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New IRS Guidance for Taxation of Equity Split Dollar Arrangement

February 2001
By Jeffrey D. Mamorsky, Greenberg Traurig, New York Office*

* Appreciation is extended to my partner, Steven B. Lapidus, and Lawrence L. Bell, J.D., L.T.M., Counsel for Advanced Markets, The BISYS Group, for assistance in the preparation of this Alert

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The IRS, in Notice 2001-10 (IRB 2005, 1/29/01), has announced a change in the tax rules that have governed the executive compensation tool known as split dollar life insurance since 1964. These changes are in the form of "interim guidance" without any meaningful grandfathering protection. The Notice states that it is (i) intended to "clarify" prior rulings issued by the IRS regarding the taxation of split-dollar arrangements; and (ii) provide taxpayers with interim guidance on the tax treatment of split-dollar arrangements "pending publication of further guidance."

Jeffrey D. Mamorsky
"The IRS... has announced a change in the tax rules that have governed the executive compensation tool known as split dollar life insurance..."

Proposed Clarification of Prior Rulings

At the outset, the IRS emphasized that the rules which have governed the taxation of split-dollar arrangements since 1964 involve a form of contractual agreement between the employer and employee to "join in the purchase of a life insurance contract" in which the premiums and the policy benefits are allocated between the employer and the employee (Rev. Rul. 64-328, 1964-2 C.B. 11, and Rev. Rul. 66-110, 1966-1 C.B. 12). According to the IRS, under these rulings "all amounts credited to the cash surrender value of the life insurance contract inured to the benefit of the employer" in exchange for its premium payments. 

The only economic benefit inuring to the employee was the value of current life insurance protection, which is taxed to the employee in accordance with the P.S. 58 Table contained in Rev. Rul. 55-747 (1955-2 C.B. 228) to the extent that it exceeds the employee’s share (if any) of the premium payments.

According to the IRS, although the rulings described two contractual methods — the endorsement method (under which the employer is formally designated as the owner of the contract), and the collateral assignment method (under which the employee is formally designated as the owner of the contract) – "the determination of an employee’s gross income is unaffected by ***[which]*** method is used." In either case , the IRS Notice emphasized that the rulings conclude that "all economic benefits conferred on an employee under such an arrangement, excluding economic benefits attributable to the employee’s own premium payments, constitute gross income to the employee."

In Notice 2001-10, the IRS expressed the view that none of these rulings addressed "equity split-dollar," the most common split-dollar arrangement involving a shared ownership of a life insurance contract by an employer and its employee under which the employer’s interest in the cash surrender value of the contract is limited to the aggregate amount of its premium payments, exclusive of any cash value over employer premium outlays ("excess cash premium value").

The problem with this position is that since 1964 the IRS has taxed the employee each year solely on the value of the insurance protection provided under the policy in excess of the amount paid by the insured. Specifically, in Rev. Rul. 64-328, the IRS concluded that (i) the measure of the income taxable to the employee under a split-dollar arrangement is the cost of the death benefit protection, equal to the one year term cost of the life insurance coverage to which the employee is entitled from year to year and (ii) the one year term cost is measured as the so-called P.S. 58 cost, referenced in Rev. Rul. 55-713, 1955-2 C.B. 23. Rev. Rul. 66-110 expanded the available sources to be used for determining this annual taxable term insurance cost, permitting

employees to utilize the current published term rates charged by the insurer with which the policy is placed for life insurance available to all standards of risks, if these insurer rates are lower than the P.S. 58 cost.

At no point in the text of Rev. Rul. 64-328 did the IRS suggest that, in addition to the term insurance costs, all or a portion of a split dollar policy’s cash surrender value also should be taxed to the employee. The IRS’ new position enunciated in Notice 2001-10 is that the ruling did not address an equity split dollar arrangement where the cash surrender value in excess of the repayment obligation to the employer would remain with the employee. However, such a position ignores the explicit language of Rev. Rul. 64-328 which suggests that the IRS did indeed consider equity split dollar arrangements in reaching its conclusion:

"[t]he Employer is entitled to receive, out of the proceeds of the policy, an amount equal to the cash surrender value, or at least a sufficient part thereof to equal the funds it has provided for premium payments." (Emphasis added.)

