Expert's Critical Analysis of New IRS Split Dollar Guidance

Expert's Critical Analysis of New IRS Split Dollar Guidance

Michael D. Weinberg, JD, AEP, is the president of The Weinberg Group, Inc. in Denver, Colorado. Mr. Weinberg works with individuals, families and businesses and their professional advisors to design estate and business continuity plans and fund those plans with life insurance. He is also a consultant and expert witness specializing in life insurance and a professional mediator in business, commercial, and trust and estate disputes. A Harvard lawyer (licensed, not practicing) with more than 35 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 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 the co-author of The Insured Stock Purchase Agreement, published by the ABA. He has lectured and conducted seminars for many industry groups, including the ABA, American Law Institute, Miami Estate Planning Institute, Notre Dame Estate Planning Institute, Practicing Law Institute, Southern California Tax & Estate Planning Forum, Texas Bar Association Advanced Estate Planning Course, AALU, Forum, MDRT, Society of Financial Service Professionals, and Top of the Table.

Mr. Weinberg is a nationally recognized expert on the taxation of split dollar life insurance. In this very timely interview, he discusses the new split dollar life insurance guidance provided in IRS Notice 2002-8, issued on January 3, 2002. This Notice provides interim guidance for taxation of split dollar plans. The Interviewer is our executive editor, Myron Kove, Esq.

Q. Notice 2001-10 caused an uproar in the insurance, estate and business planning communities when it was issued in January 2001. Now the IRS has issued a new Notice 2002-8 which revokes Notice 2001-10 and provides new guidance. What does the new Notice provide that planners should be concerned about?

Weinberg: This new Notice radically changes the tax treatment of split-dollar life insurance arrangements for the future, subject to some very important transitional "grandfather" rules. The Notice provides interim guidance and the IRS solicits written comments by April 28, 2002. In addition, proposed regulations will be issued, comments will be solicited on the proposed regulations, and then final regulations will be published. This process may take some time, although recent reports from Washington sources indicate that the proposed regs. could be out in a couple of months, probably by the end of March, and that the final regs. could be published by the end of this year. Obviously, the final rules on split-dollar may differ somewhat from those set forth in the Notice. I offer my comments with the caveat that this is a dynamic and rapidly changing area, and my (and others’) opinions about the meaning and effect of the Notice are likely to change in light of further developments.

Q. What radical changes does the Notice propose in the way split dollar life insurance arrangements are taxed?

Weinberg: The IRS states in Notice 2002-8 that the proposed regulations to be issued are expected to provide for two mutually exclusive regimes for the taxation of parties to a split dollar arrangement. The new rules will be effective for split dollar arrangements entered into after the date of publication of final regs. The net effect of these changes probably spells the end of equity split dollar for future plans as a practical matter. With an equity split dollar plan (usually in the collateral assignment format), 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 ILIT’s) obligation is to reimburse the employer for the lesser of its cumulative premium advances or the policy cash value. Any cash value in excess of employer premium advances, the policy “equity,” is the property of the employee (or ILIT). As discussed below (and except as otherwise provided by the grandfather provisions), under the new rules, either the policy equity will be treated as taxable compensation to the employee when transferred to the employee, or the employer premium payments will be treated as a series of loans by the employer to the employee.

Q. What is the approach of the first regime, the “endorsement” regime?

Weinberg: If the employer is formally designated as the owner of the policy, then the employee will be taxed on the economic benefits received under Code Sections 61 and 83. This regime would operate in a manner similar to what is currently known as the endorsement split dollar method. Under the endorsement method, the employer owns the policy but the employee or ILIT designates the beneficiary of the death benefit in excess of the employer’s cumulative premium payments. In this situation, the employee would be taxed on the annual economic benefit (“AEB”) or term cost of the current life insurance protection provided to the employee (less any contribution made by the employee) so long as the split-dollar arrangement remained in effect. The employee would not be taxed on any policy equity accruing during the period the split dollar arrangement was in effect. However, if the arrangement was terminated during the employee’s lifetime and the employer was then repaid its premium outlay (commonly referred to as a “rollout”), the employee would be taxed on the policy equity at that time (less any employee basis in the policy). (Presumably, although not entirely clear from the Notice, plan termination at the employee’s death would not cause taxation of the policy equity because of the Code Section 101(a) exclusion for life insurance death benefits.) Therefore, under the endorsement regime, both the AEB each year (less employee contributions) and the entire employee equity at rollout (less employee basis) would be subject to income taxation. In addition, if the policy were payable to an ILIT, the AEB each year and the equity at rollout (without reduction for basis) would be subject to gift taxation as well.

