Lawrence Brody is a partner of Bryan Cave LLP, an international law firm, resident in the St. Louis office. He is the leader of its Private Client Service Group and is a member of its Entrepreneurial, Technology & Commercial Practice Client Service Group. He is an Adjunct Professor at Washington University School of Law, teaching Estate Planning and Drafting, and is a frequent lecturer and the author or co-author of numerous articles and books on the use of life insurance in estate and employee benefit planning, including two BNA Tax Management Portfolios, two books for the National Underwriter Company, and a number in the ABA Insurance Counselor Series. Mr. Brody is a member of The American College of Trust and Estate Counsel (ACTEC) and The American College of Tax Counsel, and is a frequent participant at ALI-ABA programs and Society of Financial Professionals programs and teleconferences. He is a member of the Advisory Committee for the Philip E. Heckerling Institute on Estate Planning, of the University of Miami School of Law.
Michael D. Weinberg, JD, AEP, is president of The Weinberg Group, Inc., Denver, Colorado. Mr. Weinberg works with individuals, families and businesses and their professional advisors to design and fund estate and business continuity plans. He also serves as a consultant and expert witness in life insurance and estate planning matters. A Harvard lawyer with more than 40 years of experience in tax law and estate and business planning, Mr. Weinberg previously served as a tax attorney in the Office of Chief Counsel, Internal Revenue Service, New York City.
Mr. Weinberg is a member of the Colorado, Minnesota and New York bars (licensed, not practicing) and is a former Adjunct Professor at the University of Minnesota Law School. He is both a former chair of the Insurance Committee of the Real Property, Probate and Trust Law Section of the American Bar Association (ABA) and the editor emeritus of The Insurance Counselor primer series. Mr. Weinberg's articles have been published in the Journal of Asset Protection, Journal of Financial Service Professionals, Journal of Taxation, Probate & Property, and Trusts & Estates, and he is co-author of The Insured Stock Purchase Agreement, published by the ABA. He has lectured and conducted seminars for many industry groups.
In this timely interview, Messrs. Brody and Weinberg discuss the final split-dollar life insurance regulations issued on September 11, 2003, as well as the interim guidance provided in IRS Notice 2002-8, issued on January 3, 2002. The Interviewer is our executive editor, Myron Kove, Esq.
Q. In January 2002, the IRS and Treasury issued Notice 2002-8, which revoked the previous guidance provided in Notice 2001-10, and the government has now published final split-dollar regulations. These final regulations are tough. Contrary to industry urging, they adopt virtually intact the prior proposed regulations issued in July 2002 and May 2003 with some further tightening of the rules and little liberalizing relief. With all of these new rules, how should practitioners prepare themselves for the future?
A. Notice 2002-8 and the Final Regulations
Weinberg: Practitioners must now be concerned about several important matters. The Notice and the final regulations totally change the taxation of split-dollar plans. The final regulations apply to split-dollar arrangements entered into after September 17, 2003, and to arrangements entered into prior to that date which are materially modified thereafter. The Notice governs the taxation of split-dollar arrangements entered into prior to September 18, 2003. In effect, there are now three time frames for split-dollar plans:
1. “Old Plans” entered into before January 28, 2002. Old Plans are governed by Notice 2002-8. The December 31, 2003 safe harbor grandfather date provided by the Notice applies to these plans (further discussed below).
2. “Interim Plans” entered into between January 28, 2002 and September 17, 2003. Interim Plans are also governed by Notice 2002-8, but the December 31, 2003 grandfather date does not apply to these plans.
3. “New Plans” entered into after September 17, 2003. New Plans are governed by the final regs.
For Old Plans (pre-January 28, 2002 plans), practitioners must guide clients through the critical IRS action deadline that expires on December 31, 2003. For New Plans (post-September 17, 2003 plans), they must prepare clients for the new split-dollar regimes that are now effective. (We will not spend much time on Interim Plans since I don't think many of these were adopted as a practical matter.)
Although the net effect of the Notice and the regulations is the end of equity split-dollar as it previously existed, this is not the end of split-dollar. On the positive side, the regulations provide advisers and clients with a road map for the future. I believe split-dollar will continue in new forms, and plans will be structured to comply with the new regulations.
