Supplemental Proposed Split-Dollar Regs Cover Valuation of Economic Benefit

The Treasury and IRS have just issued a set of proposed regulations [REG-164754-01], effectively supplementing the comprehensive proposed regulations issued in July 2002 that made sweeping changes in the rules for taxation of split-dollar insurance arrangements. [For a comprehensive summary of the 2002 proposed regulations, see Current Comment 02-16, July 2002.] The newly issued proposed regs deal specifically with valuation of the taxable benefit(s) realized under a split-dollar arrangement subject to the “economic benefit” regime under the 2002 proposed regs. Essentially this deals with so-called “equity split-dollar” arrangements, the most common of which are between an employer and an employee, and under which increases in policy cash value accrue for the benefit of the employee.

The new proposed regs adopt the revolutionary position, long opposed by the financial services industry, that taxable income can result from cash value increases in a life insurance contract subject to an equity split-dollar arrangement.

Background

Is Cash-Value Build-Up Taxable in the Equity Split-Dollar Context?

Whether, and at what point, the "equity" inuring to the benefit of the employee is taxable to the employee in an equity split-dollar plan was for many years a much debated topic, as to which the IRS had not, until 1995, enunciated a position. In the absence of an IRS position to the contrary, the employee cash value build-up was typically not reported as gross income by equity split-dollar plan participants.

The legal arguments in support of, and opposed to, the taxation of the annual equity build-up inuring to the employee may be summarized as follows:

·         I.R.C. §61 theory - The portion of the increase in cash value which inures to the benefit of the employee is income under the broad general definition of gross income in §61. In this case the income represents an indirect form of compensation for the performance of services.

·         I.R.C. §83 theory - This section deals specifically with compensation of an employee for services. It provides that when property is transferred from an employer to an employee in connection with the performance of services, the value of the property represents income in the taxable year that the beneficial interest becomes transferable by the recipient or not subject to a substantial risk of forfeiture. In other words, if the property received is subject to a substantial risk of forfeiture (and cannot be transferred free of the risk of forfeiture), the income is not recognized until this risk of forfeiture is removed. Since the equity build-up represents compensation for services, it is taxable under §83 as it accrues, as long as there is no substantial risk of forfeiture. (A substantial risk of forfeiture would exist, for example, if the employee`s interest under the split-dollar plan is terminable if he should leave the company.)

·         Economic benefit theory - The economic benefit theory applies the general rule of I.R.C. §61 to situations in which a taxpayer derives an economic benefit that has a current, real, measurable value sufficient to justify taxation, even though it may not be the outright receipt of money or other tangible property. Rev. Rul. 66-110 [1966-1 C.B. 12], which discusses the value of the insurance protection received each year as a taxable economic benefit, also states that the employee may receive other benefits under the split-dollar plan, mentioning policy dividends paid in cash to the plan participant or purchasing paid-up-additions in which the employer has no interest. Based upon this language, it is argued that the increase in cash value is also a taxable economic benefit.

The arguments against taxation of the increases in cash value may be summarized as follows:

·         Applicability of §72(e).  The equity build-up in a split-dollared policy falls within the basic rule applicable to life insurance generally, under I.R.C. §72(e), that the inside build-up of equity value within an insurance policy is not currently taxable income. The constructive receipt doctrine has been held inapplicable to periodic increases in insurance policy cash values, since the increases are not available to the policy owner without surrender or partial surrender of the policy. This represents a material restriction or limitation on the constructive receipt of the cash value increment. [See Theodor H. Cohen v. Comm`r., 39 TC 1055 (1963), acq. 1964-1 CB 4]. Since 1985 this subject has been effectively governed by I.R.C. §7702; if an insurance contract passes the definitional tests for qualification as a "life insurance contract" under that section, the cash value growth within the policy will not be taxable as it accrues; otherwise it will be taxable. Taxation is deferred until the equity amount is actually received upon surrender or redemption of the policy. I.R.C. §72(e)(5)(E). Under the §72 theory the fact that the equity build-up inures to the benefit of an employee in connection with the performance of services, should not affect the applicability of the general rule of §72.

·         Inapplicability of I.R.C. §83 - Although there is an employment relationship involved, §83 does not apply because it only applies where there is a transfer of property from the employer to the employee.

Until late 1995, neither the IRS nor any court case, had enunciated a position on this question. Relying essentially on the general principal of Rev. Rul. 64-328, and interpreting it to hold that the only element of income to the employee under a split-dollar plan is the economic value of the life insurance protection, the insurance industry and tax planners made employer-pay-all equity split-dollar an increasingly popular form of tax-favored employment fringe benefit. The equity build-up was simply deemed non-taxable, and this interpretation was never challenged by the IRS--at least until the issuance of TAM 9604001 in 1995.

