Steve Leimberg's Estate Planning Email Newsletter - Archive Message #544

Date:

09-May-03 09:22 AM

From:

Steve Leimberg's Estate Planning Newsletter

Subject:

REG-164754-01 Split-Dollar Life Insurance Arrangements

 

Here is a brief summary of the proposed regulation dealing with the valuation and taxation of benefits a non-owner receives under an endorsement economic benefit regime split dollar arrangement.

This, of course, is not the final regulation we had been expecting, nor even a significant part of it.

But it is a strong indication that the IRS has not backed off the general direction it started to go in the ’96 TAM and has continued since then; i.e. an employee enriched must pay tax currently and a shift of wealth from one party to another will have immediate tax consequences. 

To understand the current IRS tactic, one must understand two key tax law principles, the constructive receipt doctrine and the economic benefit (cash equivalency) theory.

Constructive Receipt:

Income will be taxed currently, even though not actually received, in the first taxable year in which it is (a) credited to his account, (b) set apart for him, or (c) otherwise made available so that he may draw upon it at any time. The unqualified right to receive it (the taxpayer’s choice to take or not take) causes current taxation even though the income has not been reduced to the taxpayer’s possession.

Economic Benefit Theory:

Any economic benefit conferred upon an employee as compensation, no matter what the form or mode, is taxable when it is the “equivalent of cash”.  This concept is triggered when the taxpayer has received something with (1) a current, (2) real, and (3) measurable value, i.e., the taxpayer received from his employer a present benefit capable of measurement and subject to tax.

EXECUTIVE SUMMARY:

On May 8, 2003 , the IRS issued Reg. 164754-01 which contains proposed regulations relating to the valuation of economic benefits under certain equity split-dollar life insurance arrangements.

The major thrust of these proposed regulations is that a non-owner who has current access (as broadly defined below) to policy cash values becomes richer each year and must therefore annually report current income, not because of the application of Code Section 83 , but because of the operation of the doctrines of (1) constructive receipt, (2) economic benefit, and (3) cash equivalence.

THE BACKGROUND:

Last July, the IRS published a notice of proposed rulemaking (REG-164754-01) proposing comprehensive rules for the income, gift, and employment taxation of equity and non-equity split-dollar life insurance arrangements.

The 2002 proposed regulations will apply to split-dollar life insurance arrangements entered into after the date final regulations are published in the Federal Register and to arrangements entered into on or before that date that are materially modified after that date.

Under certain conditions, taxpayers may rely on the 2002 proposed regulations for split-dollar life insurance arrangements entered into on or before the date final regulations are published in the Federal Register.

SPLIT DOLLAR DEFINED:

The IRS defines split-dollar life insurance as an arrangement between two or more parties to allocate the policy benefits and, in some cases, the costs of a life insurance contract. This is deliberately a very broad definition.

EQUITY SPLIT DOLLAR DEFINED:

The IRS defines equity split-dollar life insurance as an arrangement under which one party typically receives an interest in the policy cash value (or equity) of the life insurance policy disproportionate to that party’s share of policy premiums in addition to the benefit of current life insurance protection.

NON-EQUITY SPLIT DOLLAR DEFINED:

The IRS defines non-equity split-dollar life insurance as an arrangement under which one party typically provides the other party with current life insurance protection but not any interest in the policy cash value.

TWO MUTUALLY EXCLUSIVE REGIMES OF TAXATION:

These 2002 proposed regulations provide two mutually exclusive regimes for taxation of split-dollar life insurance arrangements. The first is a loan regime and the second, an economic benefit regime.

THE LOAN REGIME:

Under the loan regime , which generally governs the taxation of collateral assignment arrangements, the non-owner (e.g. employer) of the life insurance contract is treated as lending the amount of its premium payments to the owner (e.g. employee or employee's trust) of the contract. The loan regime generally will govern the taxation of collateral assignment arrangements.

THE ECONOMIC BENEFIT REGIME:

Under the economic benefit regime , which generally will govern the taxation of endorsement arrangements the owner of the life insurance contract is treated as providing economic benefits to the non-owner of the contract. The 2002 proposed regulations reserved on the rules for valuing economic benefits provided to the non-owner under an equity split-dollar life insurance arrangement governed by the economic benefit regime, pending receipt of comments from interested parties.

