A Practical Guide to the Final Regs. Governing Split- Dollar Life Insurance

Transcription

1 PERSONAL A Practical Guide to the Final Regs. Governing Split- Dollar Life Insurance Author: By Gary Lee and Deborah Walker GARY LEE is National Director of Insurance Consulting Services for Deloitte & Touche LLP, specializing in life insurance. He is located in Boston. DEBORAH WALKER leads the Global Employment & Individual Solutions Practice in the Washington National Tax Practice of Deloitte & Touche LLP, specializing in employee benefits. Both authors have previously written for The Journal. Copyright 2003, Deloitte & Touche LLP. The government has made good on its promise to change the treatment of split-dollar life insurance arrangements, and practitioners and taxpayers certainly had ample warning. Now that the Regulations are final, however, and the "two-regime" approach is in place, the biggest danger may lie in the potential for inadvertently converting a pre-existing split-dollar arrangement into one taxed under the new rules, via the undefined mechanism of a "material modification." Final Regulations (TD 9092, 9/11/03) govern the taxation of split-dollar life insurance arrangements, effective for arrangements entered into or materially modified after 9/17/03. The final Regulations adopt virtually unchanged a set of Proposed Regulations issued in July 2002 and supplemental Proposed Regulations issued in May This article discusses the tax treatment of existing arrangements as well as arrangements that will be governed by the new rules. Prior articles discussing both sets of Proposed Regulations should be consulted for a full appreciation of the technical aspects of the regulatory structure. 2 OVERVIEW In its broadest sense, split-dollar is a method of sharing the costs and benefits of life insurance among multiple parties. While the arrangements can be entered into between various individuals and entities (e.g., an employer and an employee, a donor and a donee, a corporation and a shareholder, an individual and an irrevocable life insurance trust), for ease of understanding this article will focus on arrangements entered into between an employer and employee or the employee's irrevocable life insurance trust. In general, the principles outlined will apply to all split-dollar arrangements, the only difference being the characterization of the tax being imposed, which is governed by the relationship of the parties. 3 Split-dollar life insurance arrangements are classified as either endorsement or collateral assignment arrangements, depending on which party to the arrangement is designated as the owner of the underlying contract. In an endorsement arrangement, the employer owns the policy and endorses certain rights to the employee. In a collateral assignment arrangement, the employee owns the policy and assigns an interest back to the employer as security for the employer's premium advances.

2 In both types of arrangements, the employer usually bears the bulk of the premium costs and the employee is provided a benefit. The only structural difference between the arrangements is which party owns the policy. Nevertheless, the Regulations provide substantially different tax consequences based on whether the employer or the employee is deemed to be the owner of the policy. Both endorsement and collateral assignment arrangements may be structured as either non-equity or equity arrangements. In a non-equity arrangement, the employer retains all rights to the cash value account of the life insurance contract. In an equity arrangement, the employer limits its cash value interest, allowing the employee to share in some portion of the cash value account. As noted above, the final Regulations govern the tax treatment of split-dollar arrangements entered into or materially modified after 9/17/03. Arrangements entered into before 9/18/03 are governed by Notice , CB NOTICE The IRS in Notice offered two sets of transition rules for taxing split-dollar life insurance arrangements not subject to the final Regulations: One set of rules addresses valuation issues related to the use of "alternative rates" to value the death benefit provided within split-dollar arrangements. 5 The second set provides certain "safe harbors" for avoiding tax on the transfer of the equity element of the life insurance contract. Use of Alternative Rates to Value Death Benefits For arrangements entered into before 1/29/02, alternative rates may be used to value current death benefits purchased. If the carrier's alternative rates are not used, IRS Table 2001 (found in Notice ) must be used. For arrangements entered into after 1/28/02 and before 9/18/03, two additional tests must be met if carrier-specific alternative rates are used: (1) The insurer generally must make the availability of such rates known to applicants applying for term insurance. (2) The insurer must regularly sell policies at those rates to individuals applying for term insurance through the insurer's normal distribution channels. Plan participants who are unable to use qualifying alternative rates may use the rates set forth in Table Avoiding Tax on Transfer of the Contract Arrangements in existence before 1/28/02 in which the employer either has received or is entitled to receive full repayment of its premium payment advances can be terminated by 12/31/03 or treated as a loan arrangement for all periods after that date without triggering taxes for any contract cash value accruing to the employee. If loan treatment is chosen, both the employer and the employee must report the arrangement consistent with the below-market loan requirements of Section 7872 and the OID provisions outlined in Sections

