The Importance of Reviewing Split Dollar Arrangements
From 2001 through 2003 there was a flurry of IRS and Treasury Department activity focused on split dollar arrangements. This activity culminated in final regulations that applied to any split-dollar life insurance arrangement entered into or “materially modified” after September 17, 2003. Many of our clients who have implemented split dollar arrangements are unaware of the drastic changes made by these final regulations and their options going forward. The following is a brief history of the actions taken.
The final regulations were the result of a series of actions by the IRS and Treasury to reexamine and set forth technical rules and guidance for the taxation of split-dollar life insurance arrangements. The following is the series of IRS guidance culminating in the final regulations.
- TAM 9604001, held that increases in the cash surrender value of an equity split-dollar arrangement are currently taxable under section 83.
- Notice 2001-10, 2001-5 IRB 459, treated an equity split-dollar arrangement either as a loan, taxable under section 7872 and sections 1271-1275, or a section 83 transfer of property (cash value build-up) upon “rollout.” It also replaced P.S. 58 rates with those in Table 2001.
- Notice 2002-8 revoked Notice 2001-10 and stated that regulations would be promulgated that would base split-dollar taxation on the formal ownership of the insurance contract. It also provided some effective dates and safe harbor rules with respect to existing split-dollar arrangements, the most important of which allowed arrangements entered into prior to January 28, 2002, to be terminated or converted to a loan on or before December 31, 2003 – with no recognition of income by the recipient of the equity. Notice 2002-59, following quickly on the heels of a New York Times article about the incomparable wealth-shifting benefits of reverse split dollar, dealt severely with valuation games and the purported tax advantages of these arrangements.
- Proposed regulations (REG-164754-01) issued in 2002 followed the basic principles first voiced in Notice 2002-8 for federal income, gift, and employment taxation of both equity and nonequity split-dollar life insurance arrangements. The final regulations are almost entirely based on these proposals.
- Supplementary proposed regulations (REG-164754-01; 68 F.R. 24898-24903), stated the rules for valuing all economic benefits provided under an endorsement equity split-dollar life insurance arrangement. Most importantly, these proposed regulations made it clear that the IRS intended to tax equity annually, and would not wait until the “rollout” of the contract. Section 83 was abandoned by the Treasury and IRS as the guiding principle for the taxation of split-dollar arrangements in favor of the constructive receipt, cash equivalent, and economic benefit doctrines under section 61.
These final regulations also apply to any split-dollar life insurance arrangement entered into on or before September 17, 2003, if the arrangement is materially modified after September 17, 2003. While the regulations did not provide a bright-line test for what constitutes a “material” modification, they did include a nonexclusive list of modifications that would not be considered “material”. For example, changes in the mode of premium payment, policy-loan interest rates or beneficiary choices (provided the beneficiary is not a party to the arrangement) are not material.
A material modification after September 17 has the following implications:
- it forces the client into one of the two tax regimes of the regulations;
- it forces taxation based on policy ownership; and
- it eliminates the use of insurance company term rates after 2003, unless they meet new and more stringent standards.
Reviewing Split Dollar Arrangements
There are many different variations of split dollar arrangements and the final regulations define split dollar in a very broad manner in order to capture all of these different variations. These final regulations have created a rather complex set of rules for taxing split dollar arrangements. It is very important for clients who have implemented split dollar arrangements to review these plans to assure they are recognizing the proper taxation and determine whether their plan remains the most financially viable solution to achieve their goals. As part of our due diligence, we will conduct a full audit of your existing Split Dollar arrangements to assist you and your tax and legal advisors to determine your best course of action regarding the arrangements going forward.
*This material does not constitute tax, legal or accounting advice and neither Bowen, Miclette & Britt Insurance Agency, LLC nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. Comments on taxation are based on our understanding of current tax law, which is subject to change.