5.5 Special Life Insurance

• Library: Corporations and Partnerships in Virginia (Virginia CLE) (2016 Ed.)

5.5 SPECIAL LIFE INSURANCE

5.501 Split-Dollar Insurance. Split-dollar insurance is whole life or universal insurance purchased through an arrangement under which the term insurance element of the policy is separated from the investment element. Typically, the employer purchases a whole life insurance policy as sole owner and beneficiary. By a supplemental agreement, the employer and the employee agree that the employee will make payment of the portion of the premiums attributable to the insurance element in return for control over the insurance element of the policy, and the corporation will pay the amount of the premium attributable to the investment portion of the insurance policy.

The division of the premiums between employer and employee is done simply. The employer pays an amount each year equal to the annual increase in the cash value of the policy, and the employee pays the remainder of the premium. By agreement, the employer is the "owner" of the cash value of the policy, and the employee is the "owner" of the term portion or the "pure insurance." The employer, as owner of the cash surrender value at maturity, could borrow against this portion of the policy during the employee's lifetime or could otherwise exercise control over it.

When an employee dies, the employer receives a portion of the insurance proceeds equal to the premium paid by it (generally, an amount equal to the cash surrender value), and the employee's beneficiary receives the balance of the proceeds. Ordinarily, if the employee terminates employment before death, the employer agrees to sell its interest in the policy to the employee for an amount equal to the greater of the aggregate premiums that the corporation had paid or the cash value.

The general rule relating to the taxation of split-dollar insurance arrangements is stated in Revenue Ruling 64-328. ³⁰⁸ This ruling describes the situation in which the employee had a right, whether through ownership of the policy or by endorsement from his or her employer, to the death proceeds under the policy. The employer received, whether by assignment or by retention, the right to the cash value of the policy. The ruling concluded

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that the employee realizes taxable income equal to the value of the economic benefit provided under the plan, less the amount the employee contributed. In the situation described, the economic benefit was the current life insurance protection, the value of which is measured by the lesser of the PS-58 rate or the insurer's rate for one-year term insurance available to all standard risks if those rates are all lower than the PS-58 rates. The PS-58 rates are the one-year term premium rates provided by the IRS, which are used in computing the taxable amount of current life insurance protection provided under various employee benefit plans. ³⁰⁹

Upon termination of such a split-dollar arrangement, the employer's interest in the policy is rolled out to the insured employee or the employee's assignee. The taxation of the rollout varies depending on how it is accomplished. If the employer surrenders sufficient paid-up additions to recover its interest, there is no tax consequence to the employee. However, if the employee must first repay the employer through a policy or outside loan and the employee surrenders the paid-up additions to pay off the loan, the employee will be taxed but only to the extent the surrendered amounts exceed the employee's basis in the policy. It should be noted that this should not occur before the 15th year in order to avoid the adverse consequences of I.R.C. § 7702(f).

The foregoing discussion focuses on split-dollar arrangements where the company is entitled to all cash value and the employee is entitled only to death benefits. Where...