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IRS Takes Shot at Split-Dollar Life

Riddle: What kind of rifle should a blind hunter use? A loud one. If he misses the target, maybe he can scare it to death.

Some recent pot shots by the Internal Revenue Service against a popular planning technique, “split-dollar” life insurance, recall our blind hunter. It may not matter that the Service seems to be firing in the dark. Split-dollar life has always been something of an adventure, so the IRS shooting spree may be enough to send more cautious buyers scrambling for the exits. Those who remain should worry that eventually the hunter’s aim will get better.

Split dollar has been around for decades. It is not, as some believe, a particular type of life insurance; the policies are nearly always plain-vanilla whole or universal life. Split dollar is an arrangement that governs who pays the premiums for those policies. As the name implies, the cost is typically split between two parties, generally an employee and his or her employer.

Too often, in my experience, split-dollar arrangements are proposed simply because people seem more willing to write a big check for insurance premiums against their company’s account than they are to pay the same premiums from their own pocket. In these cases split dollar is just an agent’s tool to sell a large policy that may or may not be justified. However, in some situations, split dollar can be a significant tax saver, and that is what is attracting renewed attention from the Service.

Human Resource Manager’s Friend
One of the most popular forms of split dollar these days is called “equity split dollar.” Generally, the employee or a related party (such as a trust the employee establishes for his family) acquires a large cash-value (whole or universal life) insurance policy on the employee’s life. The employee or other owner of the policy simultaneously enters into an agreement with the employer. The employer will pay most or all of the policy premiums as long as the employee remains with the company. At the employee’s departure or death, the company recovers the premiums it has paid from the policy’s cash value or death benefit. If the employee has stayed with the employer long enough to be vested before leaving, the employee gets to keep any cash value (the policy’s “equity”) in excess of the premiums that must be returned to the employer.

Human resource managers like this plan because it provides an incentive for talented young executives to stay with the company. Executives like it because it can provide a hefty death benefit to protect their families in the short term, while allowing them to accumulate substantial cash value in the policy over the long term.

Most tax aspects of this arrangement were settled by a pair of IRS rulings issued in the 1960s. Rev. Rul. 64-328 held that if the employee contributes none of the premium he or she must pay tax on the current value of the death benefit, which is the cost of an equivalent amount of term insurance. Since cash-value insurance premiums are much higher than term, the employee avoids paying income tax on the remainder of the premium paid by the employer. Many split-dollar deals require the employee to contribute an amount equal to the term insurance cost, so the employee pays no tax at all on the employer contribution. Rev. Rul. 66-110, issued two years later, established that if a company’s standard term insurance rate is lower than the rates published in IRS tables, the employee need pay only the smaller amount to avoid income tax.

So far, so good. The firestorm erupted in January of this year when the Service released TAM 9604001, a technical advice memorandum written to help an agent who was auditing a taxpayer’s equity split-dollar arrangement. The TAM asserted that all the rules set out in the 1960s-vintage revenue rulings still apply, and then proceeded almost without explanation to change the result. Besides paying tax on the term-insurance value of the death benefit, as the old rulings required, the new TAM said employees should be taxed on any annual increase in the policy’s cash value except for amounts that would revert to the employer. In other words, the TAM said, the buildup of “equity” in equity split dollar life insurance is a taxable event.

The insurance industry was aghast. After all, Section 72 of the tax code says that the annual increase in an insurance policy’s cash value is not taxed until it is actually withdrawn from the policy. The TAM did not even mention Section 72, let alone explain how it could disregard this section to reach its conclusion. The TAM instead asserted that under Section 83, the increased cash value is a taxable “transfer” to the employee. Insurers pointed out, logically, that nothing is being transferred because the employee or his surrogate own the policy and its cash values at all times. The only transfer from the employer to the employee is the cash for paying the premiums, and this has always been non-taxable because the employer has the right to recover those premiums later.

Soothing Statements, Little Comfort
Some insurers have issued soothing statements in the wake of the TAM. IRS officials have privately told the industry that this memorandum did not receive high-level review and therefore may not reflect agency policy. As with any TAM, it is not binding on taxpayers outside the case in which it was issued, and it has no force of law or precedent. Thus, say these insurers, clients should take the TAM into account but with a large grain of salt.

This may be so, but I believe there is an element of wishful thinking here. Even before TAM 9604001 was released, the IRS was publicly looking for an avenue to tighten the rules on split dollar. In Young v. Commissioner, T.C. memo 1995-379, the IRS made arguments very similar to those it set out in the 1996 TAM. The IRS won the case on other grounds in the Tax Court, and the case presently is on appeal in the Eleventh Circuit.

The Service also has other bullets in its pouch. It has never opined on whether Section 7872, which Congress enacted in the 1980s to crack down on loans with below-market interest rates, applies to split-dollar programs. Most split-dollar arrangements are, economically, an interest-free loan from employer to employee, so the IRS may have a good argument that the subsequent legislation changed the 1960s-vintage rules governing split dollar.

Also, most split dollar arrangements eventually end in a “roll-out.” This occurs when the employee leaves the employer, repays the employer’s premium contributions (often by borrowing against the insurance policy), and keeps the policy. Does the termination of the employer’s interest in the policy result in a taxable Section 83 “transfer” to the employee? Nobody knows, because the courts and the IRS have never ruled on this point. But this is exactly why many advisers, myself included, prefer the approach cited in TAM 9604001, in which the employee or his designate has legal ownership of the policy at all times in order to weaken the argument that a “transfer” has occurred.

Some experts are suggesting that the threat of TAM 9604001 can be avoided by various devices, such as avoiding policies that build up large cash values. Spot the tree, miss the forest: These policies are usually a bad deal economically.

Would I recommend that a client consider a split-dollar arrangement today? If the client hates to get into controversies with the IRS, probably not. This issue is clearly in the Service’s sights, even if the Revenue folks can’t seem to get the cross-hairs lined up yet. For a more aggressive client in the right situation, I would recommend split dollar, and soon. When the Service thinks it knows what it is doing, we can expect to see a more authoritative pronouncement that will likely have an immediate effective date. Given the problems with the latest TAM and the lenient state of the current law, this may be the last big window of opportunity for split dollar deals.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.