Author: CHARLES L. RATNER AND STEPHAN R. LEIMBERG
CHARLES L. RATNER is National Director of Personal Insurance Counseling and Managing Director, The Ernst & Young Center for Family Wealth Planning at Ernst & Young LLP in Cleveland. He is also an attorney, CLU, and ChFC. His e-mail address is firstname.lastname@example.org. STEPHAN R. LEIMBERG is an attorney and CEO of Leimberg Information Services, Inc. (http://www.leimbergservices.com), a provider of commentary on recent cases, rulings, and legislation; CEO of Leimberg and LeClair, Inc., an estate and financial planning software company in Bryn Mawr, Pennsylvania; and President of Leimberg Associates, Inc., a software and publishing company. His e-mail address is email@example.com. Copyright © 2003, Charles L. Ratner and Stephan R. Leimberg.
Recent Proposed Regulations address the valuation of economic benefits under certain equity split-dollar life insurance arrangements. This article discusses these Regulations, and suggests strategies for dealing with split-dollar plans.
During the past two years, there has been a sea change in the popular technique called split-dollar life insurance. This change occurred both in the regulatory context, with the Sarbanes-Oxley Act seeming to bar the use of collateral assignment (loan) type plans in publicly traded corporations, and in tax law via IRS Notices 2001-10, 1 2002-8, 2 and 2002-59, 3 as well as Proposed Regulations issued in July 2002 4 and May 2003. 5
We'd like to emphasize three things:
First, all split-dollar plans, meaning the arrangements and the policies, should be evaluated now in light of the Notices and monitored until the final Regulations are issued and their implications fully understood.
Second, every equity split-dollar plan should be reviewed very carefully—and very soon. Some plans that have substantial employee equity should be terminated or converted into loans prior to 2004. In other cases, plans should be retained beyond 2003 but converted to loans before equity develops. Calm deliberate consideration and planning action are indicated. Wishful thinking is not!
Third, ignorance or complacency—either regarding these developments or the status of the policy and its adaptability to potential change—will lead to dissatisfied and potentially litigious clients. Do not wait until December to study the issues and develop a game plan and, if appropriate, an escape strategy! 6
Q. 1: For starters, who's on first? What sets of rules apply to which plans?
A. 1: As a general rule, neither set of Proposed Regulations applies to existing split-dollar arrangements nor to any split-dollar arrangement implemented before the Regulations are finalized. Both sets of Regulations are to take effect upon the publication in the Federal Register of final split-dollar Regulations. So neither set applies to an arrangement in effect prior to the date final Regulations are published in the Federal Register.
It appears at this point that the rules of Notice 2002-8 (discussed below) apply to all existing plans and will continue to apply to these arrangements even after the final split-dollar Regulations are issued.
There are two important exceptions to these general rules. First, if there is a "material modification" to a pre-final Regulation arrangement after issuance of the final Regulations, it will be governed by the Proposed and final Regulations. Second, taxpayers with existing arrangements will be able to apply (borrow from?) certain provisions of the Proposed Regulations as an alternative to the provisions in Notice 2002-8.
Q. 2: How is the annual economic benefit under a split-dollar arrangement measured?
General rule. Notice 2002-8 initially allows the continued use of the applicable Table 2001 rates or, if lower, the insurer's generally available, published, one-year term rates. [Caveat: Notice 2002-59 makes it clear that, regardless of the existence of Table 2001, the use of any technique by any party to understate or overstate policy values or benefits in order to distort the income, employment, or gift tax consequences of the arrangement and which does not conform to, and is not permitted by, any published guidance will not be respected!]
Pre-1/28/02 arrangements. The use of alternative term rates will continue to be
allowed for such arrangements—meaning the continued use of an insurer's
one-year term rates as an alternative to the government's tables is
permissible, assuming those rates meet the requirements of prior rulings. 7
They will not be subject to the more restrictive rules applied to agreements
established on or after
(1) the "generally available, published one-year term rate tests" (i.e., the "old" tests), and an additional, more restrictive test,
(2) the "regularly being sold through the carrier through its normal distribution system" test.
Post-final Regulation arrangements. Both sets of Proposed Regulations suggest that instead of alternative term rates, the economic benefit may be measured by "uniform term factors." Supposedly, these term factors will be published in Internal Revenue Bulletins.
Q. 3: Do P.S. 58 rates still apply?
A. 3: P.S. 58 rates may no longer be used. Currently, Table 2001 rates must be used, or the alternative term rates if lower.
After the final Regs. are issued, it is likely that the IRS will publish its own tables (uniform term factors) that may or may not be interpolations or averages of actually used insurer term rates. These will probably replace the Table 2001 rates.
