Writers Criticize Proposed Regs on Split-Dollar Life Insurance Plans


Edward Marron and Christina Simonte of the Equitable Life Assurance Society of the United States have criticized the proposed regulations on split-dollar life insurance arrangements as abandoning well-developed taxation principles on the issue.

Document Type: Public Comments on Regulations

Tax Analysts Document Number: Doc 2002-23100 (6 original pages) [PDF]

Tax Analysts Electronic Citation: 2002 TNT 198-19

Citations: (7 Oct 2002)


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


Edward Marron and Christina Simonte of the Equitable Life Assurance Society of the United States have criticized the proposed regulations on split-dollar life insurance arrangements (REG-164754- 01) as abandoning well-developed taxation principles on the issue. (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.)

The writers noted that annual taxation on non-owners' interests in the cash value of a policy is inappropriate and that the tax should apply to equity interests only on termination of the split- dollar arrangement as set out in Notice 2002-8. (For a summary of Notice 2002-8, 2002-4 IRB 398, see Tax Notes, Jan. 7, 2002, p. 35; for the full text, see Doc 2002-386 (7 original pages) [PDF], 2002 TNT 3-5 , or H&D, Jan. 4, 2002, p. 129.) The writers also noted that requiring that there be only one owner of the policy would inaccurately reflect the economic substance of a split-dollar arrangement and lead to inequitable results.


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

October 7, 2002

CC:ITA:RU (REG-164754-01)
Room 5226
Internal Revenue Service
POB 7604
Ben Franklin Station
Washington, DC 20044

Re: Proposed Split-Dollar Life Insurance Arrangement Regulations

Dear Sir/Madam:

[1] Set forth below are The Equitable Life Assurance Society of the United States' ("Equitable") comments on the proposed split- dollar life insurance regulations published in the Federal Register on July 9, 2002.1 Please note that, while Equitable recognizes the effort that the Department of Treasury and the Internal Revenue Service ("IRS") have given to the proposed regulations, we have concerns relating to several of the principles on which the regulations are based. Specifically, we are concerned that the proposed regulations do not appropriately reflect the economic substance of split-dollar arrangements and that such regulations, if finalized, will discourage many taxpayers from utilizing a valid life insurance funding technique that can be extremely beneficial from the perspectives of employee benefit planning, business succession planning (especially with respect to small businesses) and estate planning. In addition, over the years, numerous rulings have been issued by the IRS regarding the taxation of split-dollar arrangements. These rulings have established a set of principles recognizing the unique circumstances of such arrangements -- namely that they represent a sharing between two parties (typically an employer and an employee or a parent and a child) of the benefits and burdens of a life insurance policy. The proposed regulations seem to abandon these well-developed principles. The comments below further explain our concerns.

Taxation of Equity under the Economic Benefit Regime

[2] First, although the proposed regulations suggest that, under the economic benefit regime, a non-owner will be taxed annually on any interest he/she has in the cash value of the policy, they do not specify a particular methodology for such taxation (Section 1.61-22(d)(3)(ii) of the proposed regulations states that such issue is "reserved"). We expect that, in accordance with the Administrative Procedure Act, any further guidance with respect to this issue will be issued in the form of proposed regulations and that we will have further opportunity to comment. We would like to state at this time, however, that annual taxation is inappropriate and that tax should apply to any such equity interest only upon termination of the split- dollar arrangement in accordance with the principles set forth in Notice 2002-8.

[3] Taxing a non-owner annually on an interest in the cash value of the policy is contrary to the open transaction doctrine. The open transaction doctrine, a guiding tax principle set forth in Burnett vs. Logan, 283 U.S. 404 (1931), states that taxation may not be imposed in connection with a transaction until the amount of income derived therefrom can be properly determined. In the case of an equity split-dollar arrangement, it is generally impossible to measure the amount of cash value to which the non-owner will be entitled until termination of the arrangement. That is, at the time a premium is paid, there typically is no immediate interest in any cash value in the policy. Thereafter, for many policies, any policy cash value is subject to policy charges (including mortality charges) and the investment performance of the policy's account value. Accordingly, because the cash value of the policy fluctuates from year to year, it is impossible to know how much cash value, if any, will ultimately be transferred to the non-owner.

