PERSONAL FINANCIAL PLANNING

SPLIT-DOLLAR UPDATE

By Richard B. Freeman

Recent developments in IRS pronouncements on split-dollar life insurance plans will affect nine areas, including the most contentious one--the taxation of policy equity under TAM 9604001.

Taxation of Split-Dollar Equity Under TAM 9604001. The TAM deals with the taxation of policy equity in a collateral assignment, split-dollar arrangement between an irrevocable insurance trust and a subsidiary of the insured's employer. Any increases in policy value beyond the corporation's premium advances would belong to the trust, thus making it an equity split-dollar arrangement. For the first time, the IRS took the position that the equity buildup was taxable each year to the insured under IRC section 83, which taxes transfers of property in connection with the performances of services. The TAM also takes the position that since the policy was trust owned, the employee was deemed to have made an annual gift of that amount to the trust.

There is much disagreement among commentators about the validity of the TAM. Rather than take sides on this narrow pronouncement, a more useful approach is to step back and look at the big picture. To use a golf analogy, if the IRS bogeyed the hole today, will it shoot par tomorrow? A practical approach is to assume it will reach into its golf bag for another club and try again. What advice should be given?

For existing plans, obtain an in-force illustration to see where the plan stands on equity buildup. An equity buildup may take perhaps three to seven years from plan inception depending on how things were structured. Assuming that the TAM or its successor(s) negatively impact equity buildup, there are three possible outcomes or strategies:

• They get lucky and all existing plans are grandfathered.

• They retain their plans and suffer the income and gift tax consequences. The action they take will depend upon the terms of the trust, the number of beneficiaries, and the availability of the unified credit. The split-dollar arrangement (versus making gifts from day one) will have achieved a delay in recognition of making gifts.

• Terminate the arrangement. There are a variety of ways for terminating split-dollar plans. They range from paying the employer back quickly or slowly using policy cash values, employer bonuses, loans, employee funds, etc. This will also result in a delay of gift recognition from plan inception until future gifts must be made to continue the insurance.

For proposed plans, the key is to assess the risk of a wait-and-see approach versus moving ahead. Clearly, the possible risk should be considered. Modeling the exposure at different points in time would be useful. Because the equity buildup takes a few years to occur, however, the exposure is not generally present for a significant period of time. There should be some additional guidance from the IRS or the courts by then. The following decision options may help.

Wait and See

1) Delay in receiving plan benefits.

2) Never implement the plan because the issues linger.

3) If change occurs and grandfathering is provided, opportunity is lost.

Move Ahead and Receive Immediate Benefits

1) Law is not changed.

2) Law is changed with grandfathering.

3) Law is changed with no grandfathering of plans but grandfathering of prior benefits; prospective adjustments made to premiums, etc., to minimize impact.

4) Law is changed with no grandfathering of plans or benefits; IRS lookback of three years for income tax; make prospective adjustments.

5) Law change makes split-dollar plans inefficient; terminate plans and employers get back money.

This decision tree should remove the TAM as the sole objection to moving ahead. The risks of the two alternatives should be weighed for each client on a case-by-case approach.

Reverse Split-Dollar (RSD). In RSD the employee/insured owns the policy and endorses part of the death benefit to the business. Key-person insurance is often the purpose of this arrangement. The business pays an amount of premium equal to the economic benefit of the plan which is usually the higher of the PS 58 rates or the one-year renewable term rates. The employee contributes additional funds as desired. At plan termination, the employee owns the policy and reassigns the death benefit. The marketing pitch is that this is a tax savings device in that the business is allowed to pay a high premium relative to the true costs of the economic benefit. To the degree this happens, equity builds up in the policy on behalf of the employee. Three broad tax issues are relevant here:

• PLR 9026041 covered the estate-tax treatment of the death benefit of RSD. It was included in the estate of the insured but a deduction (under IRC section 2053) was allowed for the payment to the business.

• There have been no rulings or guidance from the IRS directly relating to the income tax issues associated with RSD.

• TAM 9604001 may cast further doubt on any strategy relying on equity buildup to make it attractive.

Private (Family) Split-Dollar. This arrangement may be made between family members, between a trust and a family member, or between any two parties who agree to split the costs and benefits of a life insurance policy. Although there is little formal guidance as to how the IRS would tax this, recent private rulings give more information on probable IRS positions.

In PLR 9636033, the service looked at an arrangement between an irrevocable insurance trust created by the insured and the spouse of the insured. The trustee purchased a life insurance policy on the grantor's life and entered into a collateral-assignment, split-dollar arrangement with the grantor's spouse. The trust paid the term insurance cost and the spouse paid the balance due from her separate property. This provides a way for a spouse, as collateral assignee, to access the cash value of a policy owned by the other spouse's insurance trust.

