Dealing With Split Dollar Before Regulations Are Final
As lawmakers grapple with finalizing the much anticipated split-dollar regulations, agents in the field are still confused with what to do with plans currently in place.
In a workshop at this years Association for Advanced Life Underwriting meeting, Thomas Bates, vice president of sales for the Todd Organization, Greensboro, N.C., assessed the legislative and regulatory developments that impact split dollar, and gave strategies for working with current clients who are participating in split-dollar plans.
IRS Notice 2002-8 impacts all participants of split-dollar plans, he said. While it is still unknown what rules will apply to plans implemented prior to Jan. 28, 2002, the notice created some voluntary safe harbors for these plans. The potential benefits of these safe harbors should be analyzed, he said.
Further complicating matters is the recent passage of the Sarbanes-Oxley Act. This impacts directors and officers of public companies, “generally all senior officers of the company,” said Bates. The rules under the act affect loans to covered participants of a split-dollar plan. Since split-dollar plans have elements that are similar to loans, they may be impacted. And, while current balances are protected, future payments into the plan may result in a violation of the act, he explained.
The first step advisors need to take is to educate their clients on their options, Bates said. “Clients are confused right now–if theyre not then theyre just not aware of it. Its a good idea to sit down with them.”
When evaluating collateral assignment equity split-dollar plans put in place prior to Jan. 28, 2002, Bates said his organization will spend time with clients analyzing several different alternatives. First, he will consider what he refers to as a “worst case scenario–what happens if the equity in the policy gets taxed at rollout?”
Then, Bates works through the different safe harbors written into Notice 2002-8. “We look at converting to a loan, and we look at what happens if we roll the policy out before Dec. 31, 2003.”
Bates firm will then evaluate the appropriate economic benefit costs. “We look at what happens to policies that were placed prior to Jan. 28, 2002, after Jan. 28, and then what might happen if we were to write a new plan after the final regulations are out.”
To illustrate the process, Bates shared an example of a contributory collateral split-dollar arrangement entered into just prior to Notice 2002-8 becoming effective.
First, since these older plans are still allowed to use the insurers alternate term rates, he only introduces the possibility of Table 2001 being used to measure the economic benefit. “The contribution made by the client will remain the same, well just introduce Table 2001 at this point,” he said.
Next, he will walk a client through what would happen should the equity be taxed at the time of the policy rollout. The illustration Bates displayed shows the participant continuing to pay the insurers term charges and paying a large tax bill at the time of rollout several years later.
Bates then compared this outcome to converting the plan to an agreement that qualifies under the loan regime, section 7872. In this instance, “each premium payment is treated as a loan; as premium payments are made the aggregate loan amount is going to increase,” he said.
The participant will continue to make the same contribution to the plan but will be taxed on the imputed income in excess of that, he said.
Using a net present value analysis, Bates compared the loan option to the “worst case scenario” of taxing the cash value at rollout. In this example, the net present value of the costs associated with the plan under the loan regime was higher than paying the tax bill at the rollout of the plan. “Its actually more expensive to do the loan than to tax the equity,” he said. “So, youd be better off taking the risk of the equity being taxed.”
Another safe harbor option available under the Notice is to roll the policy out early and terminate the agreement. The first issue Bates sees with this is whether the policy is in a position to be rolled out. “Most split-dollar plans were designed to run around 15 years. If you roll out the policy prior to the 15th year and you surrender cash from the policy to make payment, you may trigger a forced out gain.”
But rolling out the policy early puts the company in a better position, he said. And, since the company is recovering its costs sooner than expected, there may be an opportunity to use some of those cost savings to help offset some of the benefits the participant is losing, he said.
A similar strategy to an early rollout is the use of a partial rollout. In this scenario, “well roll out about 90% of the interest in the policy,” he said. Under the language of the Notice, taking this step should keep the equity in the policy from being taxed, he said. At the time of death, the company will receive the balance of the benefit owed to it.
Even though this is an area of the safe harbor Bates has presented to clients, he hasnt seen much interest in it. “The primary reason for that is they [employers] are not comfortable tying themselves to an employee that far in the future,” he said.
But certainly in a family-owned, or privately owned company, he feels this is a viable option.
Reproduced from National Underwriter Edition, May 12, 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.