Moreover, in Rev. Rul 66-110 the IRS addressed whether the value of the "other benefits" provided pursuant to a split dollar life insurance arrangement, in addition to the annual cost of the life insurance protection, also had to be included in an employee’s taxable income in the year accrued. The ruling concluded that certain "other benefits" should be included; however, it provided as examples of "other benefits" dividends and additional life insurance. The ruling did not include as an "other benefit" the annual accrual of excess cash value to which the employee ultimately may be entitled. This implicitly confirmed in many practitioners’ minds that the IRS shared their view that the employee should not be taxed on excess cash surrender value. Rev. Rul. 78-420, 1978-2C. B. 67, which significantly was issued after the statutory enactment of Section 83 of the Internal Revenue Code of 1986, as amended (the "Code"), further confirmed this conclusion.

Interim Guidance

IRS Notice 2001-10 discards as inapplicable to equity split-dollar the traditional theories of Rev. Ruls. 64-328 and 66-110 and sets forth two new alternative theories of taxation, one of which – the "Section 83" analysis – closely mirrors the IRS position in Technical Advice Memorandum (TAM) 9604001.

In TAM 9604001, the IRS found that Code Section 83 is applicable to an equity split dollar life insurance arrangement between the employer and employee. However, the TAM is vague as to the manner in which Code Section 83 should be applied to such arrangements. According to the TAM, not only is the value of employer-provided current annual life insurance protection includible as taxable compensation to the insured employee each year, but, in addition, the employee equity portion of the policy’s cash surrender value also is taxable to the employee under the principles of Code Section 83.

In IRS’ "interim" guidance set forth in Notice 2001-10, the taxpayer is offered a choice, "pending consideration of public comments and publication of further guidance," of treating the equity split-dollar arrangement either as a loan, taxable under Code Section 7872, or as a transfer of property (cash value build-up) under Code Section 83. In general, the parties’ characterization under either option will be followed provided that:

  1. the characterization is not clearly inconsistent with the substance of the arrangement;
  2. the characterization has been consistently followed by the parties from the inception of the arrangement; and
  3. the parties fully account for all economic benefits conferred on the employee in a manner consistent with the characterization.

As a loan, the arrangement would be taxable under Code Section 7872 which recharacterizes an interest-free or below-market interest rate loan (which may be a "term" loan or a "demand" loan) as an arm’s length transaction involving an imputed payment from the lender (in this case the employer) to the borrower (in this case the employee) in an amount equal to the difference between the stated interest rate and a statutory interest rate (the "applicable federal rate", or "AFR"), and a corresponding payment of imputed interest from the borrower to the lender in the same amount. In the case of a compensation-related below-market loan, the imputed payments to the borrower are treated as compensation income.

According to IRS Notice 2001-10, in any case in which an employer’s payments under a split-dollar arrangement have not been consistently treated as loans, the parties will be treated as having adopted a non-loan characterization of the arrangement, and the parties must "fully account for all the economic benefits that the employee derives from the arrangement in a manner consistent with that characterization and with Rev. Rul. 64-328, Rev. Rul. 66-110, and the general tax principles upon which those rulings are based."

According to IRS, this means that (i) the employer will be treated as having acquired beneficial ownership of the life insurance contract through its share of the premium payments, (ii) the employee will have compensation income under Code Section 61 equal to the value of the life insurance protection provided to the employee each year that the arrangement remains in effect, reduced by any payments made by the employees for such life insurance protection, (iii) the employee will have compensation income under Code Section 61 equal to any dividends or similar distributions made to the employee under the life insurance contract, and (iv) the employee will have compensation income under Code Section 83(a) to the extent that the employee acquires a substantially vested interest in the cash surrender value of the life insurance contract, reduced under Code Section 83(a)(2) by any consideration paid by the employee for such interest in the cash surrender value.