The preamble to the 2002 proposed regulations states that any proposal “for a specific methodology should be objective and administrable” and describes a potential approach under which the non-owner would include in income the difference between current premium payments and the net present value of the amount to be repaid to the owner in the future.

GENERAL OVERVIEW OF PROPOSED REGULATIONS:

The proposed regulations are intended to supplement the 2002 proposed regulations.

They provide guidance only on the valuation of economic benefits (including the valuation of an interest in policy cash value) under an equity split-dollar life insurance arrangement governed by the economic benefit regime.

Other issues will be addressed when both sets of proposed regulations are finalized.

These proposed regulations apply for purposes of Federal income, employment, and gift taxes.

WHAT THE PROPOSED REGS SAY:

These proposed regulations provide that, in the case of an equity split-dollar life insurance arrangement:

The reportable value of the economic benefits provided to the non-owner for a taxable year equals

the sum of

(1) the cost of any current life insurance protection provided to the non-owner,

(2) the amount of policy cash value to which the non-owner has current access (to the extent that such amount was not actually taken into account for a prior taxable year), and

(3) the value of any other economic benefits provided to the non-owner (to the extent not actually taken into account for a prior taxable year).

CURRENT ACCESS TO CASH VALUE:

The IRS believes that, generally, under an equity split-dollar life insurance arrangement governed by the economic benefit regime, the owner (e.g. employer or senior family member) of the life insurance contract pays policy premiums, thereby establishing a pool of assets with respect to which the non-owner has certain rights under the arrangement (for example, rights of withdrawal, borrowing, surrender, or assignment).

Additionally, under the IRS theory, the pool of assets is held by a third party, the life insurance company.  The effect of this theory is that policy cash values are effectively placed beyond the reach of the employer or the employer’s general creditors in many cases.

These rights, according to the IRS, confer upon the non-owner (e.g. the employee or employee’s or grantor’s trust), immediate and ongoing rights to economic enjoyment (direct or indirect ) of policy cash value.

Consequently, this current ability to make withdrawals, borrow, surrender, or assign cash values, triggers current taxation of the non-owner under the doctrines of constructive receipt, economic benefit.

AT WHAT POINT DOES THE NON-OWNER HAVE CURRENT ACCESS?

The most important word in the entire proposal is the word, " access " .  According to the proposed regulations, a non-owner has current access to any portion of the policy cash value that is

(A) directly or indirectly accessible by the non-owner,

(B) inaccessible to the owner , or

(C) inaccessible to the owner’s general creditors.

Note that the term “access” is broadly construed. It includes ANY direct or indirect right under the arrangement of the non-owner to obtain, use, or realize potential economic value from the policy cash value.

EXAMPLE:

Suppose a non-owner can directly or indirectly

(a) make a withdrawal from the policy,

(b) borrow from the policy, or

(c) effect a total or partial surrender of the policy.

The non-owner will be considered to have current access to policy cash values.

EXAMPLE:

Suppose the non-owner can

(a) anticipate,

(b) assign (either at law or in equity),

(c) alienate,

(d) pledge, or

(e) encumber the policy cash value.

The non-owner will be considered to have current access to policy cash values.

EXAMPLE:

Suppose the policy cash value is available to the non-owner’s creditors by

(a) attachment,

(b) garnishment,

(c) levy,

(d) execution, or

(e) other legal or equitable process.

The non-owner will be considered to have current access to policy cash values.

TAXATION OF “TYPICAL” EQUITY SPLIT DOLLAR ARRANGEMENT:

The IRS assumes that generally the non-owner in an equity arrangement will have current access to all portions of the policy cash value in excess of the amount payable to the owner.

The Service also will treat the non-owner as having current access to the portion of the cash value payable to the owner if, for example, for any reason either the owner or the owner’s general creditors can’t reach any or all of the policy’s cash value.

FORGET GAMES WITH SURRENDER CHARGES , OTHER VALUATION PLOYS, OR TIMING TRICKS!

These proposed regulations make it clear the IRS will expect taxpayers to determine policy cash value without taking any surrender or other similar charges or reductions or valuation manipulations into account.

The proposals spell out in no uncertain terms that,

“if any artifice or device is used to understate the amount of policy cash value to which the non-owner has current access on the valuation date, then, …, the date on which the amount of policy cash value is determined is the date on which the amount of policy cash value is greatest during that taxable year."

