Split-Dollar Regime Change 2004

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.

Split-Dollar Basics

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.

A second option for pre-January 28 arrangements-but not at public companies, because of the Sarbanes-Oxley Act's prohibition on executive loans-is to switch to the new loan regime spelled out by the final regs. Doing so locks in tax-free treatment for any excess equity at a later rollout, says Dean Mioli, director of financial planning at eMoneyAdvisor Inc., in Conshohocken, Pa. The switch does not have to take place by December 31.

In the loan regime, the employee is considered the policy owner and the employer's premium payments are deemed to be loans to her. When the switch to this regime occurs, all premiums previously paid by the employer are cumulated to arrive at the beginning loan balance. No retroactive interest is added but, starting at the beginning of the year in which the switch occurs, the loan must bear interest at the AFR, Mioli says. Future premium payments made by the company will fatten the loan.

Not surprisingly, interest expense is the biggest potential bugaboo with this approach. Happily, the AFR is currently very low, like other money rates. Still, "the client could end up with a big annual cost," Cushing says. And personal interest cannot be deducted, he adds, although if the client took out a home-equity loan to pay off the employer, that interest might qualify for an income-tax deduction. In determining whether to embrace the loan regime, you must consider the economics of borrowing "as with any other leveraged investment," Cushing says. "You want the (asset) to appreciate by more than the rate of interest that you're paying."

Switching makes the most sense for policies requiring significant future premiums-in other words, ones that currently have little or no excess equity. Weinberg advises continuing such a pre-January 28 arrangement until just before the cash value surpasses the premiums paid, and then moving to the loan regime. Although the employee will have to pay tax on the annual term cost of the insurance until the switch, changing later rather than sooner saves the employee interest in the interim. And until the switch occurs, the carrier's old, dirt-cheap rates may be used to compute the insurance cost, holding the annual tax bite on the employee to a minimum.

Keep in mind that making an IRS-defined material modification to a plan after September 17, 2003, brings it under the new regs immediately. Therefore, the advisor must be cautious about tampering with an old arrangement that is awaiting a move to the loan regime, or the potential benefits of the delayed-switch strategy could be lost, warns attorney Lawrence Brody, a partner at Bryan Cave in St. Louis.

Planners should provide clients with analyses that forecast how existing arrangements would fare under these options. Cushing says, "This is a chance for people to determine if their arrangement is going to achieve what they had hoped and, to the extent that the economics have changed, whether it still makes sense." Weinberg's firm is among those that have developed sophisticated modeling software for this purpose.

The Final Regs

For new arrangements and existing ones that are materially modified, policy ownership determines which of two mutually exclusive tax regimes applies. If the employee owns the policy, then the arrangement falls under the loan regime, unless it happens to be a non-equity collateral assignment plan (that is, one which assigns a portion of the policy values to the employer to secure repayment of the premiums). In that case, or when the employer owns the policy, taxation is per the economic benefit regime.

The latter views the employer as providing economic benefits to the employee-benefits that are taxable. The employee must declare as income the annual cost of the insurance, the yearly increase in the cash value that she can access, and the value of any other economic benefits received, Brody says. Moreover, the entire death benefit is taxable income to the beneficiary if the employee did not help pay the premiums, or failed to pay tax on an amount equal to the annual economic benefits received.nomic benefit regime. However for non-equity arrangements-which still function as an attractive employee benefit, according to New York Life's Barry-annual taxation is simply on the term cost of the insurance. Unfortunately, that cost can no longer be computed using carriers' old, inexpensive rates. Instead, Weinberg says, the final regs require use of a new life insurance premium factor, not yet published at the time of this writing, but expected to be higher than carriers' old rates and lower than those found in Table 2001 (issued in IRS Notice 2001-10). Until the new figure is released in the Service's monthly Internal Revenue Bulletin, use Table 2001 to calculate the insurance cost, Weinberg advises.

Although the final regs are only 90 days old, back rooms at insurance companies and consultancies are already birthing techniques that can leverage the new rules. But then, isn't that what regime change is all about?

Paying tax on the growing cash value clearly has little appeal, and experts expect to see minimal creation of new equity arrangements falling under the economic benefit regime. However for non-equity arrangements-which still function as an attractive employee benefit, according to New York Life's Barry-annual taxation is simply on the term cost of the insurance. Unfortunately, that cost can no longer be computed using carriers' old, inexpensive rates. Instead, Weinberg says, the final regs require use of a new life insurance premium factor, not yet published at the time of this writing, but expected to be higher than carriers' old rates and lower than those found in Table 2001 (issued in IRS Notice 2001-10). Until the new figure is released in the Service's monthly Internal Revenue Bulletin, use Table 2001 to calculate the insurance cost, Weinberg advises.