Split-Dollar Life Insurance

By Thomas L. Ledbetter, George B. Kozol, and Joseph E. Godfrey III

In Brief

Limited Window for Safe Harbor

IRS Notice 2002-8, as amplified by proposed Treasury regulations, outlines certain “safe harbor” steps that must be taken by January 1, 2004, to sanction either of two split-dollar life insurance regimes: endorsement split-dollar or employer loan split-dollar. The authors identify the basic knowledge necessary for employer sponsors to resolve the complex interplay of issues raised by the new split-dollar rules as well as by the Sarbanes-Oxley Act’s effect on public company split-dollar plans.

In January 2002, the IRS published Notice 2002-8 (which replaced Notice 2001-10) to clarify the taxation of equity split-dollar arrangements and to outline the conditions for providing a safe harbor for life insurance plans that were established on or before January 28, 2002. Notice 2002-8 provides transition rules for plans adopted before the publication of final regulations and sets ground rules for new plans adopted after the publication of final regulations.

On May 9, 2003, the Treasury Department published proposed regulations on split-dollar taxation (REG 164754-01). Employer sponsors will be seeking recommendations regarding existing split-dollar plans and, in some cases, proposed alternatives. These regulations echo much of Notice 2002–8 and confirm that December 31, 2003, is an important date for the tax status of existing split-dollar programs.

Background

Split-dollar plans have been among the most significant forms of executive benefits for more than 40 years. Split-dollar describes a method of paying for insurance by splitting the premiums and proceeds between the employer and the employee. The dominant use of such plans filled the gaps in a deferred compensation plan for key employees. Split-dollar insurance has also been used to provide additional retirement income to participants through a Supplemental Executive Retirement Program (SERP). These plans gained popularity because they offer an economical way to provide survivor benefits, generally with favorable income tax consequences to the family.

Equity split-dollar plans can avoid the security issues associated with deferred compensation, which relies on the future financial success of the employer. Under the employer loan regime, there comes a point in time when the policy values accrue to the benefit of the executive. These values are not subject to claims of corporate creditors. The endorsement split-dollar regime is essentially a form of deferred compensation for an individual employee. While appropriate for providing deferred compensation, the employer loan regime usually provides superior tax and security benefits for the participating executive.

Of prime importance are the tax and financial benefits associated with split-dollar insurance. In a properly designed split-dollar program, employer contributions are not currently taxable to the executive, who can later receive income tax–free withdrawals up to the cost basis (usually cumulative premiums paid) and take tax-free policy loans thereafter.

When the employee’s share of the policy equity should be taxed in the split-dollar transaction has been the subject of controversy for many years. A tax history of split-dollar plans and descriptions of several types of split-dollar plans are included in the Sidebar 1 and Sidebar 2. Until the IRS issued Notices 2001-10 and 2002-8, an “equity” split-dollar plan typically provided the executive benefits described above. The authors believe that the two IRS notices and the recent proposed regulations make the traditional equity split-dollar design obsolete.

The Future of Split-Dollar Insurance

What, then, is the future of split-dollar insurance as an executive benefit? Split-dollar is not only alive and well, but also is primed to play an even more important role as the foundation of executive benefits for key executives. Furthermore, the IRS-mandated “employer loan regime” offers comparable benefits to an equity split-dollar plan, but with predictable federal income tax consequences and in many cases, particularly for older executives, a lower-cost benefit. A number of viable options are available in structuring the program to offer both the corporation and the executive the flexibility previously afforded by equity split-dollar. Split-dollar plans can easily be adopted by private companies and tax-exempt organizations, because they do not fall under the Sarbanes-Oxley Act, which prohibits loans by public companies to executives.

From the corporation’s perspective, there is little difference between equity split-dollar and the employer loan regime, which will henceforth be referred to as “leveraged split-dollar.” The employer’s current outlay is essentially the same, but an amount equal to the annual insurance premium is now evidenced by a series of interest-bearing notes to the executive. The corporation recovers its investment when the plan is terminated. Recovery comes in the form of repayment of the loan, upon either the death or the retirement of the insured executive. The typical “cost” to the employer is the loss of the use of the funds while the program is in effect, which is what provides the benefit to the executive and which, in turn, is why the Treasury Department wants to impute an interest rate.

From the executive’s perspective, instead of paying income taxes annually on the value of the life insurance protection, the executive’s current outlay is limited to income taxes on the actual or imputed interest amount that the employer provides for the particular year. Note that the cost of this fringe benefit is now driven by the interest rate rather than age. Under a classic equity split-dollar plan, the executive pays taxes on the value of the life insurance protection. Of course, the nature of life insurance is such that the cost increases with age. Thus, under a classic split-dollar plan the value of the economic benefit increased each year, as did the tax cost to the insured executive. Also, even if premium payments were stopped under a premium offset or contractually ceased at a point in time, the executive still had escalating economic benefit charges with split-dollar; under the loan regime, the cumulative loan and imputed interest is capped (see Exhibit 1).

Under a financed benefit plan, the tax cost does not vary with age. The cost to the insured executive is a function of the prevailing federal interest rate. The executive pays an appropriate amount of interest on the loan, which can, in turn, be “bonused” to the executive and deducted by the company, assuming that total compensation is reasonable.