(See “VIII. The Future of Split-Dollar” for further discussion.)
B. Old Fashioned Equity Split-Dollar
Q. Before we review the interim guidance and the final regulations, why is the IRS concerned about equity split-dollar?
Brody: In a typical equity split-dollar arrangement, the employer advances the premiums for a life insurance policy owned by the employee or an irrevocable life insurance trust (ILIT) created by the employee. The employee's (or ILITs) obligation is to reimburse the employer for the lesser of the employers' cumulative premium advances or the policy cash value, or, in come cases, its premiums. To secure the employers advances, the policy is collaterally assigned to the employer. On termination of the arrangement, any cash value in excess of employer premium advances, the policy “equity”, is the property of the employee (or ILIT). In TAM 9604001, the IRS first advanced the position that this equity was taxable to the employee under Code Sec. 83, and this position was confirmed in subsequent IRS Notices 2001-10 and 2002-8. As discussed below (and except as otherwise provided by the Notice grandfather provisions), under the new rules, if a new equity split-dollar plan is adopted, generally, the policy equity will be treated as taxable compensation to the employee annually, based on “access” as defined in the regulations, unless the employer premium payments are treated as a series of loans by the employer to the employee.
II. Notice 2002-8
Q. Does Notice 2002-8 provide any grandfather rules for old equity split-dollar plans?
A. Grandfather Rules
Weinberg: Yes. Limited grandfather protection is provided by the Notice for Old Plans. If an equity split-dollar plan was entered into before January 28, 2002, and the plan is terminated on or before December 31, 2003, by repayment of the employer's premium advances (i.e., a “rollout”), the employee will not be taxed on any then existing policy equity. Although that appears to be a big break, this option to terminate the plan before January 1, 2004, will be most meaningful for mature equity split-dollar plans but it probably will not be beneficial for immature plans.
B. Termination of Plan
Q. What is the difference between mature and immature Old Plans (pre-January 28, 2002 plans)?
Brody: A “mature” Old Plan is a plan that on or before December 31, 2003, it will make sense to rollout (terminate during the employee's lifetime). Such a plan will have substantial policy equity after repaying the employer (sufficient to carry the policy with no or minimal future premiums), and the termination safe harbor in the Notice will avoid taxation of that equity at the time of plan termination. An “immature” Old Plan is a plan where policy equity doesn't yet exist, or isn't substantial, so that, after rollout, substantial future premium payments will be required after 2003. If the immature plan were terminated by December 31, 2003, the employee would be faced with the prospect of paying the full amount of future premiums with after-tax dollars (or finding some other source for future premium payments), and those same amounts would also be subject to gift taxation if the policy were owned by an ILIT.
C. Switch to a Loan (“Switch-Dollar”)
Q. What other alternative is available for an “immature” Old Plan?
Weinberg: Alternatively, on or before December 31, 2003, an Old Plan may be switched to a loan between the employer and the employee. Conversion to a loan before January 1, 2004 will avoid taxation to the employee of policy equity existing both at the time of the switch and at a later rollout. This loan safe harbor requires that all pre-2004 employer premium payments be picked up as the beginning loan balance as of the beginning of the taxable year in which the switch occurs (although interest need not retroactively accrue on these prior employer payments), and that subsequent employer premium payments be treated as additional loans. This is the safe harbor that will likely be used by most immature old split-dollar plans, and the technique has come to be called “switch-dollar.”
Before leaving the topic of Old Plans and the Notice 2002-8 safe harbors, it is important to note that not all Old Plans need to be rolled out or switched to a loan by December 31, 2003. (There is much confusion on this point.) Although every Old Plan should be examined and analyzed prior to December 31st , action is required to be taken only for those plans that will have equity as of that date. If an Old Plan (perhaps adopted a short time before January 28, 2002) will not have equity by December 31, 2003, the switch to a loan can be delayed until just before the plan accrues equity in a future year without causing adverse tax consequences. The reason for delaying the switch to a loan and continuing in split-dollar is to preserve the use of favorable split-dollar term rates for as long as possible. This delayed switch is another facet of the switch-dollar technique. (See the later discussion in “V. Continuation of Pre-Final Regulations Plans” for further elaboration of these points.)
