Birmingham, AL

The IRS recently issued final regulations on the taxation of split-dollar life insurance arrangements. The final regulations are effective for arrangements entered into after September 17, 2003, and for other arrangements that are materially modified after September 17, 2003. The final regulations adopt the proposed regulations without significant modification. This article summarizes key provisions of the regulations

In a related ruling, Rev. Rul. 2003-105, the following prior rulings are obsoleted: Rev. Rul. 79-50, Rev. Rul. 78-420, Rev. Rul. 66-110 (except as provided in Notice 2002-8 and Notice 2002-59), and Rev. Rul. 64-328. Taxpayers may continue to rely on the obsoleted rulings with respect to arrangements entered into on or before September 17, 2003, to the extent described in Notice 2002-8.

The regulations do not address the application of Sarbanes-Oxley to split-dollar arrangements, leaving that to the jurisdiction of the Securities and Exchange Commission. Keep in mind that arrangements entered into before January 28, 2002 still have an opportunity to take advantage of certain transition rules, including the ability to terminate the arrangements before January 1, 2004 and avoid subjecting the policy equity to taxation.

A split-dollar life insurance arrangement is broadly defined as any arrangement between an owner and a non-owner of a life insurance contract where (1) either party pays all or a portion of the premiums (including payment by a loan to the other party secured by the contract), (2) at least one of the parties paying premiums is entitled to recover all or a portion of the premiums from, or recovery is secured by, the proceeds of the contract, and (3) it is not a group term life insurance plan. Certain arrangements are deemed to be split-dollar arrangements whether they meet this definition or not, (these arrangements include any arrangement between an owner and a non-owner if it is entered into in connection to the performance of services and is not part of a group term life plan) with the employer paying all or some of the premiums and either the beneficiary of the death proceeds is designated by the employee (or is someone the employee would reasonably be expected to designate) or the employee has any interest in the policy cash value.

Ownership. As under the proposed regulations, split-dollar arrangements are treated under one of two mutually exclusive regimes, depending on who owns the insurance contract: the economic benefit regime and the loan regime. In general, the person named as the owner of the contract is the owner under the rules. If two or more persons are named as owners and each has, at all times, enjoyed all the incidents of ownership with respect to undivided interests, each person is treated as the owner of a separate contract to the extent of such person’s undivided interest. If each person does not, at all times, enjoy all incidents of ownership, then the person who is the first-named owner is treated as the owner of the entire contract. However, an employer is treated as the owner if, at all times, the only economic benefit provided under the arrangement is current life insurance protection. Furthermore, under attribution rules, if an arrangement is entered into in connection with the performance of services, the employer is treated as the owner if the owner is a trust described in Code § 402 (b), a trust owned by the employer, a welfare benefit fund under Code § 419 (e)(1) or a member of the employer’s control group or trade or business under common control with the employer.

The Economic Benefit Regime. Where the employer owns the insurance policy, the arrangement is taxed under the economic benefit regime. Under this regime, economic benefits are treated as being provided to the non-owner (i.e. the employee) who must take into account the full value of all economic benefits provided, reduced by any consideration paid by the non-owner. The value of the economic benefits provided equals the total of the cost of current life insurance protection, the policy cash value to which the non-owner has current access (to the extent not actually taken into account for a prior taxable year) and the value of any other economic benefit (to the extent not taken to the account in a prior taxable year). For this purpose, current life insurance protection is the excess of the death benefit over the total amount payable to the owner, less any cash value taken into account or paid for by the non-owner. This amount is then multiplied by the applicable premium factor to determine the cost of the current life insurance protection. Policy cash value is determined without regard to surrender or other similar charges, and includes paid up additions.

Current access is a broad concept. A non-owner is deemed to have current access to the portion of the cash value (1) to which the non-owner has a current or future right and (2) that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.

The economic benefits are valued on the last day of the non-owner’s taxable year, unless the owner and non-owner agree to use the policy anniversary date instead. When an arrangement terminates, however, value is determined as of the date of termination.

An example illustrating the economic benefit regime is attached as Exhibit A.

The Loan Regime. The loan regime applies to arrangements where the employee owns the policy. The tax treatment depends on whether the loan is or is not a below market loan. If it is not a below market loan, then the arrangement will be taxed under the general rules for debt instruments. If it is a below market loan, then taxation is generally governed by Code § 7872. In either case, the owner is treated as the borrower and the non-owner is treated as the lender if payment is made directly or indirectly by the non-owner to the owner (including a premium paid by the non-owner to the insurance company), the payment is a loan under general tax principles, or a reasonable person would expect the non-owner to be repaid in full with repayment made from and/or secured by the policy’s death benefits, cash surrender value, or both.

Under the loan regime, different rules apply depending on whether the loan is a demand loan, a term loan (any loan other than a demand loan), and whether payment is non-recourse to the borrower (i.e. a contingent payment). The regulations also provide rules for testing whether an arrangement provides sufficient interest, which determines whether it is a below market loan. Demand loans are tested based on the blended annual rate whereas term loans are tested based on the applicable Federal rate for the loan’s term.

There are many special provisions that apply to special situations involving arrangements taxed under the loan regime. This overview has not attempted to address the special situations.

An example illustrating the loan regime is attached as Exhibit B.

Employers with existing split-dollar arrangements need to review those arrangements to determine if their needs are still being met by them and if not, consider an exit strategy. New arrangements should be avoided absent a complete understanding of the treatment thereof under these final regulations.

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