Split-dollar life insurance

CPA Journal, The, Sep 2003 by Ledbetter, Thomas L, Kozol, George B, Godfrey, Joseph E III

A plan that will bear fruit

In January 2002, the IRS published Notice 2002-8 (which replaced Notice 2001-10) to clarify the taxation of equity split-dollar arrangements and to outline the conditions for providing a safe harbor for life insurance plans that were established on or before January 28, 2002. Notice 2002-8 provides transition rules for plans adopted before the publication of final regulations and sets ground rules for new plans adopted after the publication of final regulations.

On May 9, 2003, the Treasury Department published proposed regulations on split-dollar taxation (REG 164754-01). Employer sponsors will be seeking recommendations regarding existing split-dollar plans and, in some cases, proposed alternatives. These regulations echo much of Notice 2002-8 and confirm that December 31, 2003, is an important date for the tax status of existing split-dollar programs.

Background

Split-dollar plans have been among the most significant forms of executive benefits for more than 40 years. Split-dollar describes a method of paying for insurance by splitting the premiums and proceeds between the employer and the employee. The dominant use of such plans filled the gaps in a deferred compensation plan for key employees. Split-dollar insurance has also been used to provide additional retirement income to participants through a Supplemental Executive Retirement Program (SERP). These plans gained popularity because they offer an economical way to provide survivor benefits, generally with favorable income tax consequences to the family.

Equity split-dollar plans can avoid the security issues associated with deferred compensation, which relies on the future financial success of the employer. Under the employer loan regime, there comes a point in time when the policy values accrue to the benefit of the executive. These values are not subject to claims of corporate creditors. The endorsement split-dollar regime is essentially a form of deferred compensation for an individual employee. While appropriate for providing deferred compensation, the employer loan regime usually provides superior tax and security benefits for the participating executive.

Of prime importance are the tax and financial benefits associated with split-dollar insurance. In a properly designed split-dollar program, employer contributions are not currently taxable to the executive, who can later receive income tax-free withdrawals up to the cost basis (usually cumulative premiums paid) and take tax-free policy loans thereafter.

When the employee's share of the policy equity should be taxed in the split-dollar transaction has been the subject of controversy for many years. A tax history of split-dollar plans and descriptions of several types of split-dollar plans are included in the Sidebars. Until the IRS issued Notices 2001-10 and 2002-8, an "equity" split-dollar plan typically provided the executive benefits described above. The authors believe that the two IRS notices and the recent proposed regulations make the traditional equity split-dollar design obsolete.

The Future of Split-Dollar Insurance

What, then, is the future of split-dollar insurance as an executive benefit? Split-dollar is not only alive and well, but also is primed to play an even more important role as the foundation of executive benefits for key executives. Furthermore, the IRS-mandated "employer loan regime" offers comparable benefits to an equity split-dollar plan, but with predictable federal income tax consequences and in many cases, particularly for older executives, a lower-cost benefit. A number of viable options are available in structuring the program to offer both the corporation and the executive the flexibility previously afforded by equity split-dollar. Split-dollar plans can easily be adopted by private companies and tax-exempt organizations, because they do not fall under the Sarbanes-Oxley Act, which prohibits loans by public companies to executives.

From the corporation's perspective, there is little difference between equity split-dollar and the employer loan regime, which will henceforth be referred to as "leveraged split-dollar." The employer's current outlay is essentially the same, but an amount equal to the annual insurance premium is now evidenced by a series of interest-bearing notes to the executive. The corporation recovers its investment when the plan is terminated. Recovery comes in the form of repayment of the loan, upon either the death or the retirement of the insured executive. The typical "cost" to the employer is the loss of the use of the funds while the program is in effect, which is what provides the benefit to the executive and which, in turn, is why the Treasury Department wants to impute an interest rate.

From the executive's perspective, instead of paying income taxes annually on the value of the life insurance protection, the executive's current outlay is limited to income taxes on the actual or imputed interest amount that the employer provides for the particular year. Note that the cost of this fringe benefit is now driven by the interest rate rather than age. Under a classic equity split-dollar plan, the executive pays taxes on the value of the life insurance protection. Of course, the nature of life insurance is such that the cost increases with age. Thus, under a classic split-dollar plan the value of the economic benefit increased each year, as did the tax cost to the insured executive. Also, even if premium payments were stopped under a premium offset or contractually ceased at a point in time, the executive still had escalating economic benefit charges with split-dollar; under the loan regime, the cumulative loan and imputed interest is capped (see Exhibit 1).