What Have They Done to My Split Dollar Plan?

The Internal Revenue Service has published proposed regulations to implement significant changes in how Split Dollar plans are treated for tax purposes. With these new regulations, there are now only two kinds of split dollar plans and only two ways they will be taxed under the Internal Revenue Code.

For the first time, the IRS has given us a definition of what they mean by split dollar. For the purposes of taxation, a split dollar arrangement is one in which there is an owner and a non-owner and

1. Either party pays, directly or indirectly, any or all of the premiums due on a life insurance contract, and
2. At least one of the parties is entitled to recover any or all of premiums paid from either or both the cash surrender value and the death benefits, and
3. The arrangement is not part of a group-term life insurance plan described in Section 79 of the Code.

The IRS has even gone as far as to define the two types of split dollar. In IRS terminology the two types of arrangements are non-equity split dollar and equity split dollar and there are only two ways a split dollar arrangement will be taxed. The IRS has created two mutually exclusive taxation methods which means that any split dollar arrangement will be taxed under one or the other of the "Economic Benefit Regime" generally applicable to non-equity split dollar plans, or the "Loan Regime" that will apply to equity split dollar. Who owns the life insurance policy and who is paying for it to provide benefits to the other party will determine which regime applies.

For the purposes of the new rules, the IRS will consider the owner to be the entity so named in the insurance policy. If there is more than one entity named, the IRS will consider the first-named entity to be the owner unless each named owner controls all aspects of the portion of the policy of which it has been named as owner. In this case for the purposes of the split dollar rules, each owner will be considered to own separate policies, even though there is a single life insurance policy in place. The method of taxation depends on what benefits the owner is providing to the non-owner and what if any benefits the non-owner is providing to the owner.

The New Rules - Economic Benefit Regime

Under this approach, the owner of the contract provides to the non-owner only current insurance protection. The non-owner must report and pay taxes on the value of the benefit thus provided by the owner. The value of the insurance protections is determined by using IRS published tables or the insurance carrier's term rates and is valued annually. The most recent IRS rates are encompassed in Table 2001, published as part of IRS Announcement 2001-10. The insurance carrier's rates my only be used if strict requirements are met by the carrier. To be eligible, the term rates must be for a policy that is generally sold through the carrier's normal distribution channels. So-called "phantom" term rates will no longer be accepted as the valuation for economic benefits provided by a split dollar arrangement.

This regime preserves the treatment of classic endorsement split dollar plans. The following examples will show the taxation of a split dollar plan under the economic benefit regime.

Death Benefit Only To Non-Owner

Assume an employer that provides one of its employees with a promise of $1,000,000 in death benefits if that employee should die prior to retirement. To secure that promise, the employer purchases a $1,000,000 life insurance policy and pays all premiums and gives the employee the right to name a beneficiary for the agreed upon death benefit. Other than control of $1,000,000 of death benefit through the designation of the beneficiary, the employee has no other rights in or control over the policy. All cash value remains under the sole control of the employer.

The employer will be considered the owner and the employee the non-owner. Each year, the IRS will consider the owner to have transferred to the non-owner the value of the death benefit using the appropriate term rates. The amount of the death benefit provided will be the excess of the average death benefit during the year over the amount payable to the employer. In the simplest approach the value will be the total death benefit, less any cash value controlled by the owner, multiplied by the term rate per thousand. Both the owner and the non-owner will be responsible for reporting this benefit. Presumably, the employer will need to generate a 1099 for the value of the benefit.

Death Benefit And Control Of Some Cash Value To Non-Owner

In this case the employer will pay all premiums and be entitled to receive its premiums paid at the earlier of the termination of the agreement or at the employee's death. The employee has the right to name a beneficiary for the $1,000,000 death proceeds and had the right to access any cash value accruing to his/her account that exceeds the owner's claim.

The employer will be considered the owner and the employee the non-owner. As in the first example, the IRS will consider the owner to have transferred to the non-owner the value of the death benefit using the appropriate term rates. The amount of the death benefit provided will be the excess of the average death benefit during the year over the amount payable to the employer. The value will be the total death benefit, less any cash value controlled by the employer, multiplied by the term rate per thousand. However in this case the non-owner is receiving an additional economic benefit. Since the owner is entitled to its premiums, but not the entire cash value, the non-owner will have access to cash value at the time the value in the policy exceeds the owner's claim. According to the regulations, the cash value is determined without regard to any surrender charge or any other similar adjustment. Thus the non-owner will have to report the value of the death benefit plus the cash value to which the non-owner has access to the extent that the cash value was not reported in previous years. This effectively includes in the non-owner's income the increase in gross cash value each year, less any increased claim due to a premium payment by the owner. The cash value accruing to the non-owner will not be subject to the economic benefit calculation since the non-owner will have reported the cash value as a taxable quasi-distribution each year.

