A Look At The IRSs Additional Proposed Split-Dollar Regulations

By Mark A. Teitelbaum

On May 8, 2003, the Treasury and Internal Revenue Service issued additional proposed regulations relating to split dollar. These proposed regulations amend the 2002 proposed regulations. Their primary focus is the taxation of equity split-dollar arrangements–where the cash value of a policy accrues to someone other than the premium payor.

In the preamble, the IRS states that other taxation issues will be covered in the final version of the regulations. Nevertheless, the scope of these regulations can be expansive. As with the 2002 proposed regulations, these new guidelines primarily apply to arrangements entered into after their effective date. They will, however, also apply to those arrangements that are substantially modified after these new regulations are finalized.

Taxation Of Benefits. In keeping with earlier IRS publications, these new proposed regulations attempt to tax all benefits (economic or otherwise) that are received by the insured under a split-dollar program.

First, in all split-dollar cases the value of the death benefit protection provided must be calculated. While the IRS does not state the rate that must be used to calculate this benefit, it is expected that this would be a standard rate per thousand of death benefit available to the insured under a split-dollar program.

Under these proposed regulations, the death benefit calculation is based on the average death benefit available during the course of the year, although the IRS provides no guidance as to how to calculate the average benefit (e.g., monthly, daily, etc).

Beyond that basic aspect, clients must take into account all other benefits received from the life insurance contract. This would include benefits, rights and features in a contract, such as dividends, paid-up additions, etc. More substantially, it would include the cash value increases accruing to the non-owner of the contract under an equity arrangement.

Under the new proposed regulations the increase in cash value would be calculated based on the increased stake the non-owner has in the pure cash value, over their stake from the prior year. This would be done without regard to surrender charges or other items that might reduce the cash value increase, such as loans. However, the non-owner can reduce the death benefit amount, used in the calculation, to adjust for the cash value equity that they constructively own.

There are also other potential taxes associated with equity split dollar. As with equity split-dollar arrangements prior to these proposed regulations, in a gift situation there may be gifts associated with the split-dollar program. Under these proposed regulations the gifts will include the equity increases.

Additionally, the IRS has raised the possibility of FICA and other employment taxes associated with all benefits associated with the split-dollar programs. For years it has been an open issue whether or not the economic benefit associated with split dollar is subject to employment taxes. Based on wording in these proposed regulations, it appears that the IRS clearly believes this to be the case. But in most cases this will not be a significant issue as split dollar typically is offered only to those above the FICA wage base.

Issues and Surprises in the Proposed Regulations. In addition to the ability to build a split-dollar basis through the economic benefit recognition, there are some clarifications and surprises in these proposed regulations. Also, some omissions from earlier guidelines remain unanswered by these 2003 proposed regulations.

Certainly the greatest surprise is that these proposed regulations only focus on equity split dollar under the economic benefit approach. While this would appear to be limited in its scope, it could trap unwary clients who amend their arrangements after the date of the final regulations.

By issuing these regulations with a focus on equity arrangement, a key question is: How will the IRS treat the taxation of non-equity arrangements?

One of the surprises, or lack of surprises, is any statement related to what the IRS calls “the life insurance premium factor.” This is the economic benefit rate, or what has been commonly, and mistakenly, referred to as the P.S. 58 rate. Presumably, for now, this is Table 2001, the revised rates the IRS initially introduced in Notice 2001-10 or alternate insurer rates under the stricter guidelines first detailed in Notice 2002-8. In the 2003 proposed regulation, the IRS goes on to refer to this as the rate “permitted in guidance published in the Internal Revenue Bulletin”

Presumably, the IRS left the door open for further and, perhaps, periodic rate changes, or perhaps comments in the final regulations. This is not surprising. Since IRS Notice 2001-10, the IRS actively has sought feedback on its rates and the economic benefit calculations. In its earlier pronouncements the IRS sought guidance whether to use one table (for standardization and ease) or multiple rate tables (presumably to allow for health differences).