CALCULATION MADE AT END OF YEAR:

Policy cash values must typically be determined as of the last day of the non-owner’s taxable year. The Service claims this is for uniformity, certainty, and administrative ease. It’s also to prevent valuation manipulations.

EMPLOYMENT TAX ISSUES:

Solely for employment tax purposes and the penalty for failure to pay estimated income taxes, the portion of the policy cash value that is treated as provided by the owner to the non-owner during the non-owner’s taxable year is treated as so provided on the last day of that taxable year.

NO BASIS CREDIT FOR INSIDE BUILD-UP:

The IRS refused in this proposed regulation to allow credit on “inside build-up” on the taxable portion of the policy cash value to a non-owner. The rationale for denying such credit is that no part of the life insurance contract is actually transferred from the owner to the non-owner by reason of the non-owner’s taking policy cash value into account.

NO LOSS ALLOWED IF POLICY CASH VALUES DROP:

Continuing its very strong constructive receipt/economic benefit position, the Treasury in the proposed regulation refused to allow a loss deduction - even if the difference has already been included in income in a prior year - if the policy cash value drops in value from its prior year amount.

The Treasury’s rationale for this position is that the doctrines of constructive receipt, economic benefit, and cash equivalence, which form the basis for the proposed regulation’s equity split dollar valuation theory, would not allow the taxpayer to recognize a loss.

However,  if a life insurance contract is transferred from an owner to a non-owner (the transferee), the transferee’s investment in the contract under section 72(e) will include the amount of economic benefits previously taken into account by the transferee prior to the transfer.

TAXATION OF TERM INSURANCE ELEMENT:

A non-owner of an equity split-dollar arrangement governed by the economic benefit regime must include in current income the cost of current life insurance protection. The measure of this cost in any year is equal to

A.    The amount of the current life insurance protection (net amount at risk)

multiplied by

B.    the life insurance premium factor designated or permitted in guidance to be published in a future IRS Internal Revenue Bulletin.

So we don't know at this point if we will be able to use an insurer's one year term rates but my guess is that we will not.

CALCULATION OF NON-OWNER’S CURRENT LIFE INSURANCE PROTECTION:

To prevent double taxation of the non-owner, the amount of the current life insurance protection (including paid-up additions) provided to the non-owner in a taxable year is calculated as follows:

A. Average death benefit of the life insurance contract over

B. the sum of

i. the total amount payable to the owner (including any outstanding policy loans that offset amounts otherwise payable to the owner) and

ii. the portion of the policy cash value actually taken into account for the current taxable year or for any prior taxable year.

OTHER BENEFITS RECEIVED MUST ALSO BE REPORTED CURRENTLY:

The non-owner in an equity split-dollar life insurance arrangement governed by the economic benefit regime must report, in addition to the amounts described above, the value of all other economic benefits received – but only to the extent not actually already taken into account for a prior taxable year.

The proposal interprets the term “other economic benefits” broadly. So other benefits include any benefit, right, or feature of the life insurance contract (other than current life insurance protection and policy cash value) the arrangement provides the non-owner.

WHEN DOES THE PROPOSED REGULATION BECOME EFFECTIVE?

These proposed regulations apply to split-dollar life insurance arrangements entered into

A. After the date final regulations are published in the Federal Register and

B. To arrangements entered into on or before that date that are materially modified after that date .

RELIANCE ON PROPOSED REGULATIONS:

A. For arrangements entered into on or before the date final regulations are published in the Federal Register , taxpayers may rely on these proposed regulations for equity split-dollar life insurance.

B. For taxable years beginning after December 31, 2002, taxpayers may rely on these proposed regulations only if the value of all economic benefits taken into account by the parties is determined in accordance with these proposed regulations.

PUBLIC HEARING BEFORE FINAL ADOPTION:

The IRS and Treasury will consider and make public taxpayers’ comments before these proposed regulations are adopted as final. These comments may be written or electronic and submitted in a timely manner. Specifically, comments on the clarity of the proposed rules and how they may be made easier to understand have been requested.

EXAMPLE 1:

Assumptions:

R is the Employer-owner and (E) is the employee non-owner of an equity split dollar life insurance contract.

The policy is a valid life insurance contract under 7702 and is not a 7702A MEC.

R does not withdraw or obtain a loan of any portion of the policy cash value and does not surrender any portion of the life insurance contract.