Q. What is the approach of the second regime, the “loan” regime?

Weinberg: If the employee or ILIT is formally designated as the owner of the policy, then the premiums paid by the employer will be treated as a series of loans by the employer to the employee, assuming the employee or ILIT is obligated to repay the employer its premium advances. This regime would operate in a manner similar to what is currently known as the collateral assignment split dollar method. Under the collateral assignment method, the employee or ILIT owns the policy but the policy is collaterally assigned to the employer as security for its premium advances.

Q. What principles will govern the loan regime?

Weinberg: If not interest-bearing, the loans will be subject to the interest-free loan rules of Code Sec. 7872 that apply to various types of below market loans and to the original issue discount rules of Code Sections 1271-1275. These rules are quite complex, and they are explained in detail in proposed regulations that were issued 17 years ago and never finalized (maybe now they will be finalized). Loan treatment will eliminate one vexing issue, namely, the taxation of policy equity. Policy equity will not be taxed, unless and until it is withdrawn from the policy in excess of policy-owner basis (and other than by policy loan). This tax result is analogous to that of mortgaging property – appreciation in the value of the property is not taxed until the property is sold.

One interesting question is whether the loan regime would have to be used exclusively where the employee is a controlling stockholder of the employer corporation in order to keep the insurance proceeds received by an ILIT from being taxed in the employee/controlling stockholder’s estate. If the endorsement method were used where the employer corporation owned the insurance policy, it would be difficult to prevent the corporation’s incidents of ownership in the policy from being attributed to the employee/stockholder, resulting in estate taxation of the proceeds. On the other hand, what do you do where applicable state law prohibits making a loan to an officer or director of a corporation, and your client is an officer or director? Are you limited to the endorsement split dollar method in this situation? Hopefully, we’ll have answers to these questions (and many others) by the time the final regulations are published.

Q. What if there is no obligation on the part of the employee to repay the employer loans?

Weinberg: In that situation, the Notice provides that the premium payments are additional compensation to the employee at the time the premiums are paid by the employer. (This arrangement seems to be what is commonly referred to as a “section 162 bonus plan.”)

Q. When will these new rules be effective?

Weinberg: The Notice states that the new tax regimes will be effective for split dollar arrangements entered into after the date final regulations are published. However, there are important interim rules, including special grandfather rules, set forth in the Notice that affect all existing split dollar plans and new plans entered into before the date of final regs.

Q. One of the criticisms of the 2001 Notice was the lack of guidance on grandfathering existing plans. Does the new Notice provide such guidance?

Weinberg: The new rules, although an improvement over the 2001 Notice, provide only limited grandfathering for existing split dollar plans. Unfortunately, complete grandfathering of existing plans was not forthcoming, although the insurance industry, and particularly AALU, worked very hard for that result.

For grandfather purposes, there are at least four important dates. The first two dates are January 28, 2002 and January 1, 2004. (The third date is the date of publication of final regulations, and the fourth date is the effective date of future guidance for determining annual economic benefit, both of which we’ll get to shortly.) Split-dollar arrangements entered into before January 28, 2002 are entitled to the limited grandfather protection provided for existing plans under the Notice's "safe harbor" rules. Existing split-dollar plans (pre-Jan. 28th plans) may continue in split-dollar mode, and if they terminate before January 1, 2004, the employee will not be taxed on then existing policy equity.

Q. This seems like a big tax break for equity split dollar plans?

Weinberg: I think this safe harbor grandfather provision, the option to terminate the plan before Jan. 1, 2004, will be most meaningful for mature equity split-dollar plans but it probably will not be beneficial for immature plans. A “mature” plan is a plan that before Jan. 1, 2004 will have arrived at its time for rollout. Such a plan will have substantial policy equity after repaying the employer, and the termination safe harbor will avoid taxation of that equity at the time of the plan termination. An "immature" plan is a plan where future premium payments will be required on or after Jan. 1, 2004. If the immature plan were terminated on Jan. 1, 2004, the employee would be faced with the prospect of paying the full amount of future premiums with after-tax dollars, and those same amounts would also be subject to gift taxation if the policy were owned by an ILIT.

