Steve Leimberg's Estate Planning Email Newsletter - Archive Message #581

Date:

12-Sep-03 02:34 AM

From:

Steve Leimberg's Estate Planning Newsletter

Subject:

Final Split Dollar Regs - First Look -Part I

 

Here's LISI's first look at the just released final split-dollar regs.

This is Part I. Part II will be in your e-mail by the time you finish reading this. LISI's Actual Text (Keeping Current) tab will lead you to the actual text of the final regulations and accompanying Revenue Ruling.


On Thursday, September 11th, The IRS and Treasury jointly released final split dollar regulations, officially TD 9092 and titled Split-Dollar Life Insurance Arrangements.

These regulations are designed to provide guidance to persons who enter into split-dollar life insurance arrangements and cover income, employment, and gift taxation aspects.

EFFECTIVE: These rules apply to any split-dollar life insurance arrangement entered into after September 17, 2003. So go back and study IRS Notice 2002-8 because it will be your primary source of guidance for split-dollar arrangements entered into prior to January 28, 2002 (which as Lee Slavutin reminded me is hopefully most or all of our split-dollared clients).

To illustrate the sense of humor of the Service and Treasury, not only do they release this bomb on 9/11 – on my birthday and one day before Charlie Ratner was scheduled to go on vacation - but they provide the following statement under the side-splitting title, Paperwork Reduction Act,

"The estimated annual burden per respondent varies from 15 minutes to 30 minutes, depending on individual circumstances, with an estimated average of 17 minutes."

So much for the dark (if unintended) humor. On with the show!

SANS SARBANES:

The final regulations do not address the possible application of section 402 of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), Public Law 107-204, to all or certain split-dollar life insurance arrangements entered into by companies subject to Sarbanes-Oxley. The position of the IRS and Treasury is that "interpretation and administration of Sarbanes-Oxley fall within the jurisdiction of the Securities and Exchange Commission."

Having disposed of that, let's move to the main act:

THE PAST IS YOUR GUIDE TO THE FUTURE:

99 PERCENT OF THE FINAL REGULATIONS IS TAKEN VERBATIM FROM THE TWO SETS OF PROPOSED REGS. SO I'M GOING TO REVIEW THEM FIRST.

2002 PROPOSED REGS:  July 9, 2002, the Treasury and Service issued proposed regulations (REG–164754–01) that contained comprehensive rules for the income, gift, employment, and self-employment taxation of equity and non-equity split-dollar life insurance arrangements.

These 2002 proposed regulations set the stage and are largely followed in the final regulations. I strongly suggest you obtain a copy of two articles, both from Estate Planning Magazine: "Proposed Regs on Split-Dollar Impose Tax on Shifts of Wealth" (November 2002, Vol. 29, No. 11, Pg. 547) and "Planning for Split-Dollar Under the Latest Prop. Regs: 20 Questions". (Best bet if you don't subscribe to Estate Planning is a good law library or call 800 828 7571 and ask for the Back Issue Department.)

SPLIT DOLLAR DEFINED: The regulations, both proposed and final, define split-dollar as an arrangement between two or more parties to allocate the policy benefits and, in some cases, the costs of a life insurance contract.

EQUITY SPLIT-DOLLAR DEFINED: An equity split-dollar life insurance arrangement is defined as one in which one party to the arrangement typically receives an interest in the policy cash value (or equity) of the life insurance contract disproportionate to that party's share of policy premiums. In other words one party less more than his/her/its share and the other party pays more. The party that pays less than his/her/its share also typically receives the benefit of current life insurance protection under the arrangement.

NON-EQUITY SPLIT DOLLAR DEFINED: A non-equity split-dollar life insurance arrangement exists where 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: The 2002 proposed regulations provide two mutually exclusive regimes for taxation of split-dollar life insurance arrangements. The first is a loan regime. The second is an economic benefit regime.

