Split dollar MEC Tax-Exempt Employer

[Carol V. Calhoun]

We have a grandfathered split dollar arrangement based on a modified endowment contract (MEC).  The employer is entitled to the premiums paid (without interest) upon surrender of the contract or upon death.

At this point, the employer (which is a tax-exempt organization) would like to get out of the contract, by either taking its share as a loan or by taking a cash withdrawal of its share.  At that point, the employee would own the contract.

The issue is what the tax consequences of this would be.  Normally, distributions from an MEC are treated as coming first out of income (taxable) and only after that out of basis (nontaxable).  However, in this case, the party taking the distribution would be a tax-exempt organization.

Does anyone believe that either a) the employee would be taxed on the amount withdrawn, even though it is the employer getting the money, or b) the employer would be subject to UBIT on amount withdrawn?

[XTitan]

I believe the employee would be taxed on the amount withdrawn if they own the policy prior to withdrawal (including the additional 10% if the employee is under 59.5) as the owner is subject to the tax consequences.  If the employer owned the policy, it's generally accepted that insurance isn't subject to UBIT (no citation though), so other than the employee being subject to tax on the transfer of the cash value post-withdrawal (and of course the policy is still a MEC), there isn't any tax consequence to the employer.

[Linda Wilkins]

I believe that the employee who is the owner of the policy (assuming this is a collateral assignment arrangement) would be taxed.  Although the tax exempt employer receives the funds, there is a loan on the policy and the employee/owner is using the distribution from the policy to repay the loan.

Have you checked whether the MEC is grandfathered? Issued before June 21, 1988?