III. Final Split-Dollar Regulations
Q. What is a split-dollar arrangement under the final regulations?
Brody: Effective for arrangements entered into, or materially modified, after September 17, 2003, the regulations broadly define a split-dollar arrangement as any arrangement between an owner of a life insurance policy and a non-owner under which either party pays part or all of the premiums, and the party paying the premiums is entitled to recover all or part of the premiums from the proceeds of the life insurance contract or such recovery is secured by the contract.
As defined, the regulations will apply to both corporate split-dollar arrangements between an employer and employee and a corporation and a shareholder and to private split-dollar plans between a donor and a donee. A special rule also applies to arrangements entered into for the performance of services and arrangements between a corporation and its shareholders. Under this special rule, the arrangement will be treated as split-dollar regardless of whether the premium payer is entitled to recover from, or is secured by, the policy (an “unsecured” arrangement).
The only arrangements excluded from the definition of split-dollar are group term life insurance plans under Code Sec. 79 (other than those providing permanent protection to the employee), the purchase of life insurance between the policy owner and the life insurance company issuing the policy, and key person insurance where the corporation owns all of the rights in the policy. Further-more, any plan under which there is no expectation of reimbursing the party advancing the premiums is not a split-dollar plan. In such situations, the premium payments will be treated as either taxable income, a dividend, or a gift, depending on the relationship between the parties.
B. Economic Benefit vs. Loan Regimes
Q. What types of split-dollar plans are provided for under the regulations?
Weinberg: The regulations create two mutually exclusive regimes for the taxation of split-dollar plans. These are the economic benefit regime and the loan regime. Under the economic benefit regime, the owner of the policy is treated as providing economic benefits to the nonowner. All endorsement arrangements, where the nonowner has the right to designate the beneficiary, will be governed by the economic benefit regime. The economic benefit regime will also apply if the arrangement is entered into in connection with the performance of services and the employer or service recipient is the owner of the policy. A similar rule applies in the case of private split-dollar where the donor (e.g., the insured) is the policy owner. Under the loan regime, the nonowner of the life insurance is treated as loaning the premiums to the policy owner. All collateral assignment arrangements will be governed by the loan regime, except that a collateral assignment plan in which the employee or donee has no equity in the policy (i.e., a “non-equity” collateral assignment plan) will be treated as an endorsement plan and taxed under the economic benefit regime, regardless of who owns the policy. Presumably, this exception will allow for a non-equity corporate controlling stockholder or insured private split-dollar arrangement that will avoid incidents of ownership in the insured for estate tax purposes.
C. Economic Benefit Regime
Q. What are the income tax consequences of the economic benefit or endorsement regime under the regulations?
1. Taxation of Annual Economic Benefits (“AEBs”)
Brody: The traditional economic benefit taxation of a split-dollar arrangement will be mandated for any arrangement in which the employer is formally designated as the owner of the life insurance contract, the typical endorsement arrangement. In a non-equity arrangement, the employee will be taxed on the value of the current life insurance protection, that is, on the annual term cost. Currently, such value is based on Table 2001 published in Notice 2001-10. Presumably, insurance company alternative term rates may no longer be used to measure this benefit, and the regulations' “life insurance premium factors” will govern in the future. (We'll have more to say about split-dollar term costs later in “III. Annual Term Costs.”)
In an equity endorsement arrangement, where the owner of the policy (e.g., the employer) is entitled to receive the lesser of the policy cash value or its premium advances, the nonowner (e.g., the employee) is taxed on the current value of the life insurance protection, plus the annual increase in the amount of the policy cash value equity to which the nonowner has “current access,” plus the value of any other economic benefits provided to the nonowner.
If the nonowner is an employee, the annual economic benefits (AEBs) are taxed as compensation; if a share-holder, they are taxed as a dividend; and if a donee (e.g., an ILIT), these amounts are treated as a taxable gift.