Q. What if an existing split dollar plan continues after January 1, 2004?

Weinberg: Alternatively, for existing split dollar plans (pre-January 28, 2002 plans), the plan may continue in split-dollar mode until 2004. Then, before January 1, 2004, for all periods beginning on or after that date, the plan may be converted to a loan from the employer to the employee. Conversion to a loan before Jan. 1, 2004 will avoid taxation to the employee of policy equity existing at the time of the conversion. This loan safe harbor requires that all pre-2004 employer outlays for premiums must be picked up as the beginning loan balance at the beginning of the taxable year in which the conversion to a loan occurs, and that subsequent premiums paid by the employer must be treated as additional loans. If this safe harbor is entered, policy equity accruing after the conversion to a loan (as well as before) will not be taxed, unless and until it is withdrawn from the policy in excess of policy-owner basis (and other than by policy loan).

As previously noted, these loans may be interest-free and taxed as "below-market" loans under Code Section 7872 and the original issue discount (“OID”) rules of Code Sections 1271-1275. Or, presumably, the loans may be interest-bearing and taxed under the usual tax rules, without the complexities of imputed interest, below-market loans. (Please note that Interest-bearing loans at the appropriate applicable federal rate (“AFR”) are not taxed under the imputed interest rules). As a practical matter, I believe that the loan regime will be the grandfather protection most used by existing immature plans where future premium payments remain to be made. Questions remain to be answered, such as whether various split dollar arrangements are to be reclassified as demand loans or term loans (demand and term loans being treated very differently for tax purposes), whether each premium payment is a separate loan or whether premiums may be aggregated and treated as a single loan, and when and how the OID rules will apply.

It’s also worth noting that for pre-Jan. 28^th existing split dollar plans, existing carrier alternative term rates can continue to be used to measure the annual economic benefit or term cost under the plan – we’ll discuss this topic in detail later in the discussion.

Weinberg: For all existing plans (i.e., plans entered into before January 28, 2002), I would be very cautious about amending the terms of the plan if the intent is to preserve the limited grandfather protections provided by the Notice. In effect, the Treasury and IRS have given us a two-year grace period to figure out what to do with existing plans. I’ll have more to say at the end of this interview about how we are handling existing plans.

Q. As a practical matter, how should plans created after January 28, 2002 be designed?

Weinberg: I previously mentioned that a third important grandfather date is the date of publication of final regulations. (Of course, we don’t yet know what that date will be and it could come as early as the end of this year). I’ve already commented on plans entered into after the date of final regs. Such plans will either be taxed as endorsement split dollar plans or as employer loan plans.

For split dollar plans entered into before the date of publication of final regs. (including both new plans entered into after Jan. 28, 2002 and pre-Jan. 28, 2002 existing plans that do not elect the Jan. 1, 2004 safe harbors), there are two other 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 annual economic benefit (“AEB”) or term cost, and the employee will not be taxed on any policy equity accruing during this time period. This result seems similar to taxation of an endorsement plan entered into after the date of final regs., previously discussed. In short, the employee will be taxed on the annual economic benefit (less any employee contribution) during the remainder of the employee’s life. A rollout during the employee’s lifetime in order to end this continuing and increasing term cost will 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 (without reduction for basis). Consequently, continuing a split-dollar plan under this safe harbor results in a plan without an exit strategy as a practical matter.

Weinberg: Alternatively, for split dollar plans entered into before the date of final regs., there is a second safe harbor. Such plans can elect to be taxed under an employer loan regime. If employer loan treatment is elected from the outset, the result seems similar to the taxation of collateral assignment plans entered into after the date of final regs., previously discussed, where all employer premium payments will be treated as loans.

However, it appears that for 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 at the beginning of the taxable year in which the switch occurs. The purpose of continuing in split-dollar mode would be to preserve the (presumably) lower AEB cost for a period of time instead of the higher interest cost if employer loan treatment were elected at the outset of the plan. The result of a switch to a loan would probably be that any employee equity existing at the time of the switch (less employee basis) would be taxable. But, what if the switch occurs just before equity appears? There would be no equity to tax, and favorable split-dollar (AEB) taxation would have continued up to the time of the switch. Moreover, as previously noted, policy equity accruing after the switch to a loan would not be taxed, unless and until withdrawn from the policy in excess of basis (other than by policy loan). Assuming my analysis is correct, this switch-before-equity technique seems applicable to a new plan adopted after Jan. 28, 2002 and before the date of final regs. It also seems to apply to an existing plan (pre-Jan. 28^th plan) that will have no equity on Jan. 1, 2004 and, therefore, does not elect the Jan. 1, 2004 safe harbors.