[4] The treatment of equity split-dollar arrangements as open transactions is consistent with the treatment of nonstatutory stock options ("NSOs"). Under Internal Revenue Code ("Code") Section 83, a service provider is not taxed in connection with NSOs until they are exercised unless the NSOs have a "readily ascertainable market value." Thus, the tax treatment of NSOs contemplates that it would be inequitable and inappropriate to tax service providers in connection with such options until the time of exercise because of their fluctuating value.

[5] This treatment applies even where a service provider's rights in the NSOs are vested and he/she could exercise them at any time. The same principle should apply in the split dollar context.

[6] An even more compelling argument against annual taxation is made when considering that, under many equity split-dollar arrangements, the non-owner does not have the right to access any life insurance policy values prior to the termination of the split- dollar arrangement. Because a non-owner with such limited access to the cash value of the policy is analogous to the holder of an unvested NSO, it would be highly inconsistent and inequitable to tax such non-owner.

Sole Owner Approach

[7] Equitable's second major concern relates to the principle under the regulations that, for tax purposes, there can generally be only one owner of a life insurance policy subject to a split-dollar arrangement.2 That is, requiring that there can only be one owner of the policy inaccurately reflects the economic substance of a split-dollar arrangement and leads to inequitable results. The "one owner" principle is particularly troubling with respect to the economic benefit regime put forth by the regulations. Two major inequities caused by the "one owner" principle under the economic benefit regime are as follows:

1 -- Imputed Income Where Both Parties Contribute to Cost

a -- Issue

[8] For split-dollar arrangements subject to the economic benefit regime where the nonowner contributes the portion of the life insurance premiums attributable to the life insurance protection provided to him/her, the regulations impute income to the owner for the amount so contributed and give the owner basis in the policy for that amount. in addition, the non-owner is denied any basis in the policy for the portion of the life insurance premiums the non-owner pays. As illustrated below, such a result is highly inequitable and contrary to general tax principles.

[9] Example: Assume an employer and employee enter into a contributory split dollar arrangement subject to the economic benefit regime and the single premium due for the underlying life insurance policy is $1,000. It is determined that $300 of the premium is attributable to the pure life insurance protection element of the policy. Accordingly, the employee pays $300 of the premium and the employer pays the remaining $700.

[10] Under the regulations, the employer in this example would have $300 of income, even though the employer does not receive any income or any benefit from the $300. Rather, the $300 is simply the amount paid by the employee towards the cost of his/her life insurance protection. Taxing the employer on this amount is contrary to the general premise of Code Section 61 which is that taxpayers should be taxed only upon "accessions to their wealth." In this case, there has been absolutely no accession to the employer's wealth. In addition, under the regulations, the employer would have $1,000 of basis in the life insurance policy while the employee would have no basis in the policy. There is no valid reason for allocating the basis that the employee should have in the policy to the employer.

b -- Suggested Approach

[11] To accurately reflect the economic substance of a contributory split-dollar arrangement subject to the economic benefit regime, the non-owner's purchase of the life insurance protection element of the policy should be viewed as a separate and distinct transaction from the owner's purchase of the policy's cash values. Accordingly, no income should be imputed to the owner based on the non-owner's premium payments for the life insurance protection element and the owner should only receive basis for the portion of the premium actually contributed by the owner. The non-owner should receive basis for the portion of the life insurance premium actually contributed by him/her. Further, if a nonowner contributed more than the cost of the life insurance protection provided, the nonowner should be treated as purchasing part of the cash value of the policy. Accordingly, the owner and non-owner would each retain a separate and distinct interest in the cash value for tax purposes.

[12] This suggested approach is consistent with the income tax treatment applicable where a life insurance policy is purchased with employer contributions to a qualified plan and the proceeds of the policy are payable to the participant's beneficiary. Specifically, in that case, if the plan participant contributes the cost of the life insurance protection, no income is recognized by the employer and the participant receives basis in the policy for the amount contributed. Since the economic substance of such a transaction is similar to the economic substance of a split-dollar arrangement, the tax treatment should be the same.