3 For all arrangements in existence before 9/18/03 both pre-1/28/02 arrangements and arrangements entered into after 1/27/02 but before 9/18/03 if the participants continue to treat and report the value of the life insurance protection provided to the employee as an economic benefit included in the employee's income, the IRS will not impose additional taxes on the arrangement so long as the cash value is not accessed. To ensure continued nontaxability, the value of life insurance protection must continue to be reported until the employee dies. THE FINAL REGULATIONS The final Regulations establish two alternative regimes for taxing split-dollar life insurance arrangements, based on policy ownership: Where the company owns the policy, as in a typical endorsement arrangement, the economic benefit regime will apply, taxing the employee on all economic benefits provided through the arrangement. Where the employee owns the policy, as in a typical collateral assignment arrangement, the loan regime will apply, with the arrangement being tested and taxed under Section 7872 rules for below-market loans and the OID rules outlined in Sections The final Regulations apply to arrangements entered into after 9/17/03 and to preexisting arrangements that are "materially modified" after that date. Split-Dollar Arrangement Defined Reg (b)(1) broadly defines a split-dollar arrangement as any arrangement between an owner and non-owner of a life insurance contract where all of the following apply: Either party pays, directly or indirectly, all or a portion of premiums. A party making payments has a right to recover of all or a portion of those payments, and repayment is made from or secured by the insurance proceeds. The arrangement is not part of a group-term life insurance plan (other than one providing permanent benefits). This definition is broadened further for compensation arrangements and arrangements between a company and its shareholders. In those instances, arrangements other than a group life insurance arrangement will be considered split-dollar arrangements regardless of whether the insurance policy is used to secure repayment, so long as either of the following occurs: The employer or corporation pays premiums and the beneficiary is designated by the employee or shareholder (or is someone the employee or shareholder would be reasonably expected to designate). The employee or shareholder has an interest in the policy's cash value. Definition of Owner and Non-Owner As stated, the identification of the insurance contract owner is key to determining the taxation of the split-dollar life insurance arrangement. Despite industry concerns, the final Regulations' ownership rules retain the formalistic approach outlined in the Proposed

4 Regulations, with the owner being deemed to be the individual or entity named as owner in the insurance contract. Where multiple owners exist, the first named owner will be deemed to be the owner unless there is a division of all contract rights. Any time that an arrangement provides for an identical fraction or percentage interest of each insurance policy right, the contract is treated as separate contracts to which the rules must be applied separately. 6 A special ownership rule applies to "non-equity" arrangements in the employment and gift context. Where the employee or donee is the owner of the policy but the employer or donor retains all rights to the policy cash value (i.e., the only right being provided to the employee or donee owner is an interest in current life insurance protection), formal ownership designations will be ignored and the employer or donor will be treated as the owner of the contract. Such arrangements will be taxed under the economic benefit regime (discussed further, below). Arrangements Involving Third Parties Where an arrangement is entered into between an employer and a third party other than the employee (i.e., the employee's irrevocable life insurance trust), the arrangement will be taxed as two separate arrangements a compensatory split-dollar arrangement between the employer and the employee, and a gift split-dollar arrangement between the employee and the employee's irrevocable life insurance trust. Similar reclassification rules apply under the loan regime, such that the arrangement is taxed as two split-dollar life insurance loan arrangements. The Economic Benefit Regime The popularity of split-dollar life insurance arrangements developed in large part as a result of the theory that any rights an employee obtained in policy cash values were protected from taxation, at least in the collateral assignment structure, as tax-free inside build-up. 7 The final Regulations make it clear that taxable economic benefits include any present or future rights to the cash value accumulations and the value related to the death benefit protection or any other benefits provided in the insurance policy. Value of current life insurance protection. The value of death benefit protection is the amount of life insurance protection provided to the employee multiplied by a life insurance premium factor. Currently the life insurance premium factor is set forth in Table Present or future rights to cash value accumulation. Reg (d)(4)(ii) takes a "current access" approach to taxing cash value rights that is similar to the approach taken for taxing nonqualified deferred compensation. Specifically, the employee is taxed on any policy cash value amounts to which the employee has a current or future right and that are directly or indirectly: Accessible by the employee. Inaccessible to the employer. Inaccessible to the employer's creditors. Thus, in addition to being taxed on cash value amounts that they can access, employees will be taxed on any amounts to which they have a future right if either the employer or the employer's creditors are restricted from having access to the funds whether the restriction is due to the terms of the split-dollar arrangement or as a result of state law.