Lastly, in connection with pre-final reg. plans, I should mention that 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 final regulations.” For equity split-dollar plans, commentators are taking this to mean that you could choose not to enter into any of the safe harbors and take your chances on taxation of policy equity under existing law. Since policy equity taxation has been a very controversial area, I suspect most advisers will not opt for this risky alternative.

Q. There seem to be a bewildering number of choices under the Notice applicable to pre-Jan. 28, 2002 existing plans, new plans entered into after Jan. 28^th and before the date of publication of final regulations, and new plans entered into after the publication of final regs. In a given situation, how can a professional adviser decide which is the optimum plan for his or her client?

Weinberg: I think you will just have to run the numbers for each alternative course of action. I expect that some of the answers will be counter-intuitive, and you won’t know which to choose until you’ve modeled the alternatives.

Q. You’ve mentioned annual economic benefit (“AEB”) and annual term cost a number of times. What does the new Notice have to say about this topic?

Weinberg: There are several additional interim provisions in the Notice for valuing the cost of current life insurance protection provided to an employee under a split dollar plan, i.e., for determining AEB, frequently referred to as “annual term cost” (and previously called “PS 58 cost”). These interim provisions add more grandfather rules, this time for measuring AEB. They generally address split dollar arrangements entered into before the effective date of “future guidance,” which is the fourth important date for grandfather purposes referred to earlier. Apparently this is a different date (presumably earlier) than the date of publication of final regulations. “Future guidance” probably means another IRS notice, revenue ruling, or the proposed regulations (which may be out very soon, perhaps by the end of this month, as previously mentioned).

First, for split dollar arrangements entered into before Jan. 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….” (emphasis added) The use of actual PS 58 rates to measure AEB 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. As a result, a number of commentators have opined that PS 58 rates cannot be used to measure AEB in a pre- Jan. 28, 2002 reverse split dollar plan, although the Notice itself does not specifically refer to reverse split dollar. If those commentators are right, the use of PS 58 rates in a reverse split dollar plan has the potential for creating a tax disaster for the employee.

Second, for split dollar arrangements entered into before the effective date of future guidance, the IRS Table 2001 rates can be used to determine the cost of current life insurance protection. (They can also be used to determine AEB under qualified retirement plans and employee annuity contracts entered into before future guidance.) AALU and ACLI are working to convince the government to reduce the Table 2001 rates to more accurately measure the cost of current life insurance protection.

Be that as it may, 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. One 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 alternative 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 term rates 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.

Third, and most important, for split-dollar arrangements entered into before Jan. 28, 2002, existing carrier alternative term rates that comply with present IRS requirements can continue to be used to measure AEB, if lower than the Table 2001 rates. The use of existing carrier alternative term rates will clearly be advantageous in single life cases and, as just suggested, may or may not be advantageous in survivorship cases. (Whether existing carrier term rates can continue to be used indefinitely for the life of an existing split dollar plan is unclear, and AALU is attempting to clarify that such is the case.) The combination of the ability to continue to use existing carrier alternative term rates for pre-Jan. 28, 2002 existing plans together with the safe harbor grandfather protections provided for such plans, results in maximum future flexibility and preserves the most favorable options for existing split dollar plans. I’ve heard these grandfathered existing plans referred to as “golden plans” that will not be replaceable because of their favorable tax treatment.

Fourth, for split dollar arrangements entered into after Jan. 28, 2002 and before the effective date of future guidance, existing carrier alternative term rates can continue to be used to measure AEB through 2003. However, after 2003, carrier alternative term rates can still be used to measure AEB in such plans, but they must meet tough new standards applicable to commonly sold term policies in order for the alternative rates to be used instead of the Table 2001 rates.

Finally, for split-dollar arrangements entered into after the effective date of future guidance, the IRS may do away with the use of carrier alternative term rates altogether and require the use of government tables to measure AEB. The Notice specifically asks for comments about this issue.

Weinberg: There are a host of other questions left unanswered by the Notice. For example, the Notice states that the "same principles" will apply to split-dollar arrangements in non-employer/employee contexts, including gift contexts and corporation/shareholder contexts, but it doesn't elaborate further. The reference to “gift” contexts probably means private split dollar. In that connection, the Notice uses the terms “sponsor” and “benefited party” in several instances, perhaps to demonstrate that the scope of the Notice is broader than just employer-employee split dollar. Furthermore, as just noted in the discussion about annual economic benefit, while the Notice says nothing directly about reverse split dollar, if read literally, it seems to prevent the use of actual PS 58 costs to measure AEB in a reverse split dollar plan.

