MassMutual Urges Modifications to Proposed SDLI Regs

MassMutual has submitted comments on the proposed regulations (REG-164754-01) affecting the taxation of split-dollar life insurance arrangements.

Document Type: Public Comments on Regulations

Tax Analysts Document Number: Doc 2002-24304 (6 original pages) [PDF]

Tax Analysts Electronic Citation: 2002 TNT 211-27

Citations: (7 Oct 2002)

=============== SUMMARY ===============

Kenneth S. Cohen and Susan E. Schechter of Massachusetts Mutual Life Insurance Company, Washington, have submitted comments on the proposed regulations (REG-164754-01) affecting the taxation of split- dollar life insurance arrangements. (For a summary of REG-164754-01, see Tax Notes, July 15, 2002, p. 361; for the full text, see Doc 2002-16108 (24 original pages) [PDF], 2002 TNT 135-10 , or H&D, July 5, 2002, p. 175.)

According to Cohen and Schechter, the insurance company is concerned that the proposed regs are unecessarily rigid and harsh. They assert that the IRS and Treasury are putting form before substance by proposing two mutually exclusive methods of taxing split-dollar life insurance arrangements, the loan regime and the economic benefit regime. Arguing that it is contrary to section 72, Cohen and Schechter object to the taxation of equity in split-dollar life insurance arrangements. Finally, they expresss concern that the policy beneficiary may not be entitled to the income exclusion under section 101.

=============== FULL TEXT ===============

October 7, 2002

CC:ITA:RU (REG-16754-01)
Internal Revenue Service
Courier's Desk
1111 Constitution Avenue, NW
Washington, D.C. 20044

Re: Comments on Proposed Regulations
Split Dollar Life Insurance Arrangements

Dear Sir or Madam:

[1] This letter provides the comments of Massachusetts Mutual Life Insurance Company ("MassMutual") on the proposed regulations affecting the taxation of split dollar life insurance arrangements ("SDLI"). MassMutual is one of the largest sellers of SDLI in the United States.

[2] As a member company of the ACLI, we have participated in the development of the comments that have been submitted on behalf of the ACLI membership, and we concur with those comments. In addition, we have had the opportunity to review the comments prepared by Northwestern Mutual Life Insurance Company and we concur as well in their comments on the proposed regulations.

[3] Over the last two years, MassMutual has had the opportunity to comment on the proposed treatment of SDLI following issuance of IRS Notice 2001-10 in January 2001. Since that time, we have greatly appreciated the attention and consideration that the Department of Treasury and the IRS have given to our commentary. When the IRS issued Notice 2002-8 last January, it appeared that you had accepted many of our comments. We were pleased by the tone and direction of Notice 2002-8, specifically that the IRS and Treasury saw fit to a) grandfather existing arrangements and make any new guiding principles prospective and b) espouse the principle that there would not be current taxation of the equity in equity SDLI absent some transaction or event that gave rise to a distribution or transfer. Over the last two years, you have been careful to deliberate and take into account a wide variety of views expressed on this complex subject. In that spirit, we hope that you will accept the comments we offer here with respect to the proposed regulations.

[4] In sum, we are greatly disappointed at the tone and turn of these proposed regulations from the sense of the guiding principles set forth in Notice 2002-8. That Notice had appeared to accept the propriety of SDLI as a legitimate employee benefit and further that the equity in the SDLI would not be currently taxed absent some realization event.

[5] We thought there was consensus that SDLI should not be treated as some sort of tax shelter, but rather as a legitimate employee benefit. Life insurance is a socially responsible means to achieve private planning for retirement and protection of one's family and assets. SDLI merely provides life insurance to employees in an affordable manner. Permanent life insurance coverage is not typically offered to employees through qualified plans because of certain restrictions on what kind of assets and benefits can be provided through qualified plans. Typically, therefore, permanent life insurance benefits are offered to employees through arrangements such as split dollar.

[6] Despite this, the proposed regulations impose an unnecessarily rigid and harsh taxing regime, which we view to be both unwarranted conceptually and, in most instances, beyond statutory authority. We focus our comments on the conceptual approach of the proposed regulations.

1. Mandatory and Mutually Exclusive Taxing Regimes

[7] The proposed regulations establish two mutually exclusive regimes for taxing SDLI: the economic benefit regime and the loan regime. They are very different tax approaches and produce very different tax results. The applicable regime depends wholly on the form of SDLI: collateral assignment versus endorsement form.