E receives only reasonable compensation;

E does not make any premium payments;

E’s taxable year is the calendar year; and

E reports the amount of income required under the proposed regs.

In year 1, R and E enter into the equity split-dollar life insurance arrangement.

R pays all of the premiums on the life insurance contract until the termination of the arrangement or E’s death.

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. 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.

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.

To fund the arrangement, R purchases a life insurance contract with constant death benefit protection equal to $1,500,000.

December 31 of year 1: The policy cash value equals $55,000. R has paid $60,000 of premiums on the life insurance contract as of that date.

December 31 of year 2: The policy cash value equals $140,000. R has paid aggregate premiums of $120,000 on the life insurance contract as of that date.

December 31 of year 3: The policy cash value equals $240,000. R has paid $180,000 of premiums on the life insurance contract as of that date. 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. That means E has current access to such portion of the policy cash value for each year that the arrangement is in effect.

In addition, because R pays all of the premiums on the life insurance contract, R provides to E all of the economic benefits that E receives under the arrangement.

Therefore, E must include in gross income the value of all economic benefits provided to E under the arrangement.

YEAR 1 RESULTS:

E is provided $0 of policy cash value (excess of $55,000 cash value over $55,000 payable to R).

E is also provided current life insurance protection of $1,445,000 ($1,500,000 minus $55,000 payable to R).

So for year 1, E must include in gross income the cost of $1,445,000 of current life insurance protection. The rates are yet to be determined.

YEAR 2 RESULTS:

E is provided $20,000 of policy cash value ($140,000 cash value minus $120,000 payable to R).

For year 2, E is also provided current life insurance protection of $1,360,000 ($1,500,000 minus the sum of (a) $120,000 payable to R and (b) the aggregate of $20,000 of policy cash value that E actually includes in income on E’s year 1 and year 2 income tax returns).

So for year 2, E must include in gross income the sum of $20,000 of policy cash value and the cost of $1,360,000 of current life insurance protection.

YEAR 3 RESULTS:

For year 3, E is provided $40,000 of policy cash value ($240,000 policy cash value minus the sum of (a) $180,000 payable to R and (b) $20,000 of aggregate policy cash value that E actually included in gross income on E’s year 1 and year 2 federal income tax returns).

For year 3, E is also provided current life insurance protection of $1,260,000 ($1,500,000 minus the sum of $180,000 payable to R and $60,000 of aggregate policy cash value that E actually includes in gross income on E’s year 1, year 2, and year 3 federal income tax returns).

So for year 3, E must include gross income the sum of (a) $40,000 of policy cash value and (b) the cost of $1,260,000 of current life insurance protection.

EXAMPLE 2:

What if we assumed the same facts as above but with the following two changes:

1. E cannot directly or indirectly access any portion of the policy cash value.

2. The terms of the equity split-dollar life insurance arrangement or applicable state law provide that the policy cash value in excess of the amount payable to R upon termination of the arrangement or E’s death is inaccessible to R’s general creditors.

Because, under the terms of the equity split-dollar life insurance arrangement (or applicable state law), the portion of the policy cash value exceeding the amount payable to R is inaccessible to R’s general creditors, E is deemed to have current access to such portion of the policy cash value for each year that the arrangement is in effect.

Additionally, because R pays all of the premiums on the life insurance contract, R provides to E all of the economic benefits that E receives under the arrangement.

So E must currently report as income the value of all economic benefits provided to E under the arrangement. The computations would be the same as the results for the first set of facts.

THE BOTTOM LINE:

The FAT LADY has yet to sing – but we already have a good idea of the song.

Those of you who have clients who currently have collateral assignment equity split dollar plans should take a long hard look at the calendar – and remember that HIGH NOON is approaching – and there’s precious little time to take the 3:10 to Yuma!

LISI COMMENTATORS CHARLIE RATNER AND HOWARD ZARITSKY WILL BE ADDING THEIR COMMENTS IN THE DAYS TO COME!

HOPE THIS HELPS YOU HELP OTHERS!

Steve Leimberg

CITE AS:

Steve Leimberg’s Estate Planning Newsletter # 544 . Copyright 2003 LISI

To Search LISI Archives, Free Look, or Join LISI: http://www.leimbergservices.com

 

 



HELP US HELP OTHERS! TELL A FRIEND ABOUT OUR NEWSLETTERS. JUST CLICK HERE.