What happens when you keep putting your head in a crocodile’s mouth? Sooner or later he’s going to slam his jaws shut.
Proponents of split-dollar life insurance arrangements have advocated these plans for many years despite clear signs that the Internal Revenue Service was getting hungry, or at least ornery. Now the Service has snapped at split dollar, and it looks like an even bigger bite is still to come.
In Notice 2001-10, the Service declared that a common type of split-dollar plan involving employers and employees will be taxed either as an interest-free loan or otherwise as compensation to the employee. This approach raises doubt about the economics of many existing arrangements, and probably will greatly reduce the usefulness of split dollar in the future.
Split dollar is not, as some believe, a type of life insurance policy. It is an agreement between two parties to split the premium payments, usually on a whole or universal life insurance policy. One of the most popular forms of split dollar is an “equity split-dollar” arrangement. In such an arrangement, the employer generally agrees to pay most or all of the policy premium, while the employee either pays nothing or just a small portion of the premium, representing the value of the term insurance cost. The employee pays tax only on the value of any portion of the term cost that is paid by the employer.
The employer’s premium payment above the cost of term insurance allows the policy to build cash value. At the end of the arrangement, known as “rollout,” the employer gets back the premiums it paid, without interest, and any additional cash value of the policy (or death benefit, if the employee has died) belongs to the employee or the employee’s beneficiaries. Rollout usually occurs when the employee retires or otherwise leaves the company, or dies.
Economically, the employer has made an interest-free loan to the employee. But that was not the tax treatment, at least not until Notice 2001-10.
Until this year, two 1960s revenue rulings set the ground rules for split dollar. In 1964, Rev. Rul. 64-328 provided that the employee’s annual taxable economic benefit was the cost of an equivalent amount of term insurance determined under IRS tables, commonly referred to as the “P.S. 58″ rates. Two years later, Rev. Rul. 66-110 expanded this by providing that the employee was taxable on any other economic benefits received under the arrangement. It also established that the term insurance cost could be calculated using the insurer’s published premium rate for one-year term insurance if it was lower that the P.S. 58 rates. Because the P.S. 58 rates (based on data for 1946) greatly overstated the cost of insurance, split dollar users were able to reduce the employee’s premium or tax burden by using rates provided by insurers, as allowed under the 1966 ruling.
Meanwhile, the tax laws evolved. Section 83 codified the tax treatment of transfers of property from employers to employees in 1969. In 1984, Congress enacted Section 7872 to tax below-market or interest-free loans between employers and employees as compensation. Until Notice 2001-10, the IRS refused to say whether Section 7872 applies to split dollar plans. Now it says it does.
The new notice provides that split dollar arrangements will either be treated as below-market loans under Section 7872, or as an investment by the employer in the insurance policy, followed by a taxable transfer of that investment to the employee when the employee acquires a “substantially vested” right to the equity portion of the cash value.
Notice 2001-20 also eliminates the use of the P.S. 58 rates after 2001 and applies restrictions to using the insurer’s one-year term rates after 2003, and replaces these rates with more current “Table 2001″ rates. In most cases, this will increase the amount the employee must pay for the term portion of the coverage or the taxable income he or she must report if the employer pays the entire premium.
The Service did back away, for now, from the most controversial aspect of the split-dollar issue. One of the most cherished tax benefits of life insurance is the tax-deferred growth of cash value, which generally is not taxed until the policy is surrendered. Notice 2001-10 says the IRS will not seek to tax the employee on this “inside buildup” of cash value in split dollar arrangements, at least until future guidance is issued and, even at that point, only prospectivcly.
The Service solicited comments on Notice 2001-10 and said it will issue more guidance in the future. Although the comment period expired this spring, don’t hold your breath waiting for the final word. Notice 2001-10 hints that it may not come until after 2003.
For tips on how to respond to Notice 2001-10 click on the link below:
For a related article from an earlier issue please click on the link below:
IRS Takes Shot At Split Dollar Life (Sentinel, June 1996)