Loan Regime: Under the loan regime , the non-owner of the life insurance contract is treated as loaning the amount of its premium payments to the owner of the contract. If the transaction takes the form of a collateral assignment (the legal owner assigns the policy as collateral for the advances of the other party), the loan regime generally governs the taxation of the arrangement.

Economic Benefit Regime: Under the economic benefit regime the owner of the life insurance contract is treated as providing economic benefits to the non-owner of the contract. If the arrangement takes the form of an endorsement (e.g. the corporation ("owner) advances the money but allows the insured-covered employee (non-owner) to name the death benefit by endorsement of the contract), generally, the economic benefit regime governs the taxation. 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. Simply put, all bets were off until the IRS and Treasury were ready to state how the economic benefits the "non-owner" received would be valued.

2003 PROPOSED REGS:

On May 9, 2003, the IRS and Treasury issued REG–164754–01, a second and different proposed regulation. This proposed regulation, the 2003 proposed regulation, covers the taxation under an equity split-dollar life insurance arrangement governed by the economic benefit regime.

VALUATION OF ECONOMIC BENEFITS:  In a nutshell, the 2003 proposed regulations provide that, in the case of an equity split-dollar life insurance arrangement, the value of the economic benefits provided to the non-owner under the arrangement 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).

FINAL REGS – A FIRST LOOK OVERVIEW: Essentially, the final regulations adopt – with few exceptions - the 2002 and 2003 proposed regulations described above. The Treasury and Service made only minor changes and made it clear the were sticking with their strong and strident position.

Here are those exceptions – in the form of "amendments".

SPLIT DOLLAR INSURANCE ARRANGEMENT DEFINED: A split-dollar life insurance arrangement is generally "any arrangement between an owner of a life insurance contract and a non-owner of the contract under which either party to the arrangement pays all or part of the premiums, and one of the parties paying the premiums 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 contract.."

Exception for Policy owners and Insurers: If the only parties to the arrangement are the policy owner and the life insurance company acting only in its capacity as issuer of the contract, that an arrangement would fall outside the definition of a split-dollar arrangement.

Exception for Performance of Services and Shareholders: Certain arrangements entered into either (a) in connection with the performance of services or (b) between a corporation and another person in that person's capacity as a shareholder in the corporation will be considered split-dollar life insurance arrangements even if they might otherwise not meet the general definition of a split-dollar life insurance arrangement.

Exception for Key Employee Coverage: True key employee coverage, under which a company purchases a life insurance contract to insure the life of a "key" employee or shareholder, will not be considered a split-dollar arrangement under either the general rule or any of the special rules - if the employer retains all the rights and benefits of the contract (including the rights to all death benefits and cash value).

PLAY NO GAMES RULE: To make absolutely positively sure that no one tries to play games by inappropriately structuring contracts to avoid the application of these regulations (for instance by using separate life insurance contracts that are, in substance, one life insurance contract), the regulations remind us that the IRS has "existing authority" to challenge such ploys.

TWO MUTUALLY EXCLUSIVE REGIMES:

The two mutually exclusive regimes – an economic benefit regime and a loan regime – are retained under the final regulations for determining the tax treatment of split-dollar life insurance arrangements.

Ownership Rules: Generally, the ownership (e.g. is it the corporation or the insured-covered employee) of the policy will be the primary determinate as to which regime applies. The Regulations take the position that taxpayers can in essence elect which regime (loan or economic benefit) will apply to their split-dollar life insurance arrangements by their selection of one party or the other as the contract owner.

Special Rule: When the employer, service recipient, or donor is the owner of the insurance contract, the economic benefit regime applies. Additionally, it is applied to a split-dollar life insurance arrangement if 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 the arrangement is entered into between a donor and a donee (for example, a life insurance trust) and the donee is not the owner of the life insurance contract.