One issue was whether the premium payments made by the trustee and the spouse resulted in a gift to the trust by the spouse or a deemed gift to the trust by the insured. The IRS concluded that no gifts were made because there was no employment relationship between the insured and the trust; hence the trustee's premium payments were not compensatory in nature. Therefore, there were no deemed gifts by the insured. The spouse's consideration for paying a portion of the premium was that she would receive cash values or death benefits under the policy. Since the spouse will be reimbursed for premium payments, such payment of premiums will not be subject to gift tax.

In addition, the IRS determined that the portion of the death benefit payable to the trust and the spouse would not be includible in the insured's estate since the insured had no incidents of ownership. Finally and quite importantly, the ruling warned that no opinion was expressed as to IRC section 7872 below-market-interest-rate-loan issues. Once again, some comfort is given in the gift and estate tax area, yet a cloud hangs over the income tax exposure.

More recently, PLR 9745019 concludes that a collateral assignment, split-dollar agreement between a husband, wife, and an irrevocable trust will not result in the inclusion of the proceeds of a second-to-die insurance policy in the estate of the last to die of the insureds. Once again, no opinion was expressed regarding the application of IRC section 7872.

Controlling and Sole Shareholder Situations. In years past, the IRS attributed incidents of ownership in life insurance policies to controlling and sole shareholders through their companies that had engaged in split-dollar transactions. Thus, the policies were included in the insured's estate even though properly owned by an irrevocable insurance trust. The problem was that the companies retained too much control over the policies. This included rights to borrow cash values, assign or surrender policies, etc.

It appears that now, with careful planning and proper documentation of the split-dollar arrangement, estate tax exclusion may be achieved. The IRS should not automatically include the split-dollar life insurance proceeds in the insured's estate merely because the controlled company is a party to the arrangement. A series of PLRs support this--9511046, 961017, 9709027, 9651030, 9746004, and 9746006. The key to exclusion is to specifically prohibit the business from having any rights in the policy (such as borrowing, assigning, surrendering) and limiting the business's rights under the split-dollar agreement to merely recover premium advances at death or plan termination, etc.

S Corporations and Second Class of Stock. There has been a risk that the value of a split-dollar arrangement for a shareholder (who thus received a benefit not given to other shareholders) might be treated as a second class of stock and terminate the S election. The key benefit for shareholder split-dollar in an S corporation is the gift tax leverage of the arrangement. Fortunately, the service continues to view this as an employee benefit and not a second class of stock.

Carefully following PLRs 9331009, 9318007, and 9235020 is important. Employee shareholders are required in all three PLRs to contribute to the premium, as well as reimbursement to the corporation of any benefit derived from the corporate outlay.

Partnerships and LLCs. More guidance is now available. In PLR 9639053, the IRS approved a split-dollar arrangement between a family limited partnership and its general partner--a revocable trust that owned a policy on the life of the grantor/trustee. The ruling focused on the income tax implications only. From an estate tax perspective, PLR 9623024 held that life insurance proceeds will not automatically be includible in the gross estate of an insured partner. The thinking here is similar to the controlling shareholder issues referenced above.

Rules for Use of Insurer's One-Year Term Rates Tighter. A number of recent rulings have shown that the IRS will strictly construe the rules pertaining to the insured's use of yearly renewable term (YRT) rates when reporting the taxable economic benefit.

• Rates must be available to all standard risks. The contract must be available without regard to health or smoker status. This is a planning opportunity in that an insured with a health or smoking problem will pay standard rates for the economic benefit.

• Rates must be available in all policy sizes. This eliminates reduced rates for large policies.

• Rates must be annually renewable. This eliminates rates of a limited (such as five-year) renewable term contract which will not be allowed.

Interest Deduction Disallowance for Second-to-Die Insurance. The Taxpayer Relief Act of 1997 imposed interest deduction disallowances for split-dollar plans utilizing second-to-die insurance. For an insured other than a 20%+ owner (e.g., officers, directors, employees), there is an interest disallowance provision impacting unsecured company debt.

Documentation. The lack of IRS attention to documentation led to hundreds of agreements established without the proper paperwork. Recent cases have emphasized the importance of careful and full documentation. Taxpayers have lost the benefits of split-dollar plans due to incomplete or nonexistent documentation. Typical documents include the following:

• Corporate resolution stating that the board of directors has authorized the arrangement.

• Collateral assignment forms properly executed where this structure will be followed.

• Split-dollar agreement between the relevant parties spelling out--

  --contributory or noncontributory plan

  --division of and rights to cash value

  --repayment terms

  --division of death benefits

  --policyowner's retained rights

  --termination arrangements

The tax treatment of split-dollar plans will continue to evolve as the IRS learns more about this area and focuses attention on it. Keeping current on these issues will be important.

Richard B. Freeman, CFP, CLU, works with financial advisers serving insurance needs.

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA\PFS

Contributing Editors:
Alan Fogelman, CPA
Clarfield & Company P.C.

David R. Marcus, JD, CPA
Paneth Haber & Zimmerman LLP