Q. 4: How are the rates for survivorship (second-to-die) determined?
A. 4: It appears that it is currently possible to use the familiar "Greenberg-to-Greenberg letter" interpolation process to derive survivorship rates from Table 2001. It is probable, but not certain, that the IRS will continue to allow these extremely favorable results in the final Regulations. If it does, because of the exceptionally low rates that result from such a computation, and the consequently low income and gift tax costs, non-equity survivorship split-dollar would continue to be a very appealing arrangement while both insureds are alive. [Caveat: Don't let those low rates cause you to make today's solution tomorrow's problem. Unless the clients are willing to deal with the income and gift tax cost of the economic benefit for the rest of their lives, have an exit strategy from the split-dollar arrangement.]
Q. 5: How is the equity in equity split-dollar taxed?
A. 5: Equity split-dollar life insurance is defined as an arrangement under which one party typically receives, in addition to the benefit of current life insurance protection, an interest in the policy cash value (or equity) disproportionate to that party's share of premiums. In a non-equity arrangement, one party typically provides the other party with current life insurance protection but no interest in the policy cash value.
Pre-final Regulation arrangements. Generally, equity plans set up between now and the date final Regulations are published will be collateral assignment arrangements governed by either of two sanctioned regimes: (1) the economic benefit regime or (2) the loan regime.
The economic benefit regime, which describes traditional split-dollar, requires that the taxpayer report the term cost as measured above and the policy equity as received when the arrangement is terminated (rolled out). Thus, if the pre-final Regulations insurance policy is not rolled out during lifetime, the policy owner should not have any reportable income from the equity build-up. Consequently, if the split-dollar arrangement can remain in place until the insured's death, the equity will never be subject to income tax.
The loan regime considers the agreement between the parties as an interest-free loan under which one party charges the second with interest at the applicable Section 7872 rate. The taxpayer therefore is treated as the absolute owner of the policy and is deemed to be paying premiums with his/her own after-tax dollars. Hence, the employee must report only the imputed interest as income. There will be no separately reportable term insurance cost or annual increase in equity.
Unless and until materially modified, plans set up between now and the issuance of final Regulations will use these rules, not only until the final Regulations are issued, but even after that date.
Q. 6: What special provisions are available to pre-1/28/02 arrangements?
A. 6: If, prior to January 2004, the taxpayer either (1) rolls out the policy or (2) converts the entire arrangement to an "ab initio" interest-free loan that includes all prior employer outlays, the IRS has agreed never to subject the then existing policy equity to income tax! This conversion to a loan can, and in some cases should, be deferred until shortly before the policy develops equity. Until and unless there is employee equity, there should be no taxation because of the switch, regardless of when it occurs.
Q. 7: What happens to an arrangement established before or after 1/28/02, but before the date final Regulations are published, if you do not take advantage of either of the alternative "Get out of Dodge before noon" (terminate or convert to loans before 1/1/04) safe harbors?
A. 7: Neither safe harbor will be available after
If an arrangement is left in place, no equity is ever taken, and the insured dies prior to the receipt of any equity, there will be no income taxation for pre-final Regulation arrangements.
Another possibility is that a taxpayer could take equity in the form of a post-2003 roll out of a collateral assignment plan and be prepared to contest any challenge by the IRS. The IRS has bound itself to ignore the Proposed Regulations and Notices under the "no inference" language both in Notice 2002-8 and in the two sets of Proposed Regulations. Any claim that the equity is taxable will have to be based on cases and rulings issued prior to the Notices and Proposed Regulations.
This, of course, is the direction that should be taken by taxpayers who have a high risk-taking propensity and the affinity to litigate, strongly believe that the IRS has been wrong about taxing the equity, or who believe that the IRS will not pursue taxpayers who take this position and roll out policies or take equity in any form after 12/31/04. We think this is a potentially dangerous and expensive course of action to take, particularly if gift and generation-skipping tax are involved.
Q. 8: What if a client continues a pre-final Regulation collateral assignment split-dollar arrangement but takes policy loans or withdrawals after 2003? Will that trigger taxable income?
A. 8: There are those who maintain that if you keep the arrangement in force and merely continue to report the current economic benefit, then policy loans and/or withdrawals can be taken with tax impunity.
We are definitely not among them. It is true that the IRS has agreed that for pre-final Regulation arrangements, the IRS will not impose current taxation as long as the arrangements are kept in force and the economic benefits in the form of term costs are reported. But we don't think that's the full picture.
First, this strategy has the tail wagging the dog. (Citations omitted.) As a very practical matter, relatively few taxpayers will have the wherewithal (or the patience) to deal with the constantly rising taxable economic benefit in their late 70s, 80s, and 90s.