Q. What does “current access” to policy cash value encompass?
Brody: The regulations provide that current access is to be broadly defined. A nonowner, for example, would have current access to policy cash value if the nonowner can either directly or indirectly withdraw or borrow from the policy, effect a total or partial surrender, or if the cash value can be attached or garnished by the nonowner's creditors. In addition, access includes an inability of the owner or the owner's creditors (even under state law) to have access to the cash values. Also, please note that policy cash value is determined by disregarding surrender and other similar charges (i.e., account or accumulation value is the measure of employee “cash value,” not the cash surrender value of the policy).
2. Employee Contributions
Q. What are the income tax consequences of any amounts paid by a nonowner under an endorsement split-dollar plan subject to the regulations?
Weinberg: Since the nonowner does not have an ownership interest in the life insurance policy, any premium contributions and any amount taxable to the nonowner as AEBs are not included in the nonowner's basis or investment in the contract. Further, any amount paid by the nonowner is included in the owner's gross income. The owner is not entitled to deduct any AEBs included in the nonowner's income.
3. Policy Transfers
Q. What if the policy is transferred to the nonowner?
Brody: Under the endorsement regime, if the policy is transferred to the nonowner/employee, then the employee will be taxed on the cash value of the policy plus all other benefits not reflected in cash value, less any consideration paid by the employee for the policy. Such consideration does not include the annual term costs previously taxed to, or contributed by, the employee; however, it does include other AEBs taxed to, or contributed by, the employee. For purposes of taxing a policy transfer, presumably the “cash value” of the transferred policy means cash value disre-garding surrender charges (as in the case of taxation of annual cash value equity build-up), but that is not wholly clear from the regulations.
4. Taxation of Death Benefit
Q. Are there any income tax consequences to the employer or the policy beneficiary in an endorsement plan when the death benefit is collected?
Brody: With regard to the employer, the amount, if any, received by the employer in excess of its aggregate premiums appears not to be taxable to the employer pursuant to the Code Sec. 101(a) death benefit exclusion. (This is a change from the proposed regulations.) With regard to the employee's beneficiary, notwithstanding Section 101(a), the regulations provide that the death benefit proceeds are excluded from the beneficiary's gross income only to the extent such amount is allocable to current life insurance protection provided to the non-owner, the cost of which was paid by the nonowner, or the value of which was taxed to the nonowner as an economic benefit. The entire employee death benefit would be taxed, therefore, if the employee never contributed or paid tax on the economic benefit. There may be a discontinuity here if the employee was taxed on equity build-up under an equity endorsement plan – that portion of the death benefit may not be covered by the Section 101(a) exclusion. Fortunately, under these tough new regulations, equity endorsement plans will be rare.
D. Split-Dollar Loan Regime
Q. Turning now to the split-dollar loan regime, what are the income tax consequences of a split-dollar loan?
Weinberg: If the employee is formally designated as the owner of a life insurance contract subject to an equity split-dollar arrangement, then treatment of the employer's premium payments as involving a series of loans is mandated, so long as the employee is obligated to repay the employer from the policy's death benefit or cash surrender value. These loans are classified as either demand loans or term loans, and they are subject to the below-market loan rules of Code Sec. 7872 and the original issue discount (OID) rules of Sections 1271-1275.
2. Taxation of Below-Market Loans
Brody: Under Section 7872, when an employer enters into a below-market or interest-free loan with its employee, an amount equal to the foregone interest is treated as having been paid by the employer to the employee as compensa-tion and then repaid by the employee to the employer as interest. Each employer premium payment is treated as a separate loan to the employee. If the loan is a demand loan, then the deemed transfers of the foregone interest occur annually. With a term loan (including a loan payable at an actuarially determinable future date, such as the insured's death), the foregone interest is treated as having been transferred by the employer to the employee as income in the year when the loan is created. (A term loan's foregone interest amount is calculated as the difference between the amount loaned and the present value of all payments actually due under the loan.) This retransferred amount is then taxed to the employer as interest income under the original issue discount rules (essentially spreading the interest over the term of the loan). Special rules are provided for below-market split-dollar term loans payable at the death of an individual or conditioned on the future performance of substantial services and for gift term loans. (Note that these special rules apply for income tax purposes, but not for gift tax purposes.)