5 This definition of current access encompasses many commonplace provisions in splitdollar life insurance arrangements, such as situations in which the employer forgoes the right to take loans against existing policy cash value amounts. Such a limitation would make the cash value inaccessible to the employer and thus taxable to the employee to the extent the employee had either a current or future right. While this taxation approach is similar to that currently applied to deferred compensation arrangements, it is harsher than taxing the contract benefits as property. Were the arrangement treated as a transfer of property, any growth in the policy transferred to the employee would not be taxed, consistent with the treatment of appreciation in property transferred to an employee. The Preamble to TD 9092 clarifies that a limitation on the right of the employer or the employer's creditors to access the cash value creates taxable income to the employee only if the employee has a current or future right to access those funds, thereby eliminating the possibility of taxing amounts that would not be available to the employee. The rule delays taxation until years in which the cash value account exceeds the funds being returned to the employer for premium advances. Reg (d)(3)(i) also makes clear that cash value amounts includable in income reduce the amount of death benefit provided to the employee in calculating the taxable death benefit amount, recognizing that such amounts are no longer benefits provided by the employer. Other economic benefits. The final Regulations retain the "other economic benefit" language of Rev. Rul , CB 12, with as little clarity on what the term means as was provided in the original Ruling. While no examples of what "other benefits" might encompass is included in the final Regulations, presumably they would be benefits such as using policy dividends to provide additional life insurance protection to the employee. Example: The Regulations provide an example of the application of the economic benefit regime to an endorsement arrangement in which the employer has the right to recover the lesser of premiums paid or the policy cash value i.e., an "equity" arrangement. The illustration assumes a $1.5 million face amount, with the employer paying $60,000 in premiums annually. The illustration further assumes that the employee has the right to access cash value amounts in excess of the amount the employer has the right to recover. Exhibit 1 illustrates the tax results in the first three policy years. In year 1, the cash value does not exceed the amount to which the employer is entitled at plan termination, and the employee is therefore only taxed on the value of the death benefit provided. In year 2, the policy cash value has grown such that the employee has a $20,000 interest. Since the employee has a current right to access that amount, it is included as taxable income in year 2. The amount of life insurance protection provided to the employee is reduced by both the employer's interest and the amount of cash value the employee included in current income, with the net amount being taxable, based upon the employee's age, at the appropriate Table 2001 rate. In year 3, the employee has access to $60,000 of cash value. Nevertheless, $20,000 was included in the employee's income in year 2. The employee therefore includes only $40,000 in income in year 3 under the current access rules. The amount of life insurance protection provided to the employee is reduced by the employer's interest and the