Termination Of Agreement By Death Of Insured

Under the provisions of the new regulations and the Internal Revenue Code, in these two examples, all death proceeds will be received income tax free.

Termination Of Agreement By Reasons Other Than Death

The most likely circumstance in this case is where the employee has reached the end of the time during which death benefits would be paid. As the owner of the contract, the employer can select from various options to end the agreement. The following will examine those options for the owner and the taxation of both the owner and the non-owner.

Surrender the life insurance policy

In this case the owner would report taxable income to the extent that the surrender value exceeds premiums paid. The non-owner would have no reportable taxable income, and continue the contract with continuing premium payments. Under this option, the owner would cancel any beneficiary designation and any control over death benefits held by the non-owner. The policy would be transformed into key executive coverage and the owner would ultimately receive death benefits free of income tax. The non-owner would have no reportable taxable income.

Discontinue Split Dollar

The consequences would be identical to option 2 above. The owner would cancel any beneficiary designation and any control over death benefits held by the non-owner. The policy would be transformed into key executive coverage and the owner would ultimately receive death benefits free of income tax. The non-owner would have no reportable taxable income.

Transfer ownership to the employee

In this case, the employer would receive a tax deduction for the cash surrender value at the time of the transfer. The employee would report and pay taxes on the cash surrender value and be responsible for any future premium payments. The employee's basis in the policy would be equal to the value on which taxes were paid. At death, benefits would be received free of income tax.

Surrender the life insurance policy

Since in this set of options the employer would be getting back premiums paid, there would be no taxable event to the employer. However, in these cases the employee may have a cash value interest in the policy. Any increases in cash surrender value reported in previous years would not be taxed at surrender. Thus at surrender the employee would only be taxed on the cash value growth attributable to the final year of the policy before surrender. If the surrender value received by the employee were less that previously reported increases, there would not be a tax loss to the employee. Discontinue Split Dollar and continue the contract with continuing premium payments.

As long as the employer remains the owner, the employee would have a reportable taxable event as his or her portion of the cash value grew each year. If the owner cancels any beneficiary designation and any control over death benefits held by the non-owner, the non-owner would have no reportable economic benefit costs. This appears to be an impractical resolution since the employee would have taxable events each year the cash value increased but without a death benefit interest.

Discontinue Split Dollar and continue the contract with no continuing premium payments.

The consequences would be identical to option 2 above and just as impractical.

Transfer ownership to the employee

In this case, the employer would receive a tax deduction for its claim against the cash surrender value at the time of the transfer. This amount would be equal to premiums paid. The employee would report and pay taxes on this amount. The employee's cost basis in the contract would be the amount on which taxes were paid (the sum of premiums paid by the employer) plus any previously reported cash value increases. In essence the employee's cast basis would be at least equal to the surrender value at the time of transfer. At death, benefits would be received free of income tax.

The New Rules under the Loan Regime

Under this approach, the non-owner of a life insurance contract provides to the owner current insurance protection and other economic benefits. The typical arrangement is one in which the non-owner pays premiums subject to a claim against both cash value and death benefits. The proposed regulations refer to this arrangement as "equity split dollar" because of the control by the owner of cash values created through premium payments of the non-owner and this regime would affect both collateral assignment and reverse split dollar arrangements.

The proposed regulations establish tax treatment for this kind of arrangement. In basic terms, the payment of premiums by the non-owner is to be considered a series of loans from the non-owner to the owner. As loans, the payments may be subject to the below-market provisions of the Code, including the distinctions between "term loans" and "demand loans."

Most split dollar arrangements call for the premiums to be repaid either at death of the insured or upon surrender of the contract. Under the proposed regulations, this would be considered a "split-dollar term loan" whose term is determined by the life expectancy of the insured. A "split-dollar demand loan" would be characterized by a requirement that the loan be repaid upon demand of the non-owner who paid the premiums.

If a split dollar agreement is executed without a stated interest rate, the loan is by definition a "below market" loan and may be either a demand loan or a term loan. If the agreement contains a stated interest rate, the loan will be considered "below market" if

1. for a demand loan the stated interest rate is less than the blended annual rate published by the IRS in July of each year, or
2. for a term loan the present value of future payments is less than the amount of the loan, with the present value calculated using the appropriate (short-term, mid-term or long-term) Applicable Federal Rate (AFR).

