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From 64-328 Through 2007-34: Split-Dollar Comes Full Circle

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Life insurance representatives have used split-dollar life insurance arrangements since 1964 (or before) to assist an individual in the purchase of life insurance. Originally designed to allow an employer to provide death benefit protection at a reasonable cost to the employee, split-dollar was transformed over time into an executive benefit that also offered cash value to the executive.

In the last 5 years, however, there have been significant changes in the federal tax laws related to split-dollar. Though split-dollar arrangements have survived, they have come full circle, with the focus of many split-dollar plans today back to what they were originally designed for: Providing only death benefit protection.

Split-dollar benefits expanded

Revenue rulings first provided authority for split-dollar as a concept where one party (usually the employer) assisted another party (usually the employee) in the purchase of a life insurance policy. In Rev Ruling 64-328, the IRS indicated that arrangements similar to a traditional split-dollar plan involving shared policy features would be treated as a split-dollar. Other IRS rulings provided further guidance on how split-dollar plans should be treated.

Eventually creative life insurance experts developed types of split-dollar arrangements that provided not only a death benefit, but also a cash value component to provide an additional benefit to the employee. These so-called “equity split-dollar” arrangements used the collateral assignment method, generally with the employee owning the policy and assigning the premiums paid portion of the cash value to the employer sponsoring the split-dollar.

As a result, any growth in the cash value exceeding the premiums paid accrued to the employee, presumably tax-deferred. The theory was that since the cash value grew tax-deferred, any growth should not be taxable to the employee currently. Most equity split-dollar arrangements also relied on a theory of no taxation when the arrangement was “rolled out” or terminated.

Reverse split-dollar plans then emerged and took the equity concept further. The employee owned and controlled the entire policy and cash value, and the death benefit was endorsed or assigned to the employer business. The employer paid the premiums, but the employee was not taxed on a portion of the premium equal to the employer’s annual P.S. 58 cost or in some cases the levelized P.S. 58 costs.

Cash value benefits eroded

The IRS started chipping away at cash value benefits in equity split-dollar arrangements in Notice 2002-08 (which revoked Notice 2001-10). Retaining the new Table 2001 as a replacement for the P.S. 58 Table, the 2002 Notice addressed the roll-out of certain equity split-dollar plans and provided an opportunity for equity arrangements entered into prior to January 28, 2002, to be rolled out without taxation if the arrangement was terminated by January 1, 2004.

However, the Notice did not rule on how arrangements would or would not be taxed if they were terminated after January 1, 2004. That uncertainty led many to question how roll-outs after that date could be taxable. The famous “no inference” language in the Notice didn’t help the situation. Then effectively eliminating the use of reverse split-dollar in Notice 2002-59, the IRS disallowed the use of the P.S. 58 (now Table 2001) or the one-year term costs to value the employer’s portion of the premium in a reverse split-dollar arrangement.

Final regulations change taxation of split-dollar

In September 2003 the IRS issued its Final Regulations on split-dollar in Section 1.61-22. In these regulations the traditional economic benefit approach, or the “economic benefit regime” of taxation, was reserved for those situations where the sponsor of the split-dollar, the employer in business situations, owned or was assigned the entire cash value in the policy. When the insured employee (or the employee’s trust) owned the policy and assigned to the employer sponsor only the portion of the cash value equal to the sponsor’s premiums paid, then the arrangement would be taxed under a “loan regime.”

The traditional split-dollar “economic benefit regime” of taxation could no longer be used in those arrangements where the employee (or the employee’s trust) owned the “equity” in the cash value. Consequently an employer could no longer provide cash value benefits to the insured employee (or trust) using the one-year term costs or Table 2001 rates (formerly P.S. 58 costs) as the measure of taxation. Under these new rules, when cash value benefits are provided, the arrangement is considered a loan from the employer to the employee, subject to uncertain interest rates and the interest free loan rules.

Notice 2007-34 applies 409A to legally binding roll-outs

Even though equity split-dollar arrangements lost much of their sizzle after the final regulations, a tax issue remained related to employer promises to roll out the policy to the employee. Notice 2007-34 resolved most of those uncertainties and indicated when the new deferred compensation tax rules under Section 409A and the related regulations applied to split-dollar rollout promises.

Notice 2007-34 provided two general rules that apply initially in deciding whether a split-dollar arrangement may be subject to Section 409A. Under an exception for death benefit plans, an arrangement providing only a death benefit (a non-equity split-dollar arrangement) is not subject to Section 409A. Also an arrangement that has a legally binding right to amounts that are included in income in accordance with the exception for “short-term deferrals” is not subject to Section 409A.

For those plans entered into after September 17, 2003, and using the economic benefit approach, if there is a legally binding right to policy cash value currently or if there is any legally binding right to the cash value in a later taxable year, the plan provides deferred compensation subject to 409A. However, a new split-dollar arrangement using the loan approach to taxation will generally not be considered providing deferred compensation under Section 409A. However, if amounts on the split-dollar loan are waived, cancelled, or forgiven, the arrangement may give rise to deferrals of compensation. Similar rules generally apply to pre-September 18, 2003, grandfathered split-dollar plans.

The grandfathering rules appear to provide protection to pre-September 18, 2003 equity split-dollar plans that are still being taxed under the economic benefit regime so that 409A does not apply. However, Notice 2007-34 is not totally clear about the taxation of these equity split-dollar plans upon their termination or roll-out. A literal reading of Notice 2007-34 seems to state that there is no taxation upon termination of these arrangements as long as the requirements of Notice 2002-8 are met. However, it is unclear whether the intent of this new notice was to expand Notice 2002-8. More guidance is needed on this outstanding issue.

Closing the loop: Split-dollar goes retro

Now that equity split-dollar is no longer available with the economic benefit approach, and a formal promise to roll out the policy to the employee (or trust) is considered nonqualified deferred compensation subject to the Section 409A rules and regulations, cash value benefits promised through an economic benefit approach split-dollar are essentially eliminated.

Though low interest rates can make the loan approach attractive, many clients do not want to deal with loan administration and the uncertainty of future interest rates. Consequently, split-dollar using the economic benefit approach is often the choice and used to provide death benefits only–just as it was originally designed to do. The result is consistent with the primary purpose of most employee benefits, in this case to provide death benefit protection to an employee at an affordable cost.

After all of these changes to its benefits and taxation, split-dollar has come full circle but still remains as an attractive death benefit protection vehicle for many.

Debra Repya, J.D., CLU, ChFC, is director of advanced marketing at Securian Financial Group and its affiliate, Minnesota Life, St. Paul, Minn. Her email address is .