Tax Changes to Executive Life Insurance Benefits

Legislative and regulatory changes that occurred in 2002 left split-dollar life insurance in a state of transition and uncertainty. First, in January, Treasury Notice 2002-8 significantly changed split-dollar taxation. Then, on July 9, the IRS issued proposed split-dollar regulations providing detailed guidance for the future of split-dollar taxation. While these proposed regulations contain several key differences from Notice 2002-8, they will not be effective until the final regulations are published. Adding further confusion, a provision of the Sarbanes-Oxley Act, signed into law in July, prohibits public companies from making loans to executive officers or directors. Because certain types of split-dollar arrangements might be characterized as loans, the act might eliminate such arrangements.

All of this legislative and regulatory change leaves more questions than answers regarding existing and proposed split-dollar insurance programs.

Although the life insurance benefits that many corporations offer to their employees through group term plans are efficient in providing benefits to currently active nonexecutives, group term life insurance has several shortcomings in providing executive life insurance coverage, including:

Consequently, corporations use executive life insurance arrangements to overcome group term life insurance limitations. Usually these arrangements are structured as split-dollar plans.

Split-dollar life insurance is a financing arrangement structured around a permanent cash-value life insurance policy. The arrangement splits the policy premiums, death benefits, and sometimes the cash value between the executive and the company. Generally, the company pays most of the premiums and retains rights to the policy’s cash value and death benefit at least equal to its premium payments. The executive must contribute toward the policy premiums or be imputed an amount equal to what the IRS deems the “economic benefit” of the coverage. This calculation typically produces a significantly lower taxable amount than would be reportable for the same coverage under a group term life insurance plan.

Although different structures are in use, past practice and the recent IRS notice recognize two design approaches, depending on whether the employer or the executive owns the policy.

Collateral assignment. The executive (or the executive’s trust) owns the life insurance policy and assigns to the company policy a cash value and death benefit equal to the cumulative premiums paid by the company. The company is the primary premium payer. The executive owns the remainder of the cash value and death benefit. Generally, at retirement, the company recovers its cumulative premiums from the policy, releases the assignment, and “rolls out” the remaining policy to the executive. Prior to Notice 2002-8, the common interpretation of tax law was that this rollout did not create a taxable event for the executive or the company.

Endorsement. The company owns the policy, pays the premiums, and endorses a portion of only the policy death benefit to the executive. The executive’s cost is the tax on the imputed income equal to the economic benefit. Additionally, the amount of death benefit purchased by the corporation is sufficient to provide the executive’s death benefit and reimburse the company for its cumulative premium cost.

Because a split-dollar arrangement allows the company to recover its costs, it minimizes or eliminates the profit-and-loss impact of the program. It also provides a more efficient benefit than group term life insurance coverage. According to mortality tables, less than 20% of the population dies before age 65. This is particularly true for executives, whose mortality rate is generally lower than the average population. Group term life insurance benefits decrease significantly or disappear at retirement; therefore, under a group term plan, the company is frequently paying for a benefit that is never used.

Split-dollar isn’t used for all employees, because funding the policy sufficiently to recover the company’s costs requires significantly greater cash flow than group insurance. Although the long-term economics of split-dollar are more attractive, the appetite for cash flow is typically a consideration when deciding how many executives to include in such a program.

Notice 2002-08 recognizes two types of split-dollar life insurance: employer-owned (endorsement) and employee-owned (collateral assignment). The notice describes how each of these is to be taxed. Notice 2002-8 provides a transition period during which companies and executives can examine their split-dollar arrangements and decide how to treat the arrangements in the future.

Endorsement split-dollar arrangements will be taxed in a similar manner as before. Arrangements in place before January 28, 2002, may continue to value the economic benefit using the current carrier’s alternative term rates. Arrangements entered into after January 28, 2002, but prior to final regulations being issued may use the carrier’s alternative term rates through 2003. Thereafter, value must be based on either the carrier’s rates for commonly sold term products, or rates published in IRS Table 2001 (which can be five times higher than carrier rates).

Collateral assignment arrangements in place before January 28, 2002, will not be subject to taxation while the agreement remains in place. In addition, these arrangements may be terminated or rolled out prior to January 1, 2004, with no negative tax consequences. Arrangements terminated in 2004 or later may be subject to taxation at rollout. Premiums paid by the employer after January 1, 2004, for arrangements entered into after January 28, 2002, will be taxed to the policy owner either in their entirety or as a series of below-market loans under IRC section 7872.

In general, the proposed regulations closely follow the language of the notice. A few wrinkles are currently causing great confusion, such as:

Although split-dollar life insurance still has a place in providing executive survivor benefits, its viability in future situations depends on the facts and circumstances of each case. The primary alternative method being considered is an IRC section 162 bonus plan. Under this approach, the corporation purchases a life insurance policy, “bonuses” the premium to the executive as compensation, and deducts this bonus each year as it is paid. The company might also gross up the executive for the tax cost.

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