In split dollar arrangements to which the loan regime applies, the payment of the premium by the non-owner is considered a loan to the owner. If the loan is a "below market" loan, any foregone interest is treated as being transferred from the non-owner to the owner and then retransferred as interest from the owner to the non-owner. The regulations provide that if the owner is an employee of the non-owner the transfer of foregone interest is a compensation-related transfer and subject to income tax. In addition, the transfer of the interest back to the non-owner is not deductible for income tax purposes because it is associated with the purchase of a life insurance contract under Section 264. There are no provisions in the regulations for any "de minimus" exceptions.

These new regulations radically change the tax treatment of "collateral assignment split dollar" and "reverse split dollar" arrangements. In both arrangements, the employee is typically the owner of the life insurance contract and the employer is the non-owner and premium payer. These arrangements clearly fall under the loan regime and the following will analyze the tax consequences to the owner and non-owner under the new loan regime.

Collateral Assignment Split Dollar

In this type of arrangement, the employee typically assigns both a cash value and a death benefit interest to the employer who pays premiums. Assume that there is no stated interest rate and that the employer's claim will be satisfied at the earlier of the death of the employee or at his normal retirement age of 65. The employee is 40 years old.

The first step is to determine if the loan is a demand or term loan. Since there is no provision for the employer to be repaid upon demand, the loan will be considered a term loan. The next step is to determine the term of the loan to establish which AFR will be used. The employee's life expectancy is approximately 37 years and there are 25 years to retirement age, so the long-term AFR will be used.

The next step is to determine if the loan is below market. Since there is no stated interest rate and no schedule of repayment until retirement or death, the present value of the $0 scheduled repayment is $0 and therefore less than the amount of the loan. Thus the loan is a below market term loan for the purposes of the new loan regime.

The final step is to determine how much is taxable to the employee. Under the provisions of the new regulations, the owner must recognize as taxable income the difference between the amount of interest that would have accrued at the relevant AFR and the amount of interest that actually accrues. Since there is no stated interest rate the taxable amount will be the amount of the premium payment multiplied by the applicable AFR. Assuming the long-term AFR is 6% and the premium payment is $10,000, the consequences are as follows.

1. Each $10,000 premium payment by the non-owner will be considered a loan to the employee.
2. The employer will need to report $600 of imputed interest to the employee as of the last day of the tax year.
3. The employee will owe ordinary income tax on $600.
4. Each subsequent year the employer will have to report the current year's imputed interest which will include that year's imputed interest plus all imputed interest costs from previous years. For example, after the second premium payment, the foregone interest will be $600 from the current year and $600 from the previous year for a total of $1,200, all of which will be imputed to the owner.
5. The employee will owe ordinary income tax on the imputed interest reported by the employer.

As you can tell the imputed interest to the employee will increase each year by the AFR multiplied by the premium payment for that year. But the total imputed interest each year will be the AFT multiplied by all previous premium payments by the non-owner.

Reverse Split Dollar

In these arrangements, the employee is typically the owner with death benefits and cash value assigned to the employer. The assigned amount is typically a specific death benefit amount plus any pre-funded PS 558 costs not yet expensed by the employer. Clearly this arrangement is similar to collateral assignment with the difference being the amount of death and cash value assigned to the employer. As a consequence, the loan regime will look at a reverse split dollar in the same way as a collateral assignment split dollar. The same rules will apply and the employee will have to report all foregone interest on the premium payments by the employer as taxable income each year. The significant advantage to Reverse Split Dollar has been the higher equity growth for the employee with minimal tax consequences.

Options For Split Dollar Arrangements Under The Loan Regime

As mentioned above, all parties to any "equity" split dollar arrangement will need to analyze the options available under the proposed regulations. This includes every collateral assignment and reverse split dollar arrangement and choices will need to be made by December 31, 2003. The following will explore the options available under both collateral assignment and reverse split dollar arrangements.

Collateral Assignment And Reverse Split Dollar

Every collateral assignment or reverse split dollar arrangement faces the following three options:

1. Terminate the split dollar arrangement
2. Continue the split dollar arrangement with no changes
3. Recast the split dollar arrangement into some other form

Terminate The Agreement

In most collateral assignment split dollar arrangements, the employer (the non-owner) will have some economic claim against the death benefit and cash value of the underlying policy. To terminate the arrangement, the employer's interest must be satisfied and the agreement terminated by revoking any assignment of policy benefits. The employer's interests can be satisfied in one or more of three ways:

1. The employee can pay cash to the employer, or
2. The employer can make a withdrawal from the policy, or
3. The employer can forgive its claim against the policy.

