Developing A Game Plan For New Split-Dollar Arrangements
Many practitioners spent the last quarter of 2003 focused primarily on the review of collateral assignment split-dollar arrangements where there was equity in the life insurance policy. This was due to the safe harbors put forth in Notice 2002-8 allowing one to terminate the arrangement or switch to the loan regime before Jan. 1, 2004, without any income tax on the equity of the policy.
Now that this safe harbor period is over, what does the future hold for new split-dollar arrangements? We have no doubt that the need for life insurance has not been mitigated by the final regulations, and split dollar still provides useful and efficient income and gift tax leverage.
With this in mind, lets focus on the importance of establishing a game plan for new arrangements, primarily in the estate planning arena, complete with the following critical elements: (1) the establishment and implementation of a well-defined plan; (2) constant and diligent monitoring of the different moving parts throughout the term of the arrangement; and, (3) a well-designed exit strategy.
Game Plan For New Arrangements. Split-dollar plans established after Sept. 18, 2003, have no safe harbors and are solely governed by the final regulations. A new arrangement is classified either under the economic benefit or loan regime depending on the ownership of the policy. Final regulations also apply to pre-Sept. 18 arrangements that are materially modified.
Moving forward, an equity endorsement arrangement will most likely be rarely implemented due to the ongoing annual tax burden the final regulations place on this method. On the other hand, nonequity endorsement plans will continue to be used in the following ways:
1. As a supplemental executive benefit that provides the employee an endorsed death benefit prior to retirement. The entire cash value is owned by the premium sponsor and could be used to informally fund a nonqualified retirement plan for the employee.
The question still lingers as to whether nonequity endorsement plans are extensions of credit to executives and directors in public companies under the Sarbanes-Oxley Act. Since the executive only is receiving insurance protection and is either paying for it or reporting it for tax purposes there seems to be no violation, but counsel should be consulted prior to any decisions being made.
2. Nonequity endorsement arrangements also are useful when a company would like to maintain a key person or buy/sell policy, while endorsing part of the death benefit to the executive.
The traditional equity collateral assignment arrangement now is governed under the loan regime per the final regulations. Certain situations call for an arrangement to begin under the loan regime based on the fact that the AFR is at historical lows. New employee/trust/donee-owned arrangements also can be structured as nonequity collateral assignment plans taxed under the economic benefit regime. Although the employer/donor owns the greater of cash value or premiums paid, this method allows a client to begin a new arrangement by paying or reporting economic benefit, which in the short run typically is more cost efficient than paying loan interest. This structure may be designed to convert the arrangement to a loan prior to any equity accruing in the policy.
Exit Strategies. Although the implementation and review phase of a new split-dollar arrangement is vital, the unwinding or exit strategy is of equal importance. Traditional equity collateral assignment arrangements (under 64-328) in the employer/employee context typically were designed with excess premiums in order to have excess cash value to “rollout,” or pay back the corporation its interest. The overpayment of the premium placed no extra cost or tax burden on the employee since only the economic benefit was reported.
The new loan regime changes the dynamics in the sense that the economic benefit has been replaced with loan interest, which provides future uncertainty due to interest rate fluctuations as well as typically larger reporting requirements than the economic benefit regime.
In an attempt to manage this issue, many clients are not “overfunding” the policy in order to have excess cash value to help pay the note back at a later date. Instead, they are coupling the arrangement with another funding source to aid in the process of paying both loan principal as well as interest. The following are some examples:
1. Instead of using policy cash values to pay back loan principal, the employee/donee funds one or a series of grantor retained annuity trusts (GRAT) with the remainder beneficiary as the entity that owns the policy. In a typical employer/employee split-dollar arrangement for estate planning purposes, the employee will create the GRAT with an irrevocable life insurance trust (ILIT) as the beneficiary. If the GRAT assets appreciate favorably, there will be additional monies in the ILIT to aid in paying either loan interest or principal.
2. Another exit strategy, or method to repay the note, is through the gifting of discounted assets to the ILIT. Assuming the potential for future appreciation of the gifted asset is likely, the ILIT will have a pool of money to either pay loan or principal.
3.Another method to terminate the loan arrangement between the employer and employee is personally to loan the money to the ILIT or borrow from a financial institution.
An Alternative To Split Dollar. There are some practitioners that tout a technique known as “premium financing” as an alternative to the murky waters of split-dollar taxation and the final regulations that govern it. This technique involves the client borrowing money from a financial institution, rather than the employer or donor, in order to pay premiums. With borrowing rates at all-time lows, premium financing is receiving a great deal of attention. It can provide efficient leverage for a period of time if there is an appreciable spread between the loan rate and the growth rate of the asset being used to repay the note (whether its cash value or another asset).
One issue is the risk of rising interest rates over time causing premium financing to be too costly. Another issue is that some advisors feel the split-dollar regulations actually extend to premium financed insurance transactions, which would make them potentially subject to taxation as a below-market loan per Section 7872.
What About Administration? There is and will continue to be concern in the advisor community around the questions of who will monitor and administer split-dollar arrangements moving forward, and how will it be done efficiently and accurately? Gone are the days of simply tracking economic benefit on an annual basis for a client. The birth of the loan regime gives rise to ongoing maintenance issues. The million dollar question is: Who is going to be responsible for the coordination of all the moving parts to create a seamless ongoing transaction for the client?
A series of issues and questions that parties to a new split-dollar arrangement need to have considered are:
1. Presumably, some of the premiums will be deemed demand loans and others term loans. This adds another layer of administrative complexity. Who will track and administer these loans, since each premium payment represents an individual note?
2.Existing loans that come due possibly will need to be restructured. Who is responsible, and who is actually documenting all the changes?
3. Accrual basis corporations must account annually for the repayment of loan interest for tax purposes as income. Are there adequate accounting procedures in place to monitor these payments?
4.Trustees and accounting and legal advisors may have fiduciary concerns due to the complexity of the loan regime. Who is going to take responsibility for managing the entire process on an ongoing basis?
As an industry, we have just opened a new chapter in the book of split dollar. Although Notice 2002-8 and the final regulations have changed the split-dollar landscape, there still is plenty of income and gift tax leverage left in the split-dollar technique. Hopefully, 2004 will provide some guidance to our current questions, which will smooth the road ahead.
, CLU, ChFC, is with the insurance advisory firm of Nease, Lagana, Eden & Culley Inc., Atlanta, Ga., a member of the M Financial Group. You can contact Bo at [email protected].
Reproduced from National Underwriter Life & Health/Financial Services Edition, January 2, 2004. Copyright 2004 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.