Some split-dollar insurance arrangements require action by December 31.
With the issuance of long-awaited final regulations in September, the Internal Revenue Service finally got its way with split-dollar insurance arrangements. Since the days of LBJ's Great Society, public as well as private corporations have used this esoteric technique to provide, on a tax-free basis, key employees or shareholders with an interest in policy cash value and their beneficiaries with policy death benefits. The only cost to the employee was annual income tax on the cost of the insurance paid by the employer, and carriers published special low-ball "alternative" insurance rates to keep the tax cheap. Meanwhile, wealthy individuals were engaging in private split-dollar arrangements with irrevocable life insurance trusts to lower transfer taxes. The Service? Not happy.
Enter the final regs. "They pretty much put the death knell on split-dollar as a tax-savings device," says Gideon Rothschild, an estate-planning attorney with Moses & Singer, in Manhattan. The new rules apply to arrangements entered into after September 17, 2003, and to ones established earlier but materially modified after that date.
Yet this is hardly the end of the line for split-dollar. The arrangements continue to be viable, most experts agree, so financial advisors must know the new rules. More urgent, however, is the need for advisors to review arrangements that clients entered into before January 28, 2002. Some qualify for an IRS safe-harbor, if you act by December 31. "After the year ends, we are going to see lawsuits brought by clients against advisors who failed to take appropriate action," predicts split-dollar guru Michael Weinberg, president of The Weinberg Group, an insurance and estate-planning firm in Denver that does consulting and provides expert witness testimony.
First, some background. A split-dollar insurance arrangement is an agreement between two parties-generally an employer and employee, occasionally a donor and an ILIT (irrevocable life insurance trust)-to share a life policy's benefits and/or cost. Either party may own the policy, but the employee is the insured and designates the beneficiary who is to receive the death benefit. The premium is usually paid by the employer, although sometimes the employee contributes.
However, the agreements provide for the company to recover the premiums at a later time-either from the death-benefit proceeds if the insured dies while the arrangement is in effect, or from the insurance cash value if she separates from service and takes the policy with her, ending the arrangement. At termination (dubbed "roll out"), the cash value will be, ideally, large enough for the insured to keep the policy in force without additional premiums, even after repaying the employer. In such cases, the insured got the policy "with somebody else's dollars" says James Barry, a corporate vice-president at the Nautilus Group in Dallas, a service of New York Life Insurance Co.
There are two general types of split-dollar arrangements. Non-equity agreements give the employee death benefits, a portion of which will inevitably reimburse the employer for the premiums, while the employer retains the policy cash value. Equity arrangements, on the other hand, provide the employee with death benefits plus an interest (equity) in the policy's cash surrender value, even if the employee has not shared proportionately in premium payments. At roll out under the old rules, the equity in excess of the premiums repaid was usually not treated as income to the employee, effectively resulting in a tax-free shift of that excess cash value to her, Barry says. IRS Notice 2002-8 permits that treatment for certain older arrangements through the end of this year.
Review Old Equity Arrangements
For arrangements entered into before January 28, 2002, that are terminated by New Year's Eve, the employee can receive, free of income tax, any accumulated cash value in excess of the premiums owed to the employer, says George Cushing, a trusts and estates partner at law firm Kirkpatrick & Lockhart, in Boston. But if the arrangement continues beyond this year, income tax will be payable when the client ultimately rolls out the policy-hence Weinberg's prophecy of clients suing advisors who miss the boat. Prime candidates for termination are mature agreements with excess equity sufficient to maintain the policy with no, or very manageable, future premium payments.
To terminate, the employee can give the employer a note, with interest at the IRS-mandated Applicable Federal Rate, for the amount of premiums advanced, says attorney Myron "Mike" Kove, a partner at Kove & Kosakow in New York City and executive editor of the estate-planning newsletter Insights & Strategies. The note is secured by the death benefit or, if the policy is cashed in before death, the cash value. "Then each year, the employee pays interest on the note," Kove says.