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.”