Its Time To Sell The New Loan Regime Split Dollar
As of press time, the life insurance industry awaits final split-dollar regulations from the Treasury Department. This, however, is not a reason to hold off on helping your clients.
Its time to embrace what the split-dollar proposed regulations have already offered, and help businesses and their employees effectively pay for life insurance using split dollar. It is time to offer exactly what the Internal Revenue Service is proposing–split dollar as a “loan regime.”
Whether you call this concept “Split Dollar” or simply a business loan, in this low interest rate environment it can be an attractive benefit for key employees and owners in non-public companies (public companies are not likely to make loans to key employees as a result of the Sarbanes-Oxley Act).
Forty years ago, the IRS struggled with the issue of companies helping employees pay for personal life insurance using zero interest loans. The governments concern was that even though the employee derived an economic benefit in the form of the loan, there was no way to tax the transaction. At the time, no mechanism existed for taxing low- or no-interest loans to employees.
The need to tax this transaction led to the Revenue Ruling 64-328, which defined the economic benefit as being the mortality element of the insurance benefit. Since the employee could die during the year, an economic benefit existed, and the IRS would impute the one-year mortality cost as the taxable benefit. This is the genesis of the split-dollar concept.
The overall issue of companies providing low- or no-interest loans to employees was addressed by legislation in 1986. IRC Section 7872 established that “below market loans” to employees would result in imputed income equal to a federally reported minimum loan rate. With this provision, the IRS has a means of taxing transactions involving the lending of money between employer and employee.
So now, as the Treasury and the industry struggle with a new definition and set of rules regarding split dollar, the government has a way to tax the loan element of a split-dollar arrangement. The concept of collateral assignment split dollar being viewed as a loan is embodied in the proposed regulations issued in July 2002. Since IRC 7872 is statutory law, the IRS generally wants to use the “loan regime” in collateral assignment cases in lieu of the “economic benefit” approach, the approach used for the last 40 years.
Re-characterizing split dollar as a loan can be a viable approach to situations where the employer seeks to help the employee pay for the cost of permanent life insurance. In the right situation, the loan regime is superior to the economic benefit regime in terms of tax and financial efficiency. The three primary efficiencies are:
1. Paying tax on a low imputed loan rate is better than the employee having to acquire personal funding at a higher interest rate;
2. The employee no longer has to report an “economic benefit” for the mortality aspect of the life insurance; and,
3. At rollout, the employee isnt taxed on the equity in the policy (the difference between the cash value and the premiums paid).
Depending on the nature of the loan between the employer and employee, there are different governmental interest rates that are applied. In the case of a demand loan, Section 7872 uses the Federal Blended Annual Rate. Historically, this is a very low interest rate.
Table I shows how the Blended Annual Rate has compared with a common loan interest rate, the prime rate. During the 17 years shown, the government rate has always been lower than the prime rate and, on average, the government rate has been nearly 2% less. Since, in a typical split-dollar case the employer pays the premium for the employee, application of the loan regime means that the employee pays tax on imputed interest income calculated using this low applicable federal rate (AFR). Given the current low interest rate environment, this tax is potentially small.
A number of variables affect whether the loan regime or the economic benefit regime is superior. Lets consider the following example:
A 45-year-old in the 30% tax bracket wants to purchase a $1 million life insurance policy for an annual premium of $55,000 and assumes a gross return of 10%. Assuming a 5% AFR (for the loan regime), and government Table 2001 (for the economic benefit regime), which funding method works better? See Figure 1.
Even though the cumulative cost to the employee is higher, the loan regime provides a higher retirement payout and a higher death benefit at assumed death. Although a number of variables will affect the outcome in examples like this, two fundamental issues are what interest rate will apply to loans and what rate of return will there be on the policy cash values.
There is no way to predict what interest rates will be in the future other than to know that compared with commercial lending rates, the minimum government rate should be lower. A mitigating factor to this concern is that a loan regime split-dollar arrangement is comparatively easy to unwind. If the imputed loan rate becomes too high and the parties want to terminate the agreement, there are a number of different options:
The employee can pay off the loan using policy cash values or outside funds;
The employer can forgive the loan (generating a tax to the employee); or,
The loan can be “crawled out.” A crawl out is where the loan is slowly paid off, typically using the cash values of the policy.
When a red flag was raised about equity split dollar in 1996 in the form of a Technical Advice Memorandum, some advisors shied away from split dollar. Opportunities were missed taking this approach. Now that we have the governments clear intent established, both in the form of IRC 7872 and the proposed split-dollar regulations, it is time to move forward.
The collateral assignment loan regime split-dollar transaction is a safe and viable funding alternative for business life insurance sales.
, JD, CLU, ChFC, RHU is second vice president, life and health markets at Principal Financial Group, Des Moines, Iowa. You can e-mail him at [email protected]
Reproduced from National Underwriter Life & Health/Financial Services Edition, January 6, 2003. Copyright 2003 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.