IRS attacks split-dollar life insurance.

• Author: Gardner, John

Split-dollar life insurance techniques have become more and more prevalent in the executive compensation and general estate planning arenas over the last several years. As a result of this increased popularity, questions regarding the income and gift taxation of such techniques have arisen. The IRS has issued Letter Ruling (TAM) 9604001, which provides guidance on its position on certain split-dollar arrangements.

In the TAM, the taxpayer is chairman and chief executive officer of a holding company and owns 51% of that company. The holding company owns 98% of a subsidiary company. The subsidiary, two insurance companies and a trust entered into the following transaction: (1) Subsidiary paid X dollars to each of the two insurance companies for two paid-up $500,000 life insurance policies on the life of the taxpayer; (2) the insurance companies issued the life insurance policies to the trust as owners of the policies; (3) the trust entered into split-dollar agreements with Subsidiary; and (4) the trust assigned the policies to Subsidiary as collateral for the trust's obligation under the agreements to repay the X dollars in premiums paid to each insurance company.

Under the terms of the split-dollar arrangement, the trust continues as the owner of the policies and the designated beneficiary of the policy proceeds. The trustees retain all incidents of ownership in the policies. The subsidiary retains an unqualified right to receive a portion of the death benefits equal to the total amount of the premiums it paid. The agreements may be terminated for a number of reasons, including (a) Subsidiary's bankruptcy or liquidation; (b) termination of Taxpayer's employment; and (c) written notice by the trust or by Taxpayer. If there is a termination prior to Taxpayer's death, the trust must reimburse Subsidiary before the collateral will be returned to the trust. If the policies are canceled or surrendered, Subsidiary is to be reimbursed from the cash surrender proceeds. Under this arrangement, the cash surrender value is expected to exceed the amount of the premiums paid in year 4 of the policies.

The agreements among the trust and Subsidiary also provide that any dividends on the policies are applied to purchase paid-up additional insurance on Taxpayer's life. Additionally, the policy owners may borrow from the policies or pledge or assign them, but only to the extent that a policy's cash surrender value exceeds the amount of the premiums paid by...