Special Rule: A special rule applies when payments under the arrangement had been treated, prior to transfer, as split-dollar loans under Section 1.7872-15 and the contract is transferred from an owner to a non-owner. Under this rule, the economic benefit regime applies to the split-dollar life insurance arrangement from the date of the transfer and the payments made (both before and after the transfer) are not treated as split-dollar loans on or after the date of the transfer. The transferor of the life insurance contract must fully take into account all economic benefits provided under the split-dollar life insurance arrangement.

OWNERS AND NON-OWNERS:

One person owner: Under the final regulations, the owner generally is the person named as the policy owner. The IRS reasoning here is that it is reasonable to determine tax ownership based on who is the named owner of the policy because (a) the division of the burdens and benefits of the life insurance contract vary widely in split-dollar life insurance arrangements, (b) because title ownership generally is a factor in determining tax ownership, and (c) because this rule provides a clear objective standard so that both taxpayers and the IRS can readily determine which regime applies.

Two or more owners: If two or more persons are designated as the policy owners, the first-named person generally is treated as the owner of the entire contract.

Exception: If two or more persons are named as policy owners and each person has, at all times, all the incidents of ownership with respect to an " undivided interest " in the contract, those persons are treated as owners of separate contracts for purposes of these regulations. An undivided interest is defined as an identical fractional or percentage interest or share in each right, benefit, and obligation with respect to the contract.

Example: Assume an employer and an employee own a life insurance contract and share equally in all rights, benefits and obligations under the contract. As noted above, they will be treated as each owning a separate contract. Although, ordinarily neither contract would be treated as part of a split-dollar life insurance arrangement, if the employer and the employee agree to enter into a split-dollar life insurance arrangement with respect to what otherwise would have been treated as the employer's (or the employee's) separate contract, the purported undivided interests will be disregarded, and the entire arrangement will be treated as a split-dollar life insurance arrangement.

Facts and Circumstances Testing: The IRS will consider all of the facts and circumstances of an arrangement to determine whether the parties have appropriately characterized the arrangement as one involving undivided interests and, therefore, not subject to these regulations.

Attribution Rules: The final regulations provide attribution rules for compensatory split-dollar life insurance arrangements. They work as follows:

The employer or service recipient will be treated as the owner of the life insurance contract if the contract is owned by

(1) a member of the employer's " controlled group ",

(2) a Section 403(b) " secular " trust,

(3) a grantor trust (including a rabbi trust) treated as owned by the employer), or

(4) a Section 419(e)(1) welfare benefit fund.

NON-EQUITY SPLIT DOLLAR INSURANCE ARRANGEMENTS:

Economic Benefit Regime Governs: Non-equity arrangements entered into in a compensatory context or a gift context will be subject to the economic benefit regime.

Subsequent Modification: For purposes of these rules, the replacement of a non-equity arrangement with a successor equity arrangement will be treated as a modification of the non-equity arrangement.

(a) If the parties subsequently modify the arrangement so that it is no longer a non-equity arrangement, and if, immediately after the modification, the employer, service recipient, or donor IS the owner of the life insurance contract (determined without regard to the special rule for non-equity arrangements), the employer, service recipient, or donor continues to be treated as the owner of the life insurance contract. The result? The normal rules of the economic benefit regime for equity split-dollar life insurance arrangements apply.

(b) If, immediately after the modification, the employer, service recipient, or donor IS NOT the owner, the employer, service recipient, or donor is treated as having made a transfer of the contract to the employee, service provider, or donee as of the date of the modification.

TAXATION UNDER THE ECONOMIC BENEFIT REGIME:

Generally: The final regulations provide (essentially the same as the 2002 and 2003 proposed regulations) that, for these arrangements,

(1) the owner of the life insurance contract is treated as providing economic benefits to the non-owner of the contract, and

(2) those economic benefits must be accounted for fully and consistently by both the owner and the non-owner, and

(3) The value of the economic benefits, reduced by any consideration paid by the non-owner to the owner, is treated as provided from the owner to the non-owner.

