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?