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Service Takes Notice and Revokes 2001-10

Reprinted with permission from Tax Notes. This article also appears in the Tax Notes Today section of TaxBase (click for info on 30-day trial subscription), Tax Analysts' tax news and research service on the Web.
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A year after issuing the controversial Notice 2001-10, 2001-5 IRB 459 on split-dollar life insurance, the Internal Revenue Service has revoked the notice and reissued interim guidance. While Notice 2002-8, 2002-4 IRB 1, is not a complete reversal of last year's guidance, it does include changes that reflect an acknowledgement of the spate of criticism that Notice 2001-10 unleashed.

When it was released last January 9, Notice 2001-10 was intended to be interim guidance, but the notice's apparent immediate effective date and upending of 35 years of settled rules on the taxation of split-dollar life insurance arrangements between employers and their employees set off a storm of letter writing to the IRS and Treasury.

Some groups sent letters immediately demanding withdrawal of the notice. Several letters asked that the incoming Bush administration kill the notice as part of the review and approval of all agency decisions issued in the waning days of the Clinton administration. The new heads at Treasury didn't withdraw the notice, but in various forums over the course of the year, government officials indicated they were paying close attention to comments about it.

And there were many comments. The American Council of Life Insurers (ACLI) and the Association for Advanced Life Underwriting (AALU) each weighed in on the issue several times, and everyone from the American Bar Association's Section of Taxation to the AICPA to individual employers and employees expressed their concerns. Although many took issue with the new tax treatment that Notice 2001-10 outlined, most reserved their harshest criticism over the notice's immediate application, which appeared to make the changes retroactive without any kind of grandfathering of prior law.

First Loan Treatment, Then Not

The Service took up the tax treatment of split-dollar arrangements, in which an employer and employee jointly purchase a policy on the life of the employee subject to a contractual allocation of the policy's benefits, in Rev. Rul. 55-713, 1955-2 C.B. 23, determining that these arrangements should be treated as interest-free loans.

Nine years later the Service changed its mind. Rev. Rul. 64-328, 1964-2 C.B. 11 (amplified by Rev. Rul. 66-110, 1966-1 C.B. 12), concluded that split-dollar arrangements were not loans and that the "economic benefits" of the arrangement were includable in an employee's gross income. Under the ruling's analysis, any credits to the policy's cash surrender value were a benefit to the employer, not the employee. Accordingly, the income to the employee would be the value of the current year's insurance protection, less any premiums paid by the employee. The value of the protection was determined by using the one-year premium rates, commonly called the "P.S. 58" rates, in Rev. Rul. 55-747, 1955-2 C.B. 228, although, the insurer's term rates, if lower, could be used as an alternative.

In the three decades after Rev. Rul. 64-328, "equity split-dollar" arrangements, with the employee accruing cash surrender value, became common. As the Service said in its explanation of why Notice 2001-10 was needed, in equity split-dollar "the employee derives the entire economic benefit of any positive returns on the employer's investment in the life insurance contract." The Service felt the Rev. Rul. 64-328 approach was not adequate to address the changed circumstances.

Loan Treatment, Again, and Section 83

To deal with the problem, the Service outlined a two-option approach. The first option resurrected the old loan approach, allowing the parties to characterize an arrangement as a loan, but added that the below-market loan rules of section 7872 would determine the tax consequences.

The second option would essentially be the default treatment, applying unless the parties consistently treated a split-dollar arrangement as a loan. Under this option, the employee would still recognize income from the current year insurance protection but would also be deemed to receive compensation income as transferred property under section 83(a) "to the extent that the employee acquires a substantially vested interest in the cash surrender value of the life insurance contract, reduced . . . by any consideration paid by the employee for such interest in the cash surrender value."

The Service had previewed the section 83 approach in TAM 9604001, concluding that an employee should be taxed annually on the inside buildup of an equity split-dollar policy. In 1996 the ACLI and the AALU wrote separately to the Service, strongly disagreeing with the TAM's analysis and arguing that section 83 was misapplied or didn't apply at all. Both organizations reiterated that argument in 2001.