Relationship Governs: The tax consequences of the provision of economic benefits will depend on the relationship between the owner and the non-owner. This means when one party provides an economic benefit for another, it may be treated as:

(1) Payment of compensation,
(2) A dividend under Code Section 301,
(3) A capital contribution,
(4) A gift,
(5) A transfer having a different tax character.

The parties must account for any benefit provided based on its character.

Example: Assume an employer provides an employee with economic benefits under a split-dollar life insurance arrangement. The employee must report the benefits received as compensation on the employee's Federal income tax return for the year in which the benefits are provided. The employer would report the transaction by recording them on the appropriate employment tax and information returns.

Example: Suppose a donor provides economic benefits to an irrevocable life insurance trust through a split-dollar life insurance arrangement. The donor would take those economic benefits into account by reporting them on the Federal gift tax return the donor is required to file. The trust would not be required to take any action because those economic benefits would be excludable from gross income under Code Section 102.

HOW NON-EQUITY SPLIT DOLLAR LIFE INSURANCE ARRANGEMENTS ARE TAXED:

General Rule: The final regulations adopt the familiar tax treatment of a non-equity split-dollar arrangement under Rev. Rul. 64-328 and its progeny.

Timing of current protection valuation: Subject to an anti-abuse rule, current life insurance protection is determined on the last day of the non-owner's taxable year unless the parties agree to use the policy anniversary date. The anti-abuse rule is designed to prevent the parties from manipulating the policy cash value for purposes of determining the value of the economic benefit that the non-owner must take into account. The rule also extends to the value of the current life insurance protection. Taxpayers may change the valuation date with the consent of the Commissioner.

EQUITY SPLIT DOLLAR ARRANGEMENTS:

It is important to understand how the Treasury and IRS came to its conclusions with respect to the taxation of an equity build-up: They deny that the equity should be income tax free to the non-owner. The rationale adopted in the final regulations is that

"The tax-deferred inside build-up provided by section 72(e) properly applies only to the taxpayer that owns the life insurance contract.

If the owner of the contract provides any of the rights or benefits under the contract to another taxpayer, that provision of rights and benefits is subject to tax under the rules that otherwise follow from the relationship between the parties.

For example, this result applies whenever an employer that owns a life insurance contract compensates an employee by giving the employee rights to the policy cash value. In that case, the employer (as the owner of the contract) enjoys tax-deferred inside build-up under section 72(e), but the employee has gross income under section 61(a)(1) equal to the value of the economic benefit attributable to the employee's rights to the policy cash value. Thus, the regulations are consistent with section 72(e)."

The IRS and Treasury rejected a section 83 approach because Section 83 applies only in connection with a transfer of property, but a non-owner may have currently includible income by reason of another rule – such as the doctrines of constructive receipt, cash equivalence, or economic benefit. It was considered "inappropriate to limit current taxation to circumstances that constitute transfers of property under section 83, and it would be inappropriate in this context to apply section 83 to circumstances that give rise to income under other Code provisions or judicial doctrines."

Here's how the value of the economic benefits provided by the owner to the non-owner for a taxable year is measured under the final regulations: It's the sum of

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

(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).

Full and Consistent Accounting Required: The owner and the non-owner also must account fully and consistently for any right in, or benefit of, a life insurance contract provided to the non-owner under an equity split-dollar life insurance arrangement. This makes it clear that, no matter what a benefit is called or what form it takes, its value must be taken into account and properly reported by the parties.

The Concept of Access: The final regulations provide that the non-owner has current access to any portion of the policy cash value to which the non-owner has a current or future right and that currently is - directly or indirectly -

(a) accessible by the non-owner,
(b) inaccessible to the owner, or
(c) inaccessible to the owner's general creditors.

Impact on True Non-Equity Arrangements: Since the non-owner – under the rules stated above – is considered to have current access to policy cash value only if, under the arrangement, the non-owner has a current or future right to policy cash value; in a true non-equity arrangement, the non-owner will have no such right and therefore not be taxable with respect to the cash value.