Code Section 83(a), provides, that if "property" is "transferred" to any person in connection with the performance of services, the excess of the fair market value of such property over any amount paid therefor will be included in the gross income of the person who performed such services in the first taxable year in which the recipient becomes "vested" in the property (i.e., in the first taxable year in which the rights of the person having the beneficial interest in the transferred property are transferable or are not subject to a substantial risk of forfeiture).

Importantly, the Notice states that, "pending the publication of further guidance," the employer will not be treated as having made a transfer of the cash surrender value of the policy simply because the cash surrender value exceeds the premiums advanced by the employer. "If future guidance provides that such earnings increments are to be treated as transfers of property for purposes of Section 83, it will apply prospectively."

IRS’ assertion of the application of Section 83 under subparagraph (iv) above is unclear. Although the Notice does not directly reference "roll-outs" (where the employer at termination of employment or at some other time "rolls-out" of the policy an amount equal to the amount of the premiums advanced and relinquishes all other rights under the policy including any rights to the excess cash surrender value, the IRS has informally indicated that the reference to Section 83 in subparagraph (iv) would require income recognition at the time of the roll-out in an amount equal to the excess cash surrender value. Structuring a split dollar arrangement so that there is no roll-out, but rather the arrangement continues in effect until the employee’s death and the employer is reimbursed for its premiums out of the death benefit proceeds, may be the answer to this dilemma.

Revocation of P.S. 58 Rates

Notice 2001-10 replaces the P.S. 58 rates with rates in new Table 2001 for valuing death benefits under split dollar arrangements and qualified plans. Specifically, pending the consideration of comments and publication of further guidance, the following interim guidance is provided:

  1. Rev. Rul. 55-747, and the P.S. 58 Table contained therein, is revoked. However, taxpayers may continue to use the P.S. 58 rates for taxable years ending on or before December 31, 2001.
  2. A New Table 2001 may be used to determine the value of current life insurance protection on a single life provided under a split-dollar arrangement or qualified retirement plan for taxable years ending after the date of issuance of the Notice. Table 2001 is based on the mortality experience reflected in Table 1 under Code Section 79, with extensions for ages below 25 and above 70, and the elimination of the five-year age brackets. These rates are materially lower than the P.S. 58 rates at all ages.
  3. Taxpayers may continue to determine the value of current life insurance protection by using the insurers’ lower published premium rates that are available to all standard risks for initial issue one-year term insurance as set forth in Rev. Rul. 66-110. However, for periods after December 31, 2003, the IRS will not consider an insurer’s published premium rates to be available to all standard risks who apply for term insurance unless the following requirements are met:
    1. The insurer must make the availability of such rates known to persons who apply for term insurance coverage from the insurer;
    2. The insurer must regularly sell term insurance at such rates; and
    3. The insurer must not more commonly sell term insurance at higher premium rates to individuals that the insurer commonly classifies as standard risks.

What to Do

In view of IRS Notice 2001-10, it is important that care be taken in the structure of split dollar life insurance programs. The Notice does not provide for any meaningful granfathering. Accordingly, every split dollar arrangement should be reviewed to determine the potential impact of the Notice upon the arrangement. In particular, consideration needs to be given to the amount of income that must be recognized each year by the employee based upon the economic benefit he receives as measured in accordance with the Notice, potential ways of avoiding that income recognition through premium payments by the employer or other co-owner of the policy, minimizing the gift tax consequences resulting from that economic benefit (or from the premium payments made to avoid income taxation therefrom), and addressing the potential income tax consequences at the time of the roll-out. Also, the Notice states that use of the "safeharbor" approaches discussed above (loan or Section 83 treatment) must be used from the inception of the arrangement in order to avoid the negative tax implications of the Notice.

The firm’s executive compensation and employee benefits group can help you structure a program to minimize the potential impact of IRS Notice 2001-10 as well as accomplish other income and estate tax goals for your executive workforce.

 

© 2001 Greenberg Traurig


Additional Information:

For more information, please review our Executive Compensation & Employee Benefits Group description, or feel free to contact one of our attorneys.


This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs. The Firm’s responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.