[8] We are surprised that the IRS and Treasury would exalt form over substance in determining the taxation of this type of arrangement. Forty years ago, after significant consideration and study, the IRS concluded, correctly in our view, that regardless of form of SDLI, the "arrangement" is in substance the same: the provision of a life insurance benefit. Now, suddenly, form prevails and leads to markedly distinct treatment of SDLI. This reliance on form is made even more surprising in light of the IRS' litigating position on another form of life insurance ownership, namely corporate-owned life insurance. In a series of court cases, the IRS has successfully argued that the proper evaluation for the taxation of the transaction is substance over form, and that tax consequences should be driven by the economic substance of the transaction (which the IRS found lacking in the transactions at issue there). But for SDLI, the IRS proposes to look primarily to "form" to drive tax results. We believe reliance on form over substance makes for bad tax policy.

2. The Loan Regime

[9] None of the parties to a collateral assignment SDLI treat it as a loan. For 40 years, the IRS concurred that it was not a loan. We do not believe loan characterization fits the transaction in substance. Rather, we view the collateral assignment as the means by which the parties record the allocable ownership interests of the parties to the SDLI with the life insurance company. Loan treatment should not be mandated unless the transaction is, in substance, a loan.

[10] We urge the IRS and Treasury to step back from this mandatory bifurcation based on the form of SDLI. We do not object to having a "loan" regime alternative. Parties can choose how to structure their arrangements. If they choose to establish a loan as a means to finance the employee's outright purchase of permanent life insurance, and if section 7872 would apply to that loan, then loan treatment for tax purposes is appropriate. It's the mandatory jamming of a square peg into a round hole that we find objectionable. Substance should prevail over form.

3. The Economic Benefit Regime

[11] More troubling than the mere reliance on form is that fact that the proposed regulations impose a form fiction on the SDLI that does not reflect the transaction entered into by the parties. It appears to us that the proposed regulations have been designed to impose a harsh and punitive regime on equity SDLI as a means to circumvent the tax rules that permit deferral of inside build-up of a life insurance policy and exclusion of the death proceeds. Putting these proposed regulations under section 61 may be the government's attempt to avoid the section 72 and section 101 rules. However, the proposed regulations cannot create economic accession to wealth where it doesn't exist.

[12] The proposed regulations attempt to do just that by not only focusing on form, but then by imposing fictional form which bears no resemblance or relationship to what the arrangement actually provides. The "owner" and "non-owner" fiction ignores that, by contractual arrangement, both parties are owners. It ignores that each party has rights and obligations (such as an employee's obligation to pay a share of the premium). Ignoring the realities of the arrangement in favor of the fiction is a fundamental flaw in these proposed regulations.

[13] The proposed regulations confuse the split dollar arrangement (which should be the focus of the regulations and the driver of the tax treatment) with the underlying life insurance policy. By focusing solely on the titular policy ownership,1 the proposed regulations miss the bigger target, i.e. the ownership sharing arrangement. This misfocus on policy ownership, together with other aspects of the imposed fiction, drives a series of tax results that are both unwarranted and, under the Code, unauthorized.

a. Taxation of the Equity

[14] In Notice 2002-8, the IRS stated:

The proposed regulations will not treat an employer as having made a transfer of a portion of the cash surrender value of a life insurance contract to an employee for purposes of section 83 solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the employer.

[15] Yet, now using section 61 instead, that is exactly what the proposed regulations do. We urge the IRS and Treasury to make good on the promise of Notice 2002-8.

[16] In the preamble, the current tax on the equity in equity SDLI is justified on the basis that, unlike nonqualified deferred compensation, equity SDLI gives the employee an interest in the policy and, further, that the employee in equity SDLI is in a superior economic position because of the equity right. We agree that the employee gets an interest in the policy; we've always acknowledged that interest. That's why we object to the proposed regulations which, by treating the employee as a "non-owner," refuse to recognize that interest. But we strongly disagree that the purported economic superiority of owning that interest leads to current economic taxable income.

[17] The equity right is a future economic promise, just like nonqualified deferred compensation. It does not confer any economic income to tax on a current basis because a) there may not be any equity in the policy now or later (look at variable products today), and b) more importantly, the equity is not accessible by the employee during the term of the SDLI. The employee has no dominion and control over the equity, and no right to reach or use it. Treating the [sic] this future right to equity as currently taxable doesn't withstand scrutiny under rules of constructive receipt and rules relating to substantial risk of forfeiture.

[18] Applying the reasoning of the proposed regulations, an employee who is eligible to participate in a nonqualified deferred compensation plan is in an economically superior position to an employee who is ineligible, and therefore should be taxed currently. No one would suggest, however, that the nonqualified deferred compensation is currently taxable simply because of that eligibility. Rather, one must consider whether or not there is constructive receipt or substantial risk of forfeiture. Similarly, an employee under a 5-year employment contract that provides for an annual salary of $100x over the contract term can be said to be in an economically superior position to an at-will employee or a one-year contract employee, but no one would suggest that the 5-year contract employee has current income for those future payments.

