirements of Rev. Rul. 66-110
will not be met unless an individual seeking to purchase only
a basic policy of initial issue term insurance could obtain
it at those rates.

[22] Accordingly, the rates used by Taxpayer may not be applicable to only nonsmokers, they may not be applicable only to policies in excess of a certain dollar amount, they may not be dividend option rates, and they may not be applicable to, for example, only five-year term insurance.

LAW AND ANALYSIS - Issue 2

[23] Rev. Rul. 78-420 further amplified Rev. Rul. 64-328 to conclude, in situation 2, that, when the split dollar arrangement calls for the employee's wife to be the owner of the policy, to select the beneficiary, and to pay a portion of the annual premiums, the employee receives income equal to the value of the insurance protection discussed in Rev. Rul. 64-328. Also, Rev. Rul. 78-420 concludes that the value of the life insurance protection provided by the employer which is included in the income of the taxpayer is deemed to be transferred by the employee to the wife for purposes of section 2511 of the Code, and is subject to the gift tax imposed by section 2501.

[24] Accordingly, in this case, Taxpayer is considered to have made a gift to Trust each year equal to the amount included in his income each year under the split-dollar arrangements with Subsidiary.

[25] CONCLUSIONS

(1) Under the split-dollar arrangements described above, under sections 61 and 83 of the Code, Taxpayer must include in income each year that the arrangement is in force (a) an amount equal to the one- year term cost of declining life insurance and (b) any cash surrender buildup in the policies that exceeds the amount that is returnable to Subsidiary when the arrangement is discontinued. The issue of whether Taxpayer included the proper amount in income each year is a factual question that may be resolved by the District Director in accordance with the guidelines set out above.

(2) Taxpayer has made a gift to Trust for purposes of section 2511 of the Code each year equal to the amount included in his income each year under the split-dollar arrangements wish Subsidiary. This amount is subject to the gift tax under section 2501.