In September, 1995, the IRS, for the first time, promulgated a position on the taxation of equity split-dollar. In Technical Advice Memorandum ("TAM") 9604001, involving a specific set of facts, the IRS held that under an equity split-dollar plan, the employee/insured is taxable each year on not only the value of the economic benefit from the pure insurance coverage, but also any increase in the cash value of the policy in excess of the amount ultimately payable to the employer under the plan. The legal support for this position is based upon I.R.C. §61, generally requiring that a taxpayer include in gross income compensation received for services. §83 was also relied upon, the Service taking the position that property is considered "transferred," for purposes of §83(a), when a person acquires a beneficial interest in the property. Under §83, the increase in cash value inuring to the benefit of the employee was deemed by the IRS to be a transfer of property, includable in gross income unless subject to a substantial risk of forfeiture.

Thus, the employee`s gross income in any year would be based upon three factors: the value of the pure insurance protection provided, plus the increase in cash value inuring to the employee, minus the amount of any premium contribution paid by the employee up to an amount equal to the value of the current protection. Any income so reported would increase the employee`s basis in his interest in the policy. Income that may be realized by the employee upon subsequent rollout of the policy would be net of his cumulative basis on the rollout date.

The position and legal reasoning taken in this TAM was strongly challenged by insurance industry groups, which solicited IRS reconsideration. In 2001 the IRS issued Notice 2001-10, a comprehensive revision of the tax treatment of split-dollar plans generally. Notice 2001-10 was later revoked, to be replaced by a new set of formal regulations, which were issued in proposed form in July 2002. At that time the Service announced (in Notice 2002-8) that, until the final adoption of the new regulations, it would not attempt to tax inside cash value build-up in equity split-dollar arrangements.

The supplemental proposed regulations just issued now clearly adopt the approach of taxing the annual equity accretion for the benefit of the employee.

[These proposed regulations will have the same applicability date as that set forth in §1.61-22(j) of the 2002 proposed regulations. Thus, these 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.]

The New Landscape: Loan Regime and Economic Benefit Regime

The 2002 proposed regulations provide two mutually exclusive regimes for taxation of split-dollar life insurance arrangements—a loan regime and an economic benefit regime. Under the loan regime (set forth in §1.7872-15 of the 2002 proposed regs), the non-owner of the life insurance contract is treated as loaning the amount of the premium payments to the owner of the contract, and the imputed interest rules of §7872 will apply. The loan regime will generally govern the taxation of the so-called collateral assignment form of split dollar arrangement.

Under the economic benefit regime (set forth in §1.61-22(d)-(g) of the proposed regulations), the owner of the life insurance contract is treated as providing economic benefits to the non-owner of the contract. The economic benefit regime generally will govern the taxation of endorsement arrangements (i.e., where the owner of the policy endorses over to the other party a partial interest in the policy proceeds). In addition, a special rule requires the economic benefit regime to apply (and the loan regime not to apply) to any split-dollar life insurance arrangement if (i) 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 (ii) 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.

Equity split-dollar arrangements are taxable under the economic benefit regime if the employer (or donor, in the case of private split-dollar) is the owner of the policy, and under the loan regime if the employee (or donee) is the owner. Specific guidance regarding valuation of economic benefits under an equity split-dollar arrangement was reserved in proposed §1.61-22, pending comments from interested parties concerning an appropriate valuation methodology. After a public hearing and receipt of written comments, supplemental proposed regs have now been issued on this valuation issue.

Proposed Valuation Methodology

The new proposed regulations deal only with the valuation of economic benefits under an equity split-dollar arrangement governed by the economic benefit regime. In summary, these regulations provide that the value of the economic benefits provided to the non-owner for a taxable year equals—

·                     the cost of any current life insurance protection provided to the non-owner,

·                     the amount of cash value increase during the year (to which the non-owner has access), and

·                     the value of any other economic benefits newly provided to the non-owner under the arrangement during the year.

Cost of Current Life Insurance Protection

The new proposed regulations provide that the cost of current life insurance protection provided to the non-owner under an equity split-dollar arrangement is measured by the amount of such current protection multiplied by the life insurance premium factor designated or permitted in guidance to be published in the Internal Revenue Bulletin. The amount of the insurance protection provided to the non-owner (including paid-up additions) equals the excess of the average death benefit over the sum of (a) the total amount payable to the owner (including any outstanding policy loans that offset amounts otherwise payable to the owner), plus (b) the portion of the policy cash value taken into account (for the current and prior years) as a taxable economic benefit. This effective subtraction of the portion of the cash value taken into account by the non-owner, from the actual amount of pure insurance protection, prevents double taxation of such amount—once as part of the policy cash value to which the non-owner has current access, and again as an amount provided to the non-owner in the form of death benefit protection.

Accessible Increases in Policy Cash Value

Generally, under an equity split-dollar life insurance arrangement governed by the economic benefit regime, the owner 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). Thus, an equity split-dollar life insurance arrangement is deemed under the regulations to confer on the non-owner rights to direct or indirect economic enjoyment of policy cash value, making current taxation of the non-owner’s interest in the cash value appropriate under the doctrines of constructive receipt, economic benefit, and cash equivalence. Thus, the general rule is that the non-owner is taxable each year to the extent of any currently accessible increase in policy cash value for the year.

