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Guest Article

IRS Issues Guidance on Split-Dollar Life Insurance Arrangements


By Andrew C. Liazos, David R. Fuller and Susan M. Nash
Summary: On Jan. 9 the IRS issued Notice 2001-10, which provides the first general guidance on split-dollar life insurance arrangements (SDAs) in over three decades. SDAs are a popular way for employers to provide permanent life insurance, supplemental retirement income and estate tax planning opportunities to their employees. Notice 2001-10 proposes to change longstanding tax practices governing the income taxation of SDAs.

(March 2) - On Jan. 9 the IRS issued Notice 2001-10, which provides the first general guidance on split-dollar life insurance arrangements (SDAs) in over three decades. SDAs are a popular way for employers to provide permanent life insurance, supplemental retirement income and estate tax planning opportunities to their employees. Notice 2001-10 proposes to change longstanding tax practices governing the income taxation of SDAs. (See ¶413 of the Handbook.)

What is Split-Dollar Life Insurance?

An SDA is a financing technique under which employers and employees agree to share obligations and benefits under a permanent life insurance policy. Premiums, death benefits, policy cash value and dividends may be split under the SDA. Either the employer or the employee may own legal title to the policy covered under an SDA. Two common types of SDAs are classic SDAs and equity SDAs.

Classic SDAs. Classic SDAs generally require the employer to pay for a portion of the premium equal to the increase in policy cash value. The employer, in return for paying premiums, retains a right to receive an amount equal to the policy's cash value during the employee's lifetime and at death from policy death proceeds. The employee is then responsible to pay the remaining premium cost, which decreases as the employee grows older and the cash surrender value increases. The employer may provide a bonus to the employee to finance the employee's share of the premium cost. This form of SDA, while prevalent in the 1960s, is used less frequently today.

Equity SDAs. Equity SDAs, the prevailing form of split-dollar insurance used today, operate in a manner similar to classic SDAs, except that the employer's interest in cash value is limited to its premium payments. Death benefits and cash value exceeding premium payments are allocated to the employee. The employee's "equity" under this type of arrangement is the permanent cash value allocated to the employee under the SDA. It is not uncommon for cash values, particularly with modern variable life insurance policies, to exceed premiums in a relatively short period of time, thereby providing a valuable benefit to the employee. It is for this reason that employers often use equity SDAs to provide a source of funds an employee can access for retirement benefits.

IRS Notice 2001-10

Notice 2001-10 addresses three important issues affecting SDAs: the proper income taxation for equity SDAs, P.S. 58 rates and alternative term rates.

Equity SDAs. The IRS has narrowed its interpretation regarding tax treatment of SDAs, which represents the IRS' apparent position that an employee receives economic benefits from equity SDAs in excess of current term life insurance coverage. The notice states that "it is necessary to account for the employee's rights in cash surrender value under an equity split-dollar arrangement in a manner consistent with the substance of the parties' contractual positions."

The notice offers three approaches for taxing equity SDAs in lieu of Rev. Rul. 64-328, the previous IRS guidance on tax treatment of SDAs.

  1. The employer is treated as the policyowner consistent with the substance of the arrangement. The employee would then be subject to income tax on the cash value transferred by the employer to the employee.

  2. The arrangement is treated as involving a below-market interest-free loan under Section 7872. Treating premium payments as interest-free loans will be appropriate when the substance of the arrangement is such that the employee is the owner of the policy. This occurs when the employer has "a reasonable and bona fide expectation of repayment [of its premium payments]."

  3. The employee is taxed on the entire premium payment when made. There would be no premium split, no imputed compensation income and no equity taxation under this approach. Immediate taxation of the entire premium payment appears limited to situations in which there is no bona fide intent for the employer to retain any interest in the policy.

P.S. 58 rates. P.S. 58 rates have historically been used to report the value of current death benefits coverage. The IRS has replaced the P.S. 58 rates with a new standardized set of insurance rates. This is not a surprise as the P.S. 58 rates were based on mortality tables from the 1940s and were unrealistically high. The IRS reasonably determined that the P.S. 58 rates overstated the value of current term life insurance protection.

Effective beginning in 2002, IRS Table I must be used instead of the P.S. 58 rates to report the value of current death benefit coverage. The rates under IRS Table I are materially lower than the P.S. 58 rates at all ages. Employers, under a limited exception, may nevertheless continue to use P.S. 58 tables for SDAs and tax-qualified retirement plans until the end of 2001. (See ¶430 of the Handbook.)

Alternative term rates. The IRS has questioned whether alternative term rates developed by insurers under current rules reflect an appropriate measure of the economic benefit under an SDA. The notice states that alternative term rates "may not realistically be available for all standard risks who apply for term insurance." It appears in some cases that alternative term rates have been based on contracts filed with the state insurance commissioner that have never been sold to the public. Even assuming that alternative term rates reflecting economic realities are used to report income, the IRS is considering whether life insurance protection provided to different taxpayers should be valued differently depending upon which insurer has issued the SDA policy.

Interim Rules Pending Final Guidance

Notice 2001-10 constitutes interim guidance that affects both new and existing SDAs without any permanent grandfather exceptions. However, the IRS will allow parties to treat equity SDAs as subject to either Section 83 (regarding taxable transfers of property) or Section 7872 (regarding taxable interest-free loans) pending issuance of further guidance. The IRS will recognize the selection of tax treatment by the parties so long as "(i) such characterization is not clearly inconsistent with the substance of the arrangement, (ii) such characterization has been consistently followed by the parties from the inception of the arrangement and (iii) the parties fully account for all economic benefits conferred on the employee in a manner consistent with that arrangement." If the parties do not qualify for loan treatment under this rule, the default treatment for the equity SDA will be taxation under Section 83.

Notice 2001-10 is the first step in what is likely to be a significant period of regulatory review and public comment. The IRS has requested comments on the tax treatment of SDAs and is likely to receive numerous responses from several trade associations and employers. It is unclear what changes will be adopted in final form.

Andrew C. Liazos is a partner at the Boston office of McDermott, Will & Emery. David R. Fuller is a partner at McDermott, Will & Emery's Washington, D.C. office and Susan M. Nash is a partner in the employee benefits department in McDermott, Will & Emery's Chicago office. Fuller and Nash are the contributing editors of the Employer's Handbook: Complying With IRS Employee Benefit Rules.

Excerpted from the March 2001 supplement to Employer's Handbook: Complying With IRS Employee Benefit Rules. Copyright 2001, Thompson Publishing Group, Inc. All rights reserved.


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