On Jan. 29, 2001 the IRS issued Notice 2001-10 in which it announced that changes were on the horizon for split dollar plans, and went on at length about what those changes might be. On Jan. 3, 2002, Notice 2002-8 was released, revoking Notice 2001-10, sort of, and again announcing that changes are on the horizon for split dollar plans.
In 1955 the position of the IRS was that a split dollar arrangement was a form of interest-free loan. In 1964 it took the position that in substance a split dollar arrangement was not a loan, but rather a means by which an employer provides an employee with taxable economic benefits. Over the last three months, rumors of a clash between Treasury and the IRS over which of these theories to apply have been resolved. The answer is both.
Notice 2002-8 promises comprehensive guidance on split dollar in the form of tax regulations. (In the pecking order of tax law, regulations are just below an act of Congress.) Most split dollar rulings have dealt with employer related split dollar arrangements. The new rules promise to address split dollar arrangements between a “sponsor” and a “benefited party.” This should include so-called private split dollar and reverse split dollar.
A long-standing principle of tax law says the substance of an arrangement and not the form controls tax treatment. Ignoring this, the Notice says the treatment of plans where an employer is the formally designated owner (usually the endorsement form) will be different from that accorded to arrangements where the employee is formally designated as the owner (collateral assignment form). Plans of the latter type may be treated as loans.
Conversion from economic benefit treatment to loan treatment has often been viewed as an exit strategy for older split dollar plan participants, who face escalating P.S. 58 costs. Plans entered into before the date of publication of final regulations may convert to loan treatment as long as all net contributions of the plan employer are treated as borrowed on the first day of the year the plan is converted.
Some split dollar plans can be terminated at any time by the employer and are similar to demand loans. As a loan, this type of plan would result in annual imputed income based on an interest rate. Other plans stay in effect until death. Converting a plan of this type to a loan will result in a taxable amount in the year of conversion so substantial that conversion may not be a viable exit strategy.
Most changes will apply to arrangements entered into before date of publication of the final regulations. The value of life insurance protection such arrangements provide may be computed using Table 2001, which was published with Notice 2001-10. And if the plan covers more than one life taxpayers should make “appropriate adjustments” to the rates.
The appropriate adjustment of choice for second-to-die plans will be to multiply the Table 2001 rate for the first life by the probability of death in the current year for the second life, resulting in lower imputed income while both are alive than has been reported up until now.
Arrangements entered into before Jan. 28, 2002 are accorded special treatment. These plans may also continue to determine the value of life insurance protection by using the insurers lower published premium rates that are available to all standard risks for initial issue one-year term insurance.
This is both good news and bad news. Insurers will continue to be able to pretend that they offer term insurance to 90-year-olds at $34.65 per thousand while the Table 2001 safe harbor rate is $144.30 per thousand. But only the practice of using company rates to report income has been grandfathered. No company rates have been grandfathered.
In practice, the IRS has repeatedly determined that insurers low-ball YRT rates fail to meet the requirements of Rev. Rul. 66-110 as a measure of the value of life insurance protection under split dollar plans. The lack of additional guidance leaves split dollar plan participants in a bind. Knowing they cannot count on using insurer rates makes it risky to continue a split dollar plan until death. At age 80, $1 million of coverage results in taxable income of $12,160 using one companys rates while the safe harbor rate produces $54,560, and the spread grows geometrically with age.
Split dollar second-to-die insurance acquired to pay estate taxes becomes split dollar on a single life at the first death. It would be foolish to adopt such a plan without the insurers guarantee that its rates are valid for income reporting purposes.
Post-Jan. 28, 2002 plans will have further guidance on the use of company rates. (They actually talk in terms of before Jan. 28, 2002 and after Jan. 28, 2002, so it is probably not a good idea to start a split dollar plan this January 28.) For periods after 2003, the term rates must be made known to persons who apply for term coverage with the insurer and the product must be regularly sold to individuals who apply for term coverage through the insurers normal distribution channels.
Since compliance with these two requirements is entirely within the control of the insurer, an insurer must guarantee compliance if split dollar plan participants are to be expected to rely on the rate. In short, for all existing and future split dollar plans, the only reporting rates that a participant can count on are the P.S. 58 rates and the Table 2001 rates.
The big issue in Notice 2001-10 was tax treatment of the equity in equity split dollar. For employer sponsored plans that pre date publication of the final regulations, the IRS will not tax the equity under 83 (the transfer of property section) solely because the cash value is worth more than the employer is entitled to under the plan. This probably means that the year-to-year growth in equity will not be taxed prior to rollout, at which point it likely will be.
For sponsor/person-benefited plans, there will be no transfer of property as long as the parties continue to treat and report the value of life insurance protection as an economic benefit and this without regard for the level of economic interest retained by the sponsor. This seems to validate both private split dollar and simplified split dollar.
Finally, a pre-Jan. 28, 2002 equity split dollar plan can be rolled out before Jan. 1, 2004 without triggering tax on the equity.
Has Notice 2002-8 provided enough guidance to let us sell split dollar with confidence about the likely tax treatment? In a limited way, yes, if you do not count on using a company term rate that does not come with guaranteed tax treatment and you do plan to have the equity taxed on rollout.
, J.D., L.L.M., is an attorney and advanced planning consultant in Chatham, Mass. He can be reached via email at email@example.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, January 14, 2002. Copyright 2002 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.