New Rates

Also, Notice 2001-10 revoked the P.S. 58 rates, finding that the rates no longer reflected "an appropriate relationship to the fair market value of current life insurance protection." Further, the IRS was concerned that the rates had been used to understate the actual benefits provided to employees in some arrangements and also questioned the use of insurers' alternative rates.

The notice issued a new rate table (Table 2001) as the proper method for determining the value of current year insurance protection, but allowed the use of the P.S. 58 rates through the end of 2001. The new table was criticized by commentators, however, for its basis in group term rates.

While most commentators took issue with the notice's substance, almost everyone criticized its immediate effect and lack of any safe harbors for existing arrangements. Many worried about the confusion the changes would cause. At an insurance conference last summer, panelists discussed the real possibility that some split-dollar arrangements could be subject to three different tax regimes: those before, during, and after Notice 2001-10. By the end of 2001, the ACLI asked that the Service suspend the notice. The industry group worried that as a practical matter, employers and employees would not be able to adequately characterize the arrangements for the 2001 tax year.

Notice 2002-8

It appears Treasury and the IRS listened carefully. Notice 2002-8 was issued January 4 and begins by immediately revoking Notice 2001-10. Further, the new notice announces a regulation project "providing comprehensive guidance" on the tax treatment of split-dollar arrangements.

However, Notice 2002-8 doesn't fully abandon the analysis in Notice 2001-10. The new notice outlines what Treasury and the IRS expect the forthcoming guidance will contain, and some of the analysis of Notice 2001-10 survives. For example, the new notice reiterates the two-option regime but applies it more strictly. Rather than relying on the parties' characterization, the ownership of the insurance contract will control. If the employee is the owner, the arrangement will be treated as a loan. The Service notes that in the loan situation, section 7872 as well as the original issue discount rules (sections 1271-1275) will apply.

If the employer owns the contract, the employee will be taxed under section 61 on the current value of the insurance protection. A transfer of the policy to the employee will be taxed under section 83. The Service says, however, that the proposed regs "will not treat an employer as having made a transfer of a portion of the cash surrender value of a life insurance contract to an employee for purposes of section 83 solely because the interest or other earnings credited to the cash surrender value of the contract cause the cash surrender value to exceed the portion thereof payable to the employer." The prior notice's "substantially vested" language does not appear in Notice 2002-8.

Rates

Also, the Service says the P.S. 58 rates remain revoked and re-ups Table 2001 as the correct tool for valuing insurance protection until further guidance is published. Parties may continue to use insurers' alternative rates, and for arrangements entered into before January 28, 2002, parties may continue to use the P.S. 58 rates.

Further, Notice 2002-8 provides grandfathering to arrangements entered into before the publication of final regulations. The Service also notes that if parties characterize an arrangement before final regs as a loan, the Service will not challenge good faith efforts to comply with the OID and below-market loan rules.

Response

The new notice should be welcomed by employers and employees. The life insurance industry is pleased with it, according to the ACLI's chief counsel, Laurie D. Lewis. "We view this new notice as a positive acknowledgement that last year's notice was not the appropriate way to handle the issue," she said, adding that a "responsive Treasury listened to what the public said."

Commenting on what the notice's immediate impact will be, Lewis told Tax Analysts the notice "provides clarity on what you put on your tax return this year." But more importantly, the notice allows reliance on the old rules. The notice "doesn't change prior law," Lewis said, emphasizing that the notice provides safe harbors for existing arrangements.

Lewis was pleased that Notice 2002-8 previews coming guidance. "It gives everyone time to comment so that the new rules aren't coming out of the blue," she said. Lewis added that the ACLI will most likely comment on the notice, specifically on the rate tables.

Comments on Notice 2002-8 are due April 28.

Copyright 2002, Tax Analysts; all rights reserved. Reprinted for a limited time on BenefitsLink by permission.

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