New split-dollar life insurance arrangements probably will be rarer than South Florida snow storms, and existing split-dollar plans may need to be modified or terminated, now that the Internal Revenue Service finally has announced a workable plan to tax the economic substance of these deals.
Notice 2002-8, which the IRS issued in January, removed most of the uncertainty that the Service created last year when it offered guidance that provided too many options. (See “IRS Bares Teeth At Equity Split-Dollar Plans” in the June 2001 issue of Sentinel. The article is available at www.palisadeshudson.com .
In most split-dollar arrangements, an employer agrees to pay most or all of the premiums on a whole or universal life insurance policy. The employee pays nothing or a small portion of the premium, representing the value of the term insurance cost, and only pays tax on the value of any employer-paid term insurance cost. Meanwhile, the employer’s premium payment above the term insurance cost allows the policy to build cash value. At the end of the arrangement, known as “rollout,” the employer is generally reimbursed for the premiums it has paid, and any excess cash value (or death benefit, if the employee has died) belongs to the employee or employee’s beneficiaries. Rollout generally occurs when the employee retires or otherwise leaves the company, or dies.
Here is how the IRS expects the regulations that it will issue under notice 2002-8 to treat split-dollar life insurance arrangements:
Employer-Owned Policies:
If the employer owns the policy, the employee will be taxed each year on the value of the employer-paid term insurance cost. The employee also will recognize taxable compensation income on the policy’s cash value buildup when the policy is transferred to the employee at rollout or as other benefits become available to the employee.
If the arrangement was established before Jan. 28, 2002, the employer may continue to value the term insurance benefit provided to the employee using the so-called “P.S. 58” rates mandated back in the 1960s. Employers may also continue to use the insurer’s lower published one-year term rates, without restriction, until the regulations’ effective date, when new valuation guidelines will be provided. However, for arrangements established on or after January 28, 2002, the insurer’s one-year term rates can be used until 2004, at which point restrictions may make these rates unavailable. If the insurer’s one-year term rates are unavailable, employers must use higher Table 2001 rates to value the employer-paid term insurance benefit.
Employee-Owned Policies:
If the employer is entitled to reimbursement for premiums paid on an employee-owned policy, the premiums paid by the employer are treated as a series of loans to the employee. If the employer is not entitled to be reimbursed, the payments are treated as taxable compensation to the employee when paid. Rather than recognize taxable income based on the value of the insurance protection provided, the employee will have taxable income for any “imputed” interest not paid to the employer.
Recognizing that it does not provide clear guidelines for calculating the imputed interest income to the employee, the notice provides that the IRS will not challenge good-faith efforts to account for and report the premiums as a loan arrangement since inception. While the rollout date and thus the appropriate applicable federal interest rate may be uncertain in most arrangements, parties should use a rate that is consistent with the arrangement’s intent.
But what about pre-existing employee-owned policy arrangements that have not been treated as below-market or interest-free loans from the employer? The parties have until Jan. 1, 2004, either to roll out the arrangement or to treat employer-paid premiums since inception as loans. Otherwise the employee will recognize a taxable transfer of the policy’s cash value.
