Writer Recommends Changes to Proposed Split-Dollar Regs
Kirk D. Sherman, Sherman & Danielsen Ltd., has submitted comments on the proposed regulations (REG-164754-01) regarding the taxation of split-dollar life insurance arrangements.
Document Type: Public Comments on Regulations
Tax Analysts Document Number: Doc 2002-24382 (4 original pages) [PDF]
Tax Analysts Electronic Citation: 2002 TNT 212-19
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Kirk D. Sherman of Sherman & Danielsen Ltd.,
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Internal Revenue Service
Ben Franklin Station
Re: Comments on Proposed
Dear Sir or Madam:
 This letter responds to your request for comments on the
A. Substantial Risks of Forfeiture
 In the compensation setting, under the economic benefit regime, a non-owner of a contract is taxed under section 61 principles each year the arrangement continues in effect, and under section 83 principles when the arrangement terminates, as follows:
 The issue left open by these provisions is when to tax economic benefits that accrue before the policy is transferred, where the benefits are subject to substantial risks of forfeiture. The absence of a reference to substantial vesting under section 61 leaves open the possibility that benefits that accrue prior to the policy being transferred to the non-owner would be taxable each year even if they were non-vested and forfeitable. That result would be anomalous when compared to section 83 treatment that defers taxation until substantial vesting. The anomaly is particularly poignant considering that prior to being transferred to the non-owner, the benefits are subject to claims of the employer's creditors, whereas after the transfer they are protected from such claims. General tax principles would conclude that if the section 83 transfer taxation is deferred until the risks lapse, the argument for deferring the section 61 taxation is even stronger.
 The following example illustrates this situation:
Employer (R) purchases a life insurance contract on the life of employee (E). R is named as the policy owner. R and E enter into an arrangement under which R will pay all the premiums on the life insurance contract for 10 years. The contract's death proceeds are to be divided between R and the beneficiary E designates. If E continues employment with R until the end of the 10 year, R will withdraw from the policy's cash surrender value the lesser of the aggregate premiums or the cash surrender value of the contract. R will then transfer ownership of the contract and its remaining cash value to E. However, if E terminates employment prior to the end of the 10th year, the arrangement will terminate, and E will forfeit all rights in the policy and its cash value.
 Absent a specific exception for substantially unvested interests, § 1.61-22(d)(3)(i) could result in E being taxed each year on the cash surrender value growth in excess of R's premiums, notwithstanding the risks of forfeiture. If, on the other hand, R simply transferred the policy to E with the same cash value and subject to the same restriction that E remain employed for 10 years, taxation would be deferred until the end of the tenth year.
 To recognize the concept of substantial vesting before the arrangement terminates, we recommend adding a new sentence to the end of § 1.61-22(d)(3)(i) reading as follows (the new wording is italicized):
In the case of a split-dollar life insurance arrangement subject to the rules of paragraphs (d) through (g) of this section other than an arrangement described in paragraph (d)(2) of this section, any right in, or benefit of, a life insurance contract (including, but not limited to, an interest in the cash surrender value) provided during a taxable year to a non-owner under a split-dollar life insurance arrangement is an economic benefit for purposes of this paragraph (d). For purposes of the foregoing, any right or benefit that is subject to substantial risks of forfeiture (as defined in § 1.83-3(c)) shall not be taken into account under this paragraph (d)(3) until the substantial risks of forfeiture lapse.
 We believe adding a new example in § 1.61-22(h) would also be helpful to illustrate this concept, as follows:
Example 9. (i) The facts are the same as in Example 1, except the arrangement provides that, if E remains employed with R until the end of Year 5, R will transfer ownership of the policy and all of its cash value to E at that time, and the arrangement will terminate.
(ii) The arrangement is described in paragraph (d)(3) of this section and E must include in gross income each year the value of the economic benefit attributable to E's interest in the life insurance contract. However, no economic benefit attributable to the contract's cash value is includable in E's income unless and until he remains employed to the end of Year 5.
B. Taxation of Death Benefit Protection under General Tax Regime
 Section 1.61-22(b)(5) provides that split dollar arrangements that are not taxed under either the economic benefit regime or the split dollar loan regime ("(b)(5) arrangements") are taxed under "general income tax, employment tax and gift tax principles." As we attempt to apply general tax principles to such arrangements, however, we are unable to find specific reference to how to tax the value of the death benefit protection under (b)(5) arrangements.
 Consider the following example:
Employer (R) purchases a life insurance contract on the life of employee (E). E is named as the policy owner. R and E enter into an arrangement under which R will pay all the premiums on the life insurance contract for 3 years. If E dies during the 3-year period, R will receive a portion of the death proceeds equal to one-half the premiums paid. The only time R will be entitled to any of the policy's cash value is if E's employment terminates prior to the end of the 3rd year. In that case, E will transfer ownership of the policy and of all policy cash value to R.
 This arrangement qualifies as a split dollar life insurance arrangement under § 1.61-22(b)(2)(ii) -- it is established in connection with the performance of services, R pays premiums, and E can designate the beneficiary of death proceeds. Since E owns the policy, the economic benefit regime does not apply. Moreover, R cannot reasonably be expected to be repaid in full, so the arrangement is not a split dollar loan. Therefore, § 1.61- 22(b)(5) dictates that general tax principles apply.
 Under general tax principles, R is making a section 83 transfer of property each time it pays a premium. See Treas. Reg. §§ 1.83-1(a)(2), 1.83-3(e). The cash value is subject to a substantial risk of forfeiture, and therefore will not be taxable until the risks of forfeiture lapse. See IRC § 83(a). In the meantime, E has taxable income each year equal to the Section 61 value of the death benefit protection received. See Treas. Reg. § 1.83-1(a)(2). Here is where the difficulty arises.
 The proposed new sentence in § 1.83-1(a)(2), instructs:
For the taxation of life insurance protection under a split- dollar life insurance arrangement (as defined in § 1.61- 22(b)(1) or (2)), see § 1.61-22.
 The general reference back to § 1.61-22 appears circular since, as noted above, § 1.61-22 specifically does not apply to (b)(5) arrangements.
 To clarify the taxation of the death benefit protection in (b)(5) arrangements, we recommend that the cross-reference in § 1.83-1(a)(2) be made more specific to the portions of § 1.61-22 that deal with valuation of death benefit protection, and that the reference either in § 1.61-22(b)(5) or in § 1.83- 1(a)(2) be modified to require the death benefit protection of (b)(5) arrangements to be determined under § 1.61-22.
 Thank you for your consideration of these comments and recommendations. If you have questions or would like to discuss these issues further, please contact me.
SHERMAN & DANIELSEN, LTD.
Code Section: Section 61 -- Gross Income Defined; Section 83 -- Property Transferred for Services
Subject Area: Insurance company taxation
Industry Group: Insurance
Cross Reference: For a summary of REG-164754-01, see Tax Notes,
for the full text, see Doc 2002-16108 (24 original pages) [PDF], 2002 TNT
135-10 , or H&D,
Institutional Author: Sherman & Danielsen Ltd.