In a recent notice issued January 9, 2001, the IRS published "interim guidance" on its position with respect to "split-dollar life insurance arrangements." It is expected that the IRS will seek comments and issue further guidance on this subject. In the meantime, the Announcement raises uncertainty for the future of split-dollar insurance arrangements and does not provide complete protection for the tax consequences of split-dollar arrangements that are already in effect.
In a split-dollar insurance arrangement, the funding obligations and/or the cash value and death benefits of an insurance policy are "split" between the employer and employee (or often, the employee's assignee such as an irrevocable insurance trust). Although there are historical IRS rulings upon which the foundation of split-dollar planning is based, the IRS in this latest Announcement indicates that these past rulings do not adequately address the "equity split-dollar" arrangements that are in place today whereby the employer's interest in the cash surrender value of the contract is limited to its premium payments without regard to any earnings or cash value buildup in the policy beyond the premiums paid.
The 2001 Announcement states that this equity split-dollar arrangement must be treated as either a tax-free loan, with the taxation governed by Section 7872 of the Internal Revenue Code, which would tax the imputed interest payments on the interest free loan as compensation income to the employee. Alternatively, the IRS suggests that the proper tax treatment might be viewed under Section 83 of the Internal Revenue Code requiring taxation to the employee when he or she receives economic benefits under the insurance contract (i.e., through the provided death benefit or policy earnings). Until further guidance is issued, the taxpayer may generally characterize the arrangements under either the "interest free loan" characterization or the "Section 83 compensation" characterization.
Under the Section 83 characterization, however, the party must "fully account for all economic benefits conferred on the employee." In general, this means that the employee will have compensation income equal to the value of the insurance protection provided to the employee each year (this is consistent with the historical view on taxation of split-dollar policies, although P.S. 58 tables, which measure this compensation element, will change under this new Announcement). The employee will also have compensation income equal to any dividends or similar distributions made to the employee. In addition, the employee will have compensation income under Section 83 to the extent that the employee acquires a "substantially vested" interest in the cash surrender value of the life insurance contract. It is important to note, however, that the Announcement provides that, until there is further guidance, the employer will not be treated as having made a transfer of the cash surrender value of the policy simply because the cash surrender value is greater than the premium advanced by the employer. This guidance suggests, however, that "roll out" transactions, whereby the policy, along with certain built in cash value, is transferred or retained by the employee as a result of satisfying or discharging the premium repayment obligations to the employer will create compensation income to the employee at that time.
The Announcement goes further to revoke the P.S. 58 rates which were the previously published tables providing general guidance on the income allocable to an employee as a result of an employer providing death benefits to the employee under a split-dollar arrangement. The P.S. 58 table is replaced by a new table - "Table 2001" - which provides for materially lower rates than the previous P.S. 58 rates. After 2003, taxpayers will no longer be able to use the current term rates published by a carrier unless certain requirements are met; currently, these published rates have been used by most taxpayers in order to substantially reduce the charges to the employee that would otherwise be required under the P.S. 58 table. The Announcement does not provide any guidance or clarification on changes with respect to second to die or survivorship life insurance where currently P.S. 38 tables are being used.
Finally, it is important to recognize that although the IRS's guidance has focused strictly on the income taxation of split-dollar insurance, where the policies are owned by an irrevocable insurance trust, the income tax consequences addressed may result in additional deemed transfers to the trust for gift and generation-skipping tax purposes.
In conclusion, the future of split-dollar insurance planning is uncertain and will remain uncertain until further clarification from the IRS is issued; the insurance industry is sure to lobby for clarification in this area. Pending further clarification, new split-dollar arrangements should be structured in a manner that is reasonably consistent with the IRS's position, and existing split-dollar arrangements should be examined so that alternatives can be considered in case additional grandfathering protection is not forthcoming.
