The Final Split-Dollar Regulations– What To Do?

In the next few months, how should agents analyze split-dollar arrangements that existed before Jan. 28, 2002?

Those are the plans that may elect transitional rules under the new split-dollar regulations. (See Treasury Decision 9092 for the complete regulations.) Decisions concerning the plans are complex, so many advisors are searching for effective strategies.

The final regulations are effective only for split-dollar arrangements established after Sept. 17, 2003. If a split-dollar arrangement is materially modified after that date, the new rules will apply to it.

Since most questions agents have about this involve what were formerly called “collateral assignment plans,” this article will focus only on those plans. (We will not address employer-owned endorsement type plans. Also, we assume that readers know the provisions of the new regulations regarding the tax treatment of employee-owned loan type arrangements.)

In a collateral assignment plan, now called “employee-owned,” the employee owns the life policy, the employer pays most if not all of the premium; the policy is collaterally assigned to the employer to secure repayment of the employers premiums; and the employee pays income tax on the value of the economic benefit (what used to be called the PS-58 cost or alternative one-year term cost).

In deciding what to do, the agent, client and attorney have different roles to play.

The agent needs to provide the attorney with an in-force ledger. As the attorney, I expect the agent to be able to show important numbers in this ledger, such as total premiums paid, current cash values, whether there is policy equity (i.e., whether the cash values exceed the amount collaterally assigned to the employer), and growth projections for the policy.

The agent also should be prepared to discuss:

–Whether the agent believes the growth projections are reasonable. While no one can predict the future, explaining how the insurer is determining interest credits lends credibility to the agent, and is another piece to the puzzle.

–Whether the policy itself is still suitable for the clients needs, or whether another policy may be more appropriate. If the policy needs to be changed, we believe that a Section 1035 exchange would constitute a material modification that would subject the split-dollar arrangement to the new final regulations.

The attorneys role is to determine the type of agreement (Employer-owned “endorsement” or Employee-owned “collateral assignment”) and what the employers interest is under that agreement. The attorney should also determine whether a transitional rule is available and how to elect it.

For pre-Jan. 28, 2002, policies, there are three choices:

One choice is to end the split-dollar arrangement before Jan. 1, 2004. In that case, the Internal Revenue Service will not pursue equity in the policy. This choice is most likely to be made if the policy has equity in it, depending on the clients needs, as discussed below.

Comment: Ending the split-dollar arrangement is different than ending the policy. To end the split-dollar arrangement, the employee must pay off the employers interest. If the policy is then surrendered, the usual rules of taxation would apply to any amount received above the employees basis in the policy. So, this transition rule applies to the split-dollar arrangement, as distinct from the policy itself.

A second choice is to elect loan treatment for premiums paid after 2003. In this case, all premiums paid by the employer from plan inception must be treated as loans. And, the IRS will not pursue any equity in the policy at time of the election. Since the employee owns the policy, equity accruing after that date would be owned by the employee and so not be subject to income tax.

Comment: With interest rates so low, loan treatment may be advantageous. For example, if total paid-in premiums are $100,000 and if the applicable federal rate is 4%, the employee will include $4,000 in income for that year. The highest federal tax rate on that income is 35% for 2004, so the tax due would be about $1,400. For older clients, this amount could be much less than the applicable one-year term rates.

The third choice is to do nothing. In that case, the old rules should continue to apply.

Comment: We do not expect the IRS to pursue equity build-up on these policies unless the equity is accessed. The employee can continue to report income tax on the value of the economic benefit.

After 2003, what rate to use for that value is not clear. Some commentators feel the insurers one-year alternative term rate can continue to be used. I believe, though, that based upon the comments it is soliciting, the IRS is moving toward a solution where all taxpayers determine the economic value based upon the same rates–so the tax treatment will be the same regardless of the carrier.

Hopefully, the IRS will not pursue pre-Jan. 28 policies in this regard. But, even if the Table 2001 rates are required, the result will be favorable to many taxpayers.

We have discussed the agents role and the attorneys role. But what is the clients role? It is to answer questions such as: “Is the purpose of the insurance still valid? Have your needs changed? If so, what are your needs now?”

Usually the purpose of the policy is for estate liquidity or retirement planning. If estate liquidity is the purpose, the policy would be kept in force until death. In that case, the client may choose not to do anything, as discussed above.

If retirement planning is the purpose, the intention is to access the equity. In that case, the client may want to elect a transitional rule, or end the split-dollar arrangement. For example, the plan could be converted to an executive bonus plan once the employers interest is paid off. Or, the client can continue under the “old” rules but with the expectation that equity will be taxed when accessed.

Another consideration is what to do if there is no written split-dollar agreement. Cases exist where the policy was put in force, but the split-dollar arrangement was never documented. It appears that many of these instances are unintentional.

In these cases, I advise the client to ask his or her accountant how the premiums were accounted for. That usually starts a discussion that can lead to many conclusions.

It may be that what the accountant thought was happening was not, in fact, happening. For example, sometimes premiums have been deducted and sometimes premiums have not been deducted but no PS-58 costs were charged to the employee. Whatever the case, my view is that these are issues the client and accountant must address. In general, unless the difference in income taxes is significant, the accountant may not want to file amended returns.

Finally, concern exists that litigation may ensue from these regulations. If the IRS loses that litigation, as some observers suggest, a client who elected a transitional rule or otherwise ended a split-dollar arrangement may have unnecessarily lost a favorable tax situation. This is impossible to predict, but it definitely is something the client should discuss with the attorney when considering whether to end a pre-Jan. 28 arrangement.

I wish there were a simple answer for how to handle all such cases. But, as shown above, the answer depends on the facts of each situation and on unpredictable events. Therefore, it is critical that each case be evaluated individually, based on input from client, advisor and attorney.

Douglas I. Friedman, a partner in the Friedman & Downey, P.C. law firm of Birmingham, Ala., is national counsel on estate and business planning for insurers. His e-mail is doug@fdatty.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, October 17, 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.