Impact of Restrictions on Owner's Creditors' Rights: If the non-owner has any of the access rights described above, any restriction on the owner's creditors to reach policy cash value, whether established by contract or by local law, results in an economic benefit to the non-owner.

According to the Treasury and IRS, this follows the economic reality of an equity split-dollar life insurance arrangement, i.e., if the owner commits funds to a life insurance contract and promisses it will not withdraw those funds, the amounts so committed are no longer a general asset of the owner since the owner has parted with the ownership and use of the funds for the benefit of the non-owner.

Broad Construction of Term " Access ": The access concept will be broadly construed. It includes any direct or indirect right under the arrangement allowing the non-owner to obtain, use, or realize potential economic value from the policy cash value.

Example: A non-owner is deemed to have access to policy cash values if he/she/it can directly or indirectly (1) make a withdrawal from the policy, (2) borrow from the policy, or (3) effect a total or partial surrender of the policy.

Example: A non-owner is deemed to have access to policy cash values if the non-owner can (1) anticipate, (2) assign (either at law or in equity), (3) alienate, (4) pledge, or (5) encumber the policy cash value or (5) if the policy cash value is available to the non-owner's creditors by attachment, garnishment, levy, execution, or other legal or equitable process.

When the Owner Is Deemed to Have NO Access: The final regulations consider policy cash value to be inaccessible to the owner if the owner does not have the full rights to policy cash value normally held by an owner of a life insurance contract.

When Owner's Creditors are Deemed to Have NO Access: Policy cash value is deemed to be inaccessible to the owner's general creditors if, under the terms of the split-dollar life insurance arrangement or by operation of law or any contractual undertaking, the creditors cannot, for any reason, effectively reach the policy cash value in the event of the owner's insolvency.

Special Acceleration Rule: In certain cases, a separate tax rule may require a non-owner to include an amount in gross income under an equity split-dollar life insurance arrangement at a time earlier than would be required under these regulations. This may constitute a tax trap for the unwary.

Example: Code Section 457(f) generally requires an employee of a tax-exempt organization (other than a church organization or of a state or local government to include deferred compensation in gross income when the employee's rights to the deferred compensation are not subject to a substantial risk of forfeiture.

According to the final regulations, an equity split-dollar life insurance arrangement governed by the economic benefit regime constitutes a deferred compensation arrangement. Accordingly, an employee of a tax-exempt organization or of a state or local government may have to include an amount in gross income attributable to an equity split-dollar life insurance arrangement even if the employee does not have current access to the policy cash value under these regulations.

OTHER TAX CONSEQUENCES:

Non-Owner Has No Investment In Contract: A non-owner has no investment in the contract under Code Section 72(e) prior to a transfer of the contract. The Treasury/IRS rationale is that only one person is generally treated as the owner of the life insurance contract and, since only the owner of a life insurance contract can have an investment in that contract, a non-owner employee cannot have basis in the contract for any of the costs of current life insurance protection.

Nor can the non-owner include such costs in the non-owner's basis or investment in the contract if and when the non-owner becomes the owner of the contract. The rationale for this is that, because those payments were made for annual life insurance protection – and that protection was exhausted prior to the non-owner's acquisition of the contract – there's nothing to add to basis.

Inclusion in Owner's Income Required: Any amount paid by the non-owner to the owner for any economic benefit must be reported in the owner's gross income. The fact that the split-dollar life insurance arrangement may require the non-owner to reimburse the owner for the cost of the death benefit protection provided to the non-owner does not mean that such payment is not income to the owner. The rationale? The owner is "renting" out part of the benefit of the life insurance contract to the non-owner for consideration and that consideration constitutes income to the owner.

HOPE THIS HELPS YOU HELP OTHERS

Steve Leimberg

Copyright LISI (Leimberg Information Services, Inc.) 2003  To join LISI: http://www.leimbergservices.com

CITE AS:

Steve Leimberg's Estate Planning Newsletter #   581

To be continued in Part II to follow:

 

 



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