More to the point, in our opinion, the spirit of the law requires that, in order for equity to continue to be deferred from current taxation, no equity be taken—in any form—during the insured's lifetime! Our prediction is that the IRS will treat any receipt of such otherwise deferrable income (any "accessing of the policy values") as currently taxable no matter how the taxpayer structures the transaction or what he calls it. The IRS will treat the equity as not having been left in the policy. In our opinion (and certainly there are those who disagree with this viewpoint), direct or indirect receipt of the equity (in excess of what little basis the trust or other owner has) will be treated as a violation of the spirit of the "Keep the Policy in Force and We Will Not Tax You" promise by the IRS (which we interpret as really meaning, Don't Take the Equity and We Will Not Tax It!).
As to basis, our concern is that the IRS may not give basis credit to a taxpayer's payment of economic benefit costs against policy equity and will argue that what was paid (i.e., the cost of term insurance) was used up in obtaining that term coverage—and cannot be double-credited against policy cash values.
Q. 9: OK...Can you summarize the alternatives that we should be discussing with our clients who have pre-1/28/02 collateral assignment equity plans?
A. 9: Here is a description of five alternative strategies for dealing with these plans. Bear in mind that an employer who has one arrangement for several employees can deploy different strategies for different employees. While there will be variations on the theme of each strategy, we think you'll find this summary helpful.
Strategy one—Leave the arrangement intact and the parties' options open. The plan can be left in place. Notice 2002-8 provides that as long as the employee is taxed on the yearly economic benefit, the equity will not be taxed. The insurer's one-year term rate can still be used as the measure of the economic benefit for income and gift tax purposes.
One variation of this strategy is that the plan would ostensibly be left intact with the intention that it remain in place until the employee dies. Additional premium may or may not be required to support the death benefit on a permanent basis. If the employer is willing to agree that it will defer its recovery until the employee dies, then the cash value will not have to be tapped to repay the employer upon the employee's retirement and would be available to support the death benefit for the long term.
An important accounting consideration here is that the employer would have to reflect that the value of its receivable must be discounted for the employee's life expectancy. Again, we believe that if the plan is left in place after 2003 and the employee chooses to take a policy loan or make a partial surrender from equity (should equity develop), then the proceeds of that surrender or loan in excess of any basis would be taxable to the employee.
This scenario is not attractive for several reasons, not the least of which is the prospect of the employee's having to report the increasing economic benefit as taxable income (and a gift, if applicable) for the rest of his or her life. Nevertheless, this scenario does afford flexibility, because if, after 2003, the IRS announces that it will not pursue taxation of the equity when this type of arrangement is terminated (or if the IRS tries to pursue taxation and loses in the courts), then the employee could plan on a roll out whenever it was feasible under the policy.
Strategy two—Taxable roll out for no consideration. The employer can terminate the plan before the end of 2003 by releasing the collateral assignment for no consideration from the employee. The employee would include the amount of the forgiven sum (i.e., the amount in excess of the employee's equity) in income. So, for example, if the employer had advanced $100,000 under the arrangement and the cash value is $125,000 when the employer releases the collateral assignment, the employee will have $100,000 of income. If the policy is owned by an irrevocable trust, the employee has made a gift of $100,000. The employee would continue to make any additional premium payments on the policy. The funds for such payments can come from the employer as taxable compensation (bonus) to the employee or from the employee's own funds.
If the plan is indeed terminated but the employer wishes to enable the employee to maintain a life insurance program that will provide the employee with permanent insurance coverage, the employer may want to consider a couple of steps. First, the employer might explore what can be done with the existing policies to reduce the premium needed to support a given amount of death benefit. For example, there would be no further need to have an increasing death benefit design because the employer no longer has an interest in the policy. Furthermore, the policies would no longer have to support the withdrawal of the employer's premiums, so there wouldn't be the need for robust cash value accumulation.
Once the employer has determined all it can do to redesign the existing policies for a lower outlay, it can explore an exchange of the policies for new cash value products that may be designed to provide similar life insurance protection for a lower outlay. Products have evolved in the last few years and the employer might find that some of the new products are more appropriate and cost-effective in a post-split-dollar arrangement than the existing policies. Of course, medical underwriting may be an issue with some employees. If medical underwriting might make an exchange unfeasible, the redesign of the existing policies would have to suffice.