It is, perhaps, a little surprising that the IRS continues to offer no guidance related to the calculation of economic benefits associated with multiple life policies (both first-to-die and second-to-die policies). Again, this may be addressed in the final regulations.

In earlier guidance the IRS offered statement(s) allowing for “appropriate adjustments” to its rates to accurately reflect “protection covering more than one life.” Nevertheless, many commentators sought better guidance. Just as the IRS once suggested reasonable calculations could be made to account for cash value increases in equity arrangements, only to impose a strict method in these new proposed regulations, the IRS may likely change its approach to multiple life contracts. This, however, remains to be seen.

Perhaps the greatest impact of these proposed regulations, and one where substantial comments are likely, is in the timing of the economic benefit calculation.

The 2003 proposed regulations state that all equity economic benefit calculations must be made “on the last day of the taxable year of the non-owner.” For most clients this would be Dec. 31, and it would apply to individuals and trusts where split dollar is often used for funding life insurance. For either situation, imposing a Dec. 31 valuation date is likely to have a major impact where clients wish to do some type of offset arrangement to minimize their income taxation.

If the actual economic benefit is not known until the last day of the taxable year, offsets may be difficult or impossible. For trust arrangements, where clients must often make gifts ahead of the premium due date, planning will become more difficult. In many cases, those clients will be forced to make gifts to a trust, during the weeks and months prior to Dec. 31, based on a best estimate. It also remains unclear if non-equity arrangements will fall under these same, tight timeframes.

Another impact is the longstanding issue as to whether the economic benefit derived from split dollar is subject to FICA taxation. This question has never had clear guidance, but in this years proposed regulations FICA taxation is referred to at several points when discussing split-dollar economic benefits. Presumably, this is how the IRS will treat the economic benefits derived from all split-dollar approaches and not just equity arrangements.

Effective Dates. The provisions of this set of proposed regulations will not be in effect until after the regulations are finalized. It is unclear if the Treasury and IRS intend to finalize both sets of proposed regulations at the same time (the 2003 set amends the 2002 proposals), or if the regulations will be finalized piecemeal.

Impact to Existing Arrangements. One of the key items lurking in the proposed regulations is the potential impact to existing arrangements. Because these calculations apply to split-dollar arrangements set up after the effective date and finalization of these proposed regulations, it might be tempting to say that they will be of little impact. This is because the general consensus appears to be that few individuals are likely to set up equity types of split-dollar programs after that date. For collateral assignment approaches that involved equity transfers, “Split-Dollar Loan” will control the taxation.

However, an important exception remains for existing arrangements in place prior to the effective date of these guidelines. If there is a substantial modification of these cases, the split-dollar arrangement may find its equity taxed. This could be true even of split-dollar arrangements that are thought of as “grandfathered” due to IRS Notice 2002-8.

Because the IRS has not provided firm guidance as to what constitutes a substantial modification, whether or not a change to an arrangement meets that definition is likely to be determined on a case-by-case basis. Those clients looking to modify their split dollar arrangements might wish to consider modifying them before final regulations, if they wish to avoid this issue.

As mentioned earlier, split-dollar remains a viable approach. Until the regulations have been finalized clients can still consider equity split-dollar, although they must do this with caution and a clear rollout strategy prior to the equity crossover point. Once the regulations have been finalized, clients and advisors will need to examine many variations of split dollar. Either the “Economic Benefit” approach or a “Split-Dollar Loan” approach may be appropriate depending on the specific client situation.

Although seemingly limited in their impact, these additional proposed regulations should not be overlooked. They are likely to control the calculation of split-dollar economic benefits, at least prospectively. Moreover, without careful planning, when making changes to, or planning for, existing arrangements, these regulations may control arrangements that are otherwise considered exempt.

Mark A. Teitelbaum, JD, LLM, CLU, ChFC, is second vice president of advanced sales for Travelers Life & Annuity, Hartford, Conn. He may be contacted at mark.a.teitelbaum@citigroup.com.


Reproduced from National Underwriter Edition, June 23, 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.