AALU in its Washington Report Bulletin (No. 02-1) provides the following lengthy list of unanswered questions concerning which it may submit comments to the IRS:

“AALU expects to formulate its response to this request for comments over the coming months, particularly as it applies to the appropriate rate tables to be used in valuing term insurance protection. In addition, as the Revenue Service moves toward proposed, and eventually final, regulations, numerous issues not addressed in Notice 2002-8, principally relating to the application of section 7872 and, where applicable, the OID (original issue discount) rules, may require AALU’s input. These include (among other possible issues): (i) the characterization of the split dollar arrangement as a demand loan or term loan under various fact patterns, (ii) the determination of whether a loan occurs with each premium payment, or whether premium payments may be aggregated, (iii) the application of the numerous exceptions to the OID rules under various fact patterns, (iv) the interaction of the OID rules, section 7278 and section 264, (v) rules to deal with a situation in which the employer’s recovery increases over time, (vi) the application of employee payments (if any) to interest and principal over time, and (vii) the imposition of complex record keeping and reporting requirement on insurers and employers. Other, more general, questions remain concerning the treatment of private and reverse split-dollar arrangements, the recovery, and definition, of basis in contracts at rollout, and the availability of a deduction for the employer under section 83.”

Q. What planning are you undertaking at the present time with respect to both new and existing split dollar plans?

Weinberg: Counter-intuitively, I think huge opportunities are presented by the changes to and confusion over split dollar resulting from the Notice. Radical change usually brings great opportunity in its wake. Let me tell you what we plan to do this year.

First, we intend to implement as many new collateral assignment split dollar plans this year as we can. The reason is that automatic employer loan treatment for collateral assignment plans does not apply until after the date of publication of final regulations. Therefore, new collateral assignment split dollar plans can be entered into before the publication date of final regs., which is unlikely to occur before the end of this year. The use of collateral assignment split dollar at the outset, instead of an employer loan, means that the measure of employee taxation will be the annual economic benefit, rather than the (presumably) higher loan interest, while the split dollar arrangement is in effect. I suggested earlier that the plan can be kept in split dollar mode until just before policy equity appears. It can then be switched to a loan to avoid taxation of policy equity to the employee since there will be no equity at the time of the switch. Policy equity accruing after the loan switch will not be taxed, unless and until it is withdrawn from the policy in excess of policy-owner basis (and other than by policy loan). Therefore, there appears to be a window of opportunity for new collateral assignment split dollar plans entered into before the date final regs. are published. This window closes on that date, probably sometime after the end of this year. (The situation is somewhat similar to the narrower window of opportunity for split dollar plans entered into between Jan. 3^rd and Jan. 28^th of this year in order to preserve the Jan. 1, 2004 safe harbor grandfather protections applicable to existing plans. That window closed on Jan. 28, 2002.)

Second, we are being very careful not to disturb the grandfather protections of existing split dollar plans entered into before Jan. 28, 2002. We are notifying clients and advisers to just sit tight for now and not make any substantial modifications to these plans that would risk the loss of grandfathering. After all, we have until Jan. 1, 2004 to decide how to proceed with existing plans in the light of subsequent developments. This two-year grace period should provide adequate time for thoughtful decisions, and hasty action is ill advised.

In this connection, an important question for existing split dollar plans is whether, after Jan. 28, 2002, policies can be exchanged tax-free for new policies under Code Section 1035, increased in face amount, or issued to new employees under an existing plan? Several commentators have observed that since the Notice addresses the availability of the Jan. 1, 2004 safe harbors in terms of split dollar arrangements entered into before Jan. 28, 2002, rather than policies issued before that date, policy changes after Jan. 28^th should not constitute a substantial modification of an existing arrangement. It would be very helpful to receive further guidance from the IRS on this question.

Third, we are developing sophisticated computer models that illustrate the effects of Notice 2002-8 on split dollar plans, quantify alternative strategies, and help determine the optimum solutions for both new and existing plans. Our goal is to minimize income, employment, gift, estate, and generation-skipping taxes.

Weinberg: Yes, we are available to provide consulting and modeling services for split dollar plans.

Disclaimer: Nothing contained in this interview is to be considered as the giving of investment, legal or tax advice. Each person is responsible for consulting his or her own investment advisors, lawyers and accountants concerning the plan or plans and the ideas and techniques discussed.

We do not express any opinion on the investment, legal, or tax consequences of this plan, and you are responsible for consulting your own investment advisors, legal counsel, and accountants for all such advice.

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