3. Adequate Interest
Q. What if adequate interest is charged?
Weinberg: If adequate interest (based on the Applicable Federal Rate or AFR) is charged on a loan, then Section 7872 generally does not apply. Accordingly, especially when interest rates are low, it has been suggested that the best course of action may be to arrange the transaction as a term loan that states adequate interest. Because adequate interest is stated, it can be paid annually, or even accrued until the end of the term, instead of treated as being transferred upon creation of the loan. However, if the employer directly or indirectly pays the interest to the employee, the stated interest will be disregarded, and the loan will be treated as a below-market loan under Section 7872.
E. Gift Taxation
Q. What are the gift tax consequences of split-dollar arrangements under the regulations?
Brody: The regulations will apply for gift tax purposes to private split dollar arrangements. In a typical private split-dollar arrangement, the donor would make premium payments on a life insurance policy owned by an ILIT. If it is reasonably expected that the donor is to be repaid the premiums, then the arrangement is deemed to be a loan from the donor to the ILIT and is treated as a split-dollar loan. If the loan is repayable on the death of the donor, normally, the term of the loan would be the donor's life expectancy and the value of each gift (assuming no stated interest) would be the total premium payment less the present value of the donor's right to receive repayment at life expectancy. If the premium payments are not split-dollar loans, then the payments are governed by general tax principles.
Similar rules apply to the gift portion of the transaction in employer-employee equity split-dollar if the policy is owned by the employee's ILIT. This will be taxed the same as private equity split-dollar, treating the insured employee as the “donor.”
In a non-equity donor/donee arrangement, gift tax consequences will be determined under the economic benefit regime, regardless of who owns the policy.
IV. Annual Term Cost (“ATC”)
Q. How is the cost of current life insurance protection, that is, the annual term cost (ATC) determined?
A. New Rates
Brody: Prior to the Notice (and its predecessor, Notice
2001-10), the ATC was measured based on the PS 58 table. Alternatively, the ATC could be measured by using the insurance company's published, standard risk, one-year term rate, and this rate was always much lower than the PS 58 rate. Notice 2001-10 introduced Table 2001 to measure ATC. Although the rates under the 2001 table are much lower than the PS 58 table, they are still substantially higher than the old carrier alternative term rates. For example, the Table 2001 rate for a 55-year old is $4.15 per $1,000 of insurance coverage, which is lower than the PS 58 rate of $13.74 per $1,000, but higher than a typical insurance carrier's individual alternative term rate of about $1.10 per $1,000 of coverage.
B. “Life Insurance Premium Factor”
Weinberg: The final regulations provide that from hereon, the cost of current life insurance protection (ATC) is to be measured by the “life insurance premium factor.” These factors were not provided in the regulations which state that they will be published in the Internal Revenue Bulletin, issued monthly, perhaps in a manner similar to AFRs.
C. Notice 2002-8
Q. How is the ATC determined under Notice 2002-8?
1. PS 58 Rates
Brody: For old split-dollar plans entered into before January 28, 2002, where required by the terms of an agreement between employer and employee, actual PS 58 rates can continue to be used in these plans to determine the value of current life insurance protection provided to the employee. The use of actual PS 58 rates to measure ATC is relevant principally in reverse split-dollar plans. However, in reverse split dollar, the insurance protection is provided to the employer, not to the employee, and a footnote in the preamble to the 2002 proposed regulations confirmed that PS 58 rates may not be used in reverse split-dollar or other non-compensatory plans.
Furthermore, IRS Notice 2002-59 says that neither the Table 2001 rates nor the carrier's alternative term rates can be used to measure the benefit in reverse split dollar. The Notice does not say what rates can be used to measure this benefit.