Strategy three—Roll out for consideration. The plan is terminated by having the employee pay the employer all or part of what the employer is then due under the plan. If the employer accepts less than the amount due, it foregoes collection of any difference. If the employer accepts less than it is then due under the plan, it treats the difference between the amount received and the amount due as a taxable bonus to the employee. The employee will have reportable income in that amount. The employee continues the policy, paying any additional premiums that may be required. If a trust is involved, any taxable bonus will be a gift to the trust, as will any ongoing premiums. The product analysis described in the above scenario would be done here as well.
Strategy four—Recast as a loan. If the plan is recast as a loan, the employer's entire premium advances to that date would be considered a continuing loan to the employee and any subsequent premiums paid by the employer would increase the amount of the deemed loan. The annual measure of taxation under a loan approach would be determined by the structure of the transaction as a demand obligation or a term obligation, and applicable interest rates. The annual income under the loan approach may well be higher than the current contribution by the employee as measured by the insurance carrier's one-year term rates. However, recasting as a loan would completely avoid tax on the equity.
As discussed above, a strategy that some are embracing is to maintain the plan as split-dollar, reporting or contributing the one-year term costs as the case may be, until the year before there is going to be equity in the policy. At that juncture, the plan is recast as a loan. While Notice 2002-8 does not directly support this strategy, it does appear that this "wait and switch" strategy falls within the spirit of the Notice.
In many cases, the economics of recasting as a loan are likely to be no better than the economics of the current situation and would, in fact, be less predictable.
Strategy five—Roll in and terminate the plan or maintain it under an endorsement arrangement. Under this approach, the employee transfers the policy to the employer. The employer can terminate the plan. However, if the employer would like to maintain all or part of the insurance protection that the employee now has under the plan, the employer can modify the plan from collateral assignment to endorsement. Under the endorsement plan, the employer would remain the owner of the policy, but would allow the employee to designate a beneficiary for a certain amount of the death benefit. The employee will have imputed income for the annual economic benefit of the insurance coverage for the rest of his or her life.
A potential downside of this approach is that by modifying (see Question 10 below) the split-dollar arrangement from collateral assignment to endorsement, the insurer's one-year term rates may not be available after 2003 to measure the annual economic benefit. Instead, Table 2001 (or another table) may have to be used, which may have the effect of substantially increasing the annual economic benefit.
Q. 10: What is meant by "material modification"?
A. 10: The answer is not clear. Certainly, common sense suggests that a significant increase in the coverage or a substantial expansion or change in the rights or benefits of the party who is the benefited party in the split-dollar arrangement would be considered a material modification. But a more definitive explanation must await the issuance of final Regulations.
Q. 11: What is the major thrust of the latest Proposed equity endorsement split-dollar Regulations? 8
A. 11: The major thrust of these Proposed Regulations, which apply for not only income tax but also gift and employment tax purposes, is that a non-owner of a post-final Regulations arrangement 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 Section 83, but because of the operation of the doctrines of (1) constructive receipt, (2) economic benefit, and (3) cash equivalence.
Q. 12: Mechanically, how is the equity—in an equity endorsement split-dollar arrangement—to be taxed?
A. 12: The latest Proposed Regulation (effective only upon the publishing of final Regulations) provides that equity increases from endorsement (employer owns the policy) arrangements established after final Regulations are published are taxed currently. 9
Under the new Proposed Regulations, the rationale for current taxation is one or more of the following judicial theories or doctrines: 10 constructive receipt, economic benefit, and cash equivalence—assuming:
(1) The employee has "access" to the policy's cash value, or
(2) The employer does not have access to the policy's cash value, or
(3) The employer's creditors do not have access to the policy's cash value.
The existence of the access triggers #2 and #3 (above) overrides the normal rules regarding risk of forfeiture and substantial limitations or restrictions.
After the final Regulations are issued, to use economic benefit to determine the cost, you must—in measuring the equity—ignore all surrender charges and any "device or artifice" designed to suppress cash values! (Expect to see the IRS extend this phrase and philosophy to "pension rescue," Section 412(i), and other contexts to warn against or thwart valuation ploys and artificial suppression of policy values.)
Q. 13: How are variable life policies that are held in an endorsement split-dollar arrangement affected by the latest Proposed Regulations?
A. 13: These policies, which continually vary in value, are subject to the general rule above. In other words, for uniformity, certainty, and administrative ease (and to prevent valuation manipulations), cash values must typically be determined as of the last day of the non-owner's taxable (typically calendar) year. If the policy values drop, no loss is allowed. Gain would probably not have to be recognized until it exceeded the prior year's value.
Q. 14: What is the impact of a switch (roll out) after 2003 of a pre-final Regulations arrangement contract from an economic benefit equity split-dollar to a loan?