If the employee pays off the employer in cash, there are no tax deductions and the employer replaces a claim against the policy cash value with cash. Similarly, if the employer withdraws cash from the policy, it replaces a claim with cash. If the employer forgives its claim, the employee must report that forgiveness as taxable income and the employer gets a corresponding deduction.

The payoff of the employer can actually involve more than one of these options. For example, assume the employer has a claim of $50,000 against the policy, having made five $10,000 premium payments. Also assume the policy has $55,000 of surrender value and $85,000 of accumulated value. Obviously if the employer withdraws $50,000, there may not be enough value in the policy to support it without ongoing premium payments from the employee. However, the employee could pay the employer $20,000, leaving $30,000 to be satisfied. The employer could withdraw $15,000 from the policy and forgive its claim for the balance of $15,000. The end result is that the employee would pay $20,000 in cash and pay tax on $15,000, the amount of the employer's claim that was not satisfied with the cash payment and withdrawal. Under the proposed regulations the employee would owe tax on the forgiven claim ($15,000) but not on $70,000 of accumulated cash value that would remain in the policy.

Continue The Split Dollar Arrangement.

As discussed above, if the split dollar arrangement remains in place, as of January 1, 2004 all premium payments, both prior and ongoing, will be treated as loans from the non-owner to the owner, and the owner must report imputed loan interest. Under this set of assumptions, the employer would have to report the foregone interest to the employee and the employee would then owe taxes on his/her 2004 income tax return. Since most split dollar arrangements have no interest rate connected to them, the reported interest would be the AFR multiplied by the total loans. The prior premium payments that are recharacterized equal $50,000 and assuming a 6% AFR, the imputed interest to the employee would be $3,000 plus 6% of any future premium payments made by the employer. While this tax cost may look appealing, the employer's claim remains against the policy, so the employee is paying at least $3,000 per year plus 6% of any future premium payments and still must repay the employer at death or cancellation of the split dollar arrangement.

Recast Arrangement Into Some Other Form

This option must be examined carefully. One option is to recast the collateral assignment arrangement into an endorsement split dollar arrangement. To accomplish this end, the policy ownership would be transferred to the employer, thus making the employer the owner and the employee the non-owner. The employer would then grant the employee control over some portion of the death benefit but retain all interest in the cash value. This change would thereby make the arrangement subject to the economic benefit regime. Under the proposed regulations, the employer would report the value of that benefit to the employee and the employee would pay income tax on the value of the benefit.

There are some complicating factors to this option. If the employee is a shareholder in the employer, the transfer of the equity interest of the employee could be a contribution of capital to the employer, thus raising the employee's basis in the employer. This transfer would also be an exception to transfer for value rules, thus preserving the tax-free receipt of death benefits. If the employee is not a shareholder, the treatment of the transfer of the equity interest is not clear. It would be a transfer for value and cause part of the death benefits to be subject to income tax at death. However, if the employee receives stock in exchange for the equity, the transfer would represent a contribution of capital and thus establish an ownership interest and basis in the employer. Because the employee would be a shareholder, the transfer would be an exception to transfer for value rules and thus preserve the tax-free receipt of death benefits.

One of the most significant requirements in the proposed regulations is that the parties involved are both responsible for accurate reporting to the Internal Revenue Service of the financial consequences of the arrangement. The apparent result of this requirement is that each year the employer, whether in the role as owner of non-owner, must report the value of any economic benefit transferred to the other party. This will place a significant reporting burden on the employer. Because of this requirement, many employers who participate in split dollar arrangements may look to recast the arrangement into something other than a split dollar arrangement.

Recast Arrangement Into Non-Split Dollar Arrangement

The basic objective of a split dollar arrangement has always been to have the employer pay for benefits provided to the employee. These benefits may be death benefits only, or some combination of death benefits and cash value. Under the proposed regulations, the tax consequences of some split dollar arrangements are more significant than before, and the reporting requirements are more demanding. This may lead the parties in a split dollar arrangement to examine other alternatives. The following will discuss some of these alternative benefit arrangements and describe some of the steps necessary to transform the split dollar arrangement taxed under the economic benefit regime and the loan regime.

Deferred Compensation

Deferred compensation arrangements are typically structured so that the employer makes an unsecured promise to an employee to pay certain benefits. In most circumstances, these benefits take the form of a death benefit if death occurs prior to some specific date, or supplemental retirement benefits if the employee is still employed by the sponsor at retirement. To protect these promises, the employer will usually own, pay for, and be the beneficiary of a life insurance policy on the life of the employee. Because the promise from the employer to the employee is unsecured, a properly constructed deferred compensation agreement will not be considered a split dollar arrangement, nor will it be treated as a funded plan under ERISA. Consequently, there will be no imputed income to the employee while the agreement is in force, and the employer can be selective in who participates in such agreements.