6 amount of cash value the employee included in income both for the current and prior years, with the net amount being taxable, based on the employee's age, at the appropriate Table 2001 rate. Amounts received under the contract. In addition to taxing death benefits and cash value rights under a split-dollar life insurance arrangement, Reg (e) provides that amounts received by the employee from the policy during the year may be taxable. This would include policy dividends paid in cash, amounts withdrawn through surrendering paid-up additions, and amounts taken as policy loans. Regardless of the actual recipient (i.e., even if amounts are paid directly to the employee by the insurance carrier), all amounts are treated as first paid to the employer and then paid by the employer to the employee as compensation. Reg (f)(2) makes clear that only the owner of an insurance contract can have an investment in the contract under Section 72 or create basis. As a result, only the employer as owner can benefit from the favorable Section 72 tax treatment afforded a life insurance contract. The employee can, however, reduce the amount that otherwise would be taxable by offsetting the payment with amounts previously recognized in income under the current access rules. Thus, policy dividends will be treated as tax free to the employer until investment in the contract is exceeded. If those amounts are received by or paid to the employee, they will be treated as taxable compensation paid by the employer to the employee. The same treatment would apply to policy loans or withdrawals, creating taxable compensation income to the extent such amounts were received by or paid to the employee. The employee would, however, be able to reduce the amount of taxable compensation by amounts previously included in income under the current access rules. Transfer of the insurance contract. Not surprisingly, the Regulations state that transferring a contract from the owner or employer to the non-owner or employee is taxable to the extent the FMV of the contract exceeds the sum of the amount the employee pays for the policy plus the amount of any economic benefits previously taxed, other than amounts related to death benefit protection. Amounts related to death benefit protection the traditional economic benefit calculation for death benefits provided may not reduce the gain on transfer, since such amounts were deemed to be "expended" in providing term life insurance protection in those prior years. For purposes of determining the FMV of the contract, surrender charges are disregarded, as are any lapse restrictions. In the employment context, however, any substantial risk of forfeiture provisions that would otherwise postpone taxation under Section 83 would continue to apply. Special rules. The amount of taxable income to an employee related to the death benefit protection provided under the economic benefit regime is reduced by any employee payments made for such benefits. Reg (f)(2)(ii) requires that such payments, whether made to the employer or made directly to the insurance company, be treated as taxable income to the employer. Again, the Regulations apply the rationale that only one party can be the policy owner, and, thus, payments by a nonowner would be a purchase of benefits from the owner. Reg (f)(3)(i) also contains a provision that could limit the application of Section 101(a), which allows beneficiaries to receive life insurance proceeds tax free. The Regulations provide that the Section 101(a) exclusion applies only to the extent a beneficiary (other than the owner) has paid for or included the value of the death benefit

7 protection in income. To the extent that amount has not been paid for or included in income by the beneficiary, the life insurance proceeds will be taxed as ordinary income. While the Regulations are silent as to whether this rule will be applied annually or on a cumulative basis, a similar rule for disability payments under Section 105 is applied annually. The Loan Regime If the employee is the owner of the life insurance contract, the final Regulations use a loan regime applying the rules of Section 7872 for below-market loans, and the OID rules of Section for taxing split-dollar life insurance arrangements. A split-dollar loan is an arrangement where all of the following conditions exist: A payment is made by the non-owner to the owner or the insurance company. The payment is a loan for federal income tax purposes, or a reasonable person would expect amounts to be repaid to the non-owner. Repayment is made from or secured by the policy's death benefit, cash value, or both. To the extent the arrangement is a split-dollar loan, it is tested under Section 7872 to determine if it is a below-market loan. If it is a below-market loan, interest is imputed to the employee as compensation and deemed to be repaid to the employer. The employer must report the deemed repayment as interest income, but is generally able to deduct the imputed interest deemed paid to the employee as compensation, creating no net tax consequences for the employer. The employee, however, generally must include the imputed interest income as compensation with no offsetting interest deduction, as a result of the Section 264 denial of interest deductions related to insurance policies and the classification of such interest as a personal interest expense under Section 163(h). To test below-market-value status under Section 7872, split-dollar loans must be classified as either demand loans or term loans. Reg (e)(5) provides for a hybrid-type loan treatment for (1) certain term loans payable at death or conditioned on employment, and (2) gift loans. A special rule applies to nonrecourse loans (i.e., those in which the non-owner's security interest is limited to the value of the life insurance contract). Such loans are treated as "contingent" loans. They are therefore tested as if all contingencies occurred in a manner that the lowest possible interest rate applied to the loan, and, if there is an adjustment of the rate during the term, that the longest possible term applied, creating the least favorable result for the taxpayer. This result can be avoided, however, if all parties to the arrangement make a written representation, attached to each party's income tax return annually, that a reasonable person would, in fact, expect the loan to be repaid in full. Reg (a)(4) also addresses split-dollar arrangements in which a separate deferred compensation agreement exists that provides for the non-owner or lender to pay directly or indirectly interest amounts related to the loan. If such an arrangement exists and the deferred compensation arrangement was entered into as part of the split-dollar life insurance arrangement, the stated interest will be disregarded and the arrangement will be tested as if there was no stated interest. The Preamble to TD 9092 states that similar treatment will apply when there is an agreement between the owner and non-owner that provides the owner will not be