How the Loan Regime Works

Leveraged split-dollar plans typically involve a series of loans from the employer to the executive. The loans will bear interest at the Applicable Federal Rate (AFR). The current low-interest-rate environment makes this plan particularly attractive by using term loans. While a term loan carries a moderately higher interest rate, it creates a cap on the interest and the resulting tax costs associated with the program for a long period of time.

Using a demand loan would allow for a lower initial interest rate. Such a loan, however, would detract from the reliability of the financial leverage forecasts necessary to install and maintain a leveraged split-dollar plan, because the interest rate on a demand loan changes every month (with a blended rate, the rate changes once each year). The demand loan approach carries two other risks. First, a demand loan would expose the parties to unpredictable spikes in the AFR. Moreover, by definition, a demand loan permits an employer to demand payment from the executive at any time. This unfettered right to demand payment would be a serious concern for a minority shareholder or nonshareholder executive.

Such loans would be private transactions, so the parties can arrange the program to allow for refinancing to take advantage of periodic interest-rate declines. Unlike mortgage refinancings, there are no fees or charges to the executive, so there is no reason not to refinance whenever a lower rate is obtainable; this lower rate is then locked in. Exhibit 2 illustrates historical AFR rates as announced by the IRS through its monthly bulletin (for example, Revenue Ruling 2003-45, I.R.B. 2003-19, April 17, 2003). They portray the potential advantages of refinancing long-term loans.

Although the leveraged split-dollar program is a fringe benefit, employers should not be tempted to bestow the benefit to the executive in the form of an interest-free or below-market loan. Such a design would detract from, if not eliminate, the potential for favorable financial leverage. In this regard, IRC section 7872 accelerates the tax cost of interest-free or below-market loans. For example, a $100,000 interest-rate loan made to an insured executive at a rate of 4.5% and for a term of 20 years (assuming a long-term AFR of 4.5%) would result in a taxable income of $58,536 in the year of loan origination ($100,000 minus $41,464, the present value of $100,000 at 4.5% over 20 years). This negative tax outcome is easily avoided by using the applicable AFR.

Thus, with the new loan regime, an executive can enjoy the same long-term financial benefits previously associated with equity split-dollar programs:

To reiterate—because it is important but potentially confusing—a leveraged split-dollar plan will not be appropriate for executives employed by publicly traded corporations. The Sarbanes-Oxley Act prohibits corporate loans to the top five executives, but does not affect private corporations or tax-exempt organizations.

Split-Dollar Plan Termination

While the leveraged split-dollar plan operates like the previous equity split-dollar plan, there are significant tax differences upon eventual termination of the split-dollar plan, called the rollout. Consider a typical equity split-dollar arrangement for a 43-year-old executive with an employer loan and cost-recovery leveraged split-dollar plan (see Exhibit 3). In both examples, the employer makes annual bonus payments to the executive to eliminate any out-of-pocket cost on the part of the executive. Note that the taxation on rollout under the equity split-dollar plan is significant and continues to escalate, while the rollout of the leveraged split-dollar plan is zero.

Grandfathering Rules

The IRS has protected the tax status of plans that were installed before the rule change through a grandfather clause. Under the new tax rules, which apply to equity split-dollar plans originated after January 28, 2002, the executive’s share of the policy values will be taxed as they accrue. Thus, the taxation of policy values will no longer be deferred until rollout, unless the executive’s interest in the policy values is subject to a substantial risk of forfeiture. Of course, such a risk is not typically employed because it would detract from the perception that the split-dollar program is a valued fringe benefit. To make matters worse, if the policy is held in an insurance trust, the cash value growth accruing and currently taxable to the executive is viewed as a future interest gift as it accrues. This characterization means that the cash value growth would not be eligible for annual exclusion protection, negating the equity split-dollar plans value as a planning tool.

The IRS will allow parties to split-dollar agreements that originated prior to January 28, 2002, to either exit the split-dollar plan or convert it to a formal loan arrangement on or before December 31, 2003, and thereby preserve some of the favorable tax treatment that has heretofore been accorded equity split-dollar plans.

Therefore, all split-dollar plans should be reviewed promptly to determine whether the IRS would define them as equity split-dollar arrangements. If so, and if it was entered into before January 28, 2002, then the parties should consider terminating the arrangement by December 31, 2003, or converting it into a leveraged split-dollar plan. Otherwise, the participant faces the risk of significant future taxation.

Equity split-dollar plans entered into after January 28, 2002, do not have the benefit of the safe harbor rules and, therefore, participants and advisors should consider converting them to a leveraged split-dollar plan immediately, or at such time as there is one dollar or more of cash value in the policy on the executive’s side of the ledger. This strategy has become known as “switch split-dollar.” To wait, however, is to risk forgetting or failing to track the cash value build-up in the policy and switch at the proper time.

The bottom line is that split-dollar arrangements are very much alive and well and all of the tax and economic benefits that made them so popular in the first place are still available. The good news, which is definitely a positive result, is that planning for the financial and tax consequences can be done with greater certainty. The loan regime should prove to be better for most—but not all—situations, because what is appropriate will vary with the actual facts and circumstances. Participants in split-dollar programs should seek competent and capable advisors to advise them regarding appropriate current actions and future compliance with IRS rules.