Under provisions of the Internal Revenue Code, the employer will not be able to deduct its premium payments for the life insurance policy and will not owe current income tax on the growth of the cash value in the life insurance policy. If death occurs prior to retirement, the employer will receive the death benefits income tax free and will pay the promised benefits to the heirs of the employee. The payment of benefits will be tax deductible to the employer and taxable to the heirs. If the employee meets the requirements to receive supplemental retirement benefits, these payments will also be deductible to the employer and taxable to the recipient. The employer may then recover the after-tax cost of retirement benefits from the cash value of the policy, or from the death benefits when the employee ultimately dies.

Transform To Deferred Compensation Agreement

If the existing split dollar arrangement is an endorsement method split dollar with no cash value interest to the employee, no changes need to be made to the agreement. However, if the employee has any cash value interest, the agreement should be recast to eliminate any cash value claim in the hands of the employee. To transform a split dollar arrangement taxed under the economic benefit regime is fairly straightforward since the employer is already considered the owner. During the life of the split dollar arrangement, the employee (the non-owner) has been paying taxes on the value of the death benefit provided by the owner's premium payments. In those cases where the employee has had no access to any cash value and the employer is the owner, the following steps need to be taken.

1. The split dollar arrangement should be terminated.
2. Deferred compensation agreements should be executed.

There will be no tax consequences to either the owner (employer) or the non-owner (employee). The same steps should be taken where the employee has some interest in the cash value. Any cash value interest for the employee should be satisfied by payment from the employer, or the employee will be required to report and pay taxes on the cash value claim each year. Alternatively, if the employee is also a shareholder the cash value interest could be contributed to the employer as a contribution of capital.

Transformation To Avoid The Loan Regime

Every collateral assignment split dollar arrangement, whether true collateral assignment or reverse split dollar, will need to be carefully restructured to avoid loan regime treatment under the proposed regulations. In these arrangements, the employee is typically the owner and the employer the non-owner. As described above, if the arrangement was not changed before January 1, 2004 the employee will have to recognize and pay taxes on the foregone interest on all previous and ongoing premium payments by the employer.

To successfully avoid loan regime or economic benefit regime treatment under the proposed regulations, the split dollar arrangement should be recast into key executive insurance or to a plan of deferred compensation. If transformed to key executive insurance, the employee will give up any death benefit and cash value interest in the policy and the employer will reap all benefits. A transformation to a plan of deferred compensation will at least preserve death benefits prior to retirement and a supplemental retirement benefit after retirement. Since the employee is the owner of the life insurance policy that is part of either a collateral assignment or reverse split dollar arrangement, and the employer needs to be the owner of any insurance policy involved with deferred compensation, the following steps should be followed.

1. Any cash value interest owned by the employee should be satisfied by either payment from the employer, or by making the cash value a contribution to capital by the employee.
2. The ownership of the policy should be changed to the employer.
3. Deferred compensation agreements should be executed.

If the employer satisfies the cash value claim by paying the employee, there will be no adverse tax consequences to either party if the payment is made before January 1, 2004. If the cash value claim is considered a contribution to capital by a shareholder employee, there will be no adverse tax consequences. Once the deferred compensation agreements are in place, the employee will have no imputed taxable income, but benefits received, either death benefits or retirement income, will be taxable upon receipt.

Consequences Of Transformation To Deferred Compensation

Under deferred compensation agreements, the employee has only the unsecured promise from the employer to pay agreed-upon benefits. The employee can have no direct or indirect access to the cash value or death benefits of the life insurance policy. Many participants in split dollar agreements might not be willing to give up those benefits. In that case they must evaluate the ongoing costs of keeping a split dollar arrangement versus the unsecured promise of the employer.

In some cases, deferred compensation arrangements do not remain in force until the employee's retirement. Many agreements provide for any life insurance policy to be distributed or sold to the employee if the employee terminates employment prior to retirement. If the policy is distributed to the employee, the employer gets a deduction for the cash value of the policy and the employee recognizes the cash value as taxable income. In those cases where the policy is not transferred to the employee, the employer will either surrender the policy or continue the policy in force. Should the employer surrender the policy, it will owe taxes on any gain in the policy. Should the employer keep the policy in force, death benefits will be received income tax free upon the death of the former employee. Naturally, in this case the employer will need to know of the death of the former employee in order to claim the death benefits. Since this will cause the employer unnecessary expense to keep track of the former employee, maintaining the contract is rarely done except in the case of former shareholder employees.

Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.