United States: Split-Dollar Life Insurance Significant Changes In Store For The Future

"Split-dollar life insurance" is a widely used method of providing death benefit coverage, primarily to executives. After decades of scant formal guidance on the issue, the Internal Revenue Service has issued two major announcements on the tax treatment of split-dollar in the past two years. New guidance on split-dollar arrangements was issued early in 2002 and the IRS is promising to issue proposed regulations soon. This article describes the structure of split-dollar arrangements, the advantages that such arrangements provide to employers and employees, and the changing position of the Internal Revenue Service regarding the tax consequences of such arrangements. Although split-dollar insurance arrangements can be made between private individuals, the article focuses on the use of split-dollar in the employment context.

Split-dollar insurance is not a special type of policy, but rather an arrangement that "splits" the benefits payable under a life insurance policy, and often the premiums paid for the policy, between two parties. Under a split-dollar arrangement, an employer pays all or part of the premiums, and the employer and employee "split" the death benefits that are payable under the policy. Usually the employee is the individual insured under the policy; i.e., the person whose death will trigger the payment of death benefits. Sometimes the policy is a so-called "second-to-die" policy, with death benefits paid upon the last to die of the employee or spouse.

Repayment to the employer occurs at death or surrender of the policy. Depending on the agreement, the employer will be entitled to at least the amount of premiums that it has paid with respect to the policy; the employee’s beneficiary receives the rest. In many cases, the employer is entitled to the greater of the premiums it has paid or the cash surrender value in the policy. Thus, split-dollar arrangements are essentially a means for employers to finance life insurance benefits for employees; the employer is repaid its costs when the death benefits are paid or the policy otherwise terminates.

Split-dollar arrangements are generally evidenced by a separate contract between the parties, as well as by provisions in the insurance policies used to fund such arrangements. There are two general methods of dividing the rights of the parties in split-dollar arrangements; the "endorsement method" and the "collateral assignment method."

The division of the premiums to be paid by each party varies, often based on the tax consequences desired by the parties. In some cases, the employer pays the entire premium. In a commonly-used arrangement, the employee pays the amount of premium equal to the amount of income that would be imputed to him under the tax law. Depending on the applicable guidance from the Internal Revenue Service ("IRS" or "Service"), which, as discussed below, has changed throughout the years, an employee that pays a premium equal to the imputed income might avoid any current income tax.

Split-dollar arrangements often provide that when an employee terminates employment or retires, the arrangement will end and the policy will be "rolled out" to the employee so that the employer no longer retains an interest in the policy. The rollout can be accomplished by a sale or a transfer of the employer’s interest in the policy. Sometimes any excess cash value in the policy is used to finance the rollout. The income tax consequences of the rollout depend in part on the type of arrangement used by the parties, and on the applicable IRS guidance.

Employers and employees have found split-dollar arrangements to be an attractive part of a benefit package for a number of reasons. The arrangements are sufficiently flexible to accommodate a variety of circumstances. Moreover, unlike group-term policies, the employee can enjoy an ownership interest in the policies; this became a particularly attractive feature once cash value policies and so-called "equity" split-dollar began to be used. Split-dollar arrangements are often seen as a relatively inexpensive way for employers to provide significant insurance benefits to employees, since the employer will be repaid. Thus, the only cost to the employer is the time value of the money lost between the date the premiums are paid and the date the employer is repaid.

Split-dollar arrangements also enjoy significant tax advantages. First, life insurance in and of itself enjoys the built-in tax advantage of tax-free earnings ("inside buildup"), so that any funding arrangement that can use life insurance enjoys that benefit. Second, unless certain provisions in the Code apply, such as the "transfer for value rule" of section 101(a)(2) of the Code, the death benefits received by the policy beneficiary will be tax-free. Also, until recently, under IRS guidance, split-dollar arrangements could be structured so that the employees receiving employer-paid insurance coverage were taxed at a low rate relative to the amount of death benefit protection they received; as discussed below, future IRS guidance may limit this benefit.

