Do A Year-End Check-Up On Split Dollar Planning
Notice 2001-10 has brought change to split dollar planning. As the year begins to wind down, it is important you review these changes and understand how they impact you and your clients going forward.
Notice 2001-10 primarily focused on measuring economic benefit and taxability of equity split dollar. This article will focus on the impact on various split dollar plan designs and discuss alternatives that are available.
Measuring Economic Benefit. The IRS acknowledged in Notice 2001-10 that the P.S. 58 tables are out of date and inappropriate because they no longer provide a realistic cost of term insurance. The new Interim Table 2001 provides rates that are substantially lower than P.S. 58 rates and are based on the Section 79 group term rates.
See figure 1 for a comparison of the P.S. 58 rates and Interim Table 2001 rates.
In most situations, the new Interim Table wont have much impact initially because substitute rates–the insurer’s published one-year term rates for standard risks–can continue to be used.
It is important to keep in mind, however, that after Dec. 31, 2003 there are additional tests applied to insurers’ substitute term rates:
–The insurer must let applicants for term insurance know about this product;
–The insurer must regularly sell the coverage; and
–The insurer cant commonly sell term insurance to standard risks at higher rates
Taxation of Equity Split Dollar. Under the Notice, Section 7872 (loan treatment) or Section 83 (taxable transfer) may be used. The option selected must be consistent with how the plan is managed and the parties must have followed that arrangement from inception.
Treatment as a Loan or Series of Loans:
–Imputed income on the outstanding premium loan will be taxable to the employee.
–No additional economic benefit will be charged.
–The employee will be treated as the owner of the policy and there will not be a transfer under Section 83 of any of the cash value accruing to the benefit of the employee.
If the employee does not pay off the loan based on the agreement, taxable income will be reported on the loan amount forgiven. Even if these tests are met, there could be additional income tax on distributions based on Internal Revenue Code Section 72 or 7702.
Treatment as a Section 83 Taxable Transfer:
–The economic benefit received by the employee must be fully accounted for.
–The employer is treated as having a beneficial ownership in the policy.
–The economic benefit charge reduced by any premium payments made by the employee will be taxable to the employee.
–If dividends or similar benefits are received directly or in the form of additional policy benefits, it will also be taxable to the employee.
–The employee will be taxed for any substantially vested interest acquired in the policys cash value reduced by any contribution paid by the employee for that interest in the policy.
Under the Notice a Section 83 transfer doesnt occur simply because interest and other earnings from the policy cash value are in excess of the amounts due to the employer under the agreement. A taxable event would occur at the point the employee accesses or has the ability to have full control over the policy value.
On a positive note, in the event interest or other earnings are considered subject to Section 83 under subsequent IRS guidance and taxed each year as the value grows, taxation will only occur going forward and will not be retroactive.
Existing Equity Split Dollar Plans. The first thing to do, if you havent already, is notify your client of the interim guidance. The first step in evaluating the plan is to determine whether it should be treated as an employer loan under Section 7872 or as a split dollar. Most existing plans will fall under the split dollar rules.
A second step is to determine whether there is any employee equity. Although equity does not appear to be taxable while the split dollar agreement is in force, it may be taxable income at rollout/termination of the agreement during the insureds lifetime. Hopefully, final IRS guidance will clarify. If the current design is no longer effective for the client, tax can be paid and the plan design can be switched to a bonus arrangement.
Reverse Split Dollar Plans. Notice 2001-10 confirms the IRS is concerned that the employer’s “rent” payments for the death benefit are overstated using P.S. 58 rates. In essence, the employee is benefiting from the employers payment without being taxed. By eliminating the P.S. 58 rates, the leverage created in a reverse split dollar plan is minimized.
Going forward, the employer can terminate the reverse split dollar agreement and simply bonus the premium to the owner/employee. Another option is to continue the plan with the employer paying a smaller portion based on Interim Table 2001 and the remainder of the premium as a bonus to the employee.
Private Split Dollar Plans. Private split dollar was not specifically addressed in the Notice. In a private split dollar arrangement, the insured spouse typically gifts the economic benefit to an irrevocable trust. Based on the Notice, the gift would now be based on Interim Table 2001 or insurer one year term rates.
In most situations, insurer one-year term rates are used. If the plan design follows existing private letter rulings on private split dollar, the spouse advancing premium is entitled to receive all cash value, not just premiums advanced. In this situation, the equity split dollar guidance does not apply.
If the private split dollar plan uses an equity split dollar approach, a logical extension of the Notice would result in the equity portion being treated as a gift at rollout.
Other Planning Techniques. With all the plan design flexibility available with nonqualified plans, there are many creative ways to design a plan to meet your clients needs. Here are a couple of ideas.
Split Dollar Alternative.This approach avoids both the equity split dollar and economic benefit issues raised in the Notice. This concept can be packaged as a means for employers to provide a bonus and use a second key person policy to recover costs.
Split Dollar/Selective Executive Retirement Plan (SERP) Combination. This technique delays taxation until retirement and also provides a pre-retirement income tax-free death benefit for the employees beneficiary. It is set up as either an endorsement or collateral assignment split dollar.
Notice 2001-10 creates various challenges and uncertainties. By following the steps found in figure 2, you can meet the clients need and solidify a long-term relationship.
, JD, CLU, is director of advanced markets, Principal Life Insurance Company, Des Moines, Iowa, specializing in executive benefit planning, business succession, and estate planning. He may be reached via e-mail at West.Mark@principal.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, October 15, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.