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.
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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”