A. 14: Clearly, there should be no taxation if there is no employee equity at that time. But if there is equity at the date of a post-2003 roll out, we believe the IRS will assert that the equity (in excess of the taxpayer's basis, if any) is taxable at that time. The conversion of a collateral assignment equity split-dollar arrangement to a loan would be considered a taxable event. Obviously, the taxpayer is free to defend his/her/its position in court, but—in our opinion—the taxpayer will lose.
Q. 15: How do the latest Proposed Regulations require the taxpayer under a post-final Regulations equity endorsement split-dollar to report income?
A. 15: The reportable value of the economic benefits provided to the non-owner for a taxable year equals the sum of three elements: 11
(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).
Q. 16: How is reverse split-dollar taxed as of now and after the final Regulations are issued?
A. 16: Neither set of Proposed Regulations deals specifically with reverse split-dollar, but Notice 2002-59 clearly does. Its spirit—if not its language—makes clear that to the extent reverse split-dollar is based on an unrealistic and artificially inflated valuation of term insurance, that artificial rate can't be used—no matter where it is taken from or how it is computed!
Q. 17: What is the key to understanding the direction the IRS is going?
A. 17: If you understand why, you'll understand what. The IRS is concerned that all parties account for shifts in wealth despite the "black box" of life insurance, so that when wealth is transferred—no matter what the setting (e.g., employer/employee or parent/child)—someone is taxable. Accordingly, part of the future Regulations will be an attempt to clarify and solidify the IRS' position on the law governing split-dollar transactions—and part of the future Regulations will be an effort to frustrate attempts to "game the system" to achieve results counter to the substance and spirit of the law.
Q. 18: What is the future of future (after final Regulations) split-dollar?
A. 18: Non-equity split-dollar. Assuming the IRS requires term costs to be found from government issued tables and assuming these tables are realistic, going forward non-equity split-dollar will continue to be an often used practical technique for one party to assist another party in providing life insurance for a third party.
As for non-equity split-dollar entered into
Equity split-dollar. We think that equity split-dollar as we once knew it will be rarely used after the final Regulations are issued. But in its place will be the funding of life insurance through loans from one party to another at the AFR (applicable federal rate). (AFR rates are available at no cost each month at http://www.leimberg.com under Valuation/Rates.) This means that interest will vary by type and term of the loan, typically fluctuating monthly.
In many cases, the employer will also make a taxable bonus payment to the benefited individual equal to the sum of (1) the tax on the entire amount and (2) the interest the borrower owes on the loan. These loans, sufficient to pay premiums, will then be used by the employee or other individual and/or trust to purchase life insurance. The employee or other owner will own all rights to the policy (including cash values) and can, of course, pledge the policy or use it as collateral.
Assuming the employer is willing both to make loans equal to the premiums and to pay bonus amounts equal to the sum of the tax and interest on the loans, the employee will incur no net out-of-pocket cost and will have received the use of employer dollars—a very appealing benefit arrangement. The employer's cost is the sum of the time value of its loaned money plus the after-deduction cost of its bonuses. Because the employee owns the policy, cash values will grow tax-deferred.
Q. 19: What do the two sets of Proposed Regulations foretell about the final Regulations?
A. 19: Certainly, the tough tenor of the proposals indicates the IRS is not likely to back off from the general direction it started to go in TAM 9604001 and has continued since then. The final Regulations are likely to provide that, for split-dollar arrangements established on or after the date final Regulations are issued, an employee (or other individual) enriched through a split-dollar arrangement (defined very broadly) must pay tax currently as enrichment occurs, and any shift of wealth from one party to another will have immediate tax (income, gift, or both) consequences.
We predict that the IRS will eventually eliminate the taxpayer's ability to use alternative term rates. Moreover, we expect the IRS will go overboard to prevent what it considers artifices and devices affecting valuation or other maneuvering to sidestep the purpose and spirit of basic tax law.
Q: 20: What's the expected date of the final Regulations?
A. 20: The final Regulations will be issued the week of
Ignorance or complacency regarding existing split-dollar plans will lead to dissatisfied and potentially litigious clients. Do not wait until December to study the issues and develop a game plan and, if appropriate, an escape strategy!
2001-1 CB 459.
2002-1 CB 398.
2002-36 IRB 481.
REG-164754-01, 67 F.R. 45414 (
Ratner, "Split-Dollar Interruptus," 142 Tr. & Est. 64 (Apr. 2003).
See Leimberg, "
See Steve Leimberg's Estate Planning Newsletters #s 543, 544, 545; http://www.leimbergservices.com.
Constructive receipt: Income will be taxed currently, even though not actually received, in the first taxable year in which it is (1) credited to the taxpayer's account, (2) set apart for him, or (3) 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." Here, 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.