8 required to repay the owner amounts advanced, such as when the owner and non-owner enter into a separate agreement providing for the non-owner to make a transfer to the owner sufficient to repay the split-dollar loan amount. In such circumstances, the arrangement will not be treated as a split-dollar loan and general income tax rules will apply to the premium payments made by the non-owner on the owner's behalf. Demand loans. Demand loans are tested for sufficiency of interest by comparing the interest rate on the loan to the blended applicable federal rate (AFR) published in July of each year. If the stated interest rate is less than the blended AFR, the loan is a belowmarket loan subject to Section If the interest rate is equal to or greater than the AFR, the loan is taxable under general tax rules, including those related to OID under Sections The amount of additional income imputed annually to the employee is equal to the loan amount multiplied by the amount by which the stated loan interest falls below the AFR. Each premium advance made by the employer is tested and treated as a separate loan. This amount will be imputed as income to the employer and taxable as compensation to the employee. It then will be deemed to be paid by the employee to the employer. In general, the employer will receive a compensation deduction to offset the taxable interest income of the deemed interest payment. The effect for the employee will be taxable income to the extent of the imputed interest with no offsetting deduction. Example: An employer makes a demand loan for $30,000 without interest in a year in which the AFR is 5%. The employee includes $1,500 in income ($30,000 5%). Term loans. Term loans are tested by comparing the present value of the repayment amounts using the appropriate AFR for the original term of the loan. For loans of three years or less, the short-term rate is used; for loans written between three and nine years, the mid-term rate is used; for loans with a term greater than nine years, the longterm rate is used. If the present value of all payments discounted at the appropriate AFR is less than the amount of the initial loan, the arrangement is a below-market loan subject to Section 7872; if the present value of repayments exceeds the original loan amount, the arrangement is not a below-market loan. If a loan is a below-market term loan, the difference between the present value of all repayment amounts and the amount loaned is imputed to the employee as compensation income in the year in which the loan is entered into. There is no offsetting interest expense available to the employee. The employer is generally able to deduct the imputed interest amount as compensation expense in the year the loan is made. The OID rules then require the employer to include deemed interest payments in income over the term of the loan arrangement. Example: An employer and employee enter into a split-dollar term loan arrangement whereby the employer advances a $100,000 premium payment without interest, repayable in 15 years, when the long-term AFR rate is 7%. The present value of $100,000 in 15 years discounted at 7% is approximately $36,245. The employer is treated as having transferred the difference between the $100,000 loan amount and the present value of the repayment amount as compensation to the employee, causing the employee to be taxed on approximately $63,755 of compensation income in the year in which the loan is entered into. The employer will have a compensation deduction of approximately $63,755 in the same year and would include that amount in income as interest income under the OID rules over the 15-year life of the loan.

9 Hybrid loans. Reg (e)(5) provides a hybrid treatment for loans payable at the earlier of death or a stated term, loans payable at the earlier of performance of substantial future services or a stated term, and gift term loans. These hybrid loans are tested for interest sufficiency as a traditional term loan, using the AFR related to the term of the loan and tested on the date on which the arrangement is entered into. Once a loan is determined to be a below-market loan, however, the taxation of the amount of forgone interest is included in income annually, similar to a demand loan. 8 While the hybrid type loan is afforded favorable income tax treatment, that same ability to postpone tax consequences over the life of the loan is not afforded for purposes of gift taxes: any gift taxes related to hybrid type loan arrangements must be paid in the year the loan is entered into. When an Arrangement Is Entered Into Reg (j)(1)(ii) applies to arrangements entered into after 9/17/03. The IRS requires all elements of the arrangement to be in place before the arrangement will be considered to be in existence or entered into. Specifically, the final Regulations state that an arrangement will not be deemed to be entered into until the later of the date that: The insurance contract is issued. The insurance contract is effective. The first premium payment is paid. The parties enter into an agreement with respect to the policy. The arrangement satisfies the definition of a split-dollar life insurance arrangement. Material Modifications Reg (j)(2) applies not only to all split-dollar arrangements entered into after 9/17/03 but also to pre-existing arrangements that are "materially modified" after that date. The concept of "material modification" can entangle the careless, since the Regulations do not define what constitutes a material modification. Reg (j)(2)(ii) provides a sample list of items that do not constitute a material modification, including: A change in the mode of premium payment, such as from monthly to quarterly. A change in beneficiary, unless it is to a party to the arrangement. A change in the policy loan interest rate charged. A change to preserve life insurance status under Section A change in a ministerial provision such as to whom payments should be sent. Contractual change to an ancillary agreement pursuant to a binding contractual commitment in place before 9/18/03. A change in ownership as a result of a Section 381(a) transaction in which substantially all of the former owner's assets are transferred to a new policy owner. A change required by a court or insurance commissioner as a result of insolvency of the issuing insurance company. A change in the administering insurance company as a result of an assumption reinsurance transaction to which the plan participants were not a party.

