Developing A Game Plan For New Split-Dollar Arrangements

Developing A Game Plan For New Split-Dollar Arrangements

By

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: