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EBECatty

Grandfathered, Unsecured Split Dollar ILIT Loan Forgiveness

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Hoping someone can provide some input on a rather obscure split dollar issue. 

Employer extended one loan to employee's ILIT to buy second-to-die life insurance policy. Everything occurred before 2002/2003 and arrangement has never been modified. The arrangement was unsecured, i.e., no collateral assignment, just a note from the ILIT to the employer promising to repay with interest. Payment is due upon earlier of (1) sixty years later; or (2) 90 days after death of employee and spouse (both still living). Loan obligation now far exceeds cash value; significant additional premiums would need to be paid in to maintain policy. ILIT has no other assets. 

It appears that any loan forgiveness by employer would create compensation income to employee. 

It also seems to me that if the policy lapses (again, no collateral assignment or documentation at insurer), then both employee and spouse die later, the last one to die would have income (or income in respect of a decedent) at some point. 

Any way to complete a rollout without taxing the unpaid/forgiven loan amount?

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I think more information is needed.

Is the employer named a beneficiary of the policy?  Otherwise, I'm not convinced you have a split-dollar arrangement.  There doesn't seem to be any other interest in the policy by the employer.

You're right that the forgiveness of debt leads to tax consequences; I'm thinking income taxes to the grantor plus treating the forgiven loan as a gift to the trust.

I'm not quite sure what rollout means in this context, but if there is to be no tax on the forgiven loan, the only thing I can think of (and I'm not being facetious) is to repay the loan; the grantor makes a gift to the trust in the amount needed to repay the loan obligation, either with or without policy surrender.

 

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XTitan, thanks for your input. My first thought was that no split dollar arrangement existed either. The employer has no rights in the policy whatsoever. 

This is from the BNA portfolio on Insurance-Related Compensation (386; section VI.B):

Under the unsecured method, the arrangement is contractual and the policy itself is not used to protect the employer's advances. This method is used most often as an alternative when one or more of the risks of either basic documentation method appears unacceptable. Under Rev. Rul. 64-328, some commentators had been concerned that this type of arrangement could be treated as something other than a split-dollar arrangement for income tax (and transfer tax) purposes because of the emphasis that Rev. Rul. 64-328 appeared to place on the policy being available as security for the employer's advances in reaching its basic conclusion about the income tax consequences of the arrangement. The most likely alternative characterization of an arrangement documented under this method was as an interest-free loan subject to the provisions of §7872. Some commentators argued, however, that as long as the arrangement was documented as an employment-related split-dollar plan and it provided a benefit to the employee similar to that provided under either of the more traditional methods, its tax consequences should be governed by Rev. Rul. 64-328, despite the lack of policy security for the employer's advances. In FSA 1998252, the IRS concluded that as long as the benefit provided to the employee under this method of documentation was similar to that provided under traditional documentation methods, the tax consequences would be determined by the economic benefit concept.

I haven't been able to easily locate a copy of FSA 1998-252, but I assume it says what the BNA portfolio represents it as saying. 

I don't take your answer as facetious either; I genuinely don't think there's a good alternative unless someone can (a) repay the loan, or (b) pay enough into the policy to keep it in force. Grandfathered arrangements slightly pre-date my practice so I wasn't sure if there was some other commonly accepted solution here, as the guidance was unclear at best. 

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Has there been any evidence that the value of the death benefit has been imputed to the employee?  That's what the FSA would imply (usual disclaimers about not relying for precedent, only applicable to the case involved, etc).   It sounds like the situation here is a bona fide loan and not an interest-free loan.  Having to pay (capitalize) loan interest and also be taxed on the economic benefit sounds like paying twice for the same benefit.

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Not as far as I'm aware, and the loan does accrue interest. Even if you take it out of the split-dollar context, I think it's still at least cancellation of indebtedness income or possibly assignment of income if the loan is satisfied at less than full value or forgiven as part of an agreement with the former employer. Even then, I have a hard time getting around imputing compensation income to the former employee. 

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