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.
"The IRS would have done us a better service by telling us what exactly 'material modification' means," says Stephan Leimberg, president and CEO of Leimberg Information Services, Inc., Bryn Mawr, Pa. "The is a very serious issue because if a material modification puts you under the new law [IRC Section 101(j)], it may be difficult, if not impossible, to qualify for tax-free proceeds.”
Adds Terri Getman, vice president of advanced marketing in the individual life insurance business at Newark, N.J.-based Prudential Financial: “This notice is a positive development, but it doesn’t tell us all that much. We still don’t know what material modification means and what material modifications will result in the loss of grandfathering status.”
Sources observe that it’s not clear, for example, how much of a change in the contract death benefit would constitute a material modification. It’s also unclear whether a change in the insurance premium (as allowed by universal and variable universal life products) would result in the loss of grandfathered status. Similarly questionable is the 1035 exchange of one life insurance policy for another.
The lack of clarity on the last issue is troubling, says Getman, in part because the IRS has at least on one occasion lent a liberal interpretation to “material modification,” albeit within the context of a private letter ruling concerning Section 264(f). In that PLR, she says, the Service ruled that a material change had resulted in the case of a 1035 exchange involving contracts issued by with the same insurance carrier. And though the policy owner and insured were also the same, the transaction was judged a material modification because the insured was no longer an employee of the company.
The still unresolved questions respecting modifications to grandfathered split-dollar arrangements and in particular to grandfathered arrangements under section 101(j) or section 264(f) of the IRC Code, is a concern, as well, of the AALU, despite its otherwise upbeat assessment of the IRS notice.
“We welcome the guidance provided by this notice but recognize that there is still tremendous uncertainty regarding the types of other modifications that can be made to grandfathered insurance arrangements,” says AALU CEO David Stertzer. “This Notice clarifies one area in which modifications can be made without adversely affecting the grandfather status of split-dollar arrangements, but does not provide any guidance on other types of modifications that may be important to consider.”