Time To Act On Split-Dollar Safe Harbor Provisions

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The good news is that the Internal Revenue Service has issued rules finalizing the previously proposed split-dollar regulations (Treasury Decision 9092 & Revenue Ruling 2003-105 ).

The final regulations provide comprehensive tax rules governing split-dollar arrangements entered into after Sept. 17, 2003, or arrangements entered into on or before Sept. 17 that are “materially modified.”

Therefore, any existing arrangements that are not modified will continue to be subject to the rules in Notice 2002-8 and other prior tax law guidance.

The bad news? The IRS declined requests from the industry to extend the Dec. 31, 2003, “safe harbor” deadline for pre-Jan. 28, 2002, equity established in Notice 2002-8.

That means financial professionals have got to get cracking, setting appointments and reviewing existing equity split-dollar arrangements with clients and their advisors.

The provisions contained in Notice 2002-8 provide considerable grandfather protection through a few “safe harbor” rules that may help avoid taxation of participant equity. Brokers should review the practical steps that must be taken to comply with the Notice before Dec. 31, 2003.

Safe Harbor #1: Maintain Arrangement Until Death. The first safe harbor rule pertains to those split-dollar arrangements entered into before the date of final regulations (Sept. 17, 2003).

It provides that as long as the value of current life insurance protection is treated as an economic benefit, the IRS will not treat the arrangement as having been terminated and will not impose income or gift tax consequences on the non-owner employees or donees share of cash values. Consequently, it appears that simply by continuing to pay the economic benefit amount until death, the tax on policy equity is avoided.

However, this also means that if the arrangement is terminated and current life insurance protection is no longer provided, the income or gift tax consequences will be imposed on the non-owners share of cash values.

Fortunately, Notice 2002-8 contains two other safe harbor rules that, as explained below, allow the parties to certain split-dollar arrangements to avoid incurring income or gift tax consequences on equity cash values.

Safe Harbor #2: Terminate Arrangement. The second safe harbor provides that for economic benefit equity split-dollar arrangements entered into before Jan. 28, 2002, under which a sponsor has made premium payments and is entitled to full repayment, the IRS will not assert that there has been a taxable transfer of equity cash values to an employee or donee if the arrangement is terminated before Jan. 1, 2004.

This important safe harbor means that pre-Jan. 28, 2002, equity split-dollar arrangements may be terminated before Jan. 1, 2004, without the employees or donees share of cash value being subject to income or gift tax.

There are no instructions in IRS Notice 2002-8 on how a pre-Jan. 28, 2002, equity split-dollar arrangement is to be terminated to achieve the desired tax results. The rights of the parties under such circumstances should, however, be dictated by the terms of the split-dollar agreement and the agreement should be examined to determine these items:

Timing requirements for the notice of termination;

Address where the notice of termination is to be sent;

Provisions for repayment of the sponsor;

Rights of the employee/donee to the policy after the employer/donor is repaid the premium advances; and,

Rights of the employer/donor to the policy or its cash or loan values if the employer/donor is not repaid the premium advances.

The termination should be preceded by the appropriate corporate resolution authorizing the action or actions to be taken.

Any debt to the employer/donor that is forgiven at termination of the split-dollar arrangement would be income or a gift to the employee/donee depending on the relationship of the parties.

Safe Harbor #3: Convert from Economic Benefit Tax Regime to Loan Regime. Notice 2002-8 provides two circumstances under which a split-dollar arrangement may be changed from the economic benefit to the loan regime to prevent equity cash values from being treated as a taxable transfer to the employee/donee on subsequent termination of the split-dollar arrangement. Those circumstances are as follows:

Arrangements entered into before Jan. 28, 2002. For economic benefit equity split-dollar arrangements entered into before Jan. 28, 2002, under which a sponsor has made premium payments and is entitled to full repayment, the parties may treat all the premium advances as loans if for all periods beginning on or after Jan. 1, 2004, all premium advances from the inception of the arrangement (less any repayments) are treated as loans entered into at the beginning of the first taxable year that the loan treatment is adopted.

Arrangements entered into before the date of final regulations (Sept. 17, 2003). For arrangements entered into before the date of final regulations the parties may treat all the premium advances as loans if all payments by the sponsor from the inception of the arrangement (less any repayments) are treated as loans at the beginning of the first taxable year in which the loan regime is adopted.

It should be noted that for arrangements entered into before Jan. 28, 2002, the loan documents should be executed prior to Jan. 1, 2004, if the desire is to avoid tax on existing equity cash value, while the second loan safe harbor does not specify a deadline for electing the loan regime. If the policy subject to the split-dollar arrangement does not contain equity on Dec. 31, 2003, it appears that the loan regime can be elected at a later date.

The Notice discusses how to convert split-dollar arrangements from an economic benefit regime to the loan regime. Notice 2002-8 states that under either of the above circumstances the parties must report the tax treatment of the arrangements after conversion to the loan regime as loans in accordance with IRC 1271-1275 and 7872. It should be noted in this regard that the original issue discount rules of IRC 1271-1275 apply to demand loans as well as term loans.

The actual steps for converting from the economic benefit regime to the loan regime would seem to start with the creation of a corporate resolution authorizing the change and then the drafting of the appropriate documents as follows:

New split-dollar loan agreement;

Demand of term note;

Collateral assignment; and,

IRS written representation letter (for a premium loan that is nonrecourse to the borrower).

In the case of nonrecourse loans, the proposed regulations indicate that the parties (lender and borrower) must file a signed written representation that a reasonable person would expect that all payments under the loan would be made.

The regulations provide that until the Commissioner prescribes otherwise, both taxpayers must sign the representation not later than the last day (including extensions) for filing the federal income tax return of the borrower or lender, whichever is earlier.

The regulations provide that the signed written representation must include the names, addresses and taxpayer identification numbers of the borrower, lender and any indirect participants.

Finally, the regulations provide that the representation be filed with the federal income tax return of the lender and borrower for any taxable year in which the lender makes a loan to which the representation applies.

Once again, the final regulations do not extend the Dec. 31, 2003, safe harbor deadline for pre-Jan. 28, 2002, equity established in Notice 2002-8. Therefore it is incumbent upon financial professionals to act to review their affected clients cases.

, JD, CLU, ChFC, is vice president, marketing, for Prudential Insurance Company of America, Newark, N.J. She can be reached at terri.getman@prudential.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, November 7, 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.