10 The final Regulations do not address whether "material modification" includes Section 1035 exchanges, assignment of contract rights to third parties, changes in the timing or amount of premium payments to maintain coverage, and myriad other changes that may occur. CONCLUSION With the publication of the final Regulations, we move into yet another chapter for the taxation of split-dollar life insurance arrangements. Many of the challenges in adapting to these rules will be addressed over time through additional IRS guidance, court cases, or development of industry-accepted norms. Nevertheless, one caveat seems in order while the effective date may appear clear, there is a potential trap for the practitioner in the vagaries surrounding the definition of when an arrangement is "materially modified." Unless extreme care is exercised in becoming aware of and assessing potential activities surrounding pre-final Regulation arrangements, an arrangement could inadvertently move from within the auspices of Notice into the potentially harsher world of the final Regulations' "two regimes." Exhibit 1.Economic Benefit Regime Example: First Three Years Assumptions Year 1 Year 2 Year Cumulative $60,000 $120,000 $180,000 premiums Cash value $55,000 $140,000 $240, Taxable economic benefits: Current 0 20,000 40,000 access amount 2. Death benefit taxed to employee Total death $1,500,000 $1,500,000 $1,500,000 benefit protection Less: Amount (55,000) (120,000) (180,000) payable to employer Amount - (20,000) (40,000) currently taxed to employee Amount - - (20,000) previously taxed to employee Net death $1,445,000 $1,360,000 $1,260,000 benefit taxed to

11 employee Practice Notes The final Regulations make it clear that the tax treatment does not address the question of whether or not any or all split-dollar life insurance arrangements are prohibited loan transactions for the purpose of Sarbanes-Oxley. Rather, the answer to that question is left to the Securities and Exchange Commission. 1 2 REG , 7/3/02 and 5/8/03. See Walker and Lee, "New Guidance and Legislation Should Spur Taxpayers to Rethink Split-Dollar Arrangements," 97 JTAX 262 (November 2002), and Walker and Lee, "Split- Dollar Life Insurance Arrangements: IRS Fills in a Valuation Blank," 99 JTAX 34 (July 2003). 3 For example, an arrangement between an employer and an employee will be considered compensation, one between a donor and donee will be considered a gift, and one between a corporation and a shareholder will be tested under the rules governing corporate distributions. 4 5 Revoking Notice , CB 459. Rev. Rul , CB 12, allowed the employee to use the carrier's lowest oneyear initial issue term cost available to all standard risks to determine the economic value attributable to the death benefit provided to the employee. Notice , supra note 4, and Notice , CB 398, both called into question the reasonableness of the rates created by the industry, with Notice establishing stricter criteria after 2003 for using alternative rates for plans put in place after 1/28/02. 6 See Reg (c)(1)(i). Care should be taken in such arrangements if what initially is treated as two separate contracts is later changed to have either the employer or employee's portion treated as a split-dollar arrangement, the entire policy will be treated as a split-dollar arrangement subject to the Regulations. 7 8 Section 72(e). As compared with term loans, which under Section 7872 are taxed for income tax purposes in the year the loan is entered into. Document Title: A Practical Guide to the Final Regs. Governing Split-Dollar Life Insurance, Journal of Taxation, Nov 2003 Checkpoint Source: Journal of Taxation (WG&L) Copyright 2006 RIA. All rights reserved.