A substantial number of people with existing equity split-dollar life insurance arrangements failed to take advantage of grandfathering opportunities that could have saved them some taxes.
The chickens are coming home to roost for those who did not bail out of pre-Jan. 28, 2002, equity split-dollar life insurance arrangements before Jan. 1, 2004. This could result in a ticking tax time bomb, which you can help defuse.
But First, Some Background
The evolution of split-dollar life insurance has covered several periods. It began in 1955 with the Internal Revenue Service’s view that split-dollar was an interest-free loan that entailed no tax consequences. The IRS revisited split-dollar in 1964 through 1966. At that time, the IRS decided that split-dollar resulted in the transfer of economic benefits to employees in the form of current life insurance protection that could be measured using either the IRS’ P.S. 58 rates or the insurance company’s alternative term rates if they were lower and available to all standard risks.
During this period, the IRS did not, however, clearly address the tax treatment of “equity” cash values that were attributable to the employer’s premium contributions and accrued for the employees' benefit. The first attempt to raise this issue appeared in an IRS Technical Advice Memorandum (TAM). This was controversial because the IRS ruled that besides being taxed on the value of current life insurance protection, employees also were liable for taxes on the cash values as they accrued for the employees’ benefit.
The public reaction over the taxation of equity cash values, as well as disagreement regarding the proper use of insurers’ term rates to measure the value of employees’ current life insurance protection, led the IRS to issue two notices and temporary regulations. These were meant to provide interim guidance on the tax treatment of split-dollar until final regulations were issued and became effective for arrangements entered into on and after Sept. 18, 2003.
Tax Treatment of Cash Values
To understand the controversy over the taxation of cash values that accrue for the employees' benefit, it is necessary to compare the “non-equity” and “equity” approaches to split-dollar. In that regard, under the non-equity type of plan, the employer’s interest in the policy’s cash value is equal to the greater of the cash value or its total premium advances. This results in the employer owning any cash values in excess of its premium contributions. On the other hand, if the equity approach is used, the employer’s interest is limited to the amount of its aggregate premium contributions, with any excess belonging to the employee.
Valuing the Employee’s Life Insurance Protection
IRS Notice 2002-8 governs how to measure the value of an employee’s life insurance protection under a split-dollar agreement. Notice 2002-8 provided the following guidance.
P.S. 58 rates may not be used after 2001, except for split-dollar arrangements in effect before Jan. 28, 2002.
The final regulations do not allow the use of an insurer’s alternative term rates for arrangements entered into after Dec. 31, 2003, unless they are available to all standard risks for initial issue one-year term insurance on policies that are actually sold by the insurer.
Taxpayers may use the Table 2001 rates (published in Notice 2001-10) for new arrangements until further guidance is published.
Replacing Policies Under Pre-2002 Split-Dollar Agreements
In Notice 2002-8, the IRS also gave taxpayers a set of grandfather rules through which they could avoid adverse income tax consequences on the termination of pre-Jan. 28, 2002, equity split-dollar plans under the forthcoming final regulations. The first two choices were either to terminate the plan or convert it to a loan arrangement before Jan. 1, 2004. Alternatively, taxation on the employee’s share of the cash value could be avoided as long as the arrangement was kept in effect and the employee annually reported the value of current life insurance protection as taxable income.
It has become apparent that a substantial number of those with existing equity split-dollar arrangements did not take advantage of the grandfathering opportunities under Notice 2002-8. As a result, those who did not bail out of pre-Jan. 28, 2002, equity split-dollar life insurance arrangements before Jan. 1, 2004, could find themselves in a predicament. That is because the tax cost of continuing or terminating these arrangements increases with the passage of time.
The higher cost of continuing these plans relates to the annually increasing term life insurance rates that are used to measure the value of the coverage that the employee is taxed on each year. In addition, the escalating cost of termination stems from the employee’s increasing share of the policy’s cash value that will be taxed to the employee at the end of the plan. That leaves the question of what to do when a policy audit uncovers one of these ticking time bombs and possibly indicates that the taxpayer may be better off with a new replacement policy.
Replacement Considerations for Equity Plans
When considering replacement, you must understand that the transaction probably will be treated as a termination of the split-dollar arrangement and will take the policy outside the protection of the grandfather rules of Notice 2002-8. This means that in the case of an equity plan, the the employee may be taxed on the employee's share of the cash value when the plan terminates. That requires comparing the potential premium savings to the employer and any other advantages of the replacement to the possible taxes incurred by the employee on the equity cash value of the existing policy when the plan ends.
It should be noted that even when replacement is not an issue, if the policy has accumulated little or no equity, it may be advisable to terminate the plan unless the employee is in bad health and needs the coverage. This is because the tax on the reportable economic benefit will increase with the employee’s age until it may force a termination of the plan. At this point, the employee may be taxed on an even larger amount of cash value.
Replacement Considerations For Non-Equity Plans
In the case of non-equity plans, beyond the usual replacement issues, the question related to split-dollar is what effect taking the plan outside the grandfather rules of Notice 2002-8 has on the reporting of the annual economic benefit from the coverage.
In that regard, it means going from using the life company’s lower alternative term rates on the existing policy to using IRS Table 2001 for the replacement policy unless the new carrier has a qualifying alternative term contract. To put that into perspective, you should understand that for a client aged 55, the Table 2001 rate is only around a third of the P.S. 58 rate but may be several times higher than a company’s alternative term rate.
Consequently, the decision rests on whether the possible premium savings and other advantages of the replacement policy override any higher reportable income to the employee on the new coverage if the policy is to be maintained under a new non-equity split-dollar arrangement.
If replacement is not an issue, then it comes down to determining at which point the plan will have to be terminated because the reportable economic benefit to the employee is too high to justify the coverage. But again, the coverage may be worth keeping if the employee needs it and is in poor health.