IRS again revises split-dollar insurance rules.

• Author: Lerman, Jerry L.

On Jan. 3, 2002, the IRS revised the treatment of split-dollar life insurance arrangements, by revoking Notice 2001-10 and replacing it with Notice 2002-8. Notice 2001-10 clarified prior rulings on taxation of split-dollar arrangements, provided taxpayers with interim guidance pending publication of further guidance and requested taxpayer and practitioner comments. The notice expressed the Service's concern with the growth of "equity split-dollar" arrangements, under which an employee can derive valuable economic benefits beyond the current life insurance protection addressed in Rev. Rul. 64-328.

Notice 2002-8 attempts to reach a compromise between taxation of existing split-dollar plans and future plans. The Service seems open to suggestions from the industry on the rates used to value life insurance protection under future split-dollar arrangements. The IRS is accepting comments until April 28, 2002. Although it provides interim guidance on the valuation of life insurance protection, it requests specific comments on appropriate rates for valuing current life insurance protection and on standards for use of an insurer's published premium rates for valuing current life insurance protection.

Split-dollar and Equity Split-dollar Arrangements

Split-dollar plans have long been used to fund a variety of permanent life insurance needs, including buy-sell agreements, fringe benefit plans and estate liquidity needs. Rev. Rul. 64-328 has been the cornerstone for the tax treatment of split-dollar arrangements, and has provided the "traditional" compensation method used for split-dollar arrangements.

Equity split-dollar refers to a particular kind of split-dollar plan, in which an employer has the right to receive only its premium advances when the split-dollar agreement terminates or the employee dies. Endorsement arrangements exist when the employer owns the policy. When the employee or a third party owns the policy, the arrangement is known as a collateral assignment. Both of these arrangements can involve equity plans. As a practical matter, equity split-dollar issues typically arise only under the collateral-assignment method.

The "equity" in equity split-dollar refers to the "crossover" point, when the policy begins to accumulate cash value in excess of the amount the employer is entitled to recover. The critical questions are who owns this equity and when or how it is taxed.

Until Notice 2001-10, the Service had not released a public ruling that addressed the income tax treatment of equity split-dollar arrangements. In Rev. Rul. 64-328, it held that an employee had to recognize as income each year the value of life insurance protection he received. This value is known as the "economic benefit." Rev. Rul. 64-328 revoked Rev. Rul. 55-713, which treated the split-dollar arrangement as a secured loan from an employer to an employee. It retained the P.S. 58 tables, which are based on mortality tables originally published in 1946.

As a result of suggestions the insurance industry made on valuation, in Rev. Rul. 66-110, the IRS allowed a taxpayer to calculate "economic benefit" based on the insurance carrier's alternative term rates instead of on the standard P.S. 58 rates.

In addition, the Service issued Letter Rulings 7916029 and 8310027, which involved endorsement split-dollar plans. In the rulings, the IRS held that the employee was taxable on the cash surrender value less the employee's contributions, in the year the employer transferred the policy to the employee.

Letter Ruling (TAM) 9604001 held that when a policy reached the crossover point and the cash surrender value exceeded the employer's premium advances, the insured had to include in income both the economic benefit and the annual buildup in the cash surrender value in excess of the amount repayable to the corporation. Because an irrevocable life insurance trust owned the policy, the IRS concluded that the insured made a deemed gift to the trust each year of the full amount included in his income.

Anticipated Comprehensive Guidance on the Tax Treatment of Split-dollar Insurance Arrangements

In some respects, the basic structure outlined by Notice 2001-10 will remain intact under the proposed regulations. Specifically, an...