2. Table 2001 Rates
Weinberg: For pre-final regulation split dollar plans entered into before September 18, 2003, the IRS Table 2001 rates can be used to determine the cost of current life insurance protection. As noted above, for post-final reg. New Plans entered into after September 17, 2003, the regulations tell us that life insurance premium factors are to control, but we don't yet have those new rates. Until they are published, we're continuing to use Table 2001 to measure ATC in New Plans.
3. Survivorship Rates
Weinberg: It should be noted that Table 2001 only provides individual, not survivorship, term rates, and the Notice leaves it up to taxpayers to figure out survivorship rates based on the Table 2001 individual rates. Hopefully, for New Plans, the IRS will provide survivorship life insurance premium factors in addition to individual premium factors and will permit all of these new rates to be used to measure ATC in Old Plans (and Interim Plans) subject to the Notice, as well as in New Plans.
A carrier I am familiar with has calculated Table 2001-based survivorship rates by applying the “Greenberg-to-Greenberg” formula used to determine US 38 survivorship rates, which in turn are based on PS 58 individual rates. Of particular interest is that carrier's observation that survivorship term rates based on Table 2001 are actually lower than the carrier's existing alterna-tive survivorship term rates up to ages husband 70/wife 70. Thereafter, the rates cross over so that the carrier's alternative survivorship rates are lower than the Table 2001-based survivorship rates. Furthermore, the Table 2001-based survivorship rates will always be lower than the US 38 rates because the latter are based on the higher PS 58 rate table. The bottom line for survivorship split dollar plans is that, in many cases, we will be able to use more favorable survivorship rates that are actually lower than the survivorship rates now being used in those plans.
4. Carrier Alternative Rates
Brody: For Old Plans entered into before January 28, 2002, old carrier alternative term rates that comply with prior IRS requirements can continue to be used to measure ATC, if lower than the Table 2001 rates. The use of old carrier alternative term rates will clearly be advantageous in single life cases and, as Mike suggested, may or may not be advantageous in survivorship cases. For Old Plans, the ability to continue to use old carrier alternative term rates combined with the safe harbor grandfather protections previously discussed results in maximum future flexibility and preserves the most favorable options for these split-dollar plans.
Weinberg: For Interim Plans entered into after January 28, 2002 and before September 18, 2003, old carrier alternative term rates can also continue to be used to measure ATC through 2003, if lower than Table 2001 rates. However, after 2003, carrier alternative term rates can continue to be used to measure ATC in Interim Plans but only if those rates meet tough new standards applicable to commonly sold term policies. (To our knowledge, no carrier has developed such new rates.) For New Plans entered into after September 17, 2003, as noted, carrier alternative rates most likely cannot be used, and the life insurance premium factors will control.
V. Continuation of Pre-Final Regulations Plans
Q. Suppose a pre-final regulations equity collateral assignment split-dollar plan is continued after this year. What are the consequences insofar as taxation of the equity is concerned?
A. Continue in Split-Dollar
Brody: For split-dollar plans entered into before September 18, 2003, including both Old Plans entered into before January 28, 2002 that do not elect the December 31, 2003 safe harbors (presumably because there will be no equity as of that date), and Interim Plans entered into between January 28, 2002 and September 17, 2003, there are two additional safe harbors provided by the Notice. Under the first safe harbor, the plan can continue in split dollar mode so long as the employee continues to report the ATC, and the employee will not be taxed on any policy equity accruing during this time period. The problem for the employee is the increasing ATC costs as the employee ages. A rollout during the employee's lifetime in order to end these continuing and increasing term costs will, subject to the “no inference” provision of the Notice described below, likely result in the taxation to the employee of the entire policy equity at the time of rollout for income tax purposes (less any employee basis in the policy) and also for gift-tax purposes if the policy is owned by an ILIT. Consequently, continuing a split-dollar plan under this safe harbor results in a plan without a safe harbor exit strategy as a practical matter. (Concerning employee basis, as noted, the new regulations deny basis for any employee AEB contributions in the case of economic benefit regime [endorsement] plans entered into after September 17, 2003. Query whether the IRS will apply this same rule to pre-final regulations split-dollar plans, especially if the plans are collateral assignment plans.)
