A new IRS ruling, Notice 2008-42, lets businesses modify split-dollar arrangements without causing a loss of grandfathered treatment under Sections 101(j) and 264(f) of the Internal Revenue Code, so long as no material change is made to the life insurance policy funding the agreement. But questions remain as to what changes to an insurance contract are permissible.
“This notice provides welcome relief for practitioners,” says Larry Raymond, president of the Association for Advanced Life Underwriting. “It eliminates concerns that modifications to a split-dollar arrangement could adversely affect grandfathered split-dollar arrangements as long as the insurance contract itself is not modified.
“Although this notice does not provide guidance on all of the issues that could be involved, at least it provides a safe harbor for practitioners to use if they need to amend split-dollar arrangements but do not need to modify the insurance contract,” he says.
IRS Notice 2042 states that if the parties to a split-dollar arrangement (a plan wherein a business owner and a key employee agree to share the premium payments, death benefit and cash surrender value of a life insurance policy) modify the terms of the arrangement but not the provisions of the life insurance contract, then the revision “will not be treated as a material change in the life insurance contract for purposes of [IRC Sections] 101(j) and 264(f), even if the modification is treated as a material modification of the split-dollar arrangement for purposes of [IRC Section 1.61-22(j)."
Grandfathered split-dollar arrangements--those issued prior to August 18, 2006, when 101(j) became effective; and before June 8, 1997, when 264(f) went into force--become subject to these code provisions when there is a material modification to the arrangement, prompting the IRS to treat the agreement as new. The tax consequences of the change, sources say, can be substantial.
Under 101(j), death benefits paid on an employer-owned life insurance contract funding the split-dollar arrangement are hit with an ordinary income tax if, among other requirements, the section's notice and consent provisions are not met. And 264(f) prohibits deductions for the portion of a taxpayer's interest expense that is allocable to un-borrowed policy cash values of a life policy, annuity or endowment contract.
Most observers interviewed by National Underwriter say the benefit of the Notice 2008-42 is at best marginal, as material modifications generally are made to the insurance contract, rather than the split-dollar arrangement. Commentators also criticize the IRS for not specifying in the notice what constitutes material modification--either to the split-dollar arrangement or to the insurance contract--clarification which the insurance industry has long sought.