[19] This aspect of the proposed regulations is flatly contrary to the taxation of life insurance under section 72. There is no current tax on inside build-up while it's inside. The fact that parties agree to share in the rights to inside build-up does not alter the result. Until there is access to those funds through withdrawals or distributions, there is no taxable income. Nothing in section 72 supports treating SDLI differently from individually owned life insurance on this point.

[20] Even under the fiction of the proposed regulations, if the employer "owner" doesn't have current taxable income due to the equity remaining inside, how can the employer have anything to transfer to the employee to create taxable income? Where does the employee's income derive? We object strongly to the current taxation of inside build-up through this back-door approach. While inside build-up remains inside, it's deferred. Without an amendment of section 72, the proposed regulations exceed the statute.

b. Taxation of the Life Insurance Proceeds

[21] The proposed regulations suggest that, under the economic benefit regime, the death benefits payable under the policy are not excludable by the employer that owns the policy. This is contrary to the express rule of section 101(a) and is without statutory authority.

[22] It is ironic that, after pursuing a fiction that treats the employer as the sole owner of the policy, the employer would be denied the essential right under the Code that applies to such ownership: tax-free death benefits. There is no explanation offered for this radical departure from section 101, and we request that this provision be amended to make clear that any beneficiary named under the policy that is part of the SDLI is entitled to income exclusion under section 101(a) upon receipt of the death benefits.

c. Income to the Employer/Investment in the Contract

[23] A further aberration created by the form fiction adopted in the proposed regulations is the treatment of any premium payment by the "non-owner" as something other than a premium payment. This fiction leads to two unsupportable results: the employer is somehow deemed to have income resulting from the payment of premium by the employee and the employee is denied basis credit for the premium as investment in the contract.

[24] Once again, the proposed regulations ignore the economic substance. Most SDLI not only provide for sharing the life insurance contract benefits, but also provide for sharing the contract costs. How an employer can have income when an employee pays his or her own premium obligation under the SDLI is puzzling. The employer obtains no economic benefit from that payment, it has no dominion and control over the payment, it has no accession to wealth from the payment. Each party is paying an amount to the life insurance company equal to the share of the policy cost that belongs to it. There is no transfer between them and nothing that should create income to the employer. Only the fiction of owner and non-owner can lead to this strange result.

[25] The employee paying the premium share required under the SDLI is paying for all or a portion of the policy rights obtained under the SDLI. This is an investment in the contract within the plain meaning of section 72(e). The only way to undermine that plain meaning is through this form fiction that refuses to recognize the employee's ownership right. Again, nominal policy ownership is confused with the ownership rights created by the SDLI. This result is unsupported by the statute and ignores the substance of the SDLI transaction.

[26] These two provisions of the economic benefit regime should be withdrawn.


[27] In the end, we agree that the existing revenue rulings addressing SDLI are in need of modernization to take into account the evolution and growth over the last 40 years of new SDLI arrangements, particularly equity SDLI. That said, we believe and, based on Notice 2002-8, we thought you believed, that the equity in equity SDLI should only be taxed following a 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.

[28] If as part of this modernization there is a need to update the methods for valuing the economic benefit of the life insurance coverage provided through SDLI, we welcome the opportunity to assist in the development of new valuation tables or methods.

[29] We urge you to modify these proposed regulations consistent with our comments herein. Thank you for your time and attention. Please be advised that MassMutual plans to testify at the public hearing scheduled for October 23, 2002. Ms. Susan E. Schechter will testify on our behalf on the outline of points contained in this letter.

Very truly yours,

Kenneth S. Cohen
Kenneth S. Cohen
Senior Vice President and
Associate General Counsel
Mass Mutual Financial Group
Springfield, MA

Susan E. Schechter
Susan E. Schechter
Vice President and Associate
General Counsel
Mass Mutual Financial Group
Springfield, MA


1This focus on the SDLI arrangement as opposed to the policy explains why the IRS and Treasury should not consider a section 1035 exchange of the underlying policy as a material modification to the arrangement. The contractual arrangement allocates rights to the policy values and obligations. A change to the underlying policy does not change those allocable rights and obligations, it is irrelevant to them. A change to the arrangement itself, however, such as going from non-equity to equity SDLI, would constitute a material modification since the legal entitlements under the arrangement would have changed in substance. See, e.g., Cottage Savings Assn. v. Commissioner, 111 S. Ct. 1503, 67 AFTR2d 91-808 (1991).



Code Section: 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
Industry Group: Insurance
Cross Reference: For a summary of REG-164754-01, see Tax Notes, July 15, 2002, p. 361;
for the full text, see Doc 2002-16108 (24 original pages) [PDF], 2002 TNT
135-10 , or H&D, July 5, 2002, p. 175.
Author: Cohen, Kenneth S.; Schechter, Susan E.
Institutional Author: Massachusetts Mutual Life Insurance Company