B. Switch to a Loan
Q. What is the other safe harbor for a pre-final regs. split-dollar plan?
Weinberg: Alternatively, for Old Plans that do not elect the December 31, 2003 safe harbors (again, presumably because there was no equity at that date), and for Interim Plans, there is a second safe harbor provided by the Notice. Such plans can elect to be taxed under an employer loan regime. It appears that for these pre-final reg. plans, the plan can continue in split-dollar mode under the first safe harbor above, and it can then switch to a loan under this second safe harbor as long as all previous employer premium payments are treated as the beginning loan balance as of the beginning of the taxable year in which the switch occurs. This is another example of the “switch-dollar” technique.
Brody: The purpose of continuing in split-dollar mode would be to preserve the (presumably) lower ATC costs for
a period of time instead of the higher interest costs if employer loan treatment were elected. The likely result of a switch to a loan is that any employee equity existing at the time of the switch (less employee basis, if any) would be taxable, again, subject to the “no inference” provision. If the switch occurs just before equity appears, there should be no equity to tax. Therefore, since most split-dollar plans do not generate equity for some period of time, perhaps 6-8 years after policy inception, favorable split-dollar taxation (i.e., taxation measured by ATC) can be preserved during this period, up to the time of the switch. Moreover, policy equity accruing after the switch to a loan will never be taxed, unless and until withdrawn from the policy during the insured's lifetime in excess of basis (and other than by policy loan).
Weinberg: The extent, if any, to which the new regulations may apply to a pre-final regs. plan that is switched to a loan after 2003 is unclear. Assuming the switch is considered a “material modification” under the regs., for example, would the determination of when equity first occurs be measured by the cash value of the policy disregarding surrender charges or by the policy's cash surrender value reflecting surrender charges? In a similar vein, would the new split-dollar loan rules apply to the loans, for example, the nonrecourse loan rules and the provision disregarding stated interest in certain circumstances? Hopefully, the IRS will provide answers to these questions. In the meantime, prudence may suggest assuming that the new rules do apply to the switch, notwithstanding that the plan was a pre-final regs. plan.
VI. “No Inference” Rule
Q. What effect does the “no inference” language in Notice 2002-8 have on pre-final regulation plans?
Brody: The Notice states “no inference should be drawn from this notice regarding the appropriate Federal income, employment and gift tax treatment of split-dollar life insurance arrangements entered into before the date of publication of the final regulations.” For equity split-dollar plans, commentators are taking this to mean that the parties could choose not to take advantage of any of the safe harbors and take their chances on taxation of policy equity at rollout under old law. Since policy equity taxation has been a very controversial area, some advisers (including us) will not opt for this alternative, while others will, as a “wait-and-see” approach to the development of the law.
VII. Tax Traps – Material Modifications of Old Plans
A. The Material Modification Rule
Q. Can you explain the Material Modification Rule of the Final Regulations?
Brody: The final regs. apply to split-dollar arrangements entered into after September 17, 2003. However, if a plan is entered into on or before September 17 th but is materially modified after that effective date, the plan will be treated as a new arrangement subject to the regulations, which is entered into on the date of the material modifica-tion. Particularly with respect to Old Plans, advisers should be careful not to disturb the grandfather protections provided by the Notice for split-dollar plans entered into before January 28, 2002. We are telling clients and advisers not to make any “material modifications” to these plans after September 17, 2003 that would bring them within the new regulations, with the resultant loss of grandfathering under the Notice. (Similar considerations apply to a lesser extent to Interim Plans.) The government throws us a small bone by stating that modifying an Old Plan to take advantage of the December 31, 2003 safe harbors will not constitute a material modification of the plan.
B. Non-Material Modifications
Q. What do the final regulations consider “non-material modifications?”
Weinberg: The regs. provide a nonexclusive list of “non-material modifications.” These seem to be mostly administrative or ministerial, such as changing the pre-mium payment mode or the premium payment address. Noticeably absent from this list are IRC Section 1035 exchanges. Although the industry requested that 1035 exchanges be classified as non-material, the government chose not to address this issue in the regulations. Conse-quently, until informed otherwise, we are assuming that a 1035 exchange of a policy under and Old (or Interim) Plan will be treated as a material modification and will subject the plan to the new regulations on and after the date of the policy exchange.