2 -- Tax on Inside Build-Up/Death Benefits

a -- Issue

[13] For equity split-dollar arrangements subject to the economic benefit regime, the proposed regulations would apply annual taxation to the non-owner's interest in the cash value of the policy. If the policy is later transferred to him/her, the non-owner is taxed again at the time of transfer based on the cash value of the policy transferred and is only allowed to offset such amount by the amount already taken into income by him/her. The nonowner, therefore, is inappropriately taxed on the inside build-up attributable to the amounts previously taken into income. An example illustrates the over-taxation caused by the regulations' approach:

[14] Example: An employer and an employee enter into an equity split-dollar arrangement subject to the economic benefit regime on January 1, 2003 and the employer pays a single $100 premium for the policy. Under the regulations, the employee is subject to tax in 2003 based on his/her interest in the cash value of the policy. Although the regulations reserve the issue of how this interest will be valued, they suggest a method whereby the employee would be subject to tax on the excess of the $100 premium payment over the present value of the amount to be repaid the employer in the future. Assume for purposes of this example that the employee is required to pay tax on $30. In addition, assume that the cash value increases every year and that by the end of 2008 the total cash value of the policy has increased to $1,000. Under the rules set forth above, if the policy is transferred to the employee at the end of 2008, he/she will be taxed on $870 ($1000 total cash value -- $100 withdrawn to reimburse employer -- $30 already taken into income).

[15] The result in the example is inappropriate because it taxes the employee on the inside build-up on the $30 the employee has already taken into income. That is, the employee should be considered to be the owner of that $30 of the cash value and any earnings on that $30 should be tax-deferred inside build-up. The employee should not be denied the tax deferral on inside build-up that is accorded to all life insurance policies under Code Section 72 just because he/she is a party to a split-dollar arrangement. A similar inequity would occur if the employee died while the split-dollar agreement was in effect. In that case, the employee's beneficiary would be taxed on amounts that should be tax-free under Code Section 101.

b -- Suggested Approach

[16] In order to alleviate this inequity and for the reasons explained above, we suggest that the final split-dollar regulations forego annual taxation of the equity in an equity split-dollar arrangement subject to the economic benefit regime. Such equity should be taxed only upon termination of the arrangement. If the final regulations do retain such annual taxation, however, it is imperative that they treat a non-owner of a split-dollar arrangement as the tax owner of that portion of the cash value of the underlying life insurance policy upon which he/she is taxed. Accordingly, the non-owner will have basis in that portion of the cash value and any inside build-up thereon will be taxed only in accordance with Code Section 72 principles. In addition, in the employer-employee context, the employer should be entitled to a compensation deduction for the amount that is included in the employee's income at the time it is so included.

[17] This suggested approach is consistent with Code Section 83. Specifically, under that section, if property is transferred to a service provider and the service provider is taxed at that time on the value of the property under either Code Section 83(a) or a Code Section 83(b) election, the service provider becomes the tax "owner" of such property and any future appreciation therein is not taxed until a later disposition of the property. The same result should apply if the non-owner of a split-dollar arrangement is viewed as having a currently taxable interest in a portion of the underlying life insurance policy's cash value. Under Code Section 72 principles, any appreciation on that portion of the policy's cash value should be considered part of the tax-deferred inside build-up in the policy. No further taxation should occur until there has been a distribution under the policy under the rules of Code Section 72.

[18] In addition to the comments above, Equitable supports the more exhaustive comments to the proposed regulations submitted by the American Council of Life Insurers. We thank you for considering both sets of comments and look forward to the revised regulations.

Sincerely,

Edward Marron

Christina Simonte

cc: Ms. Pam Olson (via regular mail) Ms. Ann Cammack (via regular mail) Mr. Bill Sweetnam (via regular mail)


FOOTNOTES


1Equitable is a life insurance company that conducts business in all 50 states and the District of Columbia. Equitable and its affiliates provide a full range of insurance, asset management, securities and other financial products and services and have millions of customers in the United States.

2There is only a limited exception to the "one owner" principle for situations where each party has an undivided interest in each right and benefit of the contract.


END OF FOOTNOTES

 



Code Section: Section 7872 -- Below-Market-Rate Loans; Section 61 -- Gross Income Defined; Section 83 -- Property Transferred for Services; Section 264 -- Nondeductible Premiums
Geographic Identifier: United States
Subject Area: Benefits and pensions
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: Marron, Edward; Simonte, Christina
Institutional Author: Equitable Life Assurance Society of the United States