The proposed regulations provide that the non-owner has current access to any portion of the policy cash value that is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors. For this purpose, “access” is to be construed broadly and 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. Thus, for example, a non-owner has current access to policy cash value if the non-owner can directly or indirectly make a withdrawal from the policy, borrow from the policy, or effect a total or partial surrender of the policy. Similarly, for example, the non-owner has current access if the non-owner can anticipate, assign, alienate, pledge, or encumber the policy cash value or if the policy cash value is available to the non-owner’s creditors.

Policy cash value is 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. Policy cash value is 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 full policy cash value in the event of the owner’s insolvency.

In a typical equity split-dollar life insurance arrangement, the non-owner has current access to all portions of the policy cash value in excess of the amount payable to the owner. In many arrangements, the non-owner may also have current access to the portion of the cash value payable to the owner if, for example, that portion of the policy cash value is for any reason not accessible to the owner or the owner’s general creditors.

Under the proposed regulations, policy cash value is determined without regard to surrender charges or other similar charges or reductions.

To provide uniformity, certainty, and administrative ease, policy cash value generally is determined on the last day of the non-owner’s taxable year. In addition, solely for purposes of employment tax (as defined in §1.61-22(c)(5) of the 2002 proposed regulations) 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.

Dodging the §83 Argument

Several commentators on the 2002 proposed regulations asserted that those regulations were contrary to the intention, announced by the IRS and the Treasury Department in Notice 2002-8 (2002-1 C.B. 398), to publish regulations that would not treat an employer/owner as having made a transfer of a portion of the cash surrender value of a life insurance contract to an employee/non-owner for purposes of Code §83 solely because of an increase in cash value accruing to the employee’s benefit.

However, the theory for taxation of cash value increases in the proposed regulations does not involve §83; thus, the argument that §83 is not applicable because cash value accrual does not involve a transfer of property has essentially been ignored (even though §83 had been cited by the Service in its original offensive in the 1996 TAM). The approach in the regulations relies on the doctrines of constructive receipt, economic benefit, and cash equivalence, and treats the non-owner as having a taxable interest in policy cash value because, and only to the extent that, the non-owner has current access to the policy cash value.

Taxation of Economic Benefit Does Not Generate Basis

Several commentators stated that a non-owner who includes in income a portion of the policy cash value should be credited with “inside build-up” on that portion of the policy cash value. This result might be appropriate if there were actual transfers of ownership of the underlying life insurance contract (or a portion thereof) from the owner to the non-owner. Under §1.61-22(g)(4)(ii)(A) of the 2002 proposed regulations, if a life insurance contract is transferred from an owner to a non-owner (i.e., from the employer to the employee), 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. However, in the absence of such a transfer, the non-owner does not have an asset to which basis is attached. 

No Deductions When Cash Value Declines

Some commentators expressed the view that, under the economic benefit regime, if the policy cash value in one year is less than the policy cash value in a prior year, the non-owner should be allowed a loss to the extent this difference was included in income in the prior year. Without further explanation, the Service simply states, “consistent with the underlying doctrines of constructive receipt, economic benefit, and cash equivalence, a loss should not be allowed in this situation.”

Other Economic Benefits

In order to prevent any atypical form of economic benefit from slipping through the cracks, the new regulations provide that taxable economic benefits also include any economic benefit not specifically described in the paragraphs dealing with accessible increases in cash value and the value of the insurance protection. No examples are given to illustrate any specific type of such “other benefits.”

The Beat Goes On

The sigh of relief from the financial services industry that greeted the issuance of IRS Notice 2002-8 has been short-lived. The declaration in that Notice that equity build-up would not be treated as current income prior to the issuance of final regulations at least indicated that the Service was not taking dead aim at the seemingly sacrosanct principal that equity build-up inside an insurance contract was simply not a taxable event. Now it appears that the rug has been pulled out, and the Service is about to make a major inroad by taxing equity build-up in endorsement type equity split-dollar arrangements. It’s not yet written in stone, and opponents will be given the opportunity to take another run at presenting the still cogent contra arguments (the fundamentals of which are outlined above) in written comments due by July 8, and in a public hearing scheduled for July 29. Even if the new proposed regulations are eventually finalized without the Service changing its position on taxation of equity build-up, the issue seems sufficiently debatable that the regulations could be subject to court challenge—generally an uphill battle, since Treasury regulations are given a presumption of validity unless shown to be overzealous administrative action that expands, rather than merely interprets, the relevant Code sections. 

[The full text of the supplemental proposed split-dollar regs are reproduced in Section 15.2, Subdivision J.]

(Posted 05/08/03)

Copyright © 2003 Advanced Planning Press, LLC. All Rights Reserved. 800-532-9955