An important note: Once an Old Plan has been terminated by a rollout or switched to a loan in accordance with Notice 2002-8's safe harbors, a subsequent material modification does not appear to be relevant because the plan is no longer in split-dollar. Therefore, a Section 1035 exchange after such a termination or switch should be permissible without adverse tax consequences, regardless of whether the exchange is considered as a material modification.
VIII. The Future of Split Dollar
Q . What future planning techniques do you envision?
Weinberg: The focus of the insurance industry up to now has been to preserve the tax benefits of Old Plans as much as possible under the safe harbor grandfather protections of Notice 2002-8. Now, this very creative industry is turning to the future, and we will see many new techniques developed. Here are some future insurance purchase techniques we will be analyzing and modeling.
First, we are currently beta-testing a new split-dollar technique we call “Collateral Endorsement Switch-Dollar™.” This technique contemplates starting with a nonequity endorsement plan, in the collateral assignment format, and then switching to a loan just before equity arises. The idea is to capture split-dollar term rates for as long as possible, assuming they are lower than interest costs.
The Collateral Endorsement Switch-Dollar™ technique is sanctioned by the final regulations which expressly cover modifying a nonequity split-dollar plan to change it to an equity plan. The regulations provide that if the employer, service recipient or donor is not the owner of the policy immediately after the change to an equity plan, this modification is to be treated as a transfer of the policy to the employee, service provider, or donee. The policy transfer here would be in consideration for a note equal to the policy's then cash value (most likely determined without regard to surrender charges). This note and future premium loans would comply with the new split-dollar loan rules.
We will also be comparing and illustrating nonequity endorsement split-dollar plans, split-dollar loans from inception, and outside premium financing arrangements.
IX. Modeling the Alternatives
Q. There seems to be a bewildering number of choices available for pre-September 18th Old and Interim Plans and for post-September 17th New Plans. In a given situation, how can a professional adviser decide which is the optimum plan for his or her client?
Weinberg: Number crunching is a major part of the answer. Illustrations need to be prepared for each alternative course of action, using computer models such as those we and others have developed. We have found that some of the answers are counter-intuitive, and you won't know which to choose until you've modeled these alternatives.
X. Sarbanes-Oxley Act
Q. How does the Sarbanes-Oxley Act of 2002 affect split-dollar planning for public companies?
Brody: The preamble to the final regulations states that the regulations do not address the issue of the Sarbanes-Oxley Act since its interpretation and administration is within the jurisdiction of the SEC. The Sarbanes-Oxley Act prohibits a public company, either directly or indirectly, from providing any type of credit to any director or executive officer. It appears that collateral assignment split-dollar plans could fall under this Act, and some commentators believe that even endorsement arrangements could be covered. The SEC has so far refused clarification of the issue. Therefore, until further guidance is provided, where premiums are payable by the company after the Act's effective date of July 30, 2002, I think directors and executive officers of a public company should be very cautious about continuing to participate in the company's split-dollar plan, unless the plan can be considered as a binding commitment entered into prior to the Act's effective date and grandfathered under the Act. Endorsement arrangements may not be subject to this prohibition, especially if they are non-equity arrangements that provide only a death benefit.
The problem for public corporation split-dollar plans is immediate because the Sarbanes-Oxley Act does not grandfather future executive loans (i.e., loans made after July 30, 2002), unless, again, the plan is considered a binding commitment entered into before the Act's effective date and is grandfathered. Severe consequences can result from violation of the Act, including the imposition of criminal penalties. This means that paying the very next premium under a public corporation executive split-dollar plan could subject the responsible parties to criminal penalties!
Weinberg: Let's emphasize that Sarbanes-Oxley applies only to public companies. I believe that the vast majority of split-dollar plans are in closely held private companies, not in public companies. This does not diminish the problem for public companies, however, and we have developed a “Rescue Program “for public corporation split-dollar plans that will permit these plans to continue for the benefit of the executives who are affected by the Act.