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By Charles D. Epstein

One of the surest signs that a tax-planning technique is doing its job is the inevitable IRS challenge to its very existence. Anyone who has witnessed the IRS's longstanding battle against various estate freeze techniques is familiar with the drill and knows how tenacious the IRS can be when it sets its sites on a particular planning technique.

That's why a recent technical advice memorandum (TAM) on equity split-dollar life insurance plans bears careful scrutiny. Split-dollar policies have been helping owners of many closely held businesses--mostly family firms--survive into the next generation of leadership without excessive debt. Any IRS action that threatens the viability of split-dollar policies also threatens the millions of family businesses that contribute so much to the economy.

How Split-Dollar Works

Traditionally, equity split-dollar life insurance has been used by owners of closely held corporations and family businesses to handle cash flow, succession, and buyout issues in a tax efficient manner.

In the particular case that generated the TAM, the employee/taxpayer established a holding company of which he holds a majority interest. A subsidiary owned by the holding company was created simultaneously. The subsidiary then bought a life insurance policy and designated a trust, created and controlled by the employee, as the policy's owner.

As a rule, the employee does not necessarily need to be both the founder and controller of the trust. In this example they are--and that is key to the IRS's recent TAM on split-dollar insurance.

The IRS Target: Excess Cash Value

Once the cash value of a split-dollar policy is greater than the premiums paid by the subsidiary, the trust can borrow money from it against this excess cash value. This creates a low- or no-interest, tax-free, revenue source for the employee/taxpayer.

In issuing TAM #9604001, the IRS is attempting, for the first time, to tax this excess cash value. In its advisory, the IRS stated that both the one-year term cost of split-dollar life insurance and the amount of cash value in excess of corporate or subsidiary contributions should be included in the taxpayer's income.

This interpretation is based on a broadened reading of IRC Sec. 83, which deals with taxation on the transfer of property. Section 83, defines "property" as a beneficial interest in assets (including money) set aside, for example, in a trust, from the claims of the transferor's creditors. Property is considered "transferred" when a person acquires a beneficial interest in it. For split-dollar policies, IRC Sec. 83 only applies to the cash surrender value of the policy after it exceeds the premiums paid by the subsidiary. Before this, the policy's entire cash value is still subject to the subsidiary's creditors and is not considered "property."

Because the employee both established the trust and holds controlling interest in it, the IRS reasons that once the policy's excess cash value is transferred from the subsidiary to the trust, the employee has gained a beneficial interest from it. Under IRC Sec. 83, the transferred funds are now property and should be reflected in the employee's gross income. As a corollary, the IRS also deemed that any funds transferred to the trust are a taxable gift.

Split-Dollar Remains Viable--For Now

A survey of insurance company legal departments and experts on transfer of property issues reveals that equity split-dollar plans remain a viable approach to meeting a taxpayer's needs. Here are some reasons why:

* TAM #9604001 is not an IRS ruling. It is directed only at a specific taxpayer's situation. At issue is how much of the cash value of a split-dollar policy should be included as taxable income to the policy's owner. The fact that the taxpayer has established a holding company, a subsidiary, and a collateral arrangement with a trust, makes the particulars of this scenario even more unique and isolated.

* The advisory speaks solely to those cases where the individual taxpayer is controlling stockholder of a trust that was established by the taxpayer. For all other taxpayers, IRS Ruling 64.328, the existing standard for the taxation of split-dollar policies, remains firmly in effect.

* Based on an analysis of TAM #9604001 and the IRS's pattern in instituting previous rule changes, the advisory does not appear to signal a broader move to tighten the taxation or equity split-dollar policies.

Benefits Worth Fighting for

Overall, life insurance remains one of last few effective large dollar tax shelters. Split-dollar life in particular can be creatively used--especially in helping family-owned and closely held businesses deal with significant cash flow and succession issues. The following example should clarify the approach:

Retirement Planning. Using a split-dollar arrangement, a family business or closely held corporation can create a tax-free retirement income for its principals. The cash value of the policy grows tax-free. On retirement, the insured can withdraw premiums or even take a loan against the policy. As long as the policy is not surrendered, the insured is getting a tax-free stream of income. The amount owed on the policy will be paid from the death benefit.

Succession Planning. Variable split-dollar life insurance can be used as a funding mechanism for passing a family business to the next generation of leadership while the older generation is still alive. A variable policy has the advantage of enabling a business to fluctuate the insurance premiums to a predetermined maximum while allowing the insured to make all the investment decisions regarding the policy.

Corporate Planning. Large shareholders of publicly traded corporations have also used split-dollar arrangements to ensure that there are enough funds available, upon their deaths, to pay estate taxes. *

Charles D. Epstein, CLU, ChFC, is the founder and chair of the Family Business Center at the University of Massachusetts in Amherst. He is a frequent speaker on technical issues relating to investment and insurance for CPA, attorney, and family business organizations. His companies, Epstein Financial Services and Business Success Group, Inc. of Springfield, Mass., are advisors to family businesses.

Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Avery E. Neumark, CPA
Rosen Shapss Martin & Company

Contributing Editor:
Steven Pennacchio, CPA
KPMG Peat Marwick LLP

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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