It has now been over 3 years since the U.S. Treasury finalized its regulations related to split-dollar arrangements. There remains a significant misunderstanding as to the advisability of the initiation or continuation of split-dollar plans. That is perhaps because different rules apply, depending upon when a plan was established; and perhaps because these plans come in so many variations.
Scope of the discussion
Historically, split-dollar plans were arrangements wherein an employer would agree to pay most or all of the premium cost of a cash-value life insurance policy on an employee’s life, retaining an interest in the policy’s cash value and death proceeds, with the employee or a designated beneficiary holding the remaining policy benefits, primarily the death benefit.
Over time, planners have devised many variations, and split-dollar structures have migrated beyond the employment context. Split-dollar, for example, has become a valuable tool for the estate planner who is endeavoring to remove large amounts of death benefit from the taxable estate, using premium dollars that originate from within the insured’s estate in a gift-tax-sensitive manner.
The following discussion relates to split-dollar plans subject to the latest rules, contained primarily in final regulations effective for plans entered into or materially modified after Sept. 17, 2003. Two sets of grandfathering rules may apply to older arrangements, depending upon whether they were entered into before Jan. 28, 2002 (“great-grandfathered’) or after that date, and whether those plans have since materially changed. Additionally the discussion relates primarily to plans taxed under the “economic benefit” regime, as described below.
Economic benefit regime vs. loan regime
Under the new rules, split-dollar plans fall into one of two tax regimes: economic benefit regime or loan regime. In general, the applicable tax rules depend upon the identity of the policy owner in the records of the insurer.
If the employer or donor is the owner of the policy, the plan will be taxed under the economic benefit regime. In addition, if the employee or donee is the owner, but holds no interest in the cash value of the contract, the economic benefit will apply.
Other split-dollar plans are subject to the loan regime, wherein the objective is to provide a tax-favored life insurance benefit while retaining an interest in premium outlays.
Taxation under the economic benefit regime
Taxation under this regime is similar to the historic tax treatment of split-dollar plans. Essentially the employer/donor (hereinafter “sponsor”) is deemed to be providing to the employee/donee (hereinafter “recipient”) a benefit in the form of the value of the death benefit protection enjoyed by the recipient. In an employment context, the value provided is taxable income, and in the donor-donee context that value is deemed a gift, with the relevant amount reduced to the extent that the recipient is required to contribute toward its cost.
In contrast to the older tax regime, it is clear that the amounts taxed to or paid by the recipient under the plan create no investment in the policy (i.e., they create no income tax basis). Also, any amounts contributed by the recipient to the cost may constitute income to the sponsor.
If the recipient has access to the cash value, the amount to which the recipient has access will be income, but no current deduction is permitted the sponsor. Also, the recipient receives no tax-free allocation of future cash value growth based upon amounts of cash value previously taxed to him or her. As a result, economic benefit split-dollar plans involving the shifting of cash values to the recipient are generally economically unattractive.
Valuation of the death protection