The usefulness of split-dollar arrangements depends in large part on their tax treatment. The challenge faced by parties using such arrangements was initially the lack of guidance as to the tax consequences of split-dollar. Over the past few years, however, the Service has become much more vocal in explaining its views on these arrangements. However, these views have not been expressed in the formal regulatory process and have in fact changed. Fortunately, in most cases, the Service has recognized that parties have planned their compensation packages with its previously-expressed views in mind and has allowed certain arrangements to be "grandfathered" under prior guidance. No matter what guidance currently applies to a product used by the relevant parties, however, it is important for persons using split-dollar to understand the history of the IRS guidance on this subject, particularly when they are reviewing letter rulings or other prior guidance that may be based on an IRS position or tax law that has changed.

Originally, the Service characterized the employer's payment of premiums under a split-dollar arrangement as an interest-free loan to the employee in an amount equal to the premiums paid. Rev. Rul. 55-713, 1955-2 C.B. 23, revoked, Rev. Rul. 64-328, 1960-2 C.B. 11. Rev. Rul. 55-713 preceded the enactment of section 7872 of the Internal Revenue Code ("Code") in 1984. Section 7872 taxes employees on the deemed interest that would be paid on an otherwise low-interest loan; it specifies the method under which employers must determine the proper interest to be charged for a "market rate of interest loan," and provides specific guidance as to how employers calculate any forgone interest on a loan that is deemed to charge a below-market rate of interest. Prior to the enactment of section 7872, the Service had tried unsuccessfully to tax employees on an imputed interest in connection with a no-interest loan from an employer. See Dean v. Commissioner, 35 T. C. 1083 (1961), nonacq., 1973-2 C.B.4.

In 1964, the Service departed from the characterization of split-dollar arrangements as interest-free loans and adopted instead the so-called "economic benefit" approach. This approach did produce some amount of income to the employee. In Rev. Rul. 64-328, 1964-2 C.B. 11, the Service ruled that the effect of a split-dollar arrangement is to provide an economic benefit to the employee measured by the value of the annual term life insurance protection. The amount of the economic benefit was measured as the cost of the term life insurance that would provide such a benefit. The Service said that the cost was to be measured by using its one-year term rates, known as the "P.S. 58 rates," named after an old IRS ruling which used these rates in another context. In addition, the 1964 Ruling made it clear that the death benefit received under the policy was to be excluded from the beneficiary’s gross income under section 101(a)(1) of the Code.

Rev. Rul. 66-110, 1966-1 C.B. 12, amplified the 1964 Ruling. In Rev. Rul. 66-110, the Service stated that the cost of the term insurance to be included in the employee’s income could be measured by the use of the insurer’s own rates, if such rates were those generally available to standard risks. Revenue Ruling 66-110 also stated that any policy dividends received by the employee were also included in the employee’s income.

The policies in the 1964 and 1966 rulings were endorsement-type policies in which the employer owned the policy and assigned part of the death benefit to the employee, retaining an amount sufficient to reimburse the employer for premiums paid. However, the Service specifically noted that its analysis would apply whether the endorsement or collateral assignment system (employee owns the policy and assigns a portion of death benefit to employer) is used.

The Service did not provide any official guidance as to the tax treatment of split-dollar arrangements upon rollout (i.e., termination of the split-dollar arrangement). In two private letter rulings, the Service did make it clear that the employee would be taxed to the extent the cash surrender value received at rollout exceeded any amounts contributed by the employee. See Priv. Ltr. Rul. 8310027 (Dec. 3, 1982) and Priv. Ltr. Rul. 7916029 (Jan. 17, 1979). Although it could be argued that under the collateral assignment method, there is no transfer to the employee and thus no "rollout," individuals at the Service appear to have taken the position that the employee’s interest in the cash value has been transferred in this case. This question has yet to be officially resolved.

Generally, there are no gift tax consequences to a split-dollar arrangement between an employer and employee. There may be gift-tax consequences, however, if an employee assigns his rights in the split-dollar policy to a spouse or trust. In that case, it would appear that the employee would be making a gift of the value of the term life insurance to the third party. See Rev. Rul. 78-420, 1978-2 C.B. 67. The proceeds received by the employee’s designated beneficiary will be included in the employee’s gross estate for estate tax purposes if the employee has "incidents of ownership" in the policy at the time of death. Code § 2042(1). Although a discussion of estate taxes is beyond the scope of this article, financial and tax planners have suggested a variety of ways to minimize this tax.

Many employers have developed variations of the rather "traditional" methods of split-dollar arrangements described above. One variation, called "equity split-dollar," has became popular with the increased use of so-called "cash value" policies, i.e. policies that are structured and priced so that cash paid to the insured exceeds the cost of term insurance, thus leaving excess "cash value" in the policy. Under this arrangement, the employee receives some interest in the cash surrender value of the policy. This stands in contrast to the traditional arrangement, whereby the employer receives as a repayment the greater of the cash value of the policy or the premiums paid upon surrender or death.

There was little guidance as to the tax treatment of equity split-dollar until the Service issued a technical advice memorandum, T.A.M. 9604001 (Sept. 8, 1995). There, the Service ruled that the employee must include in gross income each year that a split-dollar arrangement is in force: (i) an amount equal to the one-year term cost of life insurance; plus (ii) any cash surrender buildup in the policies that exceeds the amount returnable to the employer when the arrangement terminates. The Service took the position in T.A.M. 9604001 that as soon as the cash surrender value of the policy exceeds the amount of the premiums paid by the employer, the employee would be taxed, even if the employee received no actual payments in the year.

T.A.M. 9604001 was roundly criticized by the insurance industry. An initial complaint was that it reversed a long-standing practice of split-dollar taxation based on the revenue rulings of the 1960s, although some at the Service argued that the rulings were not dispositive as to the treatment of cash value life insurance. Technical objections to the TAM were based on the argument that tax-free inside buildup in insurance policies is never taxable, and that there can be no taxable "transfer" of a policy or its proceeds until an actual transfer. It was also argued that taxing the cost of term insurance and the inside buildup in essence "double-taxed" the employee. The IRS never revoked the TAM, but it also never made any formal announcements adopting the TAM’s principles.

The IRS announced the likelihood of a major change in its thinking regarding split-dollar arrangements in Notice 2001-10, 2001-5 I.R.B. 459. That Notice set forth "interim guidance" for the taxation of split-dollar benefits that applied to both endorsement and collateral assignment split-dollar arrangements. The Notice states that, pending further guidance, in light of the rationale set forth in Revenue Ruling 64-328, and the fact that no published guidance has addressed the potential applicability of section 7872 to split-dollar arrangements, the characterization and income tax treatment of equity and other split-dollar arrangements would generally be determined under the following guidelines:

By issuing Notice 2001-10, the Service appeared to be returning to a position under which split-dollar arrangements were viewed as employer-provided loans, while providing protection to those existing arrangements treated consistently as providing annual term insurance benefits.

Notice 2001-10 nonetheless left open a number of issues. First, if the split-dollar arrangements were to be treated as loans, were there any attendant consequences at rollout or if the cash surrender value exceeded the premiums to be repaid to the employer? Arguably, the answer would be "no" because the policy would be seen as clearly owned by the employee, but the guidance was not specific on these points. Similarly, the Notice was not clear as to whether the IRS would tax the cash surrender increases in the policies under T.A.M. 9604001.

In January of 2002, the Service revoked Notice 2001-10 and issued Notice 2002-8. In Notice 2002-8, the Service stated that it intended to issue proposed regulations governing split-dollar arrangements in the near future. Notice 2002-8 provided the following guidance for the interim period.

Parties facing the decision as to how to characterize split-dollar arrangements must weigh the relative tax consequences of the alternative characterizations. The imputed interest changed for loans -- either as an item of compensation income or an interest payment that is actually charged – may in many cases be greater than the imputed economic cost of life insurance protection, particularly for younger employees. However, if rollout is contemplated or likely, the additional tax on the transfer at rollout must be considered as a cost if an economic benefit characterization is used. A non-tax issue facing employers may be corporate or other limits on loans to employees; limiting the ability to structure these transaction as loans.

The Service’s changing views as to the tax treatment of split-dollar mirrors the history of the agency’s concern with the time value of money and the development of two principles to deal with this concept. Unfortunately, it appears that guidance on split-dollar arrangements may remain uncertain for some time to come. Nonetheless, Notices 2001-10 and 2002-8 do provide a glimpse of the Service’s views on these arrangements, and give employers and employees